Trinity Industries, Inc. v. United States of America

January 29, 2010 | David C. Godbey, United States District Judge | Docket No. 3:06-CV-0726-N

 

Short Summary

Trinity Industries, a large shipbuilding company, filed a lawsuit against the United States government after the IRS denied its claims for research and development (R&D) tax credits related to several ships it designed and built in the mid-1990s. The main dispute centered on whether the costs for developing these ships qualified as “research expenses” under the federal tax code. The court examined each project and ultimately ruled that Trinity could claim the R&D credit for two of the ships, but not for the others. Overall, the decision highlights the importance of proving that most project costs are truly related to experimental research to qualify for the tax credit. 

Key Issues

• Do custom-built ships qualify as “business components” for the R&D tax credit?

  For a company to claim the R&D tax credit, the law says the work must be done on a “business component”, typically a product, process, or invention meant to be sold or used in business. The government argued that because Trinity’s ships were built for specific customers and not for general sale, they didn’t count. The court needed to decide if these custom ships still fit the definition of a business component under the tax law.

• Were most of the project costs truly part of a process of experimentation?

  The tax credit is only available if at least 80% of a project’s costs are related to a genuine process of experimentation; meaning there is real uncertainty and testing involved. The court had to look closely at each ship project to see if the majority of the work was experimental, or if it was just routine engineering or assembly.

• Did Trinity provide enough evidence to prove which costs qualified for the credit?

  To get the credit, Trinity had to show clear records or reliable estimates of how much of each project was devoted to research activities. The court examined whether Trinity’s documentation and witness testimony were specific and credible enough to back up their claims, especially since some records were lost or destroyed.

• If a whole ship project didn’t qualify, could Trinity still claim credits for smaller parts?

  Sometimes, even if an entire project doesn’t meet the strict requirements, parts of it might. The court considered the “shrinking back” rule, which allows companies to claim the credit for smaller, qualifying pieces (like a new engine system) if the main project falls short. The court needed to decide if Trinity had enough detail to use this rule for any of its ship projects.

Primary Holding

The court decided that Trinity Industries could claim the R&D tax credit for two of its ship projects (the Mark V and the Dirty Oil Barge) because more than 80% of the costs for these ships were truly spent on experimental research and innovation. However, the court denied Trinity’s claims for the other ship projects, explaining that Trinity did not provide enough proof that the majority of the work on those projects was experimental or met the requirements for qualified research. The court clarified that custom-built ships can count as “business components” under the tax law, but to qualify for the credit, a company must show that most of the project’s expenses are for genuine experimentation. Because Trinity’s evidence was not detailed enough for the unsuccessful projects, and the company could not isolate smaller qualifying parts within those ships, the court only allowed the credit where clear and convincing proof was provided. 

Specific Rulings

1. Mark V Project

   • Ruling: The court allowed Trinity to claim the R&D tax credit for the Mark V prototypes.
   • Reasoning: The court found that over 80% of the costs were spent on experimental work. The Mark V was a highly innovative special operations craft with many technical challenges, so most of the project truly involved research and development.
     
     

2. Dirty Oil Barge

   • Ruling: The court approved the R&D tax credit for the Dirty Oil Barge project.
   • Reasoning: Due to new regulations after the Exxon Valdez spill, Trinity had to design an all-new double-hulled barge, which required significant new engineering and experimentation. The court found that more than 80% of the work was experimental.
     
     

3. XFPB (Extra-Fast Patrol Boat)

   • Ruling: The court denied the credit for this project.
   • Reasoning: While there was real experimentation in making the boat faster and more durable, the court was not convinced that at least 80% of the costs were for qualified research. Trinity didn’t provide enough proof to meet this threshold.
     

4. T-AGS 60 Oceanographic Survey Ship

   • Ruling: The court denied the R&D tax credit for this ship.
   • Reasoning: Although the project involved some experimental work, much of the ship was built using standard approaches. The court decided that less than 80% of the project was experimental, so it didn’t qualify.
     
     

5. Crew Rescue Boat

   • Ruling: The court denied the credit for the Crew Rescue Boat.
   • Reasoning: The project combined many known capabilities into one vessel. While there were some research activities, most of the work was routine integration, not experimentation, and didn’t meet the 80% test.
     
     

6. Hurley Dredge

   • Ruling: The court denied the R&D tax credit for the Hurley Dredge.
   • Reasoning: Most of this project was based on improving an existing design for a specific customer, with only minor modifications. The court found that not enough of the work was experimental, and that some activities were excluded from the credit because they were just adapting an old design.

7. Evidence and Documentation

   • Ruling: The court required reliable records and proof for any R&D credit claim.
   • Reasoning: Trinity lost access to many records due to time, a business spin-off, and even a hurricane, but the court stressed that it’s the taxpayer’s responsibility to keep detailed records. If the company couldn’t prove how much of the work was qualified research, the court could not allow the credit.
     
     

8. Claiming Credits for Smaller Project Parts (“Shrinking Back” Rule)

   • Ruling: The court did not allow Trinity to claim credits for smaller parts of projects that didn’t qualify as a whole.
   • Reasoning: Trinity didn’t present enough detailed evidence about sub-components or specific research areas within the ships. The court couldn’t apply the “shrinking back” rule because there wasn’t enough data to break out qualifying pieces.
     
     

9. Inclusion of Non-Experimental Costs in Successful Projects

   • Ruling: The court allowed Trinity to include all necessary project costs in the QRE calculation for the Mark V and Dirty Oil Barge (with certain adjustments for subcontracting expenses).
   • Reasoning: The court reasoned that if the 80% experimental threshold is met for a project, even non-experimental costs like painting can be counted, because the whole project shares the risk of experimentation. However, subcontracting costs had to be calculated according to IRS rules.

Helpful Takeaways for Taxpayers 

• Keep Detailed Records for R&D Projects. 

  The outcome of this case shows how important it is to have solid documentation for any research activities you claim. Detailed time sheets, technical notes, project reports, and cost breakdowns make it much easier to prove to the IRS (or a court) that your expenses are truly related to qualified research. If records are missing or vague, you may lose out on valuable credits even if the work was genuinely innovative.

• Understand the “80% rule.”

  For your project costs to count toward the R&D tax credit, you need to show that at least 80% of the activities were experimental. This means they involved solving technical challenges, trying out new ideas, or significant testing. Routine engineering, minor tweaks, or standard production don’t count. Before filing, review your project to be sure that the majority of the effort was dedicated to real research and experimentation.

• Custom work can still qualify.

  Don’t overlook custom projects just because they’re made for a specific client or purpose. The court confirmed that custom-built products, like ships designed for particular customers, can still qualify for the R&D credit as “business components.” The key is whether the project involved significant uncertainty and problem-solving, not whether it was “off the shelf.”

• Be prepared to break out qualified costs if needed.

  Sometimes, a whole project might not meet the experimental requirements, but specific innovative parts like a new engine or control system might. If you keep detailed cost records for different project components, you may still be able to claim the credit for these smaller sections. This approach requires careful tracking, but it could save part of your credit if the whole project doesn’t qualify.

• Stay proactive about substantiation, even in tough situations.

  Unexpected events like computer changes, business restructuring, or even natural disasters can threaten your records. However, the IRS still expects you to provide clear proof of your R&D activities. Set up backup systems for your records and regularly review your documentation practices to make sure you’re always ready to substantiate your claims, no matter what happens.