Recent taxpayer experiences suggest that IRS agents are becoming more aggressive in denying taxpayer claims of research and development tax credits through narrow construction of the so-called “substantially all” test of Code § 41(d)(1)(C) which requires that the research activities constitute “elements of a process of experimentation.”

Under Treas. Reg. §1.41-4(a)(5), a process of experimentation must be a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result is uncertain at the beginning of the taxpayer’s research activities. Thus, the IRS  requires a process that fundamentally relies on the principles of physical or biological science, engineering or computer science for the following:

  • Identification of uncertainty concerning the development or improvement of a business product or component;
  • Identification of one or more alternatives intended to eliminate that uncertainty; and
  • Identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).

However, in the IRS’ view, a taxpayer may perform research activities, and the research activities may, in fact, develop or improve the function, performance, reliability, or quality of a product. However, such activities may still NOT count toward the “substantially all” test because a taxpayer failed to establish its activities also constitutes “elements of a process of experimentation” within the narrow meaning of the applicable Treasury regulations.

The question of whether a taxpayer’s activities meet the narrower “elements of a process of experimentation” test is inherently “factual,” and taxpayers and the IRS frequently disagree on which activities constitute elements of a process of experimentation.   Moreover, the IRS appears to be raising this issue more frequently and to have been emboldened by its recent win in Little Sandy Coal Co., Inc. 2021 T.C. Memo 2021-15, putting taxpayers on notice that additional care, planning, and record-keeping are likely to be required to establish entitlement to credit for their research activities.

For more information, don’t hesitate to get in touch with William E. Elwood in our Washington D.C. office at 202-659-6972, or any other attorney in our Tax Practice Group.

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About the Author:

Will Elwood is a Member with Dickinson Wright’s Tax Group. He can be reached at 202-659-6972 or, and his biography can be accessed here.