United States v. McFerrin

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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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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