March 21, 2012

Shami v. Commissioner: Wages for Research Were Not Reasonable

Houston Tax Attorney Blog

Houston Tax Attorney

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In Shami v. Commissioner, T.C. Memo. 2012-78, the U.S. Tax Court concluded that wages paid to a business owner were not reasonable for purposes of the research tax credit.

Shami was an owner of Farouk Systems, Inc. (“Farouk”). Farouk manufactured and sold internationally hair, skin and nail products. Farouk hired a research tax credit study provider to compute its research tax credits for 2003, 2004, and 2005. Farouk was a Subchapter S corporation, so the tax credits flowed through to Shami’s personal income tax returns.

The research tax credit included wages paid to Shami and others in each of these years. The wages paid to Shami were $8,735,727, $7,988,310 and $9,529,639 for 2003, 2004 and 2005, respectively.

The IRS evaluated the research tax credits and determined that the wages paid to Shami and others were not reasonable. The court limited its review to the wages paid to Shami and another employee.

Shami argued that the court must apply the Cohan rule to estimate the amount of wages allowable to qualified services if the court finds that Shami performed qualified services. The Cohan rule allows the court to estimate the amount of an expense if it can first determine that the taxpayer in fact incurred a deductible expense. The court opted not to apply the Cohan rule as it concluded that, based on the evidence presented, there was no reasonable basis upon which it could make an estimate. Accordingly, the court concluded that the wages were not reasonable for purposes of the research tax credit.

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