Key quote

“The lesson for taxpayers seeking to avail themselves of the research tax credit is to adequately document that substantially all of such activities were research activities that constitute elements of a process of experimentation. Generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time performing experimentation are not enough”.

Background

In its tax year ending in June 2014, Little Sandy Coal Co., a shipbuilder, claimed a tax credit under section 41 based on qualified research expenses—including for employee wages, contract research expenses, and supply costs—incurred in the design and construction of eleven first-in-class vessels. For purposes of the Tax Court proceeding, the parties agreed to treat two of the eleven vessels as representative of the others: a tanker barge (“Tanker”) and a dry dock (“Dry Dock”). The Tax Court found that Little Sandy Coal was not entitled to claim the research credit for any of the eleven vessels, and Little Sandy Coal appealed the decision to the Seventh Circuit.

Acknowledging that “the statute is complex,” the Seventh Circuit began by clarifying some of the relevant provisions of section 41. First, the court explained that the meaning of the term “uncertainty” for purposes of the Section 174 Test¹ must be more than just the generic uncertainty inherent in constructing or manufacturing a product. Instead, designing the product must be intended to remove the kind of uncertainty that is related to the “development or improvement” of the product. Further, “development” as used in Treas. Reg. § 1.174-2(a)(1) means more than mere construction, and “implies an advancement in technology or product concept". Thus, the court made clear that only a subset of product development is eligible for the research credit.

Second, the Seventh Circuit provided several points of guidance on the “substantially all” test.² The court clarified that the proper “substantially all” fraction is:

The Seventh Circuit noted that the numerator was broad enough to encompass research activities that are not per se experimentation or testing. In other words, elements of a process of experimentation³ are sufficient to be included in the numerator, which is helpful for taxpayers’ ultimate goal of getting the fraction to the 80% threshold. But the court also found that the process of experimentation test imposes a more structured method of discovering information than section 174 requires, because a process of experimentation must rely on “the physical or biological sciences, engineering, or computer science,” and requires the use of the scientific method to resolve uncertainty. Treas. Reg. § 1.41-4(a)(5)(i). Thus, it is possible that not all of taxpayers’ research activities that make it into the denominator will make it into the numerator, which makes it more challenging to meet the 80% threshold.

Third, the Seventh Circuit concluded that Treas. Reg. § 1.41-4(a)(6) requires that the substantially all test be applied in reference to activities, and not physical elements of the business components being developed or improved. In the Tax Court, Little Sandy Coal claimed that because the physical majority of the Tanker and the Dry Dock were new, substantially all of the activities in designing the vessels must have constituted elements of a process of experimentation. The Tax Court rejected Little Sandy Coal’s “novelty argument,” and rejected the “feels new enough” approach used by the court in Trinity Indus., Inc. v. United States, 691 F. Supp. 2d 688 (N.D. Tex. 2010). The Seventh Circuit affirmed that holding.

Fourth, with respect to pilot models,⁴ the Seventh Circuit found that pilot model production expenses would, by definition, be included in the denominator of the “substantially all” fraction, and could be considered for inclusion in the numerator as well. The Seventh Circuit expressly rejected the Tax Court’s conclusion that pilot model production activities categorically could not be elements of a process of experimentation. The Seventh Circuit determined that the Tax Court, in reaching its conclusion, had erroneously imported the distinction in section 41(b)(2)(B) between “direct support of research activities which constitute qualified research” and “qualified research” into the numerator of the “substantially all” fraction in section 41(d)(1)(C). As to how those expenses should be treated in the “substantially all” fraction, the Seventh Circuit reasoned that including “direct support and “direct supervision” activities in both the numerator and the denominator was the correct approach. The Tax Court’s erroneous conclusion that direct support and direct supervision activities were to be included in the denominator, but not the numerator, of the “substantially all” fraction would have made it exceedingly difficult to reach the 80% threshold.

Perhaps the most universally applicable lessons from Little Sandy Coal pertain to how claimants of research credits should document the qualifying research activities and expenses. The Seventh Circuit reiterated that taxpayers have the burden to document how activities were elements of a process of experimentation and that, while records do not need to be in any particular form, they must be in sufficiently usable form and detail to substantiate the credits claimed. The court found that Little Sandy Coal’s documentation lacked the extent of time that employees spent on experimentation-related research activities and determined that “[s]hortcut estimates of experimentation-related activities will not suffice”. The Seventh Circuit ultimately found that Little Sandy Coal failed to provide a principled way to determine the portion of employee activities that constituted elements of a process of experimentation, instead offering “arbitrary allocations” of employee wages that estimated the portion of employees’ time spent on qualified research. Going forward, taxpayers should hesitate to use rough estimates to determine qualifying expenses and should more precisely keep track of the time that employees spend on experimentation-related activities at the business component level (and subcomponent level, as discussed below).

The Seventh Circuit also agreed that Little Sandy Coal’s “all or nothing” strategy in claiming the development of entire vessels—as opposed to smaller subcomponents—as qualified research meant that the courts were unable to apply the shrinking-back rule in Treas. Reg. § 1.41-4(b)(2) to see if the “substantially all” test had been met for those subcomponents. The Seventh Circuit warned: “Other taxpayers seeking to avail themselves of the research tax credit would be well-advised to document research activities for subcomponents if they cannot demonstrate a process of experimentation at the business component level".

Having found Little Sandy Coal’s substantiation to be lacking, the Seventh Circuit also addressed the limits of the Cohan rule—which allows courts to estimate expenditures when there is some reasonable factual basis for such an estimate—in the research credit context. The court found that it could estimate the amount of qualified research expenses under section 41(b) only after a taxpayer establishes that qualified research has occurred under section 41(d). Because Little Sandy Coal failed to satisfy the process of experimentation test in section 41(d), the Seventh Circuit concluded that no qualified research expenses were creditable under section 41(b). Thus, going forward, taxpayers will first need to substantiate that qualified research has, in fact, occurred before being able to rely on the Cohan rule to estimate the actual dollar amount of the related expenses.

On 23 February 2023, the Tax Court issued an opinion in Moore v. Commissioner that also showcased the limits of witness testimony and the Cohan rule. The court held that none of a high-level employee’s wages could be included in the company’s research credit computation because of the “total lack of written records” showing how the employee had spent his time even though the court found the employee’s testimony was “substantially corroborated by the credible testimony” of two other employees, and found that some of his activities appeared to constitute qualified research. The Tax Court’s opinion did not even mention the Cohan rule. Thus, it would seem that contemporaneous, written documentation substantiating research activities are critical proof of research credit claims going forward.

For taxpayers looking to claim the research tax credit under section 41, two big takeaways from these recent decisions are that (1) vague estimates of what portion of employees’ wages were for experimentation-related activities are insufficient to substantiate the credit claimed, especially in the absence of documentation; and (2) substantiating research activities at the subcomponent level is essential for allowing courts to implement the shrink-back rule.

1  Under the Section 174 Test, expenditures qualify if they are “for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.” Treas. Reg. § 1.174-2(a)(1) (emphasis added).
2  Section 41(d)(1)(C) requires substantially all the research activities constitute elements of a process of experimentation, where “substantially all” is defined as at least 80% of a taxpayer’s research activities as measured on a cost or other consistently applied reasonable basis. Treas. Reg. § 1.41-4(a)(6).
3  Treas. Reg. § 1.41-4(a)(5)(i) defines a process of experimentation as a “process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.”
4 Pilot models are “any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product.” Treas. Reg. § 1.174-2(a)(4)