Tax

The Elusive Definition of Research

In trying to establish the deductibility of research activities, a lower court is ordered to take a second look at a pivotal 2009 case.
Robert WillensDecember 28, 2010

Through the years, we have found that one of the most-elusive concepts contained in the Internal Revenue Code is the notion of “research.” Nevertheless, the importance of ensuring that a given activity constitutes research cannot be seriously doubted. After all, a corporate taxpayer may treat research or experimental expenditures that are paid or incurred during the taxable year in connection with (as opposed to in carrying on) the trade or business as expenses. That’s important because expenses are not chargeable to capital accounts, and therefore are deductible. Moreover, the tax code also permits taxpayers to earn a tax credit with respect to a portion of the their qualified research expenses.

The difficulty that arises with respect to the identification of research is graphically illustrated in a 2009 case involving the famed chemical engineer Arthur R. McFerrin (see United States v. McFerrin, _F.3d_ (5th Cir. 2009)). McFerrin owned all of the stock of several S corporations, each of which reported a tax credit for “increasing research activities” that was passed through to McFerrin for use on his personal income-tax return. However, the district court found that these credits were not earned by the S corporations because their activities did not rise to the level of qualified research.

Qualified Research
The court held that activity qualified as research only 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 applied only if a “process of experimentation” involving the forming and testing of hypotheses had occurred rather than trial-and-error testing.

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The tax code, specifically Section 41, allows a 20% research credit on qualified research expenses over a base amount. To constitute qualified research expenses, the following criteria must be met: (1) the expenses must be of the type deductible under Section 174 of the Internal Revenue Code, (2) the research must be undertaken for the purpose of discovering information that is technological in nature, (3) the application of that information must be intended to be useful in the development of a new or improved business component of the taxpayer, and (4) substantially all the research activities must constitute elements of a process of experimentation.

In the McFerrin case, the district court relied on cases from other circuit courts of appeal and the tax court to determine that discovering information meant going beyond the current state of knowledge in the field. The same is true, the Fifth Circuit noted, of the district court’s conclusion that a process of experimentation requires forming and testing hypotheses. (See Eustace v. Commissioner, 312 F.3d 905 (7th Cir. 2002). See also Tax & Accounting Software Corp. v. United States, 301 F.3d 1254 (10th Cir. 2002).)

However, regulations in this area were finally published in 2003. According to those regulations, research is undertaken for the purpose of discovering information if it is intended to eliminate uncertainty concerning the development or improvement of a business component. Moreover, under these regulations, a process of experimentation involves the identification of uncertainty concerning the development or improvement of a business component; the identification of one or more alternatives intended to eliminate that uncertainty; and the identification and conduct of a process of evaluating the alternatives through, for example, a systematic trial-and-error methodology. The regulations, therefore, had vastly different definitions for “discovering information” and “process of experimentation” than the definitions adopted by the district court.

Regulations Control
Which of these conflicting definitions controlled? The 2003 regulations are effective only for taxable years ending on or after December 31, 2003. In the McFerrin case, the tax year in question was 1999. However, the government conceded that McFerrin could rely, for purposes of the litigation, on the definitions from the 2003 regulations. Accordingly, the Fifth Circuit had no choice but to conclude that the district court had erred in its refusal to review the evidence under the definitions from the 2003 regulations.

The Internal Revenue Service next argued that even if qualified research occurred, McFerrin failed to provide “adequate documentation” to substantiate the credits associated with that research. This contention was unpersuasive. The court noted that the argument goes squarely against the longstanding rule of Cohan v. Commissioner, 39 F.2d 540 (2nd Cir. 1930): that if a qualified expense occurred, the court should estimate the allowable tax credit.

Finally, the IRS contended that McFerrin’s bonus, amounting to $6.4 million, was not attributable to the research work done by the engineer, and therefore was not a qualified research expense. The court disagreed, or more accurately, reserved judgment.

The court noted that under Section 41(b) of the tax code, qualified research expenses include any wages paid or incurred to an employee for “qualified services” performed by such employee. The term wages includes all remuneration for services, including bonuses. Therefore, if a portion of the bonus was part of McFerrin’s wages for qualified services, and reasonable “under the circumstances,” it would properly be part of the S corporation’s qualified research expenses.

For all of these reasons, the Fifth Circuit was constrained to vacate the lower court’s decision and remand the case to the same lower court for a fresh look at the difficult issues this case entails. It seems almost certain, given the tenor of the circuit court’s commentary, that the district court, on remand, will return a decision completely, or at least largely, in favor of McFerrin.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.