On June 9th the Fifth Circuit vacated the opinion of the Southern District of Texas in the case of United States v. McFerrin, 2008-2 USTC ¶50,583. In doing so, the Fifth Circuit held that under the "Cohan Rule," where the taxpayer lacks records to establish the amount of the research tax credit, the court should look to testimony and other evidence in estimating the amount of the credit. The Tax Court's recent opinion in Union Carbide Corp. v Commissioner, T.C. Memo. 2009-50 (March 10, 2009), also permits taxpayers to use estimates to establish qualified research expenditures.

Over the past several years, the IRS's research credit technical advisors have been reluctant to apply the "Cohan Rule." Based on the Fifth Circuit's decision in McFerrin, along with the Tax Court's opinion in Union Carbide Corp., the technical advisors will need to revise their position to permit the usage of testimony and other evidence in establishing the amount claimed for the research credit.

A New Day for the Research Credit Issue

Most companies do not have accounting systems that gather and accumulate research costs on a project-by-project basis. Instead, many accounting systems accumulate costs by cost centers. In-house professionals or outside service providers have assisted with determining base period qualified research expenditures (1984-1988) and current year qualified research expenditures. Typically, the company gathers information with respect to the research projects conducted during the applicable years. The professionals and company representatives then interview employees to identify the research projects completed, the work performed, and the amount of time spent by each employee. The information gathered from these interviews, along with the other company records, is used to estimate the qualified research expenditures performed by each employee on the specific research projects. These estimates are used in establishing the qualified research expenditures for both the base years and the current claim years.

Prior to the designation of the research credit as a Tier I Issue (national coordination), the IRS generally accepted this form of estimation in determining the research credit. However, once the Tier I designation took place and Technical Advisors were appointed, the IRS became less willing to consider estimates of research expenditures and generally treated any material estimation of the research expenditures as a substantial litigation hazard for the taxpayer. For the most part, the IRS ignored the longstanding "Cohan Rule" rule and the prodigy of cases that followed it. The IRS's position with respect to estimation caused many companies to either accept unfavorable settlement or hold out for litigation. For those companies that used employee interviews to estimate their research expenditures and have not settled their research credit issues, the McFerrin and Union Carbide Corp. decisions provide substantial support for their position.

In light of these cases, the IRS would be expected to revise its position for examination, settlement and litigation of this issue. Ultimately, the IRS will need to apply the "Cohan Rule" in determining the proper amount of research credit that a company is entitled to.