For many years, the R&D tax credit has provided a strong incentive for businesses to increase their investment in research activities. However, these rules can be complicated, and there is a need to pay attention to the details for qualifying. Moreover, even if your expenditures qualify, you cannot receive the credit if you keep inadequate records.
The Little Sandy Coal Company learned that lesson well in a recent court battle (Little Sandy Coal Company, Inc. v. Commissioner of Internal Revenue, T.C. Memo 2021-15 Feb. 11, 2021).
Here’s what happened: The Little Sandy Coal Company successfully designed and built a new shipping vessel and a dry dock–a floating structure used for ship maintenance and repair–for customers.
However, according to the U.S. Tax Court, the company failed to establish that its efforts constituted qualified research expenditures for purposes of claiming the R&D tax credit.
This dispute between Little Sandy Coal and the IRS concerned research credits claimed for the company’s shipbuilding subsidiary. The court considered two specific projects that the parties agreed could be used to gauge whether the company met the requirements to claim the credit.
The first project involved the design of a tanker that had several unique elements relative to other tankers that the company had previously built and thereby required the testing of various proposed designs. The other project, designing a dry dock, was an entirely new type of project that the company had not designed before.
The Substantially All Clause
Among other requirements, for expenditures to qualify for the research credit, “substantially all” of the research activities must “constitute elements of a process of experimentation.”
The court acknowledged that some of the activities related to the design of the tanker and dry dock likely involved the required process of experimentation, but it concluded that the company failed to establish that substantially all the activities did.
The U.S. tax regulations define “substantially all” for the qualified research test to mean 80 percent or more. Little Sandy Coal argued that more than 80 percent of the tanker was a new design and the dry dock was 100 percent new.
The court concluded that they misunderstood the standard, though. The standard does not relate to the proportion of the physical elements of what is being developed that are new. Rather, the test is of the activities involved and whether they were substantially all part of a process of experimentation.
While testing the ship and dry dock’s design might have constituted a process of experimentation, building the physical components generally would not qualify under the rules.
The court noted that there is an exception for including construction costs of a “pilot model.” Still, it concluded that this exception was unlikely to apply as the tanker was not built as a test model but rather to satisfy a contractual obligation with a customer.
Even setting aside the production costs and looking only at the other design costs–the engineering and management oversight–the court found that Little Sandy Coal failed to establish that even this subgroup of costs met the “substantially all” standard.
The company had inadequate documentation to show what proportion of these teams’ time was spent on a process of experimentation as opposed to other activities.
The court was sympathetic that Little Sandy Coal might not have any non-tax purpose for keeping records of what proportion of the team’s time was spent on a process of experimentation versus other activities. However, that is what the rules require for purposes of claiming the research credit.
Lessons from Little Sandy Coal
- Work claiming the R&D tax credit into a company’s strategy from the get-go—make it a collective goal.
- Understand each player involved in R&D projects.
- If you integrate the R&D tax credit into the mindset of the firm, then it becomes easy to document your claim and easy to support it.
- Detailed documentation and categorizing it—showing how it supports employee activities or costs—can help protect your claim.