Tax Court denies taxpayer’s research credit claim


The Tax Court has ruled in Little Sandy Coal Co. v. Commissioner (T.C. Memo. 2021-15) that two representative projects did not qualify for the research credit because the taxpayer failed to show that “substantially all” of the cost or activity related to a process of experimentation.

For activities to constitute qualified research, “substantially all” of the activities must constitute elements of a process of experimentation that relates to a qualified purpose, under Treas. Reg. Sec. 1.41-4(a)(6). This “substantially all” requirement is generally satisfied with an 80% threshold. Further, the requirement is satisfied only if “substantially all” of a taxpayer’s research activities, measured on a cost or other consistently applied reasonable basis, constitute elements of a process of experimentation. This “substantially all” requirement is applied separately to each business component (i.e., product, process, computer software, technique, formula or invention).

The shipbuilder addressed by the case determined whether it satisfied the “substantially all” requirement by evaluating the percentage of the vessel that had new components. The taxpayer and the IRS agreed that the case would only evaluate two vessels (business components) which were representative of the 11 vessels included in the claim. Since the two vessels composed of 80% or more of new components, the taxpayer took the position that the process of experimentation “substantially all” requirement” was met.

The Tax Court, however, made their determination based on the activities performed for each business component. The Tax Court ruled that employees who provide direct support or direct supervision of qualified research are not “engaged in” research and those activities do not constitute a process of experimentation. In applying this methodology, the Tax Court concluded that the taxpayer did not meet the burden of proof that the process of experimentation “substantially all” requirement was met. Since the Taxpayer chose to employ an “all or nothing” approach, similar to Trinity Industries, Inc. v. Commissioner (691 F. Supp. 2d 688), the Tax Court was prohibited from applying the shrink back rule to evaluate if a portion of the vessel could have been qualified and included in the taxpayer’s research credit claim.

The Little Sandy Coal case emphasizes that a taxpayer bears the burden of proof when substantiating that the process of experimentation “substantially all” requirement is met at the business component level. If this rule is not met, a taxpayer must shrink back the business component to a subset until at least 80% of the activities constitute a process of experimentation.




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