Little Sandy Coal Co. Inc. v. Commissioner
T.C. Memo. 2021-15

On February 11, 2021, the Tax Court issued a Memorandum Opinion in the case of Little Sandy Coal Co. Inc. v. Commissioner (T.C. Memo. 2021-15). The primary issue presented in Little Sandy Coal Co. Inc. v. Commissioner was whether the activities of the petitioner’s subsidiary’s research in developing the ships constituted elements of a process of experimentation for purposes of IRC § 41(d)(1)(C) and Treas. Reg. § 1.41-4(a)(6).

Holdings, in Brief in Little Sandy Coal Co. Inc. v. Commissioner

The requirement of IRC § 41(d)(1)(C) and Treas. Reg. § 1.41-4(a)(6), that at least 80% of a taxpayer’s research must constitute elements of a process of experimentation applies to activities—not to physical components of the product being developed or improved. Consequently, the requirement is not satisfied simply because at least 80% of the product’s elements differ from those of products the taxpayer previously developed.  One who provides services in direct supervision or support of research is not “engaged in” research. See IRC § 41(b)(2)(B). Therefore, the activities of such a person cannot constitute elements of a process of experimentation for purposes of IRC § 41(d)(1)(C).

Because supplies are not activities, when the fraction described in Treas. Reg. § 1.41-4(a)(6), is computed using costs as a measure of activities, the costs of supplies used in the development of the product are not taken into account. Finally, because the petitioner has not met its burden of proving that substantially all of the subsidiary’s research activities in developing the vessels in issue constituted elements of a process of experimentation, none of the expenses the subsidiary incurred in that development are qualified research expenses within the meaning of IRC § 41(b).

Background to the Law

IRC § 38(a) allows as a credit against a taxpayer’s income tax the taxpayer’s current year business credit, as well as unused business credits carried from other years. A taxpayer’s current year business credit includes the research credit determined under IRC § 41(a). IRC § 38(b)(4).  A taxpayer’s qualified research expenses (QREs) include any “in-house research expenses” and “contract research expenses” paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer. IRC § 41(b)(1).  A taxpayer’s “in-house research expenses” include (i) any wages paid or incurred to an employee for qualified services performed by such employee and (ii) any amount paid or incurred for supplies used in the conduct of qualified research. IRC § 41(b)(2)(A)(i) and (ii). IRC § 41(b)(2)(B) defines “qualified services” to mean services consisting of (i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.

The Four Tests for Qualified Research

Research is qualified research if it meets four requirements provided in IRC § 41(d)(1) and is not covered by an exclusion provided in IRC § 41(d)(4).

First, expenditures with respect to the research must be eligible for treatment as expenses under IRC § 174. IRC § 41(d)(1)(A).

Second, the research must be undertaken to discover technological information. IRC § 41(d)(1)(B)(i).

Third, the application of that information must be intended to be useful in the development of a new or improved business component of the taxpayer. IRC § 41(d)(1)(B)(ii). And fourth, substantially all of the activities of” the research must constitute elements of a process of experimentation for a purpose related to “a new or improved function,” “performance,” or “reliability or quality.” IRC § 41(d)(1)(C), (3)(A). IRC § 41(d)(4) provides a list of activities that are specifically excluded from the definition of qualified research. IRC § 174(a)(1) allows a taxpayer to treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account. The taxpayer can deduct any expenditures that he treats as not chargeable to capital account. IRC § 174(a)(1). Treas. Reg. § 1.174-2(a)(1).

Fourth, and most stringent, substantially all of the activities involved in the research must constitute elements of a process of experimentation for a purpose related to a new or improved function, performance, or reliability or quality. IRC § 41(d)(1)(C), (3)(A). Treas. Reg. § 1.41-4(a)(5)(i).

The Iterative Processes

The design of each vessel involved iterative processes of the type described in Treas. Reg. § 1.41-4(a)(5)(i). The petitioner has not demonstrated that substantially all of CIS’ research activities in developing either the Apex tanker or the dry dock constituted elements of a process of experimentation for one of the purposes specified in IRC § 41(d)(3)(A).

Treas. Reg. § 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 Tax Court did not accept—indeed, petitioner did not even argue—that a business component’s proportion of novel elements is a “reasonable basis,” Treas. Reg. § 1.41-4(a)(6), for measuring the proportion of research activities undertaken in the product’s development that constitute elements of a process of experimentation for a purpose described in IRC § 41(d)(3). The work of the production employees in fabricating the physical component was not part of the process of experimentation. In fact, Treas. Reg. § 1.41-2(c)(3)(ii), instructs that the work of the production employees would not be considered part of that process of experimentation.

In sum, the petitioner did not provide the Tax Court with grounds to include in the definition of qualified research the activities of the subsidiary’s employees under Treas. Reg § 1.41-4(a)(6). Those who directly support research are, by definition, not engaged in research. See IRC § 41(b)(2)(B). Consequently, their activities cannot be viewed as elements of any process of experimentation that research might entail. Even if, contrary to the plain terms of IRC § 41(b)(2)(B), the Tax Court was to accept the possibility that the work of production employees could be part of a process of experimentation, the petitioner has not established the portion of their time those employees engaged in experimentation.

(T.C. Memo. 2021-15) Little Sandy Coal Company, Inc. v. Commissioner

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