Little Sandy Coal Co. Inc. v. Commissioner


Little Sandy Coal Co. Inc. v. Commissioner, T.C. Memo. 2021-15

Corn Island Shipyard, Inc. (CIS) operates as a shipbuilding subsidiary of Little Sandy Coal Co. They developed 11 vessels in 2014, using 2 as representatives for the others in their R&D study. The IRS disallowed the credits claimed for this research, contending that CIS failed to meet the “substantially all” requirement with respect to the “process of experimentation” test under Internal Revenue Code (IRC) Section 41.

Basic Facts

The IRS took the position that CIS did not meet the “substantially all” requirement, i.e., that substantially all of the activities involved in the research constitute elements of a process of experimentation, which according to the relevant regulations means that 80% or more of the taxpayer’s research activities constitute elements of a process of experimentation for the costs related to the business component to be qualified.

For R&D that does not meet the 80% threshold, there exists a sub-business component for the “Shrink Back” provision of Treas. Reg. §1.41-4(b)(2) to apply. This allows a taxpayer to claim certain improvement costs where the improvements made to an existing product account for less than 80% of the total product costs.

CIS argued that substantially all of the development activities constituted elements of a process of experimentation as definied in sec. 41(d)(1)(C) and sec. 1.41-4(a)(6). Their case in point was that more than 80% of the elements of each vessel differed from previous vessels. For instance, they argued that the hull, which comprises 90% of the vessel, was completely redesigned. 

CIS also argued that the work of the production employees directly supported research and constitued elements of a process of experimentation as such. Their argument specified that the work done by production workers on novel elements made up at least 87% of their work on the vessel and so they met the “substantially all” test requirements.

Court’s Decision

The court ruled in favor of the IRS and stated the following:

  • The “substantially all” test must be applied in reference to activities, not physical elements of the business component being developed or improved.
    • The hull of a ship corresponds to 90% of the product, but does not guarantee that the activities involved would meet the “substantially all” requirements.
  • Only employees directly involved in the process of experimentation are qualified expenditures.
    • The court further specified that if there had been detailed records outlining the production workers contribution to the R&D, an argument could be made to include them. However, without any evidence they could not be included.
  • The novelty of an element of a business component does not establish that the work involved in developing that element involves a process of experimentation.
    • The court further specified that developing novel components only guarantees uncertainty at the beginning of development but does not guarantee that a process of experimentation was undertaken. 

Although the court had no doubt that the vessels required iterative and detailed processes of experimentation, they remained unconvinced that CIS had proved their development activities constituted 80% of a process of experimentation. They further ruled that they could not apply the Shrink Back provision as they had chosen an “all or nothing strategy” rather than looking at a subcomponent level. The final ruling resulted in all activities related to the projects being disqualified.


This case highlights the importance of maintaining detailed records of employee contribution to R&D projects and ensuring you have the evidence to support your research tax credit claims. Identifying a detailed approach to analyzing business components and outlining methodologies is key to providing a reasonable basis which will quantify whether the “substantially all” test is met. Without sufficient substantiation to support claims, an entire research tax credit could be subject to disqualification.

Click here to read the full case.

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