R&D Tax Insight: First-in-Class
Understanding "First-in-Class"
In the context of U.S. R&D tax law (26 U.S.C. § 41), innovation doesn't need to change the world—it just needs to change your business. This interactive guide clarifies the critical distinction between "First-to-Market" and "First-in-Class" (New to Taxpayer).
The "Discovery" Rule
Many businesses assume they must invent something entirely new to humanity (like the lightbulb) to qualify for R&D credits. This is a myth.
Treasury Regulation § 1.41-4(a)(3)(i) explicitly states that research does not need to be unique to the world. It must simply be new to the taxpayer. This is the essence of "First-in-Class": solving a technical uncertainty that is novel to your organization.
Key Takeaway:
"You don't need to reinvent the wheel. You just need to invent a wheel that fits your specific, uncertain axle."
Innovation Threshold Spectrum
The green zone indicates credit eligibility.
The 4-Part Test & Uncertainty
To qualify as "First-in-Class" R&D, an activity must pass the IRS 4-Part Test. Click each component to see how it applies to "First-in-Class" innovation.
2. Elimination of Uncertainty
This is where "First-in-Class" is defined. You must demonstrate that at the outset, you were uncertain about the capability, method, or design of the project. It doesn't matter if a competitor knows how to do it; if you don't know, and the information isn't publicly available for free, it's uncertain to you.
Scenario Generator
Select an industry to see a First-in-Class example.
Installing a Standard CNC Machine
Purchasing and setting up a commercially available machine according to the manual. No design uncertainty exists.
Developing a Custom CNC Feed Mechanism
Designing a novel attachment for the CNC machine to handle a fragile, proprietary material. The method is unknown, requiring prototype testing and failure analysis.
Strategic Next Steps
How to substantiate your First-in-Class status.
1. Identify Uncertainty
Document the technical questions you couldn't answer at the start of the project. "How do we achieve X?"
2. Track Iterations
Save failed designs, test logs, and prototypes. These prove the "Process of Experimentation."
3. Separate Costs
Distinguish between "routine production" costs and the specific costs incurred to resolve the technical uncertainty.
The Research Credit, “First-in-Class” Projects, and the Process of Experimentation Burden
I. Executive Summary: The Novelty Trap of “First-in-Class”
The Research Credit (RC), codified under Internal Revenue Code (IRC) Section 41, serves as a crucial incentive, made permanent in 2017, designed to spur domestic investment in innovation by allowing businesses to offset their tax liability with qualified research expenses (QREs).1 Projects categorized as “First-in-Class” (FiC) inherently represent significant innovation, as they involve the creation of a product, process, or other business component the taxpayer has never designed or produced before.3 This novelty makes FiC projects intuitively strong candidates for the credit, as they often satisfy the initial statutory threshold of seeking to develop a new or improved component.4
However, reliance solely on the novelty of a FiC component represents a significant compliance and litigation risk. Judicial precedent has firmly established that the mere fact of building something new to the taxpayer is a necessary but profoundly insufficient condition for claiming the credit; the core legal requirement is demonstrating that the underlying activities satisfied the rigorous Process of Experimentation (POE) test.3 If an FiC credit claim fails scrutiny, the consequences have been magnified since the Tax Cuts and Jobs Act (TCJA) of 2017. For tax years beginning after December 31, 2021, Specified Research or Experimental (SRE) expenditures under IRC Section 174 must generally be capitalized and amortized over a minimum 60-month period (or 15 years for foreign expenses).5 Thus, a failed FiC claim often results not only in the loss of the tax credit but also in the adverse tax accounting treatment of having to capitalize costs that would otherwise have been currently deductible as ordinary business expenses, thereby generating a dual financial penalty for insufficient substantiation.
II. Defining “First-in-Class” (FiC) and Its Statutory Significance
The meaning and importance of “First-in-Class” projects are defined by their context within the statutory structure of the IRC Section 41 research credit, which Congress enacted to encourage the research and experimentation necessary to improve the U.S. competitive stance.6
A. Paragraph 1: Defining First-in-Class as a Business Component and Scope
Within the framework of IRC Section 41, the term “First-in-Class” refers to the initial development, design, or creation of a specific business component by the taxpayer.4 This business component may be a product, process, technique, formula, invention, or computer software.8 The designation signifies that the taxpayer has never before engineered, built, or utilized this specific component, thereby satisfying the requirement that the research activity be undertaken for the purpose of developing a new business component or improving an existing one.4 Historically, particularly in complex industries such as manufacturing or construction, taxpayers have sometimes adopted an “all-or-nothing” approach, treating the entirety of a large FiC item—such as an entire vessel or ship—as the single business component for which QREs were claimed.3 For the research to be qualified, this FiC component must be developed for a “qualified purpose,” which involves enhancing its function, performance, reliability, or quality, explicitly excluding research related purely to style, taste, cosmetic changes, or seasonal design.4
B. Paragraph 2: Importance, Link to Uncertainty, and Nuance
The importance of the FiC designation lies in the fact that the component’s novelty strongly suggests the presence of underlying scientific or technological uncertainty.9 Since the taxpayer has not previously mastered the design or manufacturing process for this specific component, the process of developing it must necessarily involve seeking to overcome technical unknowns that inhibit achieving the desired functional result.10 Congress originally enacted the credit to encourage exactly these types of experimentation activities that lead to innovation.7 However, the critical nuance separating a successful claim from a disallowed one resides in the distinction between a project being “new to the taxpayer” (FiC status) and the resolution of genuine technological uncertainty. The Internal Revenue Service (IRS) and the courts rigorously examine whether the project merely applied standard engineering principles or publicly available knowledge in a novel configuration—even if new to that specific company—or if it truly involved a systematic process to resolve uncertainty that could not be overcome based on existing knowledge.2 FiC status, therefore, must be seen not as automatic proof of qualified research, but as the scope within which the mandatory technical experimentation activities must be proven.
III. The Process of Experimentation (POE) Test: The Decisive Hurdle
FiC projects are subject to the same strict eligibility requirements as all other research claims. To be classified as a Qualified Research Activity (QRA), the activity must satisfy the statutory Four-Part Test mandated by IRC Section 41(d)(1) and (3).
A. The Statutory Requirement and the Four-Part Test
While the FiC designation typically helps satisfy the Functional Purpose Test (Requirement 3), the most rigorous and litigated requirement is the Process of Experimentation (POE) Test (Requirement 4). This test demands that the activity involve a systematic investigation that seeks to resolve scientific or technological uncertainty.3
The systematic process involves identifying technical uncertainties, developing hypotheses, testing alternatives (e.g., prototypes or computational modeling), and evaluating the results.12 Activities that qualify must demonstrate that the taxpayer encountered a genuine technical risk profile—meaning that alternative designs or approaches were explored because the technical outcome was truly uncertain, rather than merely adjusting known parameters to meet a business deadline or cost target.
B. The “Substantially All” Rule and Aggregation Risk
The POE test is tied directly to the “substantially all” rule, which dictates that at least 80 percent of the research activities, when considered in the context of the business component, must constitute elements of a Process of Experimentation.3
The decision to treat a large, complex FiC item—such as a custom-built production line or a specialized vessel—as a single business component, often referred to as the “all-or-nothing” approach 6, presents the gravest risk to the claim. When the entire component is claimed, the total research activities necessarily aggregate significant amounts of non-qualifying costs, including routine project management, administrative support, standard fabrication, and quality control. This aggregation inevitably dilutes the proportion of true experimental work, almost guaranteeing that the claim will fail to meet the 80% POE threshold. The IRS’s frequent scrutiny of large, aggregated claims, detailed in various Audit Technique Guides (ATGs) 13, reflects the common error of confusing the novelty of the final product with the qualifying nature of the daily work performed.
The key requirements for QRA, heavily influenced by the POE and FiC context, are summarized below:
Table 1: The Four-Part Test for Qualified Research Activities (QRA)
| Requirement (IRC § 41) | Definition | Relevance to First-in-Class (FiC) | Source ID |
| 1. Section 174 Test | Expenditure must be treated as research or experimental in the laboratory or experimental sense. | FiC costs related to design, prototyping, and testing typically meet this threshold. | 7 |
| 2. Technological Information Test | Research must be intended to discover information that is technological in nature (hard sciences/engineering). | FiC must resolve technical unknowns related to function/performance, excluding market research. | 4 |
| 3. Functional Purpose Test | Research must relate to a new or improved function, performance, reliability, or quality of a business component. | FiC status satisfies the “new component” aspect, linking R&D to performance goals. | 4 |
| 4. Process of Experimentation (POE) Test | Substantially all (80%) of the research activities must constitute elements of a systematic investigation to resolve technological uncertainty. | The primary focus of IRS audit. Requires detailed proof of identifying uncertainty, testing alternatives, and evaluation. | 3 |
IV. Case Law Analysis: The Disconnect Between FiC Status and Eligibility
A. Detailed Example: Little Sandy Coal Company, Inc. v. Commissioner (7th Cir. 2023)
The judicial review in Little Sandy Coal Company, Inc. v. Commissioner of Internal Revenue provides a definitive example of how “First-in-Class” status fails to guarantee eligibility for the R&D tax credit.3 The taxpayer, a shipbuilding company, claimed R&D credits for expenses incurred in the design and construction of 11 first-in-class vessels—meaning vessels the company had never constructed before.3 The taxpayer claimed expenses including employee wages, contract research, and supply costs.3
The Seventh Circuit Court of Appeals ultimately affirmed the disallowance of the credit because the taxpayer failed its burden of proof to demonstrate that at least 80 percent of its research activities for each vessel constituted elements of a Process of Experimentation.3 The central judicial finding was that the taxpayer had relied heavily on the newness of the vessels and arbitrary estimates, which the court deemed insufficient to prove the systematic resolution of technical uncertainty.3
Specific findings highlighted the taxpayer’s failure to segment activities effectively:
- Misclassification of Labor: The court found that time allocated to activities such as routine drafting (“simply drawing a design provided by an engineer”) or general supervisory roles were not elements of a process of experimentation.3 The analysis demonstrated that, regardless of the employee’s title (e.g., lead engineer or draftsman), the wages were only qualified if the time was spent directly on experimental activities.16
- Quality Control vs. Experimentation: Post-fabrication testing performed on the vessels, such as the deadweight survey (which measures water displacement to confirm cargo capacity) or the partial raise-and-lower test for the dry dock, were ruled non-qualifying.3 These activities were interpreted as standard quality control tests designed to confirm conformance with customer specifications and contractual terms, rather than experimentation intended to resolve fundamental design uncertainty.3
B. The Strategic Failure to Apply the “Shrinking-Back Rule”
A critical strategic failure highlighted in Little Sandy Coal was the taxpayer’s election of the high-risk “all-or-nothing” strategy, claiming the entire vessel as the business component.6 While the court acknowledged that certain smaller subcomponents of the FiC vessels (such as a specific stern notch or the dry dock’s outboard side plate) might have involved genuine experimentation, the taxpayer failed to provide the necessary granular documentation to segment those costs.3
Because the taxpayer failed to provide a “principled way” to determine what portion of employee time related to experimentation, the court was unable to apply the mandatory “shrinking-back rule”.3 The shrinking-back rule allows the IRS or the court to evaluate smaller subcomponents of the overall project to determine if they, individually, satisfy the 80% POE requirement. By claiming the entire vessel and failing to document the activities by subcomponent, the taxpayer forfeited the opportunity to salvage the credit claim, resulting in the disallowance of the entire expense for those components. This judicial emphasis demonstrates that the burden of credibility regarding time allocation and technical background of employees is paramount, a lesson reinforced by other documentation cases like Shami, where non-credible testimony and lack of corroborating evidence led to disallowance.16
V. Advanced Compliance and Documentation Protocols for FiC Projects
To mitigate the litigation risks inherent in FiC claims, robust, contemporaneous compliance protocols are essential, moving beyond merely asserting novelty to proving systematic experimentation.
A. Mapping the Business Component to the Process of Experimentation
The first mandatory compliance step for any FiC project is to proactively implement the shrinking-back strategy. Taxpayers must define the business component at the lowest possible level of technical uncertainty, treating the overall FiC product not as a single claim, but as a portfolio of discrete subcomponents.3
Documentation must center on Technical Narratives.10 These narratives, authored by the technical leads, must establish the baseline level of knowledge before the project began, explicitly articulate the specific technological uncertainty targeted, detail the systematic investigation pursued (including alternatives considered, modeling, and failed attempts 12), and conclude with the resulting technical advance or resolution.10 This structure ensures that the activities claimed are focused on resolving technical unknowns, differentiating them from routine engineering tasks.
B. Substantiating Qualified Research Expenses (QREs)
The ability to substantiate QREs—wages, supplies, and contract research expenses 8—is the cornerstone of a defensible FiC claim.
- Wages: Employee time tracking for FiC manufacturing projects must be granular, distinguishing time spent directly resolving uncertainty (qualifying POE labor) from routine production, quality assurance, drafting, or project management (non-qualifying activities).3 While time-tracking data is preferred, judicial precedent allows for the use of credible time estimates by technically qualified individuals, provided those estimates are corroborated by other project documentation and institutional knowledge.16 Arbitrary allocation percentages or reliance on job titles alone are insufficient.
- Supplies: Supply costs must be directly consumed in the research or experimentation phase, such as materials used for prototypes or in failed test runs, and must be distinct from materials capitalized into the final tangible property.8
- Audit Requirements: The IRS has heightened its disclosure requirements for valid research credit claims, formalized in 2021 guidance and incorporated into the revised draft of Form 6765, Credit for Increasing Research Activities.2 For any claim, taxpayers must now provide five specific elements of documentation, including identification of all business components, all research activities performed, all individuals involved, and the specific technological information sought.18 This demands that the POE analysis be fully prepared and substantiated prior to filing, rather than retrospectively.
VI. Next Steps and Policy Recommendations for Regulatory Clarity
To further clarify and explain the use of “First-in-Class” projects and address the gaps exposed by litigation, management must implement specific compliance reforms, and regulators should issue targeted guidance.
A. Suggested Next Steps for Taxpayers (Immediate Compliance Actions)
- Pre-Emptive Shrinking-Back Strategy Implementation: Mandate that all technical teams segment large FiC projects into discrete, definable subcomponents before work begins. Each subcomponent must be independently assessed against the Four-Part Test to ensure the 80% POE threshold is manageable, avoiding the reliance on the vulnerable “all-or-nothing” approach.3
- Mandatory Technical Narrative Creation and Linkage: Establish a policy that requires technical leads to create contemporaneous technical narratives for all claimed QRE hours. These narratives must explicitly detail the specific technological uncertainty that necessitated the research and the systematic alternatives that were tested or evaluated to resolve it, ensuring a direct and documented causal link between labor expenditure and the Process of Experimentation.10
- Audit Credibility of Allocation: Review and validate internal wage allocation methodologies to ensure that time tracking is based on credible, technical input, rather than arbitrary percentages. The financial team must utilize R&D tax experts with technical backgrounds to validate the documentation package, ensuring that time estimates and cost allocations meet the high substantiation standards demanded by the courts.10
- Proactive 6765 Data Collection: Implement continuous data capture systems to track the five specific elements now mandated for valid research credit claims, as required by updated Form 6765 guidance.2 This includes logging the specific information sought (the objective of the experiment) and linking it directly to the individuals involved, transforming compliance from a retrospective financial exercise into a continuous, engineering-driven data process.
B. Policy Recommendations for the IRS/Treasury (Regulatory Clarification)
To resolve ongoing ambiguities and reduce conflict between taxpayers and the IRS concerning complex tangible property development, the following guidance is recommended to clarify the use of “First-in-Class” projects:
- Issuance of FiC Tangible Property Examples: The IRS should update its Research Credit Audit Techniques Guides (ATGs) 13 to provide specific, detailed examples demonstrating the application of the Four-Part Test to large-scale, one-off “First-in-Class” tangible property (e.g., specialized manufacturing machinery, custom industrial components, or vessels). Such guidance must clearly segment qualifying POE activities (design iterations, material testing) from non-qualifying activities (routine fabrication, quality control) using lessons learned from cases like Little Sandy Coal.3
- Formal Guidance on New to Taxpayer vs. Technological Uncertainty: The Treasury Department should issue formal regulatory guidance, such as a Revenue Ruling, providing clear, objective criteria and safe-harbor examples that distinguish between a FiC component built using standard, existing industry knowledge (which does not qualify) and one that requires the resolution of genuine, technical uncertainty.2 This definition is necessary to eliminate the common misconception that organizational novelty automatically equates to qualified research.
Clarified Application of the Shrinking-Back Rule: Regulatory examples are needed to demonstrate the appropriate application of the shrinking-back rule in complex, multi-disciplinary FiC projects. This guidance should provide measurable technical criteria for defining a “subcomponent” in engineering terms, thereby actively encouraging taxpayers to adopt this mandatory, litigation-tested strategy rather than assuming the high-risk “all-or-nothing” approach.3
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What is the R&D Tax Credit?
The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
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