Questions about the R&D Credit?
Questions about IRS requirements?
Trinity – Substantially All and the Shrink-Back Rule
In a recent court case (Trinity Industries, Inc. v. U.S.), the taxpayer lost a significant amount of their R&D Tax Credit benefit due solely to their lack of project-level documentation. In this case, the Court examined six claimed research projects to determine if they met the “Substantially All” requirement (see IRC sec 41(d)(1)(C) and Treas Regs sec 1.41-4(a)(2)(iii)).
The Substantially All requirement states that 80 percent or more of a project’s qualified research activities must constitute elements of a process of experimentation. If the project fails the Substantially All requirement, the taxpayer can apply the “Shrink-Back” rule, as defined in Treasury Regulations section 1.41-4(b)(2). The Shrink-Back rule allows the taxpayer to evaluate each subcomponent of the project, as a stand-alone business component. This allows the taxpayer to capture qualified research expenses on at least their core research and development activities within a project.
Because the taxpayer did not have the necessary contemporaneous documentation, the Court could not apply the Shrink-Back rule and had to evaluate each project under Substantially All. Ultimately, the Court allowed only two of the six projects as qualified research. Of the projects that did not qualify, the Court took these positions:
“While the Court would readily accept that a significant portion of the costs was part of a process of experimentation, it has substantial uncertainty regarding the 80% threshold. In the face of that uncertainty . . . Trinity has failed to meet its burden of proof. The Court therefore finds that Trinity is not entitled to any QRE credit for the [project].”
and:
“There were clearly some qualified research costs incurred in the design and construction of the [project]. But . . . [the] Court finds that less than 80% of the costs incurred were part of a process of experimentation. The Court therefore finds that Trinity is not entitled to any QRE credit for the [project].”
In this case, the taxpayer’s lack of contemporaneous documentation precluded them from maximizing their benefit under the R&D Tax Credit regulations. Once again, the US Tax Court continued to support the IRS’ expectation for contemporaneous documentation of the federal Research and Development Tax Credit.
