R&D Tax Credit – Discovery test invalidated

Important R&D tax case back in June 9, 2009, 5th Circuit of Appeals in Texas Southern District ruled in US vs McFerrin.  The Mcferrins co-founded KMCO Inc a manufacturer of chemicals. The engaged an R&D tax credit firm to perform a study for them.  IRS challenged the credit and the district court ruled in the government’s favor that the taxpayer failed to engage in the controversial discovery of information test showing some threshold of innovation and there was no process of experimentation to substantiate the credit.

The 5th Circuit found the District COurt erred in outdated Discovery test and applied the wrong legal standard in reviewing all relevant evidence.  Also the Cohan doctrine to estimate the credit based on testimonies and other factual evidence is still relevant and the Mcferrins can show substantiation of the experimentation claim.

This case demonstrates the problem when the IRS tried to sidestep Congress’s intention to allow for more R&D tax credits regardless of the breakthrough innovations but rather technical improvements that have some risk of uncertainty and are tied to a business component.  Cohan rule for estimates continues to be supported. Of course IRS in their IRM manual still keeps favorable cases based on the old metholdologies in Eustace and Tax Accounting cases.

Feel free to call Peter Soh for more advice on R&D tax credits – 323-934-2462 or email peter@adviseinc.com