When I think of a term like “shrinking back,” I think of backing down from an issue or perhaps retreating from a position taken.

In the world of R&D tax credits, this term can mean the difference between a project qualifying for some research credits and getting denied completely.

In order for a project to qualify for research and development tax credits, 80% of the costs or another measurement must relate to the Process of Experimentation. In some cases, the IRS will deny a project at the highest level as non-qualified but may allow subsystems of a project to qualify if they feel the activities of the subsystem meet the 4-part test.

Shrinking Back to Qualify

The concept of shrinking back to a subsection of a development project when the larger business component does not meet the 4-part test is called “shrinking back.” For a review of the 4-part test, see our blog titled: Navigating the R&D Tax Credit (part 2).

Let’s use a control system for a robotic arm used in a manufacturing operation as an example. Let’s further assume the development time and effort was devoted to reducing the size of the arm and increasing the dexterity of operation for the customer when using the new product. Upon review of the development process, it was determined that some of the systems used in the new product were pulled from other products already in commercial production and their use was not uncertain. When the overall project costs were analyzed, it was found that the costs incurred at the project level did not meet the 80% threshold and, as a result, the project would not qualify for R&D tax credits. However, when taking out or “shrinking back” to the design, prototype and testing costs without the integration of the other systems (that had no uncertainty) is analyzed, the project meets the 80% threshold.

Trinity Marine Group: All or Nothing

In 2009, Trinity Marine Group took a stand that all six of their custom ships built during the period under IRS audit should qualify at the business component level and provided no detail costs that could be used to “shrink back” in the event a particular ship did not qualify.

When the court completed their review of each project, they were forced to determine whether each individual ship met the 4-part test at the “ship” level and could not look at subsets of each project because no cost or another documentation was provided or available (it is noted in the court documents that Trinity Industries no longer owned TMG and that many of the records were destroyed during Hurricane Katrina).

Ultimately, the Court found that 2 of the six ships were sufficiently novel and felt that 80% or more of the costs related to the Process of Experimentation. Had the records been available, it is reasonable to assume that some portion of each ship would most likely have qualified for R&D tax credits.

What’s the Message to Small Businesses?

Having strong documentation and understanding the “shrinking back” concept is important when taking the R&D credit. Just because an initial pass on a project may not meet the 80% test, it is worth evaluating subsets of the project for qualification of the R&D tax credit. To complete that type of analysis, your documentation must be strong enough and detailed enough.

Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Acena Consulting focuses on helping companies successfully document and secure tax incentives throughout the US. Randy has been a nationally recognized speaker as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.