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The McFerrin Decision Redefined “Research” for the R&D Tax Credit

November 10, 2021

Introduction

The research and development (“R&D”) tax credit, enacted in 1981, has been a powerful tool and incentive for American businesses to spur innovation and technology within the United States. Although now a permanent fixture of the United States tax code, Section 41 initially defined what constitutes R&D and provided the mechanisms to calculate qualified research expenses (QREs). This initial foundation of taxpayers’ knowledge and understanding of the R&D tax credit has subsequently been shaped and molded by several court cases over the last few decades. One of the most important being United States vs McFerrin.

Background

Arthur McFerrin, a chemical engineer, founded KMCO, Inc., a corporation that specializes in developing specialty chemicals for the petrochemical industry. In 2003, KMCO contracted with a financial services firm to undertake a study to determine if they qualified under Section 41 for R&D tax credits. In September of that year, the company filed amended tax returns for the tax year 1999 to claim the credit, resulting in an overall benefit to Mr. McFerrin of approximately $600,000. In 2005, the United States filed suit in district court to claim the refund plus interest citing that the credits claimed were not substantiated.

The Federal district court ruled in favor of the government and ordered Mr. McFerrin to repay the IRS the original refund plus interest. Further, the court contended 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. Additionally, the federal district 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. Mr. McFerrin went on to appeal this ruling and brought his case to the U.S. Fifth Circuit Court of Appeals.

Fifth Circuit Findings

The fifth circuit court went on to vacate the district court's original judgement. Further, the court ruled that because the research performed at KMCO, Inc. undertook a “trial and error” method of testing, that this was indeed qualified research as defined under the 2004 final regulations — T.D. 9104 (January 2, 2004) as described by the IRS.

What This Means for the Taxpayer

Prior to this ruling, R&D tax credits claimed by a company had to reach a very clear and strict definition as applied by the district court. That is, research must expand existing principles in the field or have a very high threshold of innovation. Essentially, in order to claim the R&D tax credit, a company had to demonstrate that their research was new to the world. This old way of thinking was originally called the “Discovery Rule”.

However, the new guidelines provided by the 2004 final regulations (T.D. 9104) and applied by the fifth circuit in their ruling above more broadly defined “research”. The revised definition now includes systematic trial-and-error processes undertaken by the taxpayer to resolve uncertainties encountered in the development of a new/improved product, process, formula, invention, software, or technique. This means that research does not have to be new to the world and further expand the principles of a given field of science or engineering. Rather, the experimentation and research must be new ONLY to the taxpayer. 

This ruling opened the door for many medium and small businesses to claim the R&D tax credit for their work. Whether your company is starting a new processing line, developing a new application, or designing a new widget, odds are you have at least some level of qualifying activity that can be captured towards the R&D tax credit.

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