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Details Matter: Little Sandy Coal Co.

Summary: The R&D Tax Credit represents some of the most complex tax law in the code. The recent Little Sandy Coal Co., TC Memo. 2021-15 provides some important guidelines for those utilizing and preparing this tax credit.

Innovation is vital to the US economy, which makes the foundation of this credit and its benefit to US business a laudable endeavor. It's just a bit unfortunate that the IRS, a group not known for innovation, finds itself as the gatekeepers charged with identifying science-based innovation. The Little Sandy Coal Co. case illustrates some of the pitfalls associated with definitions and R&D tax credit complexity.

Later in our examination, we compare our processes to some processes we've seen from other providers in the R&D industry to illustrate a significant difference in interpretation and application.


The Little Sandy Coal Company successfully designed and built a new shipping vessel and a dry dock (a floating structure used for ship maintenance and repair) for customers. However, according to the U.S. Tax Court, the company failed to establish that its efforts constituted qualified research expenditures for purposes of claiming the R&D tax credit.

This dispute between Little Sandy Coal and the IRS concerned research credits claimed for the company’s shipbuilding subsidiary. The court considered two specific projects that the parties agreed could be used to gauge whether the company met the requirements to claim the credit.

The first project involved the design of a tanker that had several unique elements relative to other tankers that the company had previously built and thereby required the testing of various proposed designs. The other project, designing a dry dock, was an entirely new type of project that the company had not designed before.


This case brought to light some foundational interpretation issues that exist with this complex tax code. We have always interpreted the code with a focus on processes, not products. This difference and other issues are summarized below.


The court held that, because the processes involved to build the ships were similar, the credit should have been based on processes and not products (called 'adaptation' in the regulation).

  • OTHER COMPANIES' APPROACH: Many R&D companies apply this same approach to clients in dentistry and other fields. They claim that every crown or patient is an individual R&D case.

  • OUR APPROACH - Processes not Products: We've always considered the "every patient" approach a difficult interpretation - that's why we don't use it. The credit is for the development of more broadly applicable processes, techniques, or products. I wrote a whole article on our blog (here), but the gist is that we interview our clients to identify changes to their care processes that were made in response to uncertainties in their field. If you know anything about the standard of care issues between locations or training programs, you'll realize that clinicians are faced with many uncertainties that are not resolved in training or literature. They need to find their own way to a solution in their practice. We backstop that assumption of uncertainty through our relationships with the NIH and Practice-Based Research Network (two federal entities that exist to reduce uncertainty in clinical healthcare). The reason our documents are so comprehensive is due to the description of technique development.


Among other requirements, for expenditures to qualify for the research credit, “substantially all” of the research activities must “constitute elements of a process of experimentation.” The court acknowledged that some of the activities related to the design of the tanker and dry dock likely involved the required process of experimentation, but it concluded that the company failed to establish that substantially all (80%) of the activities did.

  • OTHER COMPANIES' APPROACH: When they claim every patient or crown, they also make the assumption that at least 80% of the activity qualifies.

  • OUR APPROACH - Shrink-back: The IRS describes a process of identifying aspects ("subcomponents") of qualifying research activities and shrinking the credit back to recognize only those qualifying subcomponents. We have applied this process from the beginning with our clients by completing a shrink-back analysis during credit preparation and recognizing only those subcomponents in the calculation. For example, an orthodontist developing a wire and bracket protocol by introducing modifications will only qualify for those modifications (i.e., changing from a twin to self-ligating bracket, experimenting with a new sequence of wires that includes new metal alloys, or evaluating the impact of switching from an MBT bracket prescription to a Roth bracket prescription). Our credits are calculated on the cul=mularive value of these subcomponents and rarely seem to exceed 40-50% of the research activity.


In this case, the shipbuilders claimed over 70% of many employee wages and included executive-level members. The court found that many of these employees were unlikely to have had direct interaction with the project, even if it had been deemed a qualifying activity.

A similar fact set applied to supplies, where the company claimed all the supplies used in the building of these ships. Little Sandy Coal argued that more than 80 percent of the tanker was a new design and the dry dock was 100 percent new. The court concluded that they misunderstood the standard, though. The standard does not relate to the proportion of the physical elements of what is being developed that are new. Rather, the test is of the activities involved and whether they were substantially all part of a process of experimentation.

  • OTHER COMPANIES' APPROACH: All lab fees are claimed. When it comes to employees, they seem to make little distinction between clinical assistants and administrative staff and often claim 70-80% of time.

  • OUR APPROACH - Research Nexus: The recent R&D guidance received in October 2021 described a new summary report to be included in the return that demonstrates a 'nexus' between claimed employees and the research activity. We've always made the distinction between the three levels of employees described in the guidelines, even before the recommendation. We lay out each claimed employee's role in the research (if any). We do not include administrative staff, only clinical staff who provide direct support to our research leaders (the clinicians). For our qualifying employees, we rarely see higher than a 50% qualification and those cases would generally be outliers developing a 3D printing lab or some other technically intense modification.


In court cases, like any other statistic or study, it's dangerous to cite a result without understanding how the study or case came together. In this case, there are some analogous considerations as well as a great opportunity to define the differences between our R&D approach as compared to other's processes.


This article is not intended to provide legal advice and should not be relied upon. Your legal counsel should be consulted for evaluation and application.

If you have any questions about our services or how you may qualify for the credit, please feel free to call or email.

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