Architecture & Engineering A&E

Case Facts

Little Sandy Coal Company (taxpayer) is a subsidiary of Corn Island Shipyard, Inc. (CIS) that constructed 11 vessels for the tax year ending June 30, 2014. CIS is a corporation that designs, constructs, and launches seafaring crafts such as tankers and dry docks. The taxpayer agreed to treat two of the projects as representative of the 11 projects regarding most of the relevant activities for the courts.


The primary issue is the Internal Revenue Code (IRC) Section 41(d)(1)(C) requirement that at least 80 percent of a taxpayer’s research must constitute elements of a process of experimentation.

The taxpayer argued that substantially all the activities of research in developing the vessels constituted elements of a process of experimentation because more than 80 percent of the elements of each vessel differed from those of vessels previously developed. The taxpayer also argued the work of all the production employees constructing the novel elements of the redesigned vessel directly supported research and therefore constitutes elements of a process of experimentation. On the premise that the production employees’ work on novel elements made up at least 87 percent of the work on the vessel, the substantially all test was met.


The IRS held the following:

  1. That at least 80 percent of a taxpayer’s research must constitute elements of a process of experimentation applies to activities, not to physical components of the product being developed or improved. 
  2. One who provides services in direct supervision or support of research is not “engaged in” the process of experimentation.
  3. Based on ruling No. 1, supplies are not activities, and the costs should not be included in the substantially all calculation.
  4. None of the expenses incurred are qualified research expenses because the taxpayer has not met the burden of proof that substantially all its research activities in developing the vessels at issue constitute elements of a process of experimentation.

The two projects evaluated included a dry dock (Project 730) and Apex tanker (Project 720). 

Before the dry dock, CIS had not fully developed and designed a dry dock. CIS also used engineering calculations and modeling to design the dry dock. CIS developed several iterations of design drawings and performed calculations to test the iterations of the dry dock’s design throughout the development process. Before tendering the dry dock at the customer site, CIS conducted a partial raise-and-lower test.

The Apex tanker involved the design of a tank barge that CIS built under contract with Apex Oil, Inc. (Apex). The design of the Apex tanker was based on the design of the Penn 80, a tanker that CIS had previously built for another customer. Several elemental designs differed from those of the Penn 80 and therefore involved an iterative process in which proposed designs were tested through software modeling and engineering calculations. In analysis of time records of CIS production employees, an engineering technician determined that 87 percent of the time of those employees was spent on elements different from Penn 80. Engineering and management personnel were not factored into the calculation by the engineering technician. After construction of the Apex tanker, CIS performed a deadweight survey that is important to indicate how much cargo the vessel can carry.

The court declined to follow the court’s analysis in the Trinity Industries case due to a lack of explanation in how the court made the calculation to determine the substantially all rule was met. 

The court acknowledges that CIS efforts to design the tank and dry dock involved activities that establish a process of experimentation. In addition, a scale-back approach to account for elements of the vessel would be reasonable for design uncertainties. However, the court finds that CIS has not demonstrated that substantially all their research activities in developing either the Apex tanker or dry dock establish elements of a process of experimentation. 

The court focuses on the substantially all test being applied in reference to activities versus physical aspects of the business components. Production work can be for qualified activity, but just because the activities are in direct support doesn’t mean they are considered an element of a process of experimentation. CIS did not establish production workers were involved in a process of experimentation.

The deadweight survey was determined to not be considered testing that would require scrapping or substantial redesign of the vessel. No other testing, i.e., post-fabrication testing, was established by CIS. Novelty may create uncertainty, but resolution of that uncertainty need not require experimentation. The courts referenced the wheat hybrids project in the Siemer Milling Co. case to elaborate on the fact that uncertainties do not establish that a company engaged in a process of experimentation. It also was found that CIS’ intent for building the vessel was not to evaluate and resolve uncertainty during development or improvement of the product and test the appropriate design.


Taxpayers should evaluate the intent of why a project was built and who is involved in the process of experimentation. It is important to document employees’ roles in the process of experimentation and the nexus between activities. 

For purposes of IRC §41(d), a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial-and-error methodology). A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative. A taxpayer may undertake a process of experimentation if there is no uncertainty concerning the taxpayer’s capability or method of achieving the desired result so long as the appropriate design of the desired result is uncertain as of the beginning of the taxpayer’s research activities. Uncertainty concerning the development or improvement of the business component, e.g., its appropriate design, does not establish that all activities undertaken to achieve that new or improved business component constitute a process of experimentation.

Various forms of documentation can be helpful to support elements of the process of experimentation. Documentation created during early stages of a project like concept development documents, project plans, and design reviews can speak to elements of uncertainty. Project plans also are helpful for describing the technological nature of a project. Test plans and protocols as well as concept development documents can be useful in demonstrating the conduct of identifying and evaluating alternatives. 

For more information, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.

Related FORsights

We want to work with you

Contact Us

Get more information about our services, submit a request for proposal, or get in touch with us today!

Let's Connect