Importance of R&D Tax Credit Documentation: Lessons from Recent Court Cases

calendar iconApril 19, 2023

Taxpayer claims for the federal income tax credit for Increasing Research Activities (R&D tax credit) continue to draw scrutiny from the Internal Revenue Service (IRS). Two recent court cases highlight how taxpayers can lose their R&D tax credit claims. In Little Sandy Coal v. Commissioner[1] (Little Sandy Coal), the Court determined that the taxpayer did not provide the proper documentation to support its experimentation process necessary for purposes of claiming the R&D tax credit. In Scott Moore, et al. v. Commissioner[2] (Moore), the Court determined that the taxpayer did not sufficiently document the activities of a key employee as directly supporting the company’s research activities. Both cases were decided in favor of the IRS, and both opinions provide guidance to taxpayers on the importance of documentation and substantiation supporting qualified research expenditures (QREs) underlying R&D tax credits.

Key Lessons from These Cases

  • Taxpayers should maintain contemporaneous and detailed documentation that ties the company’s expenditures to qualified research activities.
  • The IRS continues to focus attention on the identification of a company’s business components and may challenge a taxpayer’s claim that substantially all research-related activities for that business component meet the qualifying requirements.
  • If it is determined that an identified business component does not meet the substantially-all test, taxpayers can avoid losing all of an R&D credit with the shrink-back rule. It is important for taxpayers to maintain detailed records for each activity related to a business component to take advantage of the shrink-back rule.
  • Taxpayers can expect the IRS to request information to substantiate that research activities are based in a process of experimentation.
  • With the multiple roles and responsibilities of executive and C-level employees and business owners, taxpayers may see challenges to the compensation expense of these individuals classified as QREs. Taxpayers should pay special attention to documenting the involvement and actions of these individuals in research activities.
  • The development of new products alone may not constitute research activity. All criteria of the statutory and regulatory requirements must be satisfied to qualify new product development expenditures for the R&D tax credit.

How to Qualify for the R&D Tax Credit

Taxpayers may take advantage of the R&D tax credit when the following criteria, known as the four-part test, are met. Costs of research-related activities can be considered QREs for the R&D tax credit if:

  • The activities are devoted to the development of a new or improved product, process or design (a business component);
  • The activities are intended to discover information that could eliminate technical uncertainty about the design, methodology or capability of the business component;
  • The activities involve an iterative process of experimentation; and
  • The process of experimentation relies on the principles of a hard science.

Leveraging the Shrink-Back Rule

When analyzing research activities associated with the development of a new or improved business component, taxpayers can avoid taking an all-or-nothing approach in determining whether project costs should be included in the calculation of the credit. Instead of including all costs associated with a large project, taxpayers can use the shrink-back rule. Under the shrink-back rule, taxpayers apply the four-part test at the most significant subset of elements within a business component. Essentially, the shrink-back rule applies to situations where a large scale project may not be qualified as a whole, but the project may have smaller sub-components that meet the new or improved business component test criteria of the four-part test.

How Do Qualified Research Expenditures Factor

QREs include wages paid to individuals directly engaged in qualifying research activities, as well as wages of employees supervising and employees supporting these individuals conducting direct research. It is important to document the efforts of these “one up” and “one down” employees and tie their daily efforts to business components.

R&D Tax Credit Documentation Checklist

Ensure comprehensive R&D documentation with this checklist, covering qualified employee expenses, supply expenses, and contracted expenses.

Documentation for Qualified Employee Expenses

  • Employee Form W-2s
  • Payroll Registers
  • Time Questionnaires
  • Oral Testimony
  • Meeting Minutes

Documentation for Qualified Supply Expenses

  • Chart of Accounts
  • General Ledger
  • Purchase Orders
  • Invoices
  • Receipts
  • Bills of Lading

Documentation for Qualified Contracted Expenses

  • Chart of Accounts
  • General Ledger
  • Service Contracts
  • Purchase Orders
  • Invoices
  • Form 1099-NEC (for individual contractors)

R&D Tax Credit Court Cases Highlighting the Importance of Proper Documentation

Little Sandy Coal

The taxpayer in Little Sandy Coal was a ship builder that contracted with customers to design, construct and deliver tanker barges and a floating dry dock. The tanker barges required redesign of a previous product design, while the dry dock required development of a new product design. To claim the R&D tax credit, the taxpayer defined its business component as the entire group of barges it was designing and constructing, as opposed to identifying smaller portions of the design project that met the four-part test.

First the IRS, then the Tax Court, and finally, the Appellate Court all concluded that the taxpayer failed to show that at least 80% of its research activities related to the business component constituted elements of a process of experimentation.[3]  The Court did not accept the taxpayer’s argument that the novelty of the underlying business components as prototypes, by definition, meant that all activities conducted in their development were part of a process of experimentation (i.e., just because a pilot model is being developed, all activities in its development are not part of a process of experimentation).

The Appeals Court outlined the component parts of the numerator and denominator in calculating the 80% fraction:

Research activities that constitute elements of a process of experimentation

Research activities not excluded under Section 41(d)(4) and whose expenses are deductible under Section 174

The Appeals Court addressed the taxpayer’s lack of documentation by stating that documentation must be “in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” The taxpayer missed the opportunity to provide detailed documentation that would allow the IRS and the courts to apply the shrink-back rule to smaller business components when activities of the initial, larger business component failed to satisfy the substantially-all rule.


Scott Moore and Gayla Moore claimed research credits on their 2014 and 2015 income tax returns passed through to them from Nevco, Inc. (Nevco), an S corporation. The issue was whether wages paid to the Chief Operating Officer of Nevco (COO) were QREs for Nevco’s R&D tax credit calculation.

According to the record, the COO conducted a wide range of management and research functions for Nevco, including the supervision of the company’s R&D department. Nevco included 65% of the COO’s wages as QREs in its R&D tax credit claim. The IRS examination did not find sufficient support to prove the COO’s involvement in the R&D activities and disallowed the wages. The Tax Court’s analysis focused on whether the COO was engaged in:

  • Direct performance of qualified services under section 41(b)(2)(B(ii)), or
  • Direct supervision or direct support of persons who performed qualified services (section 41(b)(2)(B)(ii)).

The Court agreed with the IRS that the taxpayer did not show support for the portion of the COO’s direct work on the new product development. Additionally, the Court noted that the COO did not directly supervise the members of the R&D department because he was two layers removed from the direct activity. The supervision activity did not meet the “one-up” requirement. Accordingly, the Court concluded that no portion of the COO’s wages were QREs, thus reducing Nevco’s R&D tax credit.

Conclusion and How Cherry Bekaert Can Help

The rulings in Little Sandy Coal and Moore were disappointing to the taxpayers claiming R&D tax credits.  However, these cases highlight the need for all taxpayers claiming R&D tax credits to bolster their documentation supporting the business components, the experimentation process and the employee supervision and support activities. Taxpayers should maintain thorough documentation of properly defined business components and maintain specific documentation of the activities performed by executives who supervise the employees engaging in direct research efforts. Ultimately, these cases provide reminders to substantiate and tie research activities to QREs.

If you have questions or want to learn more about the R&D tax credit for your company, contact Cherry Bekaert’s R&D Tax Credit professionals today.

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[1] 7th Cir. No. 21-3145, March 7, 2023
[2] T.C. Memo. 2023-20
[3] Little Sandy Coal v. Commissioner, US Court of Appeals, Seventh Circuit page 1