IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
June 9, 2009
No. 08-20377 Charles R. Fulbruge III
Clerk
UNITED STATES OF AMERICA
Plaintiff-Appellee
v.
ARTHUR R MCFERRIN; DOROTHY F MCFERRIN
Defendants-Appellants
Appeal from the United States District Court
for the Southern District of Texas
USDC No. 4:05-CV-3730
Before SMITH, GARZA, and CLEMENT, Circuit Judges.
EDITH BROWN CLEMENT, Circuit Judge:
The United States brought suit against Arthur R. McFerrin (“McFerrin”1)
seeking to recover a tax credit that the government alleges was erroneously paid
by the Internal Revenue Service (“IRS”) to McFerrin. After a six day bench trial,
the district court held that the government had proved by a preponderance of the
evidence that the tax credit was not properly supported and, consequently,
should not have been granted. The district court ordered repayment of the
1
Arthur McFerrin’s wife, Dorothy F. McFerrin, is also a party to this case because of
their joint income tax return.
No. 08-20377
erroneously paid refund plus interest. For the following reasons, we vacate the
district court’s judgment and remand for further proceedings.
FACTS AND PROCEEDINGS
McFerrin is a prominent chemical engineer2 who co-founded KMCO, Inc.
(“KMCO”), a Subchapter-S corporation, in 1975. KMCO manufactures
commodity and specialty chemicals, mainly for the petrochemical industry.
McFerrin owns three other Subchapter-S corporations which are related to
KMCO: KMCO Port Arthur, Inc. d/b/a KMTEX (“KMTEX”), South Coast
Acquisition, Inc. (“SC Acquisition”), and South Coast Deleware, Inc. (“SC
Deleware”). SC Acquisition and SC Deleware are the only partners in another
corporation, South Coast Terminals (“SC Terminals”). This case concerns tax
returns filed by these corporations and McFerrin for tax year 1999 and,
specifically, tax credits for increasing research activities under I.R.C. § 41.
McFerrin owns all of the corporations, and their pass-through income was part
of his 1999 income tax return.
In 2000, all of the corporations and McFerrin originally filed tax returns
for tax year 1999 and did not claim any credits for increasing research activities.
In May 2003, KMCO contracted with alliantgroup, L.P. to conduct a study to
determine if it was eligible for an increasing research tax credit. Based upon
this study, in September 2003, McFerrin and all of the corporations filed
amended 1999 tax returns claiming a credit for increasing research activities.
McFerrin’s income tax return claimed an overall credit of $472,092.00. Less
than a month later, the IRS, as a result of a clerical error, issued the refund,
which, including interest, was for $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
2
In 2005, Texas A&M University renamed its chemical engineering department the
Artie McFerrin Department of Chemical Engineering.
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No. 08-20377
return “included . . . no supporting documents” and thus there were no
documents provided to substantiate the claimed credits. On summary judgment,
the district court found that SC Terminals’ amended return was untimely filed
and therefore McFerrin had to return the portion of the refund relating to SC
Terminals and its owners SC Deleware and SC Acquisition. The issue of
whether the tax credits to KMCO and KMTEX were substantiated was tried for
six days before the district court which ruled in the government’s favor and
ordered McFerrin to repay the refund with interest.
The district court held in its conclusions of law 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. 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.” The district court also 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 court was unwilling to credit the rough estimates given
by employees years after the fact.
STANDARD OF REVIEW AND APPLICABLE LAW
When reviewing a district court decision after a bench trial, we review
factual findings for clear error and conclusions of law de novo. Flint Hills Res.
LP v. Jag Energy, Inc., 559 F.3d 373, 375 (5th Cir. 2009); Green v. Comm’r, 507
F.3d 857, 866 (5th Cir. 2007). “Findings of fact influenced by an erroneous view
of the law are entitled to no deference.” G.M. Trading Corp. v. Comm’r, 121 F.3d
977, 980 (5th Cir. 1997).
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No. 08-20377
In an action to recover an improperly paid refund, “the United States, as
plaintiff . . . , bears the ultimate burden of proof to show not only that some
amount has been erroneously refunded but also how much that amount is.”
Soltermann v. United States, 272 F.2d 387, 387 (9th Cir. 1959); see also United
States v. Commercial Nat’l Bank of Peoria, 874 F.2d 1165, 1169 (7th Cir. 1989)
(“In an action to recover an erroneous refund . . . , the government bears the
burden of proof.”). Tax credits are a matter of legislative grace, are only allowed
as clearly provided for by statute, and are narrowly construed. See Stinson
Estate v. United States, 214 F.3d 846, 848 (7th Cir. 2000); see also Helvering v.
Nw. Steel Rolling Mills, Inc., 311 U.S. 46, 49 (1940); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934). Taxpayers are required to retain records
necessary to substantiate a claimed credit. See I.R.C. § 6001; Treas. Reg. §
1.6001-1(a), (e). If the taxpayer can establish that qualified expenses occurred,
however, then the court should estimate the allowable tax credit. See Cohan v.
Comm’r, 39 F.2d 540, 544 (2d Cir. 1930) (“[T]he Board should make as close an
approximation as it can, bearing heavily if it chooses upon the taxpayer whose
inexactitude is of his own making. But to allow nothing at all appears to us
inconsistent with saying that something was spent.”); see also Mendes v.
Comm’r, 121 T.C. 308, 316 (2003) (refusing to estimate costs as taxpayer had
failed to substantiate any qualified deduction); Fudim v. Comm’r, 67 T.C.M.
(CCH) 3011, *12–*13 (1994) (accepting that qualified research occurred, and
then estimating the time spent on that research based on “testimony and other
evidence in the record”).
DISCUSSION
A. Failure to Sufficiently Plead
McFerrin first argues that the substantiation claims tried before the
district court should have been dismissed because the government failed to plead
with the particularity required by Federal Rule of Civil Procedure 9. We review
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No. 08-20377
de novo a district court’s denial of a motion to dismiss. Coop. Benefit Adm’rs,
Inc. v. Ogden, 367 F.3d 323, 328 (5th Cir. 2004). We accept as true all well-
pleaded facts, “viewing them in the light most favorable to the plaintiff.” In re
Katrina Canal Breaches Litig., 495 F.3d 191, 205 (5th Cir. 2007) (internal
quotation marks omitted). Rule 9 states that “[i]n alleging fraud or mistake, a
party must state with particularity the circumstances constituting fraud or
mistake.” FED. R. CIV. P. 9(b). Under the more general liberal notice standards
of Federal Rule of Civil Procedure 8(a)(2), all that is required is “a short and
plain statement of the claim showing that the pleader is entitled to relief.”
This case was tried based on a failure to substantiate tax claims with
sufficient documentation. McFerrin argues that because the government
claimed that he “misrepresented facts,” it was required to meet the more
rigorous Rule 9 standards. But no fraud or mistake was alleged. Rather, the
government only alleged a failure to document, which appeared several times on
the face of the complaint. There was therefore no need for the government to
plead a lack of substantiation with sufficient particularity to meet the
requirements of Rule 9, as there was no allegation of fraud or mistake, only a
lack of documentation. As such, the district court did not err in allowing the
case to go to trial.3
B. “Qualified Research” under I.R.C. § 41
I.R.C. § 41 allows a 20 percent tax credit on “qualified research expenses”
over a base amount. “Qualified research” has four separate and independent
requirements: (1) the expenses must be of the type deductible under I.R.C. § 174;
3
McFerrin further argues that the government only raised the substantiation argument
after motions for summary judgment had been filed, and that the IRS revenue agent did not
refer the case to IRS counsel based on a lack of substantiation. These arguments go beyond
the face of the complaint and, to the extent that McFerrin is making an argument that the
government may have waived its substantiation claim, he has failed to sufficiently appeal or
argue that issue.
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No. 08-20377
(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.” I.R.C. § 41(d)(1).
McFerrin argues that the district court misinterpreted “discovering information”
and “process of experimentation” in determining that no qualified research
occurred.
In determining that “discovering information” meant going beyond the
current state of knowledge in the field, the district court relied on cases from
other circuits as well as the tax court. See Eustace v. Comm’r, 312 F.3d 905, 907
(7th Cir. 2002) (agreeing with the tax court that research must produce an
“innovation in underlying principle”); United Stationers, Inc. v. United States,
163 F.3d 440, 444 (7th Cir. 1998) (“[Q]ualifying research must go beyond the
current state of knowledge in that field—expand or refine its principles.”);
Norwest Corp. & Subsidiaries v. Comm’r, 110 T.C. 454, 493 (1998) (“The fact
that the information is new to the taxpayer, but not new to others, is not
sufficient for such information to come within the meaning of discovery for
purposes of this test.”); but see Tax & Accounting Software Corp. v. United
States, 301 F.3d 1254, 1262 (10th Cir. 2002) (“[T]he taxpayer must show that he
discovered new information and that information must be separate from the
product that is actually developed.”). The same is true of the district court’s
conclusion that a “process of experimentation” requires forming and testing
hypotheses. See Eustace, 312 F.3d at 907 (“[E]xperiment . . . [means] forming
and testing hypotheses rather than the lay (or even engineering) sense of trial
and error.”); Norwest Corp., 110 T.C. at 496 (“[T]he process of experimentation
test is aimed at eliminating uncertainty about the technical ability to develop the
product—as opposed to uncertainty as to whether the product can be developed
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No. 08-20377
within certain business or economic constraints, even though the taxpayer knew
that it was technically possible to develop it.”).
But in Eustace, the Seventh Circuit also recognized that:
In the long run, neither our view nor the tenth circuit’s has staying
power. Both United Stationers and Tax & Accounting Software
analyzed § 41 without the benefit of the regulations that are
supposed to illuminate the path to decision. Section 41’s
predecessor was enacted in 1981, and § 41 has been on the books in
its current form since 1986, but the Internal Revenue Service has
yet to promulgate the regulations that are important to this
statutory design. (Section 41 refers ten times to regulations that
the Secretary of the Treasury is to develop and issue.)
Eustace, 312 F.3d at 908. Those regulations were finally promulgated in
December of 2003 (the “2003 Regulations”).4 Treas. Reg. § 1.41-4. Of course, we
afford Chevron deference to “an executive department’s construction of a
statutory scheme it is entrusted to administer.” Chevron U.S.A., Inc. v. Natural
Res. Def. Council, Inc., 467 U.S. 837, 844 (1984).
According to 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.” Treas.
Reg. § 1.41-4(a)(3)(ii). Rather, “[r]esearch is undertaken for the purpose of
discovering information if it is intended to eliminate uncertainty concerning the
development or improvement of a business component.” Id. § 1.41-4(a)(3)(i).
Thus, under the new 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.”
4
The 2003 Regulations were promulgated following a two year period of comment on
proposed regulations circulated in December of 2001 (the “2001 Proposed Regulations”). See
Prop. Treas. Reg. § 1-41, 66 Fed. Reg. 66362-01 (Dec. 26, 2001).
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No. 08-20377
Id. “Process of experimentation” under the new regulations is also different, as
it now 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).” Id. § 1.41-4(a)(5)(i). The 2003 Regulations thus have different
definitions for “discovering information” or “process of experimentation” than
the definitions adopted by the district court.
The 2003 Regulations are, however, only effective for taxable years
“ending on or after December 31, 2003.” Id. § 1.41-4(e). Nor can McFerrin claim
reliance on them since he filed his amended tax return in September 2003 while
the new regulations were not promulgated until October 2003. But in
promulgating Treasury Regulation § 1.41-4, the IRS stated that “[f]or taxable
years ending before December 31, 2003, the IRS will not challenge return
positions that are consistent with these final regulations.” T.D. 9104, *26
(January 2, 2004). McFerrin clearly was relying on the 2001 Proposed
Regulations, which had similar definitions for “discovering information” and
“process of experimentation.”5 Prop. Treas. Reg. § 1-41, 66 Fed. Reg. 66362-01
(Dec. 26, 2001). In the 2001 Proposed Regulations, the IRS specifically
recognized that its earlier interpretation of “discovering information” did “not
fully address Congress’ concerns regarding the importance of research activities
to the U.S. economy.” Id. at 66363. The 2001 Proposed Regulations apply only
to taxable years ending on or after December 26, 2001, but specifically state that:
5
The main difference is that the 2001 Proposed Regulations do not have the three step
“process of experimentation” test described above, and instead require a “facts and
circumstances” test to show a “process of experimentation.”
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No. 08-20377
Notwithstanding this prospective effective date, Treasury and the
IRS believe that these rules prescribe the proper treatment of the
expenditures they address, and the IRS generally will not challenge
return positions consistent with the proposed regulations.
Therefore, taxpayers may rely on these proposed regulations until
the date final regulations under § 1.41-4 are published in the
Federal Register.
Id. at 66367 (emphasis added). This appears to be exactly what happened, as
McFerrin relied on the proposed regulations in his amended returns.
The government conceded at oral argument that McFerrin could rely on
the definitions from the 2003 Regulations in defending this suit. See also Union
Carbide Corp. & Subsidiaries v. Comm’r, 97 T.C.M. (CCH) 1207, *77–*78 & n.42
(2009) (accepting that the previous definition of “discovering information” no
longer applies after the 2003 Regulations). The district court thus erred by not
reviewing the evidence under the definitions from the 2003 Regulations.
C. Harmless Error
The government argues, however, that any error was harmless and that
no new trial is merited because: (1) even under the 2003 Regulations definitions,
the work done by KMCO and KMTEX is not qualified research; and (2) the
district court’s finding of a failure to substantiate did not depend upon whether
there was qualified research.
On its first argument, however, the government concedes the point in its
brief. The government argues that “most of taxpayers’ activities did not
constitute research at all.” The district court accepted that a “few of the
project[s] identified . . . may have involved some research,” but, applying the
erroneous definitions of “discovering information” and “process of
experimentation,” was unpersuaded that these were “qualified research.” As
this finding of fact is based on an erroneous interpretation of law, it is accorded
no deference. G.M. Trading Corp., 121 F.3d at 980. The government “bears the
ultimate burden of proof to show not only that some amount has been
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No. 08-20377
erroneously refunded but also how much that amount is.” Soltermann, 272 F.2d
at 387. If most of the activities were not qualified research, then the
responsibility lies with the government to show what portion of the refund is
attributable to those activities. On the other hand, if, using the correct
definitions, some activities were “qualified research,” then McFerrin is entitled
to keep at least a portion of the refund.
The government next argues that even if qualified research occurred,
McFerrin failed to provide adequate documentation to substantiate the costs
associated with that research. But this goes against the longstanding rule of
Cohan v. Commissioner that if a qualified expense occurred, the court should
estimate the allowable tax credit. 39 F.2d at 544. If McFerrin can show
activities that were “qualified research,” then the court should estimate the
expenses associated with those activities. The district court need not credit
McFerrin’s reconstruction of expenses from years after the fact. See Eustace v.
Comm’r, 81 T.C.M. (CCH) 1370, *5 (2001). But the court should look to
testimony and other evidence, including the institutional knowledge of
employees, in determining a fair estimate. See Fudim, 67 T.C.M. (CCH) 3011,
*12–*13.
Further proceedings are warranted so that the district court may apply the
correct definitions of “discovering information” and “process of experimentation”
to the facts of this case, determine whether any qualified research occurred, and,
if so, estimate the expenses related to that research.6
D. McFerrin’s Bonus
The government argues that even if we remand for a new trial, it is
entitled to the part of the refund attributable to McFerrin’s $6.4 million bonus
6
As we are vacating the judgment and remanding for further proceedings, we need not
consider McFerrin’s argument that the government was allowed to use an impermissible
“project” based accounting methodology.
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No. 08-20377
in 1999. The government contends that this bonus was not attributable to the
research work done by McFerrin, and is not a “qualified research expense.”
Under I.R.C. § 41(b), “qualified research expenses” include “any wages
paid or incurred to an employee for qualified services performed by such
employee.” “Wages” are “all remuneration . . . for services performed by an
employee for his employer,” I.R.C. § 3401(a), and include “salaries, fees,
bonuses,” etc., even when paid as a “percentage of profits,” Treas. Reg. § 31-
3401(a)-1. If a portion of the bonus was part of McFerrin’s wages for “qualified
services” he performed at KMCO and was “reasonable under the circumstances,”
I.R.C. § 174(e), then it would be part of KMCO’s “qualified research expenses”
and justify a tax credit.
The district court did not make any findings of fact on these questions,
however, and only determined that the bonus was calculated based on the
“profits and cash flow of KMCO in 1999” and not on the research performed that
year. We decline to usurp the role of the district court as a fact-finder in this
case, and leave it to the district court to make these factual determinations on
remand.
CONCLUSION
In summary, in the lengthy bench trial, the court used incorrect definitions
for “discovering information” and “process of experimentation.” Because there
is the possibility that applying the correct definitions would result in at least
some of the tax credit being found to have legitimately issued to McFerrin, we
VACATE the judgment of the district court, and REMAND for further
proceedings consistent with this opinion.
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