Little Sandy Coal Company, Inc. v. Commissioner of Internal Revenue

March 7, 2023 | Brennan, Circuit Judge, United States Court of Appeals for the Seventh Circuit | Docket No. 21-3145

 

Short Summary

Little Sandy Coal Company, the parent of a shipbuilding business, claimed federal research tax credits for designing and building 11 new vessels, arguing that much of their work qualified as “research” under the tax code. The IRS denied the credits, saying the company did not provide enough evidence that its activities met the requirements for the credit. Specifically, the need to show a real process of experimentation. After losing in Tax Court, Little Sandy Coal appealed, but the Seventh Circuit upheld the IRS’s decision, finding that the company failed to properly document which activities counted as qualified research. As a result, the tax credits were denied. 

Key Issues

• Did Little Sandy Coal’s shipbuilding work qualify as “research” under the federal tax credit rules? 

  The court had to decide if the activities involved in designing and constructing 11 new ships went beyond routine engineering and problem-solving. The law requires that, to qualify for the credit, a company’s work must involve a structured process of experimentation aimed at resolving real uncertainty about how to develop or improve a product, not just regular design, troubleshooting, or making something new. 

• Did the company keep and provide enough detailed records to back up its research credit claim? 

  Another major question was whether Little Sandy Coal maintained sufficient documentation to show what specific tasks its employees performed and how much of that work counted as true “qualified research.” The court had to consider if estimates and broad statements were enough, or if the law requires clear, detailed records to support every part of the credit claim. 

• Do the costs of building “pilot models” count toward the research credit, and what kind of proof is needed? 

  The case also raised the issue of whether costs related to building the first versions of these ships, so-called “pilot models”, could be counted as part of the research credit calculation. The court examined whether such expenses could qualify if they are connected to actual experimentation, and what kind of documentation is necessary to prove that these costs were truly related to the process of experimentation required by the law. 

Primary Holding

The court decided that Little Sandy Coal Company was not entitled to the research tax credits it claimed for building new ships. The main reason was that the company did not provide enough detailed evidence to show that its activities met the strict legal definition of qualified research. Although the company argued that its shipbuilding projects were complex and involved some design changes, the court found that Little Sandy Coal did not prove that most of its work involved a real process of experimentation as required by the tax law. The court also explained that the company’s records were too general and relied heavily on estimates, rather than providing clear and specific documentation of qualified research activities. While the court said that some pilot model expenses might be eligible for the credit in certain situations, it found that Little Sandy Coal failed to connect those costs to genuine experimentation. Because the company did not meet its burden of proof, the court upheld the IRS’s decision to deny the tax credits. 

Specific Rulings

1. Whether Little Sandy Coal’s Shipbuilding Work Qualified for the Research Credit 

   • Ruling: The court decided that Little Sandy Coal’s activities did not qualify as “qualified research” under the law, so the company could not claim the research tax credit.
   • Reasoning: The court explained that while building new ships can be complicated, the company failed to show that most of its work involved a structured process of experimentation meant to resolve true uncertainty. The court stressed that simply making something new or using engineering skill is not enough; there must be a methodical, scientific process to test and evaluate alternatives, and Little Sandy Coal didn’t provide enough evidence of this.
     
     

2. Whether the Company’s Documentation Was Adequate 

   • Ruling: The court ruled that Little Sandy Coal’s records were not sufficient to support its research credit claims.
   • Reasoning: The court noted that the company relied on broad estimates and general allocations of employee time, instead of keeping clear records that directly tied specific activities to qualified research. The court required detailed documentation that shows how much time and expense went into genuine experimentation. Since the company’s records were vague and not broken down by project, the court could not verify how much of the claimed expenses truly counted as qualified research. 
     
     

3. Whether Pilot Model Production Costs Could Be Counted Toward the Credit 

   • Ruling: The court clarified that pilot model costs (the costs of building first-of-their-kind ships) can sometimes be included in research credit claims, but only if they are tied to a true process of experimentation.
   • Reasoning: The court said that just making a prototype or pilot model is not enough to automatically qualify those costs for the credit. The company must prove that building the model was part of a scientific process to test and resolve uncertainty. In this case, Little Sandy Coal did not provide enough detail to show that the pilot model costs were related to qualified research activities, so those expenses could not be counted.

Helpful Takeaways for Taxpayers 

• Keep detailed and specific records of all research activities. 

  Thorough documentation is one of the most important keys to successfully claiming the research tax credit. Make sure to keep clear records that show exactly which employees worked on which tasks, how much time they spent, and what those tasks involved. This includes meeting notes, engineering logs, design revisions, and time-tracking sheets. Well-organized records help demonstrate to the IRS (or a court) that your expenses truly relate to qualified research activities, making your claim much stronger. 

• Make sure your research involves a true process of experimentation. 

  The research tax credit is not just for creative or challenging projects; it’s for work that uses a systematic approach to solve technical uncertainty. This means you should be able to show that your team followed a methodical process: identifying problems, testing different solutions, analyzing results, and refining your approach. If your work involved “trial and error,” developing and testing prototypes, or using scientific or engineering methods to figure out unknowns, make sure you document those steps clearly. 

• Don’t rely on estimates or general statements when claiming credits. 

  Courts and the IRS are looking for solid, factual evidence, not just broad estimates or rough guesses, when reviewing research credit claims. Instead of using general percentages or unsubstantiated claims about how much time was spent on research, keep careful project-by-project and employee-by-employee records. The more precise and well-supported your claim, the more likely it is to stand up if challenged. 

• Understand that novelty alone does not guarantee eligibility. 

  Even if your product or process is new, cutting-edge, or unique in your industry, that’s not enough to automatically qualify for the research credit. What matters most is whether your work involved a documented, scientific process to resolve genuine uncertainty. Highlight the experimental process in your records, not just the fact that something is new or different. 

• Connect pilot model or prototype costs to experimentation. 

  Building a prototype or first-of-its-kind product can involve a lot of uncertainty and problem-solving. However, for those costs to count toward the research credit, you need to show that the pilot model was used as part of an experimental process such as testing alternatives, making improvements, or analyzing results, not just routine testing or quality control. Be ready to explain and document how building the pilot model contributed to your research efforts.