Standard for Research Activities for the R&D Tax Credit

In United States v. McFerrin, 570 F.3d 672, the Fifth Circuit Court of Appeals concluded that the trial court applied the wrong standard for determining what research is qualified and failed to estimate the amount of research expenses for the research tax credit.

Facts & Procedural History

Arthur R. McFerrin (“McFerrin”) is a prominent chemical engineer who co-founded KMCO, Inc. (“KMCO”), a Subchapter-S corporation, in 1975.

KMCO manufactures commodity and specialty chemicals, mainly for the petrochemical industry.  McFerrin owns three other Subchapter-S corporations which are related to KMCO: KMCO Port Arthur, Inc. d/b/a KMTEX (“KMTEX”), South Coast Acquisition, Inc. (“SC Acquisition”), and South Coast Delaware, Inc. (“SC Delaware”).  SC Acquisition and SC Delaware are the only partners in another corporation, South Coast Terminals (“SC Terminals”).

These corporations filed research tax credit claims totaling $472,092 for tax year 1999.  The research tax credits passed-through to McFerrin’s 1999 income tax return as McFerrin owned all of the corporations.

The IRS paid the refunds without auditing the refund claims.  The government brought suit against McFerrin seeking to recover a research tax credit that the government alleges was erroneously paid to McFerrin.

The Trial Court

The trial court had ruled in favor of the government, concluding that the research tax credit was not properly supported and, consequently, should not have been granted. The trial court ordered repayment of the erroneously paid refund plus interest.

The trial court based its decision on a belief that research was only qualified research if it expanded or refined the existing principles in the field, had a high threshold of innovation, and had broad effect.

In addition, the trial court held that qualified research only applied if a process of experimentation involving the forming and testing of hypotheses had occurred, rather than “trial and error” testing. Using these definitions, the court determined that while some of the projects “may have involved some research,” it was “unpersuaded that those few projects involved `qualified research’ for purposes of the research tax credit.”

The trial court also determined that there were no records of the hours worked on any given project or of the hours worked or supplies used that involved research. The court was unwilling to credit the rough estimates given by employees years after the fact.

The Standard for Qualified Research

The appeals court concluded that the trial court applied the wrong legal standard in determining whether research is qualified. The trial court applied the prior standard, which was set out in regulations that had since been amended as they set a standard that was higher than the standard that Congress had intended.

The appeals court noted that the amended regulations were not effective until 2003, but that they should be followed in lieu of the prior regulations, as the prior regulations did not comport with Congress’ intent. Thus, the 2003 regulations reflected the correct standard.

Substantiation for R&D Credits

The appeals court also disagreed with the trial court’s failure to apply the Cohan doctrine to estimate the amount of the expenses.

The government next argues that even if qualified research occurred, McFerrin failed to provide adequate documentation to substantiate the costs associated with that research. But this goes against the longstanding rule of Cohan v. Commissioner that if a qualified expense occurred, the court should estimate the allowable tax credit. 39 F.2d at 544. If McFerrin can show activities that were “qualified research,” then the court should estimate the expenses associated with those activities. The district court need not credit McFerrin’s reconstruction of expenses from years after the fact. See Eustace v. Comm’r, 81 T.C.M. (CCH) 1370, *5 (2001). But the court should look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate. See Fudim, 67 T.C.M. (CCH) 3011, *12-*13.

Thus, the appeals court concluded that the trial court erred by not estimating the amount of the expenses given that the trial court had already concluded that some expenses were allowable.

The Takeaway

This is a much needed decision, as the IRS exam function has been relying on the trial court case to disallow qualified R&D tax credits without giving due consideration to the credits.  Research activities are to be evaluated without the old-discovery test and estimates are allowed in some cases.