U.S. Tax Court: Research tax credit disallowed

U.S. Tax Court: Research tax credit disallowed

The U.S. Tax Court today issued an opinion disallowing a taxpayer’s research tax credit claimed under sections 38 and 41(a) for expenses incurred by the taxpayer’s subsidiary.

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The case is: Little Sandy Coal Company, Inc. v. Commissioner, T.C. Memo 2021-15 (February 11, 2021). Read the Tax Court’s opinion [PDF 188 KB]

The IRS determined a deficiency in the taxpayer’s federal income tax for its tax year ended June 30, 2014, and an accuracy-related penalty under section 6662 for that same year.  The deficiency arose from the IRS’s disallowance of a claimed research credit under sections 38 and 41(a). The claimed credit relates to activities conducted by taxpayer’s shipbuilding subsidiary in developing 11 vessels. In accordance with an agreement between the parties, the trial in April 2019 addressed issues related to just two (a tank barge project and a dry dock project) of the 11 projects in issue:

  • Whether the taxpayer met its burden of proof that substantially all (80% or more) of the activities involved elements of a process of experimentation to be qualified research under section 41(d)(1)(C) and Treas. Reg. §1.41-4(a)(6) with respect to the business components identified for the building of a tank barge and a dry dock
  • Whether any exclusion found in section 41(d)(4) applied with respect to the business components identified for the projects
  • The includible amount of qualified research expenses for the business components identified for projects
  • The issues with respect to projects on which the subsidiary collaborated with a related corporation

 The Tax Court today determined:

  • The subsidiary did not meet its burden of proof that substantially all (80% or more) of the activities involved elements of a process of experimentation to be qualified research, as defined by section 41(d), with respect to the tanker or the dry dock. Significantly, the Tax Court did not consider the direct support and direct supervision activities of the employees as being “engaged in” research under section 41(d)(1)(C). Even though section 41(b)(2)(B) and Treas. Reg. §1.41-2(c) define “qualified services” to include (1) engaging in qualified research; (2) engaging in the direct supervision; or (3) direct support of qualifying research, the Tax Court held that:

One who provides services in direct supervision or support of research is not "engaged in" research.... Therefore, the activities of such a person cannot "constitute elements of a process of experimentation" for purposes of section 41(d)(1)(C).

  • Because the subsidiary did not conduct qualified research, within the meaning of section 41(d), in developing either the tanker or the dry dock, the Tax Court did not need to consider the applicability to either project of the exclusions provided in section 41(d)(4).
  • The includible amount of qualified research expenses for each of the tanker and the dry dock pursuant to section 41(a) and (b) was zero.
  • No portion of the qualified research expenses the taxpayer reported in respect of the other projects was allowable for the purpose of computing the research credit allowed by section 41(a).

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