McFerrin-Appealed: Facts and Proceedings
McFerrin is a prominent chemical engineer(2) 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 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.
(2) In 2005, Texas A&M University renamed its chemical engineering department the Artie McFerrin Department of Chemical Engineering.
