Shipbuilder not entitled to research tax credit, 7th Circuit affirms

IL file photo

The 7th Circuit Court of Appeals has affirmed the denial of a research tax credit for a southern Indiana shipbuilder.

Little Sandy Coal Company Inc. is the parent of shipbuilding company Corn Island Shipyard Inc. in Spencer County.

During the 2014 tax year, Little Sandy Coal claimed a tax credit under Section 41 of the Internal Revenue Code based on alleged qualified research expenses incurred for the design and construction of 11 first-in-class vessels it had never built before. It claimed employee wages, contract research expenses and supply costs for the credit.

Upon review, the commissioner of Internal Revenue disallowed the tax credit and instead assessed a tax deficiency as well as an accuracy-related penalty.

Little Sandy Coal petitioned for redetermination by the United States Tax Court, which also found that the company was not entitled to claim the research credit for any of the 11 vessels. The court also upheld the tax deficiency and the accuracy-related penalty.

Little Sandy Coal then appealed to the 7th Circuit, which affirmed.

“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),” Judge Michael Brennan wrote Tuesday.

The 38-page opinion largely focused on one question: whether two of the vessels were “pilot models” under Section 174. A pilot model is defined as “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.”

Regardless of the answer, Little Sandy Coal would not prevail, the 7th Circuit concluded.

“Assuming the vessels are not pilot models, Taxpayer loses because it failed to show what, if any, portion of the activities accounted for by the nonproduction wages constitutes elements of a process of experimentation,” Brennan wrote. “If none of the vessels are pilot models, then none of the production wages would be included in the ‘substantially all’ fraction.”

Conversely, assuming the vessels were pilot models, the company still wouldn’t prevail because it didn’t show how the models were used in the process of experimentation.

“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. Instead, Taxpayer offered arbitrary allocations for nonproduction employee wages that estimated the portion of the employee’s time spent on qualified research,” Brennan concluded. “… 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.”

The case is Little Sandy Coal Company, Inc., v. Commissioner of Internal Revenue, 21-3145.

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