A new appeals court ruling could make it easier for companies to claim research and development tax credits from the IRS by allowing them to rely on oral testimony instead of a project expense-tracking system.

Dean Zerbe

The ruling by the Fifth Circuit Court of Appeals came in the case of U.S. v. McFerrin. Arthur McFerrin, a prominent chemical engineer, founded an S corporation called KMCO that manufactures chemicals mainly for the petroleum industry. The case involves the 1999 tax returns filed by McFerrin and three related companies he also owns.

He did not claim R&D credits for the companies in 2000 when he filed the 1999 returns, but in 2003, KMCO contracted with the tax services firm alliantgroup to conduct a study to see if the company was eligible for an increasing research tax credit. Based upon the study, McFerrin and his corporations filed amended tax returns in 2003 claiming an overall credit of $472,092 for 1999. Less than a month later, the IRS issued the refund. Including interest, it totaled $601,228.40.

Two years later, however, the federal government filed suit to recover the money, claiming the return did not include supporting documents and did not substantiate the credits. The Texas Southern District Court agreed, ruling that the amended returns were untimely filed and the tax credits were not properly supported. The court 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 judges were unwilling to credit the rough estimates that were given by employees years after the fact.

The district court also held that research was only qualified if it expanded or refined the existing principles in the field, had a high threshold of innovation, and had broad effect. In addition, the 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.” In light of the district court ruling, McFerrin had to return the refund.

Remanded to the Lower Court

However, in the appeals court ruling handed down on Tuesday, the judges found that the district court had used incorrect definitions for “discovering information” and “process of experimentation.”

They found that the district court erred by inappropriately applying an outdated “discovery test” to determine the threshold of innovation. The appellate court also found that the district court had applied the wrong legal standard and failed to consider all the relevant evidence to determine eligibility for the R&D credit.

Finally, the appellate court made it clear that the “Cohan Doctrine,” which allows taxpayers to use estimates when they can show that there is some factual foundation on which to base a reasonable approximation of an expense, is applicable to the R&D credit. They also determined that the testimony and institutional knowledge of employees is applicable and acceptable in order to determine a fair estimate.

Because there was the possibility that applying the correct definitions would result in at least some of the tax credit being legitimately issued to McFerrin, the appeals court vacated the judgment of the district court, and remanded the case for further proceedings. The ruling cited the district court’s inappropriate application of an outdated “discovery test” and the wrong legal standard for companies that are eligible for R&D tax credits.

The tax services firm that advised McFerrin and KMCO hailed the ruling. “It is especially important that the court made it loud and clear to the IRS that the taxpayer has a right to rely on oral testimony and other evidence to support a claim for the R&D credit,” said alliantgroup national managing director Dean Zerbe, a former tax counsel to the Senate Finance Committee. “Equally important is that the decision directed that courts, where appropriate, should look to making estimates when determining the amount of the credit.”

Ron Antal, managing director of Research Credit Group, an R&D tax credit advisory firm that sells software for tracking the credits, also felt encouraged by the ruling.

“It is especially important that companies can now rely on oral testimony when documenting qualified R&D expenses,” he said. “This should make companies more eager to file for R&D tax credits, even if their attempts have been denied in the past. Companies should go after the money owed to them, and the court’s new findings should make it easier and appealing for them to submit their studies.”