Life After Little Sandy
Q What is the takeaway from Little Sandy Coal?
A In March, the Seventh Circuit decided Little Sandy Coal Company, Inc. v. Commissioner (“LSC”). The court held that the taxpayer failed the “substantially all” and process-of-experimentation tests of Sec. 41, denying them the federal income tax credit for increasing research activities. The holding requires adequate substantiation of, and differentiation between, taxpayers’ research activities to claim the credit. While the court recognized that the taxpayer performed qualified research, they held that the company’s documentation failed to prove it. In the court’s words, “Something more, such as documentation of time spent on such activities, is necessary.”
Q What is going on in IRS audits?
A Research credit substantiation disputes have long divided taxpayers and the IRS. Since the publication of LSC, examining agents have broadly construed the opinion to deny research credits due to inadequate substantiation. The problem, however, is that the opinion did not contain actionable guidance on what would constitute sufficient substantiation. Consequently, taxpayers are currently in the dark with IRS agents resistant to accept anything as sufficient substantiation. Fortunately, the IRS added a research credit substantiation regulation project to its Priority Guidance Plan in late 2022, which should level the playing field.
Q What does this mean for Sec. 41 (and Sec. 174)?
A Documentation continues to be key to properly claiming the Research Credit. The documentation standard of Regs. Sec. 1-6001.1 applies to both Secs. 41 and 174. Without actionable guidance on sufficient substantiation, taxpayers are left wondering if what they maintain is adequate. Open questions remain regarding how LSC should be read in conjunction with Sec. 174. Will the same level of substantiation of activities and expenses that would deny the credit under Sec. 41 require capitalization and amortization of the same activities and expenses under Sec. 174? If this were the case, it would mbe a “rules for thee but not for me” situation. Would estimates based on documentation, such as Jira logs and service tickets in the software realm, also invalidate capitalization of research and experimental expenditures? This is the type of evidence the IRS currently rejects for substantiating time on research in Sec. 41 credit cases.
