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March 21, 2012

Wages for Research Were Not Reasonable

Federal Income Tax

Houston Tax Attorney

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The research tax credit provides a significant incentive to perform research.  The credit is calculated by factoring in wages paid by the business and income from the business subject to self-employment.  Given this, can a business owner pay himself an unreasonably large salary and thereby increase the amount of the credit?  The court recently addressed this (again) in Shami v. Commissioner, T.C. Memo. 2012-78.

Facts & Procedural History

Shami owned Farouk Systems, Inc. (“Farouk”). Farouk manufactures and sells 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 audited the research tax credits and determined that the wages paid to Shami and others were not reasonable.  As a result, the IRS reduced the taxpayers research tax credits.

The Research Tax Credit

The research tax credit incorporates a reasonableness requirement by referencing Sec. 174(e).  This subsection was added to the Code in response to Driggs v. United States, 706 F. Supp. 20 (N.D. Tex. 1989). 

The court in Driggs had concluded that there was no reasonableness requirement for the amounts that are used to compute the research tax deduction. 

 Section 174(e) provides that:

This section shall apply to a research or experimental expenditure only to the extent that the amount thereof is reasonable under the circumstances.

But what is reasonable?

Reasonable Compensation

The taxpayer was a key employee for the business.  It appears that he does not track his time at work, as timesheet-type records were not presented to the court.  

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.

This case does not stand for the proposition that $7 to $9 million is unreasonable compensation.  Rather, it stands for the proposition that taxpayers have to keep records establishing that they engaged in research activities.  This is particularly true for taxpayers who are higher paid owners of flow through entities, such as S corporations.  

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