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In Little Sandy Coal Company, Inc. v. Commissioner, T.C. Memo. 2021-15, Dkt. No. 17431-17, the Tax Court sustained the IRS's denial of a research credit claimed by a company for expenses incurred by a shipbuilding subsidiary because the company failed to show that at least 80% of the subsidiary's research activities constituted elements of a process of experimentation.

Facts

Corn Island Shipyard, Inc. (CIS) designs, constructs and launches vessels. It claimed a research credit for various projects. One of those projects (Project 720) was a tank barge that CIS built under a contract with Apex Oil, Inc. (Apex) and was based on the design of a tanker CIS had built for another customer. The design of several elements of the Apex tanker was different and required testing through software modeling and engineering calculations. CIS made other design changes "determined through an iterative process [that] allowed [the tanker] to handle more cargo."

CIS also built a dry dock (Project 730) for a shipyard. CIS had not developed and designed a dry dock before this project. It "used engineering calculations and modeling to design the dry dock." In designing the dry dock, CIS created several iterations of design drawings, and performed calculations to test the iterations of the design. Before delivering the dry dock to the shipyard, CIS conducted tests on the vessel, including a partial raise-and-lower test of the constructed dock.

Based on stipulations to which the taxpayer and the government agreed, Projects 720 and 730 represented all the development projects for which the taxpayer claimed qualified research expenses (QREs) for purposes of the definition of qualified research, the applicability of statutory exclusions and the determination of QREs. Therefore, the court's conclusions regarding Projects 720 and 730 were binding on the taxpayer for purposes of all 11 projects that were included in the taxpayer's credit claim. The court's resolution, however, was not necessarily binding on the government.

Projects' qualified research expenses

For Project 720, the taxpayer reported QREs of approximately $2.5 million in wages, $17,504 in contract research expenses and approximately $3.9 million in supply costs. For Project 730, the taxpayer reported QREs of $146,109 in wages and approximately $1.9 million in supply costs. The taxpayer also reported $609,276 of estimated wage expenses that were not related to a specific project.

The wages for specific projects were paid to "production employees" (employees that spent time constructing the tanker or dry dock). A portion of the estimated wage expenses included wages paid to individuals that were members of CIS's management or engineering team. Because CIS's engineers and managers did not track their time by vessel, the taxpayer estimated the wages CIS paid to those individuals for qualified services by applying to each employee's total wages an allocation percentage equal to the estimated portion of the employee's time spent on qualified research.

Holding

Did CIS conduct qualified research for the Apex tanker and dry dock?

The Tax Court ruled that CIS did not sufficiently demonstrate that it satisfied the requirements under IRC Section 41(d) for the Apex tanker and dry dock. The court found that CIS's activities "involved iterative processes in which proposed designs were tested through such means as software modeling and engineering calculations and revised as necessary." The taxpayer, however, failed to show that substantially all (i.e., 80% or more) of CIS's activities in developing the Apex tanker and dry dock were elements of an experimentation process for one of the purposes described in IRC Section 41(d)(3)(A). The court found that the taxpayer failed to provide evidence on the proportions of the CIS's employees' work that did and did not involve a process of experimentation.

Substantially all test

The taxpayer argued it met the substantially all requirement by demonstrating that every major system on the vessel was re-engineered and redesigned, essentially arguing that the 80% substantially all requirement was met based on the proportion of physical elements of the business component that were new or improved when compared to the entire business component. The court rejected that argument, observing that Treas. Reg. Section 1.41-4(a)(6) "requires that the substantially all test be applied in reference to activities — not physical elements of the business component being developed or improved." The court also stated that the proportion of novel elements of a business component is not a reasonable basis for measuring the proportion of research activities undertaken in the product's development for purposes of the process of experimentation test. Furthermore, the court said, "we would not anticipate that the extent of [the process of] experimentation would vary in proportion to the size of each element. Determining the design of smaller, more complex elements might require more experimentation than determining the design of larger but simpler elements."

To the extent the district court's opinion in Trinity Indus., Inc. v. United States, 757 F.3d 400, 404-405 (5th Cir. 2014), aff'g 691 F. Supp. 2d 688 (N.D. Tex. 2010), could be read to support the taxpayer's position that the substantially all analysis "turned on an assessment of the proportion of novel elements in each vessel," the Tax Court said it would not follow the district court's analysis. The Tax Court noted that the Trinity opinion did not explain how the district court determined that 80% of the costs incurred in developing the business components in that case were part of a process of experimentation (and suggested that the district court did not conduct a quantitative analysis under Treas. Reg. Section 1.41-4(a)(6)).

The court thus held that the requirement that at least 80% of a taxpayer's research must constitute elements of a process of experimentation is not satisfied if at least 80% of the product's elements differ from those of products the taxpayer previously developed. The court also held that the 80% requirement applies to activities, not to the components of the product being developed or improved. The court stated that "[t]he substantially all test measures activities. Therefore, even when those activities are measured by their cost, the [amount] CIS paid for supplies used in building the dry dock would not be part of the fraction described in [Treas. Reg. S]ection 1.41-4(a)(6)."

Employees' services

The Tax Court rejected the taxpayer's alternative argument that substantially all the time spent by CIS's employees constituted elements of an experimentation process. An engineering technician at CIS stated that 87% of the production employees' time constructing the Apex tanker involved "functions that were tied directly to items" that differed from the previous tanker design. The court reiterated that the "novelty of an element of a business component does not establish that the work involved in developing that element involved a process of experimentation."

In the court's view, under Treas. Reg. Section 1.41-2(c)(3)(ii), the production employees' work directly supports the research involved in testing the model, but their "work does not have a close enough nexus to the testing to be considered qualified research in its own right." The court stated that "the distinction that [IRC S]ection 41(b)(2)(B) draws between 'engaging in qualified research' and 'engaging in the … direct support of research activities [that] constitute qualified research' allows no other conclusion."

The court agreed with the taxpayer that wages paid to production employees may be for qualified services, even if the employees do not engage in the experimentation process. The court, however, disagreed with the taxpayer that the employees' activities are considered an element of the experimentation process and are claimable as qualified research expenses if the activities directly support qualified research.

Therefore, the court held that a "production worker who directly supports qualified research is not himself engaged in qualified research and thus cannot be engaged in any process of experimentation the research might involve."

If the taxpayer had been able to provide "a breakdown of the activities of those nonproduction employees by project" or provide evidence "of the portions of time they spent on each project that did or did not involve elements of a process of experimentation," the court suggested, the taxpayer may have been able to satisfy the substantially all test if the activities of the production employees were excluded from the numerator and denominator of the test's fraction.

"Even if, contrary to the plain terms of [IRC S]ection 41(b)(2)(B), we were to accept the possibility that the work of production employees could be part of a process of experimentation," the court concluded, the taxpayer had not substantiated its claim ("petitioner has not established the portion of their time those employees engaged in experimentation").

Pilot model

The court found that it was unclear whether the Apex tanker was a pilot model. The court noted that the taxpayer did not establish that the purpose in building the tanker "was to 'evaluate and resolve uncertainty during development or improvement of the product and test the appropriate design.'"

With respect to the dry dock project, the court said, "[i]f the dry dock did not qualify as a pilot model, within the meaning of [IRC Section 174], some or even all of the activities carried out by production employees in the vessel's construction might be excluded from the denominator of the fraction described in [Treas. Reg. S]ection 1.41-4(a)(6). The fraction might measure only the proportion of the activities engaged in by members of CIS' engineering and management teams in developing the dry dock that involved a process of experimentation. Again, however, the petitioner has not provided sufficient information about how its nonproduction employees spent their time — by project — to allow us to make the required determination." When discussing the substantially all ratio in the context of the tanker as a pilot model, the court indicated that the production employees' wages may not be research and experimentation expenditures, within the meaning of IRC Section 174, if the tanker was not considered a pilot model.

Shrinking-back rule

The court addressed the potential of the taxpayer to show that some of its development of Projects 720 and 730 involved qualified research by applying the shrink-back rule under Treas. Reg. Section 1.41-4(b)(2). However, the court stated, the taxpayer did not provide engineering and management activities by project or by elements of the vessels and thus "the record is not sufficiently detailed to allow us to determine activities related to specific elements of either the tanker or the dry dock that may have been part of a process of experimentation."

Are any of the expenses incurred QREs?

Because the taxpayer failed to prove that substantially all of CIS's research activities in the development of the vessels were elements of a process of experimentation, the court held that none of the expenses were QREs under IRC Section 41(b).

Implications

The court could have simply rejected the taxpayer's argument that the substantially all test under Treas. Reg. Section 1.41-4(a)(6) could be satisfied by demonstrating the proportion of new or different elements of a business component, and disposed of the case on that basis alone. It did not, however, and the result may be that taxpayers can more easily show that 80% or more of a taxpayer's research activities constitute elements of a process of experimentation.

In responding to the taxpayer's argument that the substantially all test under Treas. Reg. Section 1.41-4(a)(6) could be satisfied by demonstrating the proportion of new or different elements of a business component, the opinion in Little Sandy Coal introduces a novel interpretation of the substantially all test for purposes of determining whether research involves a process of experimentation. The interpretation has never been applied in another IRC Section 41 case; if applied in a consistent manner, it would arguably lower the bar for establishing that at least 80% of a taxpayer's activities were elements of an experimentation process.

If, as the court asserts, an employee "who directly supports qualified research is not himself engaged in qualified research and thus cannot be engaged in any process of experimentation the research might involve," then the activities of employees who directly support qualified research must be excluded from both the numerator and the denominator of the "substantially all" fraction, as they are not engaged in "research activities."

This case, despite its novel interpretation of the substantially all test, is more a case about the lack of evidence provided by the taxpayer from which the court could have applied the shrink-back rule to the components of the tanker and dry dock. The statements in the court's findings of fact and some of the commentary in its analysis, reflect the court's acknowledgement that uncertainty existed and that elements of a process of experimentation were undertaken for both projects. However, it is also clear that the court did not have enough detail regarding the activities of the nonproduction employees (engineers and managers) to apply its interpretation of the substantially all test. If the taxpayer had provided sufficient detail, the court could have found that the activities with respect to the components was qualified research (and therefore, the in-house research costs, which would include support and supervisory activities, contract research expenses, and supplies, could have been includable QREs).

With the impact of the lack of evidence in mind, taxpayers should be prepared to articulate and substantiate how they determined they satisfy the substantially all requirement in IRC Section 41(d) for employees who are directly conducting research. Similarly, for contractors, taxpayers may want to have contractors identify which contract employees are directly conducting research and which contract employees are directly supervising or supporting the direct conduct of research. It is unclear from this decision, however, whether contractors directly conducting the research would be included in the substantially all ratio. For the Tax Court, in this case, identifying activities constituting direct conduct of research with different components of the tanker or dry dock would have been essential for the application of IRC Section 41(d) under the shrink-back rule. The ability for a taxpayer to provide the IRS or courts with a way to correlate the taxpayer's activities (and proportion thereof) to specific business components (or subcomponents) is, as demonstrated by this case, important to sustaining a credit claim.

Taxpayers should be aware that the IRS is likely to start following the court's position on direct support and supervision when auditing research credit claims. Taxpayers must, therefore, be prepared to (1) defend a contrary position, (2) provide a ratio of activities limited to the activities of personnel directly conducting qualified research, and (3) substantiate the proportion of activities performed by personnel directly conducting qualified research that constitute elements of a process of experimentation by business component and, if relevant, by element of the business component.

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