Requirements for Taxpayers to Claim a Federal Income Tax Credit

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The taxpayer in Little Sandy Coal Co. v. Commissioner, TC Memo 2021-15 (February 11, 2021) appealed an adverse United States Tax Court ruling to the United States Court of Appeals for the Seventh Circuit. The decision likely misinterprets the legal and regulatory requirements a taxpayer must meet to claim federal income tax credits for qualifying research expenses. Miller Canfield Alert of March 4, 2021 summarizes the Tax Court’s decision.

The case raises the question of whether, and to what extent, the activities of a taxpayer constitute elements of a process of experimentation. The Commissioner’s memoranda to the Tax Court run to hundreds of pages, but do not include an argument that the definition of eligible research expenditures informs the definition of activities that constitute elements of an experimental process. . Nevertheless, the Tax Court itself developed this reasoning to decide that the taxpayer did not pass the experimentation process test. The court further concluded that its decision was determinative of the case and that it was not necessary to decide the other issues in the case. The court’s decision on the case is problematic, which is what this alert addresses.

Research is qualified and eligible for the tax credit if (i) the research activities aim to discover information that would eliminate uncertainty in the development of a product, (ii) the purpose of the research is to discover information which are technological, (iii) applications of the information are intended to be useful for the development of the product, and (iv) substantially all research activities constitute elements of a process of experimentation with the aim of developing the function , performance, reliability or quality of a product. (IRC §41(d))

The test of the process of experimentation: The elements of a process of experimentation testing are (i) the identification of the technological uncertainty concerning the development of a product, (ii) the identification of a design alternative intended to eliminate the uncertainty technology, (iii) identification of an evaluation process to eliminate technological uncertainty, (iv) conduct of that process, (v) evaluation of results, and (vi) design changes to address design flaws, if any. (Treasury Regulation §1.41-4(a)(5))

The technological uncertainty must be related to the development of a qualified objective, for example, a new function for the product. Almost all of the activities must constitute elements of an experimentation process relating to the development of this new function. Substantial character is satisfied if at least 80% of the research activities constitute elements of the experimental process. Research activities may be measured against the cost of another reasonable basis consistently applied. For example, to determine whether at least 80% of the research activities constitute elements of the experimental process, the cost of the research activities constituting elements of the experimental process to develop the new function is divided by the cost of all the activities of research carried out to develop the product even if one or more of the activities is not part of the experimental process to develop the function of the product. If the resulting quotient is 80% or more, the experimentation process test is passed.

We pause for a moment to ask why activities that are not part of the experimental process for a qualified purpose are even considered. This is because if almost all activities are elements of an experimental process for a qualified purpose, such as feature development, then other activities, for example, product styling, which do not is not a qualified purpose, are included in the definition of qualified research. Product styling then becomes a qualified research activity, and the credit amount increases by expenses incurred for styling. Stylistic activity never disqualifies the research carried out to develop the function. The substantially all test is intended to help taxpayers, not to sink their credit claims. If there is too much styling activity, it should be eliminated from consideration and credit given only for product function activities.

Direct research support: The court’s analysis in Little Sand erred in determining that substantially all of the taxpayer’s activities were not elements of an experimental process conducted for a qualifying purpose. The court misread the definition of qualified research expenses in the definition of Activities which constitute the elements of an experimental process. The definition of qualified research expenditure (IRC §41(b)) does not shed light on the measurement of activities that are elements of an experimental process. (Treasury Regulation §1.41-4(a)(6))

involved in Little Sand is whether the activities of the production workers who made the nautical vessels – a tank barge and a drydock – were activities that constituted elements of the experimental process. If they are, their cost is included in the numerator of the fraction calculating substantiality, and if not, they are excluded. The taxpayer argued that the manufacturing activity is part of the experimental process. The court rejected the argument.

The tribunal’s analysis began with a reference to the statutory provision (IRC §41(b)(2)(B)(ii)) which deals with the wages of an employee who “directs[ly] supports” qualified research as qualified research expenditures. The next analytical step was that an employee who manufactures an experimental model only “directly supports” qualified research and is not, itself, “research qualified”, which is correct. The last analytical step was that an activity which directly supports only qualified research and which is not itself qualified research cannot be an activity constituting an element of an experimental process, which is the pivot of the decision and which is incorrect.

The court confuses Activities that fall within the definition of qualified research with the definition of expenses who are assigned to this qualified research. Qualified research is determined first. (IRC §41(d)(1); Treas. Reg. §1-41-4(a)(5)(i)). The expenses attributable to this qualified research are determined thereafter, subsequently. ((IRC §41(b)(2)(B)(ii))

Two reasons show why the Tax Court’s analysis is flawed. First of all, research credit has two criteria that are almost all different. The measure of the salary of an employee who agrees to directly support qualified research is treated as 100% of the employee’s annual salary if at least 80% of the employee’s salary is attributable to qualified research activities. This is the “almost everything” criterion for salary costs performed by an employee engaging in the direct support of qualified research. (The same “gross-up” rule applies to the salary of an employee who conducts qualified research directly.) The Substantially All Test for Research activities that constitute elements of an experimental processwhich is a different criterion, provides that the salary of an employee providing direct support do not equal to 100% of the employee’s salary costs for the whole year even if at least 80% of the annual salary is attributable to activities constituting elements of an experimental process. Only specific salaries attributable to the activities of the employee providing direct support are counted. For this criterion of almost all, there is no increase. To underscore the court’s error, it ruled that salaries for direct support are never included as a measure of a research activity constituting an element of an experimental process even if express regulatory direction is given (Treas. Reg. §1.41-4(a)(6)) to exclude only an increased amount, but not the actual amount, for these salaries. The court’s decision violates the rules.

Second, “modeling” is expressly included as an activity that is part of an experimental process. (Treas. Reg. §1-41-4(a)(5)(i)) The ships were presumably “models” used to evaluate design alternatives. A modeller who makes a model to use experimentally is, literally, “modeler”. Subsequent sales of vessels should not disqualify the activity of modellers as an activity constituting an element of a process of an experimental process because subsequent sales do not appear to be fundamentally inconsistent with the premise on which the credit was based. (Hillsboro National Bank v. Commissioner, 460 US 370 (1983))

Supplies used for modeling: The court makes a similar error by rejecting the cost of the supplies used to make an experimental model. The court held that a supply is not an “activity” because only persons carry on activities. Therefore, according to the court, the cost of supplies of an experimental model cannot be taken into account to measure the substantial character of the activities constituting the elements of an experimental process. The court’s finding contradicts regulatory guidelines (Treas. Reg. §1.41-4(a)(5)(i)) because “modeling” is expressly defined as the “conducting” of an experimental process of ‘Evaluation.

In addition, the Tax Court’s decision has the perverse effect of failing a taxpayer the experimentation process test if the nature of the taxpayer’s business requires considerable expense to manufacture experimental models. The cost of modeling supplies is deductible (IRC §174(a)) and therefore included in the denominator of the fraction determining whether substantially all of the activities are elements of an experimental process. The court’s reasoning excludes these supply costs from the numerator. If the expenditures are substantial, the taxpayer will fail the substantially all test since the percentage will be less than 80% and will not be eligible for research credits. Those with only modest procurement expenses will be in a better position to claim the credits because they will pass the near-all test. This is an indefensible difference resulting from the exclusion of supplies for experimental models from the test of the experimentation process. Supplies used for modeling are part of the cost of modeling and a measure of activities that constitute the elements of an experimental process.

Statutory design issues: The problems of statutory interpretation of research credit are numerous. The problems of proof are heavy. An overhaul of the law that effectively incentivizes research may well be in order and save government and taxpayer resources that can be used more productively.

© 2022 Miller, Canfield, Paddock and Stone PLC National Law Review, Volume XII, Number 49


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