T.C. Memo. 2012-78
UNITED STATES TAX COURT
BASIM SHAMI AND RANIA ARDAH, ET AL.1, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 28666-08, 28667-08, Filed March 21, 2012.
28673-08, 28687-08,
28688-08, 28692-08,
5671-09, 13408-09.
Jeremy M. Fingeret, Michael A. Thompson, and Robert G. Wonish II, for
petitioners.
Sara W. Dalton, Joshua Smeltzer, and Derek Matta, for respondent.
1
This case is consolidated for purposes of trial, briefing and opinion with the
cases of Arthur J. Goertz and Jo McCall Goertz, Docket No. 28667-08; Farouk
Shami and Izziah Shami, Docket No. 28673-08; Shaukat Gulamani, Docket No.
28687-08; Rami Shami and Najat Badran, Docket Nos. 28688-08 and 5671-09; and
John McCall and Kathy McCall, Docket Nos. 28692-08 and 13408-09.
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MEMORANDUM FINDINGS OF FACT AND OPINION
KROUPA, Judge: Respondent determined deficiencies in these consolidated
cases as follows:
Dkt. No. Petitioners 2003 2004 2005
28666-08 Basim Shami $1,233.00 $2,939.00 -0-
and Rania Ardah
28667-08 Arthur J. and Jo 110,005.00 290,754.00 $58,672.00
McCall Goertz
28673-08 Farouk and 557,583.00 382,225.00 133,270.00
Izziah Shami
28687-08 Shaukat 10,722.00 7,495.00 -0-
Gulamani
28688-08 Rami Shami and -0- 7,494.00 -0-
Najat Badran
28692-08 John and Kathy 235,877.15 164,881.00 -0-
McCall
5671-09 Rami Shami and -0- -0- 2,613.00
Najat Badran
13408-09 John and Kathy -0- -0- 57,831.00
McCall
Total 915,420.15 855,788.00 252,386.00
After concessions,1 the sole issue for decision is whether certain wages
Farouk Systems, Inc. (FS) paid to petitioner Farouk Shami (Mr. Shami) for 2003,
1
The parties disagree as to whether the remaining FS employees, whose
wages FS used to claim the research credit for the relevant years, engaged in
qualified research within the meaning of sec. 41(b)(2)(B). The parties agreed,
however, at the Court’s direction to focus on the two highest FS wage earners.
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2004 and 2005 and petitioner John McCall (Mr. McCall) for 2003 and 2004 qualify
as research expenses for purposes of FS claiming the credit for increasing research
activities under section 41 (research credit).2 We hold that none of the wages
qualify.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of
facts, the supplemental stipulation of facts and the accompanying exhibits are
incorporated. Each petitioner resided in Texas when the petitions were filed.
Petitioners were shareholders of FS, an S corporation for Federal tax purposes.
FS developed, manufactured and sold internationally hair, skin and nail
products. FS had hundreds of employees and was organized into various
departments including manufacturing, marketing, sales, education and research and
development. Product development activities were spread across departments, but
activities involving scientific knowledge and experimentation were conducted by the
research and development department or were outsourced. The research
and development department staff ranged from 18 to 27 employees during the
relevant years. The staff included chemists, technicians and a vice president of
2
All section references are to the Internal Revenue Code in effect for the
relevant years, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated.
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research and development, who supervised the department. FS is most known for
developing the BioSilk, CHI hair coloring systems and flat irons, Color Vision,
SunGlitz and Deep Brilliance product lines.
Mr. Shami founded FS in 1986 after coming to the United States in the
1960’s from Palestine on an academic scholarship, eschewing his father’s desires
that he follow him into teaching, and began working part time as a hair stylist. Mr.
Shami was FS’s chief executive officer, president and secretary for 2003 and 2004.
He also served as the chairman of FS’s board of directors and as the sole member of
FS’s manufacturing and operations committee. Mr. Shami was paid wages of
$8,735,727, $7,988,310 and $9,529,639 for 2003, 2004 and 2005, respectively.
Mr. McCall was a principal for many years of Armstrong McCall, a
wholesale distributor that marketed and sold FS products. Mr. McCall became a
shareholder, officer and director of FS in the 1990s. Mr. McCall was FS’s
executive vice president and the sole member of its sales and marketing committee
for 2003 and 2004. Mr. McCall was paid wages of $5,722,699 and $1,839,581 for
2003 and 2004, respectively.
Neither Mr. Shami nor Mr. McCall have formal education or training in any
physical or biological science or engineering.
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FS contracted with alliantgroup, LP (alliantgroup) to conduct research and
development tax credit studies covering the relevant years.3 The studies concluded
that FS was eligible to claim the research credit based, in part, upon wages paid to
Mr. Shami and Mr. McCall. The results of the studies formed the basis for FS
claiming the research credit for the relevant years.
FS filed Form 1120S, U.S. Income Tax Return for an S Corporation, claiming
the research credit for each year at issue. Petitioners filed tax returns claiming their
respective portions of the research credits. Respondent issued petitioners deficiency
notices disallowing the claimed research credits. Petitioners filed timely petitions
for redetermination with this Court.
OPINION
We are asked to decide whether certain wages FS paid to Mr. Shami and Mr.
McCall qualify for the research credit. We begin with the burden of proof. The
Commissioner’s determinations in a deficiency notice are presumed correct, and
taxpayers bear the burden of proving otherwise. Rule 142(a); Welch v. Helvering,
290 U.S. 111, 115 (1933). Tax credits are a matter of legislative grace,
3
The attorneys representing petitioners are alliantgroup employees. The
Court is satisfied that the attorneys’ representation of petitioners did not create a
conflict of interest under Rule 24(g) as they obtained the necessary informed
consent.
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and taxpayers bear the burden of proving they are entitled to claim tax credits. See,
e.g., INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice
Co. v. Helvering, 292 U.S. 435, 440 (1934). The burden to disprove a claimed
credit may shift to the Commissioner if the taxpayers prove that they have satisfied
certain conditions. Sec. 7491(a); Gaitan v. Commissioner, T.C. Memo. 2012-3.
Petitioners have not shown that they complied with the requirements of section
7491(a). The burden of proof, therefore, remains with petitioners. See Rule 142(a).
We now address whether certain wages FS paid to Mr. Shami and Mr.
McCall qualify for the research credit. A taxpayer is allowed a credit against
income taxes equal to 20% of the excess (if any) of the qualified research expenses
(QREs) for the taxable year over the base amount.4 Sec. 41(a)(1). QREs include,
among other things, wages paid or incurred to an employee for performing qualified
services. Sec. 41(b)(1) and (2). Qualified services means engaging in qualified
research or engaging in the direct supervision of research activities that
4
In 1986 Congress created stricter eligibility requirements for claiming the
research credit out of concern that taxpayers were interpreting the research credit
too broadly and that “some taxpayers * * * claimed the credit for virtually any
expenses relating to product development.” S. Rept. No. 99-313, at 694-695
(1986), 1986-3 C.B. (Vol. 3) 1, 694-695; see also Union Carbide Corp. & Subs. v.
Commissioner, T.C. Memo. 2009-50; H. Rept. No. 99-426, at 178 (1985), 1986-3
C.B. (Vol. 2) 1, 178.
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constitute qualified research. Sec. 41(b)(2)(B). The term “engaging in qualified
research” as used in section 41(b)(2)(B) means the actual conduct of qualified
research (as in a scientist conducting laboratory experiments). Sec. 1.41-2(c)(1),
Income Tax Regs. Direct supervision of qualified research means immediate
supervision (first-line management) of qualified research (as in a research scientist
who directly supervises laboratory research). Sec. 1.41-2(c)(2), Income Tax Regs.
Direct supervision does not include supervision by a higher level manager to whom
first-line managers report, even if the manager is a qualified research scientist. Id.
If an employee has performed both qualified services and nonqualified
services, only the amount of wages allocated to the performance of qualified
services constitutes QREs. Sec. 1.41-2(d)(1), Income Tax Regs. All wages paid to
an employee, however, are allocable to qualified services and constitute QREs if at
least 80% of the employee’s wages are attributable to qualified services for a
taxable year. Sec. 1.41-2(d)(2), Income Tax Regs.
The amount of wages properly allocable to qualified services is determined
by multiplying the total amount of wages paid to or incurred for the employee during
the taxable year by the ratio of the total time actually spent by the employee in the
performance of qualified services for the employer to the total time spent by
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the employee in the performance of all services for the employer during the taxable
year. Sec. 1.41-2(d)(1), Income Tax Regs. Another allocation method may be used
if the taxpayer demonstrates the alternative method is more appropriate. Id.
A taxpayer claiming a credit under section 41 must retain records in
sufficiently usable form and detail to substantiate that the expenditures claimed are
eligible for the credit. Sec. 1.41-4(d), Income Tax Regs. Petitioners did not
demonstrate a more appropriate method than the one the regulations prescribe for
apportioning the wages between qualified services and nonqualified services.
Accordingly, while petitioners are not required to show that Mr. Shami and Mr.
McCall wore lab coats, petitioners must substantiate the time Mr. Shami and Mr.
McCall spent performing qualified services and the total time they spent performing
all other services. We now turn to this issue.
Petitioners claim that Mr. Shami and Mr. McCall spent 80% of their time
performing certain services related to FS product research and development
(research and development services) that constitute qualified services for 2003 and
2004 and that Mr. Shami spent 35% of his time performing such services for 2005.
Respondent argues that petitioners failed to adequately substantiate the wage
allocations for Mr. Shami and Mr. McCall. We agree.
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FS’s product research and development was conducted across numerous
departments and by many employees. Petitioners failed to provide any
documentation that establishes how much time, if any, Mr. Shami or Mr. McCall
spent performing research and development services during the relevant years.
Moreover, testimony petitioners offered to substantiate the time Mr. Shami and Mr.
McCall spent performing purported qualified services was inadequate. Petitioners
offered the testimony of Mr. Shami, Mr. McCall and two FS employees, Jason
Yates and Tai Pham. Several witnesses contradicted Mr. Shami’s testimony, and no
witnesses corroborated Mr. McCall’s testimony. The testimony of the two FS
employees was general, vague, conclusory and insufficient to establish the time Mr.
Shami or Mr. McCall spent performing any specific service. In sum, we found all of
their testimony self-serving and unreliable. We need not and do not accept any of
their testimony. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). We hold
that the inadequate substantiation prevents any amount of the relevant wages from
qualifying for the research credit.
Petitioners argue that we must estimate the amount of wages allocable to
qualified services if we find either Mr. Shami or Mr. McCall performed qualified
services. We disagree. If a taxpayer establishes that he or she paid or incurred an
expense but does not establish the amount of the expense, this Court may
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approximate the amount of the expense, bearing heavily against the taxpayer whose
inexactitude is of his or her own making. Cohan v. Commissioner, 39 F.2d 540,
543-544 (2d Cir. 1930). For the Cohan rule to apply, however, a reasonable basis
must exist on which this Court can make an estimate. Williams v. United States,
245 F.2d 559, 560 (5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. 731, 742-743
(1985). Without such a basis, any allowance would amount to unguided largesse.
Williams, 245 F.2d at 560.
Petitioners failed to satisfy the Court that there is sufficient evidence to
estimate the appropriate allocation of wages between qualified services and
nonqualified services for Mr. Shami and Mr. McCall. The Cohan rule, therefore,
does not allow this Court to make an estimate, and we decline to do so. See, e.g.,
Union Carbide Corp. & Subs. v. Commissioner, T.C. Memo. 2009-50; Eustace v.
Commissioner, T.C. Memo. 2001-66, aff’d, 312 F.3d 905 (7th Cir. 2002); Fudim v.
Commissioner, T.C. Memo. 1994-235.
Petitioners rely on United States v. McFerrin, 570 F.3d 672 (5th Cir. 2009),
in arguing that this Court must make an estimate. We follow a Court of Appeals
decision squarely on point when appeal from our decision would lie to that court
absent stipulation by the parties to the contrary. Golsen v. Commissioner, 54 T.C.
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742 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971). McFerrin is inapposite to the
present case.
In McFerrin, the Commissioner argued that even if qualified research
occurred, the taxpayer failed to provide adequate documentation to substantiate the
costs associated with the research. McFerrin, 570 F.3d at 679. The Court of
Appeals, applying the Cohan rule, held that if the taxpayer can show activities that
were qualified research, then the court should estimate the expenses associated with
those activities. Id.5 The Court of Appeals for the Fifth Circuit did not overrule, or
even address, the basic requirement under Cohan that a court must have a
reasonable basis upon which to make an estimate. See, e.g., Trinity Indus., Inc. v.
United States, 691 F. Supp. 2d 688, 693 (N.D. Tex. 2010). Moreover, the Court of
Appeals for the Fifth Circuit upheld the requirement that a court must have a
reasonable basis upon which to make an estimate in Williams. Accordingly, the
Court of Appeal’s decision does not require this Court to estimate the amounts of
5
We note that the U.S. District Court for the Southern District of Texas
decision from which the taxpayer appealed in McFerrin denied the taxpayer the
research credit because the taxpayer failed to adequately substantiate the claimed
QREs. See United States v. McFerrin, 102 A.F.T.R.2d 2008-6269 (S.D. Tex.
2008). The District Court did not apply, however, the Cohan rule because the
taxpayer failed to prove that it actually engaged in qualified research activities. Id.
Accordingly, the District Court never determined whether it could make an estimate.
Id.
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Mr. Shami’s or Mr. McCall’s wages that are allocable to qualified services given
our finding that we lack a reasonable basis upon which to make such an estimate.
We reject, therefore, petitioners’ argument.
We have considered all arguments made in reaching our decision and, to the
extent not mentioned, we conclude that they are moot, irrelevant, or without merit.
To reflect the foregoing and the parties’ concessions,
Decisions will be entered
under Rule 155.