United States v. Arthur R. McFerrin and Dorothy F. McFerrin

June 9, 2009 | Edith Brown Clement, Circuit Judge | Fifth Circuit Court of Appeals | Docket No. 08-20377

 

Short Summary

United States v. McFerrin involved Arthur R. McFerrin, a chemical engineer and business owner, and his wife, Dorothy, who claimed a large federal tax credit for research activities through their companies. The dispute centered on whether these claimed research expenses met the legal requirements for the federal research tax credit and whether they were properly documented. The government sued to recover the tax refund, arguing that the credits were not substantiated. Ultimately, the appeals court sent the case back to the lower court, finding that the wrong legal standards were used, so the decision would need to be reconsidered. 

Key Issues

• Did McFerrin’s companies perform “qualified research” under the law? 

  The court had to decide whether the projects and activities carried out by McFerrin’s companies truly met the IRS’s requirements for “qualified research.” This meant examining whether the work was technological in nature, aimed at developing or improving products or processes, and involved a real process of experimentation to solve technical uncertainties. 

• Were the research expenses sufficiently documented and substantiated? 

  Another central question was whether McFerrin and his companies kept and provided enough records to prove the amount of research expenses they claimed. The IRS and courts generally expect clear records like timesheets or supply invoices to support these credits. The court had to weigh whether the available evidence, including employee testimony given years later, was enough to back up the claimed expenses. 

• Did the district court use the correct legal definitions for “qualified research” and “process of experimentation”? 

  The appeals court needed to review whether the lower court relied on the right legal standards when deciding what counted as “qualified research” and a “process of experimentation.” Specifically, it had to decide if the definitions from the latest IRS regulations should have been used, since these clarified that research did not have to be groundbreaking, just aimed at solving technical uncertainty for the business. 

• Should the court estimate eligible research expenses if perfect records are lacking? 

  The case also raised the issue of whether the court should try to estimate reasonable research expenses when some records are missing, as long as there is evidence that at least some qualified research occurred. This question reflects a long-standing rule that, if the exact amount can’t be determined but legitimate expenses clearly happened, the court should make a reasonable estimate rather than deny the claim entirely. 

Primary Holding

The appeals court decided that the lower court made a mistake by using outdated and overly strict definitions for what counts as “qualified research” and a “process of experimentation” under the research tax credit rules. Instead, the court should have used the definitions from the most recent IRS regulations, which focus on whether the research was meant to solve technical uncertainties for the business, not just whether it was groundbreaking for the industry. 

Because the lower court applied the wrong legal standards, the appeals court had set aside its decision and sent the case back for another look. The appeals court also emphasized that if some research did qualify, the court should try to make a reasonable estimate of the related expenses, even if perfect records weren’t available. The court did not decide whether McFerrin’s research is qualified or not, leaving that for the lower court to reconsider using the proper legal standards. 

Specific Rulings 

1. Whether the Government Needed to Plead Lack of Substantiation with Particularity 

   • Ruling: The court ruled that the government did not have to meet the strict pleading requirements usually used for fraud cases when alleging that McFerrin’s tax credits were not properly documented.
   • Reasoning: The government’s claim was simply that McFerrin didn’t provide enough records to support his research tax credit but not that he committed fraud or made intentional misrepresentations. For this reason, the court explained that the more relaxed, general standard for stating a legal claim was enough. The government’s complaint clearly stated the issue is lack of documentation, so the case was allowed to proceed to trial.
     
     

2. Correct Legal Standard for “Qualified Research” and “Process of Experimentation” 

   • Ruling: The appeals court found that the district court had applied the wrong, older definitions for what counts as “qualified research” and a “process of experimentation,” making its decision unreliable.
   • Reasoning: The district court used definitions that required research to be groundbreaking in the field and to follow a strict scientific process. However, newer IRS regulations, which McFerrin relied on, clarified that research just needs to aim at overcoming technical uncertainty for the business, not the entire industry, and can involve systematic trial and error or similar approaches. The government agreed McFerrin could use these updated definitions, so the appeals court said the lower court must reconsider the evidence under these standards.
     
     

3. Estimating Qualified Research Expenses When Records Are Incomplete 

   • Ruling: The court held that if there is enough evidence to show that some qualified research did occur, the court should try to estimate the related expenses and grant a reasonable tax credit even if perfect records are not available.
   • Reasoning: Tax law has long recognized that when some qualified expenses clearly happened, but the exact amount is uncertain, the court should make a reasonable estimate based on testimony and any available evidence. Denying the credit entirely just because the records aren’t perfect is not fair if there’s credible proof that some qualifying research took place. This approach is supported by earlier tax cases, like Cohan v. Commissioner.
     
     

4. Treatment of McFerrin’s Bonus as a Qualified Research Expense 

   • Ruling: The appeals court did not make a final decision about whether McFerrin’s $6.4 million bonus could be counted as a research expense. Instead, it sent this issue back to the lower court for further examination.
   • Reasoning: The district court had only said that the bonus was based on the company’s profits and cash flow, not on research performed during the year. However, the appeals court pointed out that if any part of the bonus was for research work and was reasonable, it might count as a qualified research expense. This needed a more careful, fact-based review by the lower court, using the correct legal standards.

Helpful Takeaways for Taxpayers 

• Stay Up to Date on IRS Definitions and Guidance. 

  Tax laws and IRS regulations about what counts as qualified research can evolve. This case shows how important it is for businesses to follow the latest IRS rules, not just older case law or outdated interpretations. Regularly check for updates, and if you work with a tax advisor, make sure they’re using the most current standards when calculating and claiming research credits. 
  

• Keep Thorough and Organized Records. 

  Detailed and accurate documentation is your best defense when claiming research tax credits. The court highlighted the need for timesheets, project notes, and clear tracking of supply usage. Even years later, well-kept records make it much easier to prove your claim to the IRS or a court. Invest in good recordkeeping systems and train your team on the importance of saving this information. 

• Know That Estimation Is Possible When Some Records Are Missing

  Don’t give up on your credit if you’re missing perfect records. The law allows for reasonable estimates if you can provide some credible evidence such as testimony from employees or summary reports to show that qualified research took place. However, the more detail you can provide, the stronger your case will be, so aim for both thorough documentation and backup evidence where possible. 

• Understand What Counts as “Qualified Research.” 

  This case made it clear that research activities do not need to be revolutionary for your entire industry. Instead, the focus is on whether your work solved a technical uncertainty for your own business, such as figuring out how to make or improve a product or process. Activities like systematic trial and error or solving engineering challenges can count, as long as they follow the IRS’s definition of a process of experimentation. 

• Review Compensation Policies for Research-Related Work. 

  If your company pays bonuses or other compensation for research work, document how these payments relate to specific research activities. Payments that are clearly tied to qualified research and are reasonable in amount are more likely to be accepted as eligible expenses. Clarifying this connection in your records can help ensure these costs count toward your research credit.