Tax credit not allowed: Here’s what court said company did wrong

One business that claimed a research tax credit ended up with a tax penalty instead. The company fought back in court, but the situation didn’t end well.

The shipbuilding company had claimed the tax credit, found in Internal Revenue Code Sec. 41, for its research activity.

The activity was building 11 vessels. The primary question became: Did at least 80% of that activity involve the process of experimentation? In other words, did the company pass the “substantially all” test? According to IRS, the answer was no. Therefore, the company didn’t engage in qualified research and couldn’t claim the tax credit. The U.S. Tax Court agreed, as did the Seventh Circuit Court of Appeals.

Here’s a closer look:

Understanding the tax credit

In addition to claiming the research tax credit on supply costs, the business claimed the credit on production and nonproduction wages. The nonproduction wages weren’t attributed to any specific vessels but rather to specific employees. Note: To calculate nonproduction wages, the company properly applied an allocation percentage to each employee’s total wages. That percentage was based on the estimated portion of the employee’s time that was spent on the research.

The company had argued that the 11 vessels it built were “first-in-class” and also that it’d never built one of the vessel types previously. But asserting novelty didn’t make a difference.

In its conclusion, the federal appeals court said it had a “lesson” for taxpayers that want to claim the research tax credit for activities. As the Seventh Circuit Court of Appeals put it, they should “adequately document that substantially all of such activities were research activities that constitute elements of a process of experimentation.”