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22 March 202311 minute read

What’s Enough? Seventh Circuit affirms Tax Court’s disallowance of Section 41 R&E credit claim for lack of documentation

Ruling in Little Sandy Coal Company v. Commissioner, the Seventh Circuit has affirmed the Tax Court’s[1] disallowance of a shipbuilding company’s research tax credit under Internal Revenue Code § 41.

The opinion, issued on March 7, 2023, is likely to further encourage the IRS to continue demanding extensive, specific, detailed substantiation supporting research credits and further demonstrates the need for taxpayers to be prepared.

Section 41 provides a tax credit for 20 percent of “qualified research expenses” that exceed a base amount. As with all tax credits, a taxpayer claiming a research tax credit has the burden of showing entitlement to the credit and is required to retain records “in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.”[2] While courts may estimate the amount of qualified research expenses under the Cohan rule for purposes of determining the amount of tax credit, a taxpayer must be able to establish entitlement to the research tax credit in the first place.[3]

A taxpayer’s entitlement to a research tax credit depends on whether the taxpayer has performed “qualified research,” which is determined first at the “business component” level. If the taxpayer’s activities are not “qualified research” at the “business component level,” then the “shrinking-back rule” applies such that the activities are evaluated first with respect to the “the most significant subset” of the business component and then with respect to smaller subcomponents until either a subset of elements of the product that satisfies the requirements, or the most basic element of the product fails to satisfy the requirements.

To constitute “qualified research,” the research activities must satisfy four tests: (1) the Section 174 test; (2) the technological information test; (3) the business component test; and (4) the process of experimentation (or “substantially all”) test. The primary issue in Little Sandy Coal was whether the taxpayer’s activities met the “process of experimentation” test.

Under the “process of experimentation” test, substantially all (ie, 80 percent or more) of the taxpayer’s research activities, measured on “a cost or other consistently applied reasonable basis,” must constitute elements of a process for experimentation. “A process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.” In addition, the research activities that constitute elements of a process of experimentation must relate to (i) a new or improved function; (ii) performance; or (iii) reliability or quality.

Therefore, for “elements of a process of experimentation” to be considered “substantial,” the quantum of such elements, “measured on a cost or other consistently applied reasonable basis,” must constitute at least 80 percent of the taxpayer’s research activities. In other words, the following fraction must exceed or equal 80 percent:

 Research activities that constitute elements of a process of experimentation
 Research activities not excluded under Section 41(d)(4)[4] and whose expenses are deductible under Section 174[5]

The primary reason the Tax Court disallowed the taxpayer’s research tax credit and the Seventh Circuit affirmed such disallowance was the taxpayer’s failure of proof at every step of the Section 41 analysis.

The taxpayer (a shipbuilder) asserted that a vessel was a business component and the “process of experimentation” test should be based on the portion of nonproduction wages that were incurred in a process of experimentation for that business component. The Seventh Circuit determined that the taxpayer provided no means to support its position because the nonproduction wages were not broken down by the business component the taxpayer proposed (ie, the vessel). Furthermore, because the taxpayer did not provide any alternative positions with respect to any subcomponent and did not provide sufficient documentation supporting that its activities with respect to any subcomponent involved a “process of experimentation,” the taxpayer did not meet its burden of proof even though, as the Seventh Circuit noted, certain subcomponents might have satisfied the “process of experimentation” test.

As a result, the Seventh Circuit concluded that the taxpayer also failed to provide an evidentiary basis for the Seventh Circuit to apply the “process of experimentation” test under the “shrinking-back rule.”

The Tax Court and Seventh Circuit also found that the taxpayer failed to provide sufficient documentation to determine what portion of activities were (1) research activities as opposed to non-research activities (ie, the denominator) and (2) research activities that constitute “elements of a process of experimentation” (ie, the numerator) as opposed to other research activities. For example, the taxpayer offered estimated percentage allocations of each nonproduction employee’s wages as evidence of the employees’ time spent on qualified research, but such estimations were inconsistent with the testimony of the employees who testified. The Seventh Circuit, in line with the Tax Court, rejected the use of such uncorroborated estimations, noting that “[t]he regulations do not require records in any particular form, except that they must be ‘in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. . . shortcut estimates of experimentation-related activities will not suffice.”[6]

Key takeaways

Little Sandy Coal is a timely reminder to taxpayers of the need to maintain and offer adequate documentation to prove the quantum of their relevant research activities and to present testimony consistent with such documentation to substantiate their entitlement to the research credit. This would include documentation with sufficient detail that will enable a factfinder to identify business components and subcomponents and to quantify the related qualified research activities. In our recent experience, IRS Examination teams have upped their demands on taxpayers to produce highly detailed documentation and quantitative analyses at the business component level, and we expect these demands will only increase in light of the Seventh Circuit’s Little Sandy Coal opinion.

Little Sandy Coal also emphasizes the need to develop alternative positions at the subcomponent level to maximize the likelihood that at least some research tax credit will pass muster. This is especially true in the context of refund claims, as Field Attorney Advice 20214101F (Oct. 15, 2021) requires specific documentation for refund claims based on research tax credits, in line with the documentation the Seventh Circuit indicated was required in Little Sandy Coal.[7]

The need for sufficient supporting documentation applies not only to small taxpayers but also to LB&I taxpayers with assets equal to or greater than $10 million. Since 2020 the IRS has limited LB&I taxpayers’ ability to rely on R&D costs reported on financial statements under FASB Accounting Standards Codification (ASC) Topic 730 as sufficient evidence of qualified research expenditures, requiring taxpayers to meet the documentation requirements, among other requirements, set forth in IRS Guidance Control No. LB&I-04-0820-0016.[8]

The upshot from Little Sandy Coal is that “taxpayers seeking to avail themselves of the research tax credit [must] 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.”[9] The taxpayer in Little Sandy Coal seems to have very little relevant documentation to prove its case. Therefore, while the court’s opinion may be helpful in demonstrating the types of documentation that would be considered inadequate, little can be gleaned from it regarding the types of documentation that would be considered adequate. The extent of adequate documentation, whatever it is, must be “in sufficiently usable form and detail” to allow a factfinder to determine that elements of a process of experimentation are substantial.

Given that the research credit issue remains one of the IRS LB&I’s priority active campaigns, taxpayers would be well advised to revisit their supporting documentation, including any R&D study, to ensure such documentation will provide a sufficient evidentiary basis for a finder of fact to determine the substantiality of the relevant research activities. If, after such review (done under privilege), it is determined that the existing documentation may not be sufficient, then additional corroborating evidence should be identified to ensure that the taxpayer will be able to carry its burden of proving its entitlement to the Section 41 research tax credit.

Learn more about the implications of Little Sandy Coal by contacting the authors or your DLA Piper relationship attorney.



[1] T.C. Memo. 2021-15.

[2] Little Sandy Coal, No. 21-3145, slip op. at 16 (7th Cir. Mar. 7, 2023); Treas. Reg. 1.41-4(d).

[3] Little Sandy Coal, No. 21-3145, slip op. at 16 (citing Cohan v. Comm’r, 39 F.2d 540, 544 (2d Cir. 1930) (holding that courts may estimate the amount of a tax benefit if a taxpayer proves entitlement to such tax benefit) and Shami v. Comm’r, 741 F.3d 560, 568 (5th Cir. 2014)).

[4] Section 41(d)(4) excludes certain research activities from “qualified research,” including, among other things: research conducted after the commercial production of a business component, research to adapt an existing business component to a particular customer’s specifications, and research to duplicate an existing business component. I.R.C. § 41(d)(4)(A)-(C).  There are other exceptions irrelevant to Little Sandy Coal set forth in I.R.C. § 41(d)(4)(D)-(H).

[5] Expenses are deductible under Section 174 if they are “for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.” Treas. Reg. 1.174-2(a)(1). 

[6] Little Sandy Coal, No. 21-3145, slip op. at 30 (internal citations omitted).

[7] Namely, page 2 of FAA20214101F (Oct. 15, 2021), at (last visited Mar. 13, 2023), provides that “[f]or a taxpayer’s refund claim for the I.R.C. § 41 research credit to be valid, the taxpayer must, at a minimum:

  • Identify all the business components to which the I.R.C. § 41 research credit claim relates for that year.
  • For each business component:
    • identify all research activities performed;
    • identify all individuals who performed each research activity; and
    • identify all the information each individual sought to discover.
  • Provide the total qualified wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year”

[8] The IRS guidance on the use of financial statements pursuant to ASC 730 only applies to LB&I taxpayers (i.e., taxpayers with assets equal to or greater than $10 million). “Guidance for Allowance of the Credit for Increasing Research Activities Under I.R.C. Section 41 for Taxpayers That Expense Research and Development Costs on Their Financial Statements Pursuant to ASC 730,” LB&I-04-0820-0016 (Sept. 10, 2020), at (last visited Mar. 13, 2023). See also “Guidance for Allowance of the Credit for Increasing Research Activities under I.R.C. § 41 for Taxpayers that Expense Research and Development Costs on their Financial Statements pursuant to ASC 730,” LB&I-04-0917-005 (Sept. 11, 2017), at (last visited Mar. 13, 2023).

[9] Little Sandy Coal, No. 21-3145, slip op. at 38.