5th Circuit Largely Affirms Tax Court Decision in Shami v. Commissioner – R&D Credit Case

In the underlying TC Memo case Shami v. Commissioner, an R&D tax credit case, the Tax Court found that there was not sufficient evidence to show that two higher level managers were engaged in research activities for which the R&D credit was claimed based on their wages. The IRS agreed that the other employees and underlying supplies qualified in the lower Court’s opinion and allowed the R&D tax credit on those QREs (qualified research expenditures). But at issue before the 5th Circuit was whether sufficient evidence was provided to substantiate either (1) that the two individuals performed some R&D such that the Cohan rule may apply or (2) showing a reasonable estimate of those QREs related to the two individuals, who were both higher level managers.

The two individuals did not have technical backgrounds, and the Tax Court found their testimony unreliable and at times contradictory and that the company failed to provide adequate documentation. ¬†These findings were upheld by the 5th Circuit, reiterating that there was no evidence (documentation or testimony) reliable enough to substantiate that Mr. Shami and Mr. McCall were engaged in R&D activities or the percentage of time spent on those activities. The 5th Circuit did not hold the taxpayer to strictly a documentation standard; rather, it reiterated the Tax Court’s finding that there was contradicting testimony and self-serving testimony which did not provide a clear accounting of what time if any the two individuals spent on R&D. The 5th Circuit refused to overturn the Tax Court on these factual findings. There was also more than one instance in which the 5th Circuit noted that the taxpayer failed to adequately brief an issue; thus waiving the issue. One key point was the Cohan rule, in which the 5th Circuit believed that although referenced by the taxpayer, was not adequately briefed as to why specifically the ‘Cohan Rule’ should apply.

The 5th Circuit also commented on the ‘direct supervision’ rule where employees can qualify as QREs towards the research credit if they are directly supervising the R&D activities. On this note, the 5th Circuit made a finding that Mr. Shami was supervising the R&D Manager, who in turned managed the lab assistants. Thus, Mr. Shami was found to be one level above ‘direct’ supervision and thus did not qualify for the R&D credit under this rule.

The 5th Circuit then clarified that the Tax Court should have allowed the supply expenses claimed in calculating the R&D credit in that the parties agreed at trial and during briefing that the only issues disputed were the wage QREs of the two highly compensated managers. Thus, the 5th Circuit vacated the Tax Court’s ruling on the supply QREs and these will be allowed as part of the calculation.¬†

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