The U.S. Court of Appeals for the Fifth Circuit vacated a district court decision that had disallowed a taxpayer’s research tax credit. The Fifth Circuit held the lower court had not used the proper definitions of “discovering information” and “process of experimentation” when deciding whether the taxpayer had qualified research expenses. Since the use of the correct definitions may have resulted in some allowable research tax credit subject to estimation by the court under the Cohan rule, the court remanded the case to the district court for further review.
As part of the general business tax credit, IRC § 41 permits a tax credit for taxpayers who increase their expenditures for research and experimentation. The regular research credit is 20% of the excess of qualified research expenses over a base amount. Under IRC § 41(d)(1), qualified research is defined as undertaken to discover technological information that when applied is intended to be useful in developing a new or improved business component. Substantially all its activities must be parts of a process of experimentation relating to a new or improved function, performance, reliability or quality. Treas. Reg. § 1.41-4(a)(3)(i) defines a purpose of information discovery in this context as “intended to eliminate uncertainty,” while a process of experimentation is one “designed to evaluate one or more alternatives.”
Arthur McFerrin, a chemical engineer, owned KMCO Inc., an S corporation that manufactured chemicals and owned three other related S corporations. When filing tax returns for 1999, none of the corporations claimed a research credit; however, after engaging tax services firm alliantgroup LP, all the S corporations and McFerrin in 2003 filed amended tax returns for 1999. The corporations claimed research credits totaling $472,092, which passed through to McFerrin on his and his wife’s amended1999 return, resulting in a refund that with interest totaled $601,228.
The IRS brought an action to recover this amount in the District Court for the Southern District of Texas, which in 2007 agreed that the taxpayers had not provided enough evidence to substantiate the research credit. The district court examined the taxpayers’ research activities in light of the definitions developed in numerous previous court cases of “discovering information” (going beyond the current state of knowledge in the field) and “process of experimentation” (requiring forming and testing of a hypothesis). The earlier decisions, however, were rendered before Treas. Reg. § 1.41-4, with its definitions of the phrases, was issued.
McFerrin appealed to the Fifth Circuit, which held that the lower court had improperly examined the taxpayers’ research activities because it failed to apply the guidance of the regulations concerning the meaning of “discovery of information” and “process of experimentation.”
The final regulations, issued in 2003, were effective for tax years ending on or after Dec. 31, 2003; however, those regulations and proposed regulations issued in 2001 stated that taxpayers could rely on them for earlier tax years. According to the court, the taxpayer could use the definitions of the regulations, and some of the expenditures might be qualified research expenditures if examined under their light rather than the definitions of prior court decisions.
The appellate court also rejected the government’s argument that the credit should be disallowed in any event since the taxpayers had not sufficiently documented the amount of their research costs. The court held that if McFerrin could demonstrate that the S corporations had incurred qualified research, then the district court should estimate an amount under the Cohan rule.
U.S. v. Arthur R. and Dorothy F. McFerrin , docket no. 08-20377 (5th Cir.)
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.