Little Sandy Coal Company, Inc v. CIRLittle Sandy Coal Company, Inc v. CIR
Before ROVNER, HAMILTON, and BRENNAN, Circuit Judges.
Taxpayer Little Sandy Coal Company, Inc., the parent of a shipbuilding company, claimed expenses for 11 vessels under the tax credit. But the Commissioner of Internal Revenue disallowed the credit and assessed a tax deficiency. Taxpayer unsuccessfully challenged that decision in tax court.
We disagree with some aspects of the tax court‘s reasoning, but ultimately, Taxpayer claimed more tax credit than it could prove. Taxpayer did not offer a principled way to determine what portion of the employee activities for each vessel constituted elements of a process of experimentation, much less research activities. Instead, Taxpayer relied on arbitrary estimates and the newness of the vessels. So, we affirm.
I. Background
Taxpayer Little Sandy Coal Company, Inc. is the parent of a shipbuilding company, Corn Island Shipyard, Inc. (CIS), in southern Indiana. In the tax year ending in June 2014, Taxpayer claimed a tax credit under
Vessel Development. At trial, the parties offered much testimony on the “iterative process” of designing and constructing vessels. CIS engineer, Brian Varner, and the Commissioner‘s expert, Kenneth Smith, each referred to the process as a “design spiral.” They explained that vessel components were interdependent, so the design of some elements could not be determined until the designs of others were established. Changes in vessel weight and other metrics could trigger new calculations and designs for other parts, causing the development process to loop back to the drawing board. While engineers “tr[ied] to eliminate problems up front,” the final design of some components could not be determined until construction. Varner explained that many of these design issues got “ironed out” as they built the ship, but they still had to feel “pretty comfortable with a design before ... cutting steel.” “Any repairs or modifications [could] become very costly very quickly.”
Tanker. CIS based the design of the Apex Tanker on a previous tanker it had built, the Penn 80. But several elements were different. For example, CIS used three-dimensional modeling to redesign the stern notch, which attaches the Tanker to a pusher tug. The Tanker also featured a towing bridle that was redesigned to minimize interference with other vessel components. Designing these components often required engineering. CIS‘s lead engineer and naval architect, Bud Johnson, performed an engineering calculation—called a “wind sail” calculation—to determine the appropriate size of the vessel‘s anchor. Others performеd engineering calculations to test the strength of the ship‘s longitudinal elements and to design the tanker‘s vapor barrier system, a special coating to prevent corrosion.
Some changes in the Apex Tanker‘s design, also determined through an iterative process, gave it greater cargo capacity than the Penn 80. After constructing the Tanker, CIS performed a deadweight survey to measure its water displacement, which indicates its cargo capacity. This displacement is a common contractual specification for vessels, and a sufficient variance can result in noncompliance with agreed-to terms. After analyzing CIS production employees’ time records, one of its engineering technicians, Brian Meunier, estimated that 87% of the time those employees spent constructing the Tanker involved functions “tied directly to items” different from those of the Penn 80.
Dry Dock. A dry dock is a vessel that can partially submerge in water to raise a ship above water for repairs. CIS had never built a dry dock before it made the Detyens Dry Dock. As with the Tanker, CIS used engineering calculations and modeling to design the Dry Dock and to resolve problems. CIS drafted several versions of design drawings and performed calculations to test these designs.
One comрonent, the outboard side plate, went through five design revisions. The safety deck also went through several versions, one of which involved raising the deck 18 inches to accommodate changes in the weight of the vessel. After building the Dry Dock, CIS conducted a partial raise-and-lower test to find out whether the Dry Dock properly submerged and rose. The client, Detyens, conducted a full raise-and-lower test after taking delivery.
Taxpayer also claimed $609,276 in nonproduction “estimated wage expenses” for the 11 vessels. These expenses were not broken out by vessel, but some of the wages were attributable to specific employees: $173,996 to Bud Johnson, CIS‘s lead engineer and naval architect; $126,734 to CIS‘s management, Don Foertsch, David Foertsch, and Alan Fleischmann; and $56,895 to draftsmen, Dennis Gass, Kyle Harpenau, and Robert Kellems. Taxpayer calculated these nonproduction wages by applying to each employee‘s total wages an allocation percentage equal to the estimated portion of the employеe‘s time spent on qualified research. Some trial witnesses testified that these estimates were reasonable. For example, Meunier testified that 60% is a “reasonable” allocation for the time Johnson spent on the design and development of the 11 vessels. David Foertsch similarly attested that the percentage estimations of time various employees spent on these vessels were “fair.”
After trial, the tax court found that Taxpayer was not entitled to claim the research credit for any of the 11 vessels. The tax court upheld the tax deficiency and the accuracy-related penalty. Taxpayer timely appealed to this court under
II. Statutory & Regulatory Framework
Before we consider the parties’ arguments, we review the research tax credit and how it works. This includes examining what are qualified research expenses (including what qualifies as research); the Section 174 test, which allows research and experimental expenditures that taxpayers would otherwise capitalize to be deducted from taxable income; and the process of experimentation test and its components.
A. Research Tax Credit
Qualified Research Expenses. Qualified research expenses include “in-house research expenses” and “contract research expenses.”
Qualified Research. To constitute qualified research, the research activities must satisfy four tests in
These four tests are initially applied at the “business component” level.
B. Section 174 Test
Section 174 allows research and experimental expenditures that taxpayers would otherwise capitalize to be deducted from taxable income.
“Because the taxpayer need only be uncertain as to ‘the capability or method
Uncertainty. It is critical to correctly frame “uncertainty” in Section 1.174-2 because, as explained later, this same concept undergirds the process of experimentation test. 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. “[D]eductions under section 174 are limited to ‘expenditures of an investigative nature expended in developing the concept of a model or product,’ as opposed to the construction or manufacture of the product itself.” Union Carbide, T.C. Memo. 2009-50, at *79 (citation omitted) (quoting Mayrath, 41 T.C. at 590). 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.
That is why the regulations exclude expenses for “ordinary testing or inspection of materials or products for quality control (quality control testing).”
We read “development” as used in Section 1.174-2(a)(1) to refer to mоre than mere construction (as in the common parlance of “real estate development“). The plain meaning of “development” is the “action or process of bringing something to a ... more advanced condition“—embracing the idea of “improvement“—but it can also mean general “change” or “progression by successive stages.” Development, OXFORD ENGLISH DICTIONARY (3d ed. 2016), https://www.oed.com/view/Entry/51434?redirectedFrom=development#eid; see also Develop, WEBSTER‘S THIRD NEW INTERNATIONAL DICTIONARY (1993) (“cause to increase or improve“). The former definition fits better in context. “Development,” as used beside “improvement,” implies an advancement in technology or product concept. See
“The presence of uncertainty concerning the development or improvement of certain components of a product does not necessarily indicate the presence of uncertainty concerning the development or improvement of other compоnents of the product or the product as a whole.”
C. Process of Experimentation Test
The fourth test to constitute qualified research, the process of experimentation test, has two components: (1) substantially all the research activities must constitute elements of a process of experimentation, and (2) for a qualified purpose under Section 41(d)(3)(A).
Substantially All. By regulation, “[t]he substantially all requirement of section 41(d)(1)(C) ... is satisfied only if 80 percent or more of a taxpayer‘s research activities, measured on a cost or other consistently аpplied reasonable basis ... constitute elements of a process of experimentation.”
Research activities that constitute elements of a process of experimentation / Research activities
See id.;
Accordingly, if 80 percent (or more) of a taxpayer‘s research activities with respect to a business component constitute elements of a process of experimentation for a purpose described in section 41(d)(3), the substantially all requirement is satisfied even if the remaining 20 percent (or less) of a taxpayer‘s research activities with respect to the business component do not constitute elements of a process of experimentation for a purpose described in section 41(d)(3), so long as these remaining research activities satisfy the requirements of section 41(d)(1)(A) and are not otherwise excluded under section 41(d)(4).
This italicized portion clarifies that any non-“process of experimentation” research activities must “satisfy the requirements of section 41(d)(1)(A)” and not be “otherwise excluded under section 41(d)(4).” Id.; see also Union Carbide, T.C. Memo. 2009-50, at *80; Suder v. Comm‘r, 108 T.C.M. (CCH) 354, T.C. Memo. 2014-201, at *17 (2014). An example in the regulation reaffirms this requirement.
Research activities that constitute elements of a process of experimentation / Research activities not excluded under Section 41(d)(4) and whose expenses are deductible under Section 174
See
Denominator. The “research activities” in the denominator must not be excluded under Section 41(d)(4) and expenditures for such activities must also be deductible under Section 174. Section 41(d)(4) excludes certain research activities from “qualified research” including: research conducted after the commercial production of a business component,
Numerator—Elements of a Process of Experimentation. More importantly, the numerator—a subset of the denominator—also requires that the research activities “constitute elements of a process of experimentation.”
This raises the question: Is there daylight between the Section 174 and process of experimentation tests? The answer is “yes.” While both tests are aimed at removing the same type of uncertainty concerning the development or improvement of a business component, the process of experimentation “test also imposes a more structured method of discovering information than section 174 requires and may not include all actions a taxpayer takes to resolve uncertainty.” Union Carbide, T.C. Memo. 2009-50, at *80 (citing Norwest Corp. & Subs. v. Comm‘r, 110 T.C. 454, 496 (1998) and Eustace v. Comm‘r, 312 F.3d 905, 907 (7th Cir. 2002)). “A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science.”
This process requires the use of the scientific method to resolve the uncertainty. Union Carbide, T.C. Memo. 2009-50, at *81. By scientific method, we
A process of experimentation “must involve a methodical plan involving а series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense.” Id. at *81; Siemer Milling, T.C. Memo 2019–37, at *8. “Testing and refining a hypothesis may involve determining the strengths and weakness of the alternative tested, whether and how the process could be further refined and improved, and whether other alternatives might be better suited for achieving the taxpayer‘s goal.” Union Carbide, T.C. Memo. 2009-50, at *81. And while only one alternative need be identified and evaluated, a process of experimentation “generally should be capable of evaluating more than one alternative.” Id.;
III. Discussion
With this factual background and statutory and regulatory overview, we move to analysis of the case.
“Tax credits are a matter of legislative grace, are only allowed as clearly provided for by statute, and are narrowly construed.” United States v. McFerrin, 570 F.3d 672, 675 (5th Cir. 2009) (citing Stinson Est. v. United States, 214 F.3d 846, 848 (7th Cir. 2000)); see also VHC, Inc. v. Comm‘r, 968 F.3d 839, 841 (7th Cir. 2020). “In this case, as with all claimed tax credits, the taxpayer bears the burden of showing entitlement to the credit.” United Stationers, Inc. v. United States, 163 F.3d 440, 443 (7th Cir. 1998). “A taxpayer claiming a credit under section 41 must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.”
If a taxpayer can establish that qualified research occurred, we may estimate the qualified research expenses subject to the tax credit. See McFerrin, 570 F.3d at 679 (citing Cohan v. Comm‘r, 39 F.2d 540, 544 (2d Cir. 1930)). But this estimate relates to Section 41(b), which is a separate—albeit related—inquiry from Section 41(d). Only after a taxpayer establishes that qualified research has occurred under Section 41(d) may we estimate, if needed, the amount of qualified research expenses under Section 41(b). Shami v. Comm‘r, 741 F.3d 560, 568 (5th Cir. 2014) (“[T]he Cohan rule is not implicated unless the taxpayer proves that he is entitled to some amount of tax benefit.“). Because Taxpayer failed to satisfy the process of experimentation test in Section 41(d), we conclude that no qualified research expenses are creditable under Section 41(b).
To reach this conclusion, we explain where we agree with the tax court, we
A. Where We Agree with the Tax Court
The tax court is correct in several of its conclusions.
“Substantially All” Fraction. The tax court properly construed the “substantially all” fraction for Section 41(d)(1)(C). As we did earlier, the tax court backed into the definition of thе denominator, “research activities,” by using the parameters that the regulations imposed on non-“process of experimentation” research activities. See generally
Novelty Approach. The tax court also rightly rejected Taxpayer‘s novelty argument, namely, that because the majority of the Tanker and Dry Dock was new, substantially all of the activities in designing the vessels constituted elements of a process of experimentation. As it did before the tax court, Taxpayer repeatedly emphasizes that the eleven vessels in question were first-in-class and that Taxpayer had never built a dry dock before. But the tax court correctly recognized that “Section 1.41-4(a)(6) ... requires that the substantially all test be applied in reference to activities—not physical elements of the business components being developed or improved.” So novelty of the business component cannot be the basis for measuring the proportion of research activities that constituted elements of a process оf experimentation. See
This “feels new enough” approach was used in Trinity Indus., Inc. v. United States, 691 F. Supp. 2d 688 (N.D. Tex. 2010), aff‘d, 757 F.3d 400 (5th Cir. 2014). That case also involved a shipbuilder who built several vessels, and the district court found the expenses incurred for two of six vessels to be qualified research expenses. Id. at 690, 694–97. For example, the district court found that research expenses incurred for “a very innovative special operations deployment craft ... designed to be very fast, undetectable, and able to fit on a C–5 cargo plane for rapid deployment” were qualified research expenses based on the vessel‘s novelty. Id. at 694. But like the stealth ship in question, the court evaded the mandate in Sections 41(d)(1)(C) and 1.41-4(a)(6) to determine whether the percentage of research activities exceed 80%. Rather, it used novelty as a shortcut. True, the regulation says courts may make this determination “on a cost or other consistently applied reasonable basis.”
Component-level Analysis. Taxpayer asserts that the tax court erred by applying the process of experimentation test at a subcomponent level as opposed to
We recognize also that the Tanker‘s stern notch and towing bridle, as well as the Dry Dock‘s outboard side plate, among other elements, went through several design iterations. The research activities to develop these parts may very well constitute elements of a process of experimentation. But, as we revisit later, Taxpayer‘s documentation lacks the necessary detail to prove that. It is Taxpayer‘s burden to show entitlement to the research tax credit and to retain records to substantiate eligibility for the credit. United Stationers, 163 F.3d at 443;
B. Pilot Model Production Expenses
While we agree with the tax court‘s ultimate conclusions, we disagree in part with its treatment of pilot model production expenses. As in the tax court, Taxpayer contends that the Tanker and Dry Dock are “pilot models,” as defined by
1. Deductible Under Section 174
Assuming that the two vessels were pilot models, the tax court properly included pilot model production expenses into the denominator. “Pilot model” is a defined term for purposes of research expense deductibility under Section 174. It means “any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product.”
eliminate uncertainty concerning the development or improvement of a product.”
This conclusion is buttressed by the examples provided in
In Example 5, a mass-production manufacturer, V, “incurs $5,000 to produce a number of models of the product that are to be used in testing the appropriate design before the product is mass-produced for sale.”
In Examples 7 and 8, the research is performed to develop a new line of product rather than to fulfill existing contractual obligations.
2. Elements of a Process of Experimentation
At this point, our analysis diverges from that of the tax court. In entertaining the possibility that the vessels were pilot models, the tax court also categorically excluded model production wages from the numerator of the “substantially all” fraction. That is, it found that pilot model production activities could not be an element of a process of experimentation.
In so concluding, the tax court erroneously imported a distinction from Section 41(b)(2)(B) into the numerator of the fraction in Section 41(d)(1)(C). The court first observed the distinction that Section 41(b)(2)(B) draws between “direct support of research activities which constitute qualified research,”
Other courts have drawn similar distinctions. E.g., Shami, 741 F.3d at 570 (“In short, the supervisor of the direct supervisor of employees who conduct qualified research is not himself engaged in qualified research.“). The regulation expounding upon Section 41(b)—the scope of qualified research expenses—states, “direct support of research includes the services … of a machinist for machining a part of an experimental model used in qualified research.”
Within the “substantially all” fraction in Section 41(d)(1)(C), we see the text justifying two options as to how we can treat activities that would qualify as “direct support” and “direct supеrvision” under Section 41(b)(2)(B)(ii). Either direct support and supervision activities should be considered in both the numerator and denominator of the fraction as Taxpayer proposes, or they should not be considered at all as the amicus curiae, the National Association of Manufacturers, suggests.2 The tax court took a third approach and suggested direct support and supervision activities—more specifically, pilot model production activities—could be included in the denominator, but the court categorically excluded them from the numerator.3 We
If we were to rule for the second option—to carry over the Section 41(b) distinction between qualified research and direct support/supervision into Section 41(d)—then production activities that support qualified research would not belong in the “substantially all” fraction. For the reasons stated earlier, this approach is internally inconsistent. But applying the Section 41(b) distinction in Section 41(d) comes with more problems of its own. For one, neither the terms nor the concept of “direct support” or “direct supervision” appears in Section 41(d).
More broadly, Section 41(b) and Section 41(d) address different subjects: Section 41(b) identifies the contours of qualified research expenses subject to the research tax credit under Section 41. It includes amounts spent on supplies for and wages in direct support or supervision of qualified research.
Nothing in the regulation explaining Section 41(d)—Section 1.41-4—explicitly addresses pilot models. Recall, though, that “pilot model” means “any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product.”
A deeper dive into Section 1.41-4 is helpful. Several examples within Section 1.41-4(a)(8)
Given the regulation‘s apparent inclusion of some pilot model production activities in the numerator, we hold that those activities can be research activities (denominator) that constitute elements of a process of experimentation (numerator). Our holding does not mean that any direct support or supervision activities may be considered in the “substantially all” fraction. Recall that an activity must be a research activity, whose expenses are deductible under Section 174, to make it into the fraction at all. See
One more note about Example 3. The production of the fine-shred blades was an element of a process of experimentation because the blades were used in a “systematic trial and error process of analyzing various blade designs and materials to determine whether the new shredding blade must be constructed of a different material.”
C. Taxpayer‘s Failure of Proof
The tax court did not decide whether the two vessels were pilot models. Instead, it performed the “substantially all” analysis under alternative assumptions that the vessels were and were not pilot models. We follow thе tax court‘s lead. Under either assumption, Taxpayer fails the “substantially all” test.
1. Assuming the Vessels are Not Pilot Models
Assuming the vessels are not pilot models, Taxpayer loses because it failed to show what, if any, portion of the activities
Taxpayer asks us to take on faith that the percentage allocations of each nonproduction employee‘s wages were only for research activities that involved a process of experimentation. But Section 41(d) requires us to walk by sight, not by faith. Taxpayer has the burden to document that the activities accounted for by the nonproduction wages were elements of a process of experimentation. United Stationers, 163 F.3d at 443;
The tax court found that CIS‘s lead engineer and naval architect, Bud Johnson, spent much of his time involved in customer relаtions and management activities. And indeed, trial testimony supports that Johnson managed payrolls, took care of personnel issues, interfaced with clients, put together bids, and handled supply chain concerns. The father-and-son management team, Don and David Foertsch, were stipulated co-owners of Taxpayer, and the evidence did not demonstrate that they conducted much, if any, research activities apart from their management activities. Don Foertsch was copied on project-related emails, but none of the emails showed how his involvement was an element of a process of experimentation. He would meet with Johnson and David to review bids and ship designs. Taxpayer also alleged that Don assisted with fabrication and production issues, but nothing documents how he did so. It seems Don played a supervisory role over research activities. David Foertsch‘s testimony regarding his efforts to “troubleshoot” the Tanker‘s towing bridle indicated that he may have engaged in some research activities that constituted elements of a process of experimentation. He also testified about his involvement in designing the stern notch. But, in the end, the record gave the tax court no means of determining the extent of time David spent on experimentation-related research activities.
Another member of management, Alan Fleischmann, was CIS‘s purchasing agent and responsible for assessing and obtaining
Like the tax court, we conclude that the record does not allow us to determine the percentage of nonproduction employee activities that constituted elements of a process of experimentation—even less, research activities. Even if we assumed that all $609,276 in nonproduction wages were deductible under Section 174 and so includible in the denominator, Taxpayer has failed to demonstrate what, if any part, of that number belongs in the numerator.
2. Assuming the Vessels Are Pilot Models
Assuming the vessels are pilot models, Taxpayer still does not prevail because it failed to show how such pilot models—that is, the entire vessels—were used in a process of experimentation. If the vessels are pilot models, the production expenses for them are included in the denominator.4 See supra Section III.B.1. Then the “substantially all” fraction would be as follows: production and nonproduction wages that are elements of a process of experimentation divided by production and nonproduction wages. Remember that Taxpayer claimed the research tax credit on $2,505,491 and $146,109 of production wages for the Tanker and Dry Dock, respectively. Again, the fact that the $609,276 in nonproduction wages are not broken out by vessel presents a problem. We cannot discern a way to factor these wages into the “substantially all” fraction without a breakdown by vessel.
The tax court addressed the issue by simply assuming that all the nonproduction wages were for the Tanker. The court also assumed that all $609,276 in nonproduction wages were for elements of a process of experimentation and categorically excluded pilot model production expenses from the numerator. Using this approach, the tax court found that, at best, the relevant fraction would be 19.6% ($609,276 ÷ ($609,276 + $2,505,491))—insufficient to satisfy the “substantially all” test. For the Dry Dock, the tax court also excluded pilot model production expenses from the numerator. But, instead of assuming that all $609,276 in nonproduction wages were for elements of a process of experimentation, the court
We cut a different path. Above, we concluded that the record does not allow us to determine the percentage of nonproduction wages that account for elements of a process of experimentation. We also concluded that much of the nonproduction wages account for non-research activities. Given these conclusions, we do not strain ourselves with the sequential assumptions made by the tax court. Because we are unsure what nonproduction expenses account for research activities, we simply exclude them from our “substantially all” analysis. This is to Taxpayer‘s benefit because, under our previous conclusions, including the nonproduction expenses would only increase the denominator without any gains in the numerator.
So, whether
Tanker. The tax court began by rejecting Taxpayer‘s argument that the deadweight survey, conducted after the Tanker was built, established that the entire tanker was involved in a process of experimentation. But it also viewed with skepticism the Commissioner‘s argument that the survey was merely a quality control test that was not a process of experimentation or deductible research under Section 174. See generally
We do not doubt that Taxpayer encountered many uncertainties in building the Tanker. Plenty of trial testimony demonstrated that changes in one of several interdependent vessel components could trigger the redesign of other parts. But we
Dry Dock. The tax court found that CIS‘s partial raise-and-lower test for the Dry Dock did not establish that the design of every element of the vessel remained uncertain, and thus constituted a process of experimentation. This raise-and-lower test, too, is less experimentation than it is a quality control test that establishes whether a customer‘s specifications have been met.
We recognize that the Dry Dock is the first one that CIS built. But we reiterate that the novelty of a business component is not a proper heuristic for the “substantially all” test. The test is applied in reference to research activities—not the business component being developed or improved.
IV. Conclusion
For both vessels, Taxpayer failed to provide a principled way to determine the portion of employee activities that constituted elements of a process of experimentation.
The lesson for taxpayers seeking to avail themselves of the research tax credit is to adequately document that substantially all of such activities were research activities that constitute elements of a process of experimentation. Generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time performing experimentation are not enough.
AFFIRMED.