A Step in the Right Direction


In a step forward, the fifth circuit has correctly interpreted the Section 41 R&E Credit Rules and applied them retroactively to void prior decisions and misinterpretations of the tax code.

Case Background:

McFerrin, co-founder of KMCO, Inc. a manufacturer of commodity and specialty chemicals, mainly to the petrochemical industry, filed an amended 1999 return in September 2003 an overall credit of $472,092. Due to a clerical error the IRS issued a refund of $601,228.40. On October 31, 2005, the United States filed suit to recover this amount plus interest. Its complaint alleged, among other things, that the amended return “included…no supporting documents” and thus there were no documents provided to substantiate the claimed credits. In a six day trial before the district court, the district court ruled in the government’s favor and ordered McFerrin to repay the refund with interest.

District Court Basis:

The district court held 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. The court also held that qualified research only applied if a process of experimentation involving the forming and testing of hypothesis had occurred, rather than “trial and error” testing. Additionally, the court was unwilling to credit the rough estimates given by employee’s years after the fact.

Fifth Circuit Findings:
The fifth circuit appropriately recognized that “qualified research” has four separate and independent requirements: (1) the expenses must be of the type deductible under I.R.C. §174; (2) the research must be undertaken “for the purpose of discovering information…which 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 of the research activities must “constitute elements of a process of experimentation.”

The fifth circuit identified that the 2003 Regulations, “discovering information…does not require the taxpayer be seeking to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in the particular field of science or engineering in which the taxpayer is performing the research.” Rather, “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.” Under the 2003 Regulations, qualified research must be intended to “eliminate uncertainty.” “Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component.”

The fifth circuit also recognized that the “Process of Experimentation” under the 2003 Regulations is also different, as it involves three steps: (1) “the identification of uncertainty concerning the development or improvement of a business component,” (2) “the identification of one or more alternatives intended to eliminate that uncertainty,” and (3) “the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).”

Additionally, the fifth circuit found that the if McFerrin can show activities that were “qualified research,” then the court should estimate the expenses associated with those activities. The court should look to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate.

Key Findings and Results:

key1This case provides additional support for taxpayer R&E claims and provides a significant footprint to guide taxpayers. Key findings and interpretations include:

  • Simple recognition that the 2003 Regulations are fundamentally different than prior regulations. This fact is often overlooked or ignored by IRS examination teams.

  • Clearly determining that an activity is research if it is “discovering information intended to eliminate uncertainty…” This is a critical issue. Often IRS examiners look to define if the activity being performed is “experimental” in of itself and lose sight of the intent of the regulations and the purpose for conducting the activity in question. If a taxpayer is performing activities to discover information that will resolve a method or capability uncertainty or to develop the appropriate design of a new or improved business component these activities qualify as research.

  • Clearly defining the intention of the 2003 Regulations as to the definition of “Process of Experimentation.” The fifth circuit clearly and accurately identifies the three components of the process of experimentation. It clearly defines that the process needs to identify and be a process of evaluating alternatives and provides clear examples of modeling, simulation, or a systematic trial and error methodology. This provides clear guidance to taxpayers, in that it establishes that trial and error processes are eligible for the research credit with the caveat that it need be a systematic trial and error methodology. Our interpretation is that if a taxpayer illustrates that the trial and error process is known, managed and intentional it should meet the “systematic” requirement.

  • Determines that if activities are shown to be research then the court should estimate the expenses associated with those activities. While not prescribing how the court or the IRS should estimate, the fifth circuit does clearly state that they should estimate and not estimating goes against the longstanding rule of Cohan v. Commissioner that if qualified expenses occurred, the court should estimate the allowable tax credit.

This ruling by the fifth circuit is a very promising case for taxpayers as it supports and defines the key tenets to determining whether activities qualify as research and appropriate protocol that should be followed by the IRS.

For more information on any of the areas discussed in this article, contact:
Greg Lormand at [email protected].

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