A pair of recent U.S. court rulings make it clear: without careful planning and attention to detail, companies can waste significant time and money when applying for R&D tax credits.
In both Little Sandy Coal v. Commissioner and Scott Moore, et al. v. Commissioner, the courts found that the taxpayers couldn’t back up certain activities and their related qualified research expenditures (QREs)—mainly because they lacked proper documentation.
Beyond being a reminder about the value of good recordkeeping, these cases reveal several missed opportunities where the taxpayers could have used the tax code to their advantage.
We’ll break down those missed opportunities—and show how expert tax guidance can make a difference in R&D claims—but first, it’s important to understand which activities qualify as eligible activities under the federal Credit for Increasing Research Activities (better known as the R&D tax credit).
Understanding Qualified Research Activities and Expenses
The IRS sets out a four-part test that activities must meet to qualify as R&D tax credit QREs:
- The activities are devoted to developing new or improved performance, functionality, quality, or reliability of a product, process, formula, invention, software, or technique (a business component);
- The activities are meant to discover information to resolve technical uncertainty about the design, methodology, or capability of the business component;
- The activities involve a process of experimentation with multiple iterations; and
- The experimentation process is based on principles of a hard science.
If a taxpayer’s activities meet all four criteria, expenses like employee wages, tangible supplies, and contract research costs tied to those activities can count toward the R&D tax credit.
While there were likely several missteps throughout the claim and defense process, the main issue for taxpayers in both the Little Sandy Coal and Moore cases was the lack of documentation showing how their activities met this four-part test.
Little Sandy Coal: Missing out on the shrink-back rule
In the Little Sandy Coal case, the biggest mistake was arguably trying to claim too much by defining their QREs too broadly.
Little Sandy Coal applied for R&D tax credits for developing 11 first-in-class vessels for the tax year ending June 2014. Instead of identifying smaller parts of the ships as eligible QREs, Little Sandy Coal defined the business component as the entire barge under the substantially all rule of the R&D tax credit.
The substantially all rule applies when 80% or more of the research activities are part of a process of experimentation. This matters because, in these cases, the IRS allows 100% of eligible project expenses to be claimed for the credit.
The problem is, even though many ship components and their related expenses were new, that doesn’t mean that substantially all activities in designing and building the vessels were part of a process of experimentation. In fact, the tax court pointed out that “section 1.41-4(a)(6) … requires that the substantially all test be applied to activities—not to the physical elements of the business components being developed or improved.”
Little Sandy Coal argued that since the business components were prototypes, they were, by definition, created through a process of experimentation. But both the IRS and the Tax Court rejected this, specifically stating that Little Sandy Coal failed to provide documentation proving that at least 80% of their research activities were part of a process of experimentation.
Put simply, while the court agreed that some R&D was done, Little Sandy Coal didn’t provide enough documentation to show the process of experimentation used in developing the ships—let alone proof that 80% of the activities on each ship supported that process. Since the activities didn’t meet the threshold, the related expenses didn’t either, and the claim was denied.
What likely stings most for the taxpayers is that, by not providing detailed documentation, Little Sandy Coal missed the chance to use the shrink-back rule. This rule lets taxpayers who may have defined their business component too broadly (as Little Sandy Coal did by including all the barges in the original claim) still claim credits for smaller parts of the project—if they have enough documentation to support it.
Little Sandy Coal didn’t have backup documentation to use the shrink-back rule, so they ended up with nothing when the case was settled this past March.
Moore: A lesson in poor documentation
Little Sandy Coal was also criticized for not providing documentation linking employee activities to outcomes. This same mistake was central in the Moore case.
This case challenged Scott and Gayla Moore’s original filing for Nevco, Inc. (their S-Corp), which claimed 65% of their COO’s wages as QREs for 2014 and 2015. The COO testified that they spent “north of 50%” of their time on product development, and other employees backed this up. While the court believed the COO did some R&D, it found that not all of the COO’s product development activities qualified as R&D.
What’s more, Nevco couldn’t explain how they estimated the COO’s time spent on research and development versus general product development. In fact, the documentation showed the COO was actually two steps removed from hands-on product development.
Another point: while some court cases have accepted oral testimony to prove someone’s involvement in R&D, this case shows that’s not enough—there must be supporting documentation.
In its final decision, the Court said, “The record provides no estimates of the amount of time [COO] spent on qualified research as distinguished from the broader category of new product development.” As a result, none of the COO’s salary or bonus qualified as research. This highlights the need to document the methodology used to calculate R&D tax credit expenses and to keep records that back up the claim.
Work with experts to maximize your return—and avoid common R&D tax credit mistakes
At a minimum, businesses should do their best to track R&D and gather all relevant documentation—both as projects progress and during tax season—to make sure they don’t miss out on opportunities to defend or even reframe their claim (like using the shrink-back rule).
In both cases, the IRS wasn’t saying that parts of the costs or time weren’t qualified. Instead, they challenged the percentage of time or cost that was qualified, and whether the documentation supporting those estimates was accurate.
This matters because, while courts have long accepted estimates in R&D credit calculations, that doesn’t remove the taxpayer’s responsibility to document how those estimates were made and to ensure they’re accurate.
Bottom line: Taxpayers claiming the R&D tax credit must meet both Section 41 requirements and the IRS’s documentation standards.
A system of real-time recordkeeping—including notes, test results, time tracking, cost data, and evidence of technical uncertainty or scientific experimentation—is essential for claiming the credit.
It’s also crucial to work with partners who can help you file correctly from the start, saving you time and money at tax time—and hopefully avoiding lengthy court battles if your claim is denied.
To learn more about how your team can better track progress (and make qualifying for tax credits easier), read our recent blog, Track R&D, not Tax Credits.
Book a call with our team today to see how Boast AI has helped hundreds of businesses claim substantial R&D tax credits—fueling innovation and extending their runways.
