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In Little Sandy Coal Company, Inc. v. Commissioner of Internal Revenue, No. 21-3145 (7th Cir. 2023), the Seventh Circuit Court of Appeals affirmed the Tax Court's decision, finding that a shipbuilding company could not claim a research credit for expenses incurred because the company failed to provide sufficient evidence that a portion of its employees' work constituted elements of a process of experimentation. The Seventh Circuit, disagreed with the Tax Court, however, about the types of activities that constitute elements of a process of experimentation. For more information about the Tax Court decision, see Tax Alert 2021-0424.

Background

Little Sandy Coal Company, Inc. (Little Sandy Coal) designs, constructs and launches vessels. It claimed a research credit for various projects, and two were chosen as representative of the others for purposes of litigation. One of those projects was a tank barge built under a contract with a third party and was based on the design of a tanker Little Sandy Coal had built for another customer. The new tanker's design differed in several respects and required testing through software modeling and engineering calculations. Little Sandy Coal also built a dry dock, under contract, for a shipyard. The company 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, Little Sandy Coal created several iterations of design drawings and performed calculations to test the iterations of the design.

The wages claimed as qualified research expenses (QREs) for specific projects were primarily 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 who were members of Little Sandy Coal's management or engineering team (for performing non-production activities). Because its engineers and managers did not track their time by vessel, Little Sandy Coal estimated the non-production wages it 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. The claimed QREs included substantial supply costs and a small amount of contract research costs.

Tax Court decision

The Tax Court sustained the IRS's denial of the research credit claimed by Little Sandy Coal for its expenses because the company failed to show that at least 80% of research activities constituted elements of a process of experimentation under IRC Section 41(d)(1)(C) and Treas. Reg. Section 1.41-4(a)(6). In reaching that conclusion, the court noted that research activities did not include supervising or supporting research activities (like the activities of the vessels' production employees). Because Little Sandy Coal failed to prove that substantially all (i.e., 80% or more) of its research activities in the development of the vessels were elements of a process of experimentation, the Tax Court held that none of the expenses were QREs under IRC Section 41(b). Little Sandy Coal appealed the case to the Seventh Circuit Court of Appeals.

Seventh Circuit holding

The Seventh Circuit Court of Appeals held Little Sandy Coal failed to meet the process of experimentation test under IRC Section 41(d), so none of the expenses were QREs under IRC Section 41(b). The court pointed out that it agreed with several of the Tax Court's findings, but also explained how it differed from the Tax Court in construing the "substantially all" fraction for IRC Section 41(d)(1)(C) purposes.

Process of experimentation

In considering how the Tax Court construed the "substantially all" fraction for IRC Section 41(d)(1)(C) purposes (i.e., the "80% test" or "substantially all ratio"), the Seventh Circuit agreed with some of the findings of the Tax Court but disagreed with others.

Novelty

The court agreed with the Tax Court that the "novelty of a business" component is not "the basis for measuring the proportion of research activities that constituted elements of a process of experimentation." The court explained that the Tax Court correctly recognized that Treas. Reg. Section 1.41-4(a)(6) requires taxpayers to assess the 80% test "in reference to activities — not physical elements of the business components being developed or improved."

Pilot models

Little Sandy Coal argued that the tanker and dry dock were pilot models, so the production wages incurred for making those models were research activities that constitute elements of a process of experimentation. The Tax Court disallowed the work of the production employees in fabricating the vessels as part of a process of experimentation, even if testing the pilot model's design was part of a process of experimentation. "The work of the production employees directly supports the research involved in testing the model, but the production work does not have a close enough nexus to the testing to be considered qualified research in its own right," the Tax Court found. As such, the Tax Court concluded that the company did not provide grounds to include in the numerator of the 80% test any of the production wages, but those wages should be included in the denominator of the 80% test if it was assumed that the tanker and dry dock were pilot models.

The Seventh Circuit did not adopt the Tax Court's position on whether pilot-model-production activities are includable for purposes of the "substantially all" test. Because pilot models (that meet the definition under IRC Section 174) are produced to resolve uncertainty around the product during its development or improvement, labor costs incurred for pilot-model-production activities can potentially be included in both the numerator and denominator of the "substantially all" ratio. The court, however, held that it did not have to determine whether the tanker and dry dock were pilot models because Little Sandy Coal "failed to demonstrate that the production and nonproduction wages for each vessel account for elements of a process of experimentation — the numerator in the 'substantially all' fraction."

Observation: While allowing pilot-model-production activities to be included in the numerator of the "substantially all" ratio, the Seventh Circuit also stated that "[j]ust making a prototype model is not enough to pass the process of experimentation test. The model must be used to evaluate one or more alternatives using the scientific method." Therefore, it will be important for taxpayers to determine (1) the purpose of creating the model (the creator's intent), and (2) how the model is used in the research in determining whether the model's production activities are elements of a process of experimentation.

What activities are included in the 'substantially all' ratio

In comparing various potential formulations of the "substantially all" test, the court observed that the Tax Court "erroneously imported a distinction from [IRC] Section 41(b)(2)(B) into the numerator of the fraction in [IRC] Section 41(d)(1)(C)." The court observed that the Tax Court considered the distinction between "direct support of research activities which constitute qualified research" under IRC Section 41(b)(2)(B)(ii) and "qualified research" under IRC Section 41(b)(2)(B)(i). The Tax Court concluded that pilot model production directly supported research activities but was not qualified research on its own, so pilot-model-production activities are "not qualified research or elements of a process of experimentation." The Seventh Circuit disagreed with the Tax Court's reasoning.

Instead, the court agreed with Little Sandy Coal's approach that direct support and supervision activities should be included in the numerator and denominator of the "substantially all" fraction. The court found that "the numerator is broad enough to encompass research activities that are not per se experimentation or testing." The court pointed out that the examples in Treas. Reg. Section 1.41-4(a)(8) illustrate that pilot-model-production expenses can be included in the "substantially all" numerator. Because the regulation includes some pilot-model-production expenses in the "substantially all" numerator, the court held "those activities can be research activities (denominator) that constitute elements of a process of experimentation (numerator)." The Seventh Circuit discussed, in a footnote, the practical consequences of adopting the Tax Court's categorical exclusion of pilot-model-production expenses (which the Tax Court characterized as research support activities) from the numerator of the "substantially all" ratio, stating that, "[i]f we include such model production expenses in the 'substantially all' denominator but categorically exclude them from the numerator, as the tax court suggests, the satisfaction of the test would depend on how small the pilot model production expenses are relative to the nonproduction research expenses. It escapes reason why the 'substantially all' test should depend on how expensive it is to produce the pilot model."

The Seventh Circuit described the "substantially all" ratio as:

Research activities that constitute elements

of a process of experimentation

____________________________________

Research activities not excluded under IRC Section 41(d)(4)

and whose expenses are deductible under IRC Section 174

The Seventh Circuit agreed with the Tax Court that the "substantially all" test reflects "activities," stating " … [IRC] Section 41(d) deals with qualified research activities. [ ] The 'substantially all' fraction in [IRC] Section 41(d)(1)(C) excludes supply costs for research, but the denominator includes research activities not excluded under [IRC] Section 41(d)(4) and whose expenses are deductible under [IRC] Section 174." As noted previously, "research activities," for purposes of the process-of-experimentation requirement, include direct support, direct supervision and the conduct of research.

Observation: Although not explicitly addressed in the Seventh Circuit decision (as Little Sandy Coal waived the issue around its $17,504 of contractor costs), contractor activities that constitute research or experimentation activities under IRC Section 174 could be included in the numerator and/or denominator of the "substantially all" ratio. This can be concluded based on the Seventh Circuit's explanation that the "substantially all" test is an activities-based test and contractors can perform qualified research activities as opposed to supply or cloud-hosting expenditures, which are not costs incurred for activities performed, but rather, purchased items/hosting services.

While agreeing with Little Sandy Coal's approach of potentially allowing the inclusion of production wages (i.e., wages of the personnel constructing the tanker and dry dock models) in the numerator of the "substantially all" ratio, the court held that the company failed the "substantially all" test because it "failed to provide a principled way to determine the portion of employee activities that constituted elements of a process of experimentation." Specifically, it did not prove what "portion of the activities accounted for by the [ ]wages constitutes elements of a process of experimentation." Furthermore, Little Sandy Coal failed to break down the nonproduction wages by vessel. As a result, the court could not conduct the "substantially all" analysis at the business-component level.

Accordingly, the court held that it could not "determine the percentage of nonproduction employee activities that constituted elements of a process of experimentation."

Even assuming the tanker and dry dock were pilot models, the court continued, Little Sandy Coal still failed to prove how it used the pilot models in a process of experimentation; as such, the production wages for the tanker and dry dock could not be included in the numerators of the respective "substantially all" ratios.

Observation: The Seventh Circuit's decision confirms that direct support, direct supervision and the direct conduct of research can be included in the numerator of the "substantially all" ratio, contradicting the Tax Court's determination that direct support and direct supervision of research are categorically excluded from the numerator of the "substantially all" ratio when determining if a taxpayer has met the process-of-experimentation requirement. For such expenditures to be included in the numerator of the "substantially all" ratio, however, a taxpayer must provide sufficient evidence that the activities constitute elements of a process of experimentation.

Elements of a process of experimentation

The Seventh Circuit identified the elements of a process of experimentation, consistent with the regulations: (1) identification of uncertainty concerning the development or improvement of a business component, (2) identification of one or more alternatives intended to eliminate that uncertainty, and (3) identification and the conduct of a process of evaluating the alternatives.

Regarding the concept of "uncertainty," the court evaluated how the term is used in IRC Section 174. The court distinguished between "generic uncertainty," which it found inherent in constructing or manufacturing a product, and uncertainty around the improvement or development of the concept of a product (which require investigative activities). The court stated that the plain meaning of the term "development," in the context of IRC Section 174, "is the 'action or process of bringing something to a … more advanced condition' - embracing the idea of 'improvement'" (which, in turn, implies an advancement in technology or product concept). The court stated, "[i]f summed up in one word, expenses deductible under [IRC] Section 174 must be 'investigative.'" This term did not apply, the court explained, to testing to see whether the customer's desired specifications are met, unless they are incurred to improve or develop the concept of the product.

This concept of "uncertainty," the court stated, applies to the process of experimentation test. However, the court found a difference between the manner of resolving uncertainty under IRC Section 174 and the process-of-experimentation requirement. "While both tests are aimed at removing the same type of uncertainty," the court said, "'the process of experimentation test also imposes a more structured method of discovering information that [IRC] section 174 requires and may not include all actions a taxpayer takes to resolve uncertainty'"(citations omitted).

Scientific method to resolve uncertainty

The Seventh Circuit found that the process of experimentation used to resolve uncertainty requires the use of the scientific method. According to the court, the scientific method is "'an analytical technique by which a hypothesis is formulated and then systematically tested through observation and experimentation' … and 'must involve a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense'" (citations omitted). "'Testing and refining a hypothesis may involve determining the strengths and weaknesses of the alternative tested, whether and how the process could be further refined and improved, and whether other alternatives might be better suited for achieving the taxpayer's goal" (citation omitted). The court found that application of a scientific method to satisfy the process-of-experimentation requirement "is where Taxpayer failed as a matter of proof."

Observation: In three successive regulatory guidance projects, the IRS and Treasury Department sought to define a "process of experimentation" by incorporating a structured methodology (akin to the "scientific method" described by the Seventh Circuit). For various reasons, each project failed to capture the realities of commercial research. Finding a set definition unworkable, Treasury elected to follow a facts-and-circumstances approach in its most recent regulations (T.D. 9104) on the research credit.

In describing changes made to previous projects, the IRS and Treasury Department stated, in the Preamble to T.D. 9104, "the final regulations do not provide detailed guidance as to how the regulatory provisions are to be applied to a given factual situation. Rather, the Treasury Department and the IRS have concluded that the application of these provisions will depend on the specific activities being claimed by a taxpayer as qualified research, the nature of the taxpayer's business and industry, and the uncertainties being addressed by the taxpayer's research activities."

By incorporating a "scientific method" as the manner of conducting a process of experimentation, the Seventh Circuit apparently did not consider Treasury's abandonment of a set standard for the process-of-experimentation requirement. The Seventh Circuit's adoption of a structured method of conducting a process of experimentation could be problematic, especially since it conflicts with Treasury's existing facts-and-circumstances-based regulations.

Substantiation

Like the Tax Court, the Seventh Circuit found that Little Sandy Coal's documentation was not detailed enough to show that a process of experimentation around the two representative projects, or the subcomponents of the tanker and dry dock. While agreeing with the Tax Court's observation "that some of Taxpayer's activities with respect to certain subcomponents could involve a process of experimentation," the Seventh Circuit found that "Taxpayer's documentation lacks the necessary detail to prove that." The court provided the following advice: "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."

In determining its QREs, after analyzing employee time records, one of Little Sandy Coal's tanker engineers estimated that 87% of the production employees' time constructing the tanker involved functions that differed from an existing tanker produced by the company. For nonproduction wages, Little Sandy Coal did not provide engineering and management wages by business component but included nonproduction wages as QREs based on the estimated portion of the employee's time spent on qualified research. The company's witnesses, at trial, testified that the qualified percent of the engineer and management wages presented by Little Sandy Coal were "reasonable" and "fair." The Seventh Circuit held that Little Sandy Coal "did not offer a principled way to determine what portion of the employee activities for each vessel constituted elements of a process of experimentation, much less research activities. Instead, Taxpayer relied on arbitrary estimates and the newness of the vessels."

The Seventh Circuit, like the Tax Court, evaluated the company's satisfaction of the process of experimentation requirement in alternative ways - assuming that the vessels were pilot models and assuming they were not. If the vessels were not pilot models, the court stated, the "substantially all" ratio would be based on nonproduction expenses. The court concluded it could not perform a "substantially all" analysis because the company (1) had not provided nonproduction wages by vessel, and (2) did not provide evidence that the nonproduction wages were for activities that were elements of a process of experimentation. The court also found that much of the nonproduction wages were attributable to non-research wages. For example, the court found the following activities were not part of a process of experimentation: (1) time spent by the lead engineer and naval architect on customer relations and management activities, (2) draftsmen's drawings of the design provided by an engineer (without evidence of how models were used as part of a scientific method), and (3) the purchasing agent's procurement activities.

The Seventh Circuit, however, stated that the following activities of nonproduction personnel could involve a process of experimentation: (1) draftsmen's drawings of a model (if the models were shown to be used as part of a scientific method), (2) the purchasing agent's activities assessing material alternatives for functionality, and (3) management personnel's time troubleshooting, reviewing ship designs, assisting with fabrication and production issues, and designing a vessel subcomponent. The company's lack of proof, however, prevented the court from determining the percentage of nonproduction employee activities that constituted elements of a process of experimentation.

In evaluating the company's satisfaction of the process-of-experimentation requirement (assuming the vessels were pilot models), the court found that Little Sandy Coal failed to show how it used the pilot models in the process of experimentation. The "substantially all" ratio, if the vessels were pilot models, would include both production and nonproduction wages. "We cannot discern a way to factor these wages into the 'substantially all' fraction without a breakdown by vessel," the court said.

Even excluding nonproduction wages from the "substantially all" ratio, the Seventh Circuit agreed with the Tax Court that Little Sandy Coal "had provided insufficient evidence to include the alleged pilot model production expenses for the Tanker and Dry Dock in the numerators of the respective fractions." The Seventh Circuit, specifically, found that certain post-fabrication tests of the entire vessels were performed to determine whether the customer's specifications were met, not to remove uncertainty around the development of the concept, improve the vessel, test any hypothesis or evaluate alternatives.

Regarding production activities, the Seventh Circuit acknowledged that certain research activities had taken place, but Little Sandy Coal failed to substantiate what activities involved elements of a process of experimentation using a scientific method. Furthermore, the court had no basis on which to apply a shrink-back analysis to the subcomponents of the vessels.

Observation: The Seventh Circuit referenced emails and direct testimony by the company's employees about the research-related activities the nonproduction employees performed but found no documentation supporting how much time other members of the management team spent on the research-related activities they testified about. The court said, "in the end, the record gave the tax court no means of determining the extent of time [that was] spent on experimentation-related research activities."

Implications

The Seventh Circuit's Little Sandy Coal decision is an important roadmap for taxpayers claiming research credits on current returns and for anticipating the information that the IRS will request on examination of a research credit previously claimed. It establishes a more structured standard than articulated in the regulations and by Congress for the manner in which qualified research activities must be conducted. To the extent a taxpayer's business practices do not align with the formulaic method (e.g., a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis) described in the decision, taxpayers could face a challenging "form over substance" examination environment.

The Seventh Circuit's decision focuses on the taxpayer's evidence supporting the quantification of its research activities as elements of a process of experimentation. According to the court, "[t]he 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." As in other instances in which a taxpayer's claim is disallowed due to lack of proof, the Seventh Circuit does not provide insight on what the court would consider sufficient documentation that activities are elements of a process of experimentation; the decision only reflects what the court considers insufficient documentation. The lack of guidance in this area could result in continued controversy in IRS examinations.

The decision clearly states what constitutes the numerator and denominator of the "substantially all" test in the process-of-experimentation requirement and discusses why the Tax Court's exclusion of support and supervision of research from the numerator of the ratio is incorrect. The court's decision highlights the importance of this often-overlooked test and provides welcome clarity for taxpayers (including that pilot-model-production activities may be considered in the numerator). The court's interpretation of "uncertainty" for IRC Section 174 and IRC Section 41 purposes, its discussion of pilot models and inclusion of pilot-model-production costs as potential IRC Section 41 qualified research expenses are instructive. This case likely represents the principles that taxpayers and the IRS will have to apply until additional statutory, regulatory or judicial guidance is issued. Heeding the Seventh Circuit's advice on documenting activities for purposes of satisfying the process-of-experimentation requirement should lead to better outcomes for taxpayers.

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Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Brittenham, legal editor