In March 2023, the Seventh Circuit addressed the controversial Tax Court opinion in Little Sandy Coal v. Commissioner (Sandy). The Court of Appeals ruled against the Internal Revenue Service (IRS) on an important issue, which sought to fundamentally change the way Research and Development (R&D) Tax Credits are computed.
As indicated in our April 2021 article, “Is Your R&D Tax Credit Claim Built on a Foundation Made of Sand?”, the tax court ruled in contrast to decades-old R&D tax credit history and practice. The ruling stated that direct support and direct supervision should be treated differently than directly engaged activities when calculating whether or not a taxpayer meets the “substantially all” requirement for activities making up a process of experimentation. And although this next component didn’t make headlines at the time, the case also addressed substantiation requirements and uncertainty expectations. The decision was unpopular within the R&D community.
Little Sandy Coal Update: Tax Court
In February 2021, Judge Halpern of the US Tax Court issued a ruling that direct supervision activities and support activities involving research are not activities that “constitute elements of a Process of Experimentation” which is a requirement under Section 41(d)(1)(C) of the Internal Revenue Code (IRC).
The Tax Court arrived at this conclusion despite what many considered to be clear language within the statute which provides:
The term “qualified services” means 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 ruling examined the “80% rule”, which states that 80% or more of the taxpayer’s research activities must constitute elements of process of experimentation for each selected business component[1] in order to be considered a qualifying expenditure. The Court’s view was that direct support and supervision should not be included in the numerator for purposes of calculating whether the 80% threshold has been met. According to the Tax Court, the formula should be computed as follows:
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Qualified Research Activities (POE) |
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Production Activities, Support, Direct Supervision |
Little Sandy Coal Update: Appeals Court
In evaluating the Tax Courts’ findings, the Seventh Circuit took a close look at the formula for determining the 80% threshold. In what we believe to be a more appropriate interpretation of the statute, the Appellate Court rejected the Tax Courts’ reasoning that direct support time and direct supervision time are not elements of a process of experimentation. Rather, the Court agreed with the taxpayer that direct support and direct supervision costs should be included in both the numerator and the denominator for purposes of the 80% test. In taking this position, the Court reasoned that support and supervision time must be analyzed just like direct research time. If the activities are research activities which otherwise constitute elements of a process of experimentation, the associated costs should be included in both the numerator and the denominator of the process of experimentation fraction.
The Seventh Circuit ruling provides a favorable outcome for taxpayers by lowering the bar and making it easier to achieve the 80% threshold. Our methodology of segregating each element of the fraction is beneficial for taxpayers if or when taxing authorities request supporting documentation for these calculations including a breakout of time according to the 80% threshold formula.
The Latest in Little Sandy Coal: Not Entirely Favorable
While the Appellate Court’s rejection of the IRS position regarding how to calculate the 80% rule was favorable to the taxpayer, the overall decision was not favorable to Sandy. The court affirmed the IRS position that the taxpayer did not meet substantiation requirements nor that the uncertainty requirement was met.
In its decision the court stated that regarding uncertainty:
Generic uncertainty is inherent in constructing or manufacturing a product. That involves questions like: Will this tire fit? What kind of screws are needed to attach this panel? Or will this weld hold up this truss? But “uncertainty” in Section 174 means something more. . . . Expenses incurred merely to determine whether a product is built to satisfy a client’s desired specifications—without any indication that the expenses were incurred to improve or develop the concept of the product—do not qualify.
It added, “[A] manufacturer may not simply ‘add a few new bells and whistles’ on a pre-existing product and claim uncertainty as to the whole.”
In the absence of additional guidance from Treasury, Sandy also provides some insight into what should and should not be included as Section 174 costs under the new capitalization rules which went into effect starting in 2022.
The court felt the substantiation presented by the taxpayer in Sandy was inadequate stating, “shortcut estimates of experimentation-related activities will not suffice . . . [s]omething more, such as documentation of time spent on such activities, is necessary.”
In other words, taxpayers cannot claim R&D credits in the absence of actual technological uncertainty that requires an experimental process to resolve, and the time spent can be legitimately substantiated. Furthermore, in July 2023, the US Tax Court released a memo in Betz v. Commissioner, T.C. Memo 2023-84, which ruled against the petitioner, references the Sandy decision throughout, affirming the conclusions regarding uncertainty and substantiation.
Little Sandy Coal Update: Implications and Recommendations
Overall, the Sandy updates in 2023 have generally been considered positive for taxpayers. The method of calculating the substantially all rule, including direct support and direct supervision is back. While the ruling went against the taxpayer regarding uncertainty and substantiation, the decision was consistent with current law. Uncertainty must be related to development or improvement requiring a process of experimentation to resolve and taxpayers must be able to substantiate their activity beyond a shallow expectation that the court will simply trust them.
GTM’s methodology includes differentiating between activities that comprise a process of experimentation, direct support, direct supervision, as well as activities unrelated to developing or improving business components. A robust methodology like this should be implemented and is highly recommended, as it puts taxpayers in a favorable position to meet the requirements that Sandy has reinforced. Contact us for more information.
[1] The “Shrink Back” provision of Treas. Reg. §1.41-4(b)(2) allows costs to an existing product to qualify under certain circumstances even if those costs are less than 80% of the total product costs.
