In a recent legal development, the Seventh Circuit Court’s ruling on Little Sandy Coal Company, Inc. v. Commissioner (“LSC”) has created a climate of uncertainty around the federal income tax credit for increasing research activities under Sec. 41. 

The court found the company lacking in providing adequate substantiation for their research activities, thereby failing the “substantially all” and “process-of-experimentation” tests. While the IRS has used this ruling to broadly deny research credits during audits, it has not offered actionable guidance on what would be considered sufficient substantiation, leaving taxpayers in a precarious situation. The lack of clarity has not only complicated matters for claims under Sec. 41, but has also raised questions about its impact on Sec. 174, specifically regarding what level of documentation is required for capitalizing and amortizing research and experimental expenditures. 

The IRS is set to provide new regulations on research credit substantiation, but for now, taxpayers remain in a challenging landscape.

Source Advisors’ Lindsey Moldich Spoke with The Journal of Accountancy to detail key takeaways from this case: