Shami v. Commissioner

Case: 12-60727 Document: 00512510455 Page: 1 Date Filed: 01/23/2014
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
January 23, 2014
No. 12-60727 Lyle W. Cayce
Clerk
BASIM SHAMI; RANIA ARDAH; ARTHUR J. GOERTZ; JO MCCALL
GOERTZ; FAROUK SHAMI; IZZIAH SHAMI; SHAUKAT GULAMANI;
RAMI SHAMI; NAJAT BADRAN; JOHN MCCALL; KATHY MCCALL,
Petitioners–Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent–Appellee.
Appeals from the Decisions
of the United States Tax Court
Before WIENER, DENNIS, and OWEN, Circuit Judges.
PRISCILLA R. OWEN, Circuit Judge:
Basim Shami, Rania Ardah, Arthur J. Goertz, Jo McCall Goertz, Farouk
Shami, Izziah Shami, Shaukat Gulamani, Rami Shami, Najat Badran, John
McCall, and Kathy McCall (collectively, Petitioners) appeal the United States
Tax Court’s judgments upholding in part the deficiency asserted by
Respondent–Appellee Commissioner of Internal Revenue (the Commissioner)
related to research and development tax credits claimed by Farouk Systems,
Inc., a company in which Petitioners were investors. We affirm in part, vacate
in part, and remand for further proceedings.
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I
This case concerns tax credits claimed by Farouk Systems, Inc. (FSI) for
tax years 2003, 2004, and 2005, for increasing research and development (R&D)
under § 41 of the Internal Revenue Code. Section 41 grants a taxpayer a twenty-
percent tax credit for the amount of “qualified research expenses” (QREs) it
incurs that exceed a base amount.1 QREs include, among other things, wages
and supply costs expended on qualified research.2 Not all R&D expenses are
QREs. In order to qualify as a QRE, (1) the expense must be of the type
deductible under § 174 of the Code (i.e., R&D expenses that are reasonable
under the circumstances), (2) the research must be undertaken for the purposes
of discovering information that is “technological in nature,” (3) the information
must be “intended to be useful in the development of a new or improved business
component of the taxpayer,” and (4) “substantially all of the activities [must]
constitute elements of a process of experimentation.”3 When an employee has
performed both qualified and nonqualified services, only the amount of wages
attributable to the conduct of qualified services may be counted as a QRE.4
However, if eighty percent or more of an employee’s wages are allocated to the
performance of qualified services, then all of the employee’s wage can be counted
as a QRE.5
1
26 U.S.C. § 41(a).
2
Id. § 41(b)(2).
3
Id. § 41(d)(1); see also United States v. McFerrin, 570 F.3d 672, 676 (5th Cir. 2009).
4
Treas. Reg. § 1.41-2(d)(1) (as amended in 2001).
5
Treas. Reg. § 1.41-2(d)(2) (as amended in 2001).
2
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Each Petitioner was a shareholder in FSI for at least one of the tax years
at issue. Because FSI is a Subchapter S corporation6, Petitioners reported FSI’s
income, losses, deductions, and credits on their personal tax returns. FSI
develops, manufactures, and sells hair care and other cosmetic products. It was
founded by Petitioner Farouk Shami. During the tax years in question, FSI had
several hundred employees, including between eighteen and twenty-seven
employees on its R&D staff.
FSI contracted with alliantgroup, LP to conduct R&D credit studies. The
studies concluded that FSI could claim the following amounts of QREs:
2003 2004 2005
Wages: $16,325,5177 $11,530,159 $4,016,456
Supplies: $431,489 $0 $3,769
Total: $16,757,006 $11,530,159 $4,020,226
Although FSI claimed that dozens of its employees engaged in qualified research
each year, the bulk of its wage QREs came from the salaries of two FSI
employees: Farouk Shami and John McCall. Together, their wages accounted
for over 80% of the wage QREs FSI claimed in 2003, 2004, and 2005. Shami
served as chairman of FSI’s board of directors in each of these years and was
FSI’s president and CEO in 2003. McCall held the title of cochairman of FSI’s
board of directors in 2003 and 2004. Neither Shami nor McCall has any formal
education or training in chemistry or engineering.
The QREs allegedly incurred by FSI enabled it to claim a § 41 credit of
$1,072,170 in 2003, $749,460 in 2004, and $261,315 in 2005. The Commissioner
6
See 26 U.S.C. §§ 1361(a)(1), 1363(a) (explaining that an S corporation is “a small
business corporation” meeting specified requirements, that elects to be taxed in the same
manner as an individual).
7
FSI ultimately claimed $16,063,430 in wage QREs in its 2003 tax documents.
3
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subsequently served notices of deficiency on each Petitioner, challenging the
entirety of the credit claimed by FSI. Petitioners petitioned the Tax Court for
redetermination of the deficiency.
The Tax Court held a four-day trial during which both the Petitioners and
the Commissioner made concessions. The full scope of the Commissioner’s
concessions is in dispute. At a minimum, the parties agree that the
Commissioner conceded that, with the exception of the wage QREs attributable
to Shami, McCall, and two other highly compensated FSI employees, it would
not dispute the wage QREs claimed by FSI. The parties dispute whether this
concession encompassed the supply-cost QREs FSI claimed in 2003 and 2005.
Petitioners later conceded that the wages paid to the other two highly
compensated employees were not legitimate QREs. These concessions left the
QREs attributable to Shami and McCall as the only wage QREs in dispute.
Petitioners offered laboratory records as well as the testimony of Shami, McCall,
and two FSI employees to substantiate the amount of time Shami and McCall
spent performing qualified services.
Following the trial, the Tax Court issued its Memorandum Findings of
Fact and Opinion. The court concluded that Petitioners had not carried their
burden of proving how much of Shami’s and McCall’s wages could be allocated
to qualified services, if any. It explicitly found the testimony offered by
Petitioners to be noncredible.
After the Tax Court issued its opinion, the parties submitted proposed
calculations of the amount of deficiency as to each Petitioner. For 2003 and
2005—the two tax years in which FSI claimed supply-cost QREs—the
Commissioner’s calculations included as part of the deficiency the credit FSI
claimed based on supply-cost QREs. Petitioners disputed this part of the
Commissioner’s calculations, contending that the Commissioner had conceded
that all of FSI’s QREs were legitimate except for those attributable to FSI’s
4
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highly compensated employees. In its final Order and Decision with respect to
each Petitioner, the Tax Court concluded that the Commissioner had not
conceded the supply-cost QRE issue; because Petitioners had offered no evidence
regarding supply costs, the Tax Court adopted the Commissioner’s calculation
of the deficiencies. This appeal followed.
II
In general, we review decisions of the Tax Court using the same standard
of review we apply to district court decisions: findings of fact are reviewed for
clear error, and issues of law are reviewed de novo.8 We find clear error only
when we are “left with the definite and firm conviction that a mistake has been
made.”9 “Moreover, ‘[w]hen the trial court’s finding is based, in part, on the
assessment of credibility, we will not depart from such assessment except in the
very rarest of circumstances.’”10
We review the Tax Court’s decision to exclude evidence under Federal Rule
of Evidence 403 for abuse of discretion.11 We apply the same standard when
reviewing the Tax Court’s decision to provide relief on the basis of stipulations
of the parties.12
8
E.g., Green v. Commissioner, 507 F.3d 857, 866 (5th Cir. 2007).
9
Streber v. Commissioner, 138 F.3d 216, 219 (5th Cir. 1998).
10
Durrett v. Commissioner, 71 F.3d 515, 517 (5th Cir. 1996) (alteration in original)
(quoting Chamberlain v. Commissioner, 66 F.3d 729, 732 (5th Cir. 1995)).
11
See 26 U.S.C. § 7453 (providing that proceedings in the Tax Court shall be conducted
in accordance with the rules of evidence applicable in nonjury trials in the District Court for
the District of Columbia—i.e., the Federal Rules of Evidence); United States v. Flitcraft, 803
F.2d 184, 186 (5th Cir. 1986) (“A district court’s ruling under [Federal] Rule [of Evidence] 403
will not be disturbed except for an abuse of discretion.” (citing United States v. Burton, 737
F.2d 439, 443 (5th Cir. 1984))).
12
See Henry v. Commissioner, 362 F.2d 640, 643 (5th Cir. 1966); see also Graham v.
Commissioner, 134 F. App’x 704, 706 (5th Cir. 2005).
5
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III
Petitioners raise two issues regarding their documentary evidence. First,
they claim that the Tax Court abused its discretion by refusing to permit them
to introduce over 4,500 pages of records of laboratory tests into evidence.
Second, Petitioners assert that they used samples rather than all underlying
documents only because counsel for the Commissioner conceded that the case
was not a “documentary substantiation case.” Given this concession, Petitioners
claim that the Tax Court’s finding amounted to a “ratification of [the
Commissioner’s] reversal of a concession which [Petitioners] specifically relied
upon to address the court’s improper refusal.” Neither of these arguments is
meritorious.
A
The Tax Court did not abuse its discretion by limiting Petitioners to the
introduction of dozens of sample records of its laboratory tests as opposed to the
over 4,500 pages that Petitioners sought to admit. Under Federal Rule of
Evidence 403, “[t]he court may exclude relevant evidence if its probative value
is substantially outweighed by a danger of one or more of the following: unfair
prejudice, confusing the issues, misleading the jury, undue delay, wasting time,
or needlessly presenting cumulative evidence.”13 In this case, introduction of all
of the laboratory-test records would have resulted in needless delay, wasted
time, and unnecessary cumulation of evidence, which substantially outweighed
the minimal probative value of the additional records.
The two primary issues at trial were (1) whether Shami and McCall
engaged in qualified research and, if so, (2) the amount of time they spent on
such activities. Although Petitioners imply that the records excluded by the Tax
Court contained the evidence that would have answered both of these questions,
13
FED. R. EVID. 403.
6
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a review of the hundreds of pages of records that Petitioners successfully entered
into the record—records that they themselves described as “examples to go
through that’ll be useful to educate the Court without introducing” all of the
records—reveals that the records are devoid of evidence as to Shami’s and
McCall’s performance of qualified services. None of the records contains any
reference to McCall, and only a few dozen of the several hundred pages
submitted reflect that Shami “approved” that particular document. It is unclear
what “approving” a document means, and Petitioners do not elaborate in their
briefing. Accordingly, although the records suggest that employees of FSI
engaged in R&D, they are not probative with respect to whether Shami and
McCall did so.
Under these circumstances, the introduction of further records would have
plainly been a waste of time. We therefore hold that the Tax Court did not abuse
its discretion in limiting Petitioners to samples of the records.14
B
Petitioners next assert that, during a pretrial telephone status conference,
of which there is no record, counsel for the Commissioner conceded that the
Commissioner would not “challenge the sufficiency of available documentary
substantiation.” They argue that the Tax Court’s conclusion that they had not
proven their case amounts to acceptance of a reversal of this concession. In
essence, Petitioners contend that, in light of the Commissioner’s concession, the
Tax Court should have let Petitioners prove their case with nondocumentary
forms of evidence. Petitioners’ argument does not carry the day.
The alleged concession does not appear in the record, and it conflicts with
the Commissioner’s position reflected in the record. For example, at a May 24,
2010, hearing regarding discovery issues, counsel for the Commissioner stated
14
See, e.g., Flitcraft, 803 F.2d at 186.
7
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that the question in the case was “a substantiation question.” In any event, the
Tax Court did not hold that Petitioners could meet their burden only by
presenting documentary evidence. To the contrary, the Tax Court’s opinion
reveals that it considered all of the evidence, including the testimony proffered
by Petitioners. Petitioners might have proven their case through testimony, but
the Tax Court found the testimony they presented to be noncredible.
IV
Petitioners contend that the Tax Court imposed a “standard of exactitude”
on them, which, citing the legislative history to § 41, they claim is
inappropriately high. They assert that the court required them to provide
“specific documentary evidence showing the allocation between qualifying and
non-qualifying costs,” including “time records establishing the time its employees
spen[t] on qualified research.” Petitioners also allege that the burden imposed
by the Tax Court conflicts with precedent that permits the court to estimate the
amount of a tax benefit once entitlement to some benefit has been proven.
Neither of these arguments withstands scrutiny.
A
Petitioners’ argument that the Tax Court imposed an inappropriate
“standard of exactitude” that required them to produce specific documentation
is unsupported by the record. The Tax Court held Petitioners to the statutory
burden of proof and did not require a particular form of documentary evidence.
In the Tax Court, the Commissioner’s determination that Petitioners were
not entitled to the § 41 credit was presumptively correct; Petitioners had the
burden of proving that the determination was erroneous.15 “Tax credits are a
matter of legislative grace, are only allowed as clearly provided for by statute,
15
E.g., TAX CT. R. 142; Merryman v. Commissioner, 873 F.2d 879, 882 (5th Cir. 1989).
8
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and are narrowly construed.”16 When claiming a tax credit, “[t]axpayers are
required to retain records necessary to substantiate” the credit.17 With respect
to § 41 in particular, the relevant Treasury regulation provides that “[a]
taxpayer claiming a credit under section 41 must retain records in sufficiently
usable form and detail to substantiate that the expenditures claimed are eligible
for the credit.”18 The Internal Revenue Service has explained that this
regulation does not require a taxpayer “to keep records in a particular manner”
so long as the records maintained by the taxpayer substantiate his entitlement
to the credit.19
Petitioners contend that the Tax Court required them to provide a
particular form of documentation. This argument simply is not borne out by the
record. The court’s opinion makes clear that it considered both the documentary
evidence and testimony proffered by Petitioners: at no point did the court rule
or suggest that Petitioners could prove their case only with documentary
evidence. Rather, the court observed that Petitioners provided no
documentation to substantiate Shami’s and McCall’s QREs and explicitly
rejected the testimony they offered as self-serving and unreliable. The premise
underlying Petitioners’ claim regarding the burden placed on them by the Tax
Court is faulty. The Tax Court made no error with respect to the burden it
placed on Petitioners.
16
United States v. McFerrin, 570 F.3d 672, 675 (5th Cir. 2009) (citing Stinson Estate
v. United States, 214 F.3d 846, 848 (7th Cir. 2000)).
17
Id. (citing 26 U.S.C. § 6001; Treas. Reg. § 1.6001-1(a), (e)).
18
Treas. Reg. § 1.41-4(d) (as amended in 2004) (effective for tax years ending on or after
Dec. 31, 2003).
19
66 Fed. Reg. 66362-01, 66366 (Dec. 26, 2001) (emphasis added); see also T.D. 9104,
2004-1 C.B. 406 (“[T]he 2001 proposed regulations do not contain a specific recordkeeping
requirement beyond the requirements set out in section 6001 and the regulations
thereunder.”).
9
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B
Petitioners next assert that “[t]he use by [FSI] of [estimates of the amount
of time Shami and McCall spent performing qualified services] was indisputably
permissible” and that the type of documentation provided was adequately
supportive. We disagree.
First, Petitioners’ claim is waived. In their initial brief, the extent of
Petitioners’ argument is the sentence quoted above and a citation to this court’s
precedent in United States v. McFerrin,20 which, following the venerable Second
Circuit case Cohan v. Commissioner,21 held that “[i]f the taxpayer can establish
that qualified expenses occurred . . . , then the court should estimate the
allowable tax credit.”22 Aside from a parenthetical to the citation, Petitioners
make no effort to explain the Cohan rule or how it would apply to their case.
Petitioners make only the bare assertion that their use of estimates was
appropriate. Petitioners therefore have waived this issue by failing to brief it
adequately.23
In the alternative, Petitioners’ claim fails on the merits. A line of case
law—beginning with the Second Circuit’s decision in Cohan—holds that if a
taxpayer proves that he is entitled to a tax benefit but does not substantiate the
amount of the tax benefit, the court “should make as close an approximation as
it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of
his own making.”24 The underlying logic of the rule is that allowing no benefit
20
570 F.3d 672 (5th Cir. 2009).
21
39 F.2d 540 (2d Cir. 1930).
22
McFerrin, 570 F.3d at 675 (citing Cohan, 39 F.2d at 544).
23
See, e.g., Coury v. Moss, 529 F.3d 579, 587 (5th Cir. 2008) (citing Nichols v. Enterasys
Networks, Inc., 495 F.3d 185, 190 (5th Cir. 2007)).
24
E.g., Cohan, 39 F.2d at 544.
10
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at all “appears . . . inconsistent with [the finding] that something was spent.”25
In McFerrin, this court held that the Cohan rule applies in the context of the
§ 41 credit.26
Cohan did not compel the Tax Court to make an estimate in this case. As
the preceding discussion makes clear, the Cohan rule is not implicated unless
the taxpayer proves that he is entitled to some amount of tax benefit. In the
context of the § 41 credit, a taxpayer would do so by proving that its employee
performed some qualified services. In this case, a careful reading of the Tax
Court’s opinion reveals that the Tax Court made no such finding.
Even if the Tax Court had determined that Petitioners proved that Shami
and McCall performed some amount of qualified services, Cohan and McFerrin
are not the only case law on this issue. As the Tax Court observed, another
decision of this court issued between those two cases explains that the Tax Court
has discretion to make an estimate under Cohan. In Williams v. United States,27
this court made clear that, even though the Tax Court “might have considerable
latitude in making estimates of amounts probably spent,” the Cohan rule
“certainly does not require that such latitude be employed.”28 Our decision in
Williams explicitly held that the Tax Court “may not be compelled to estimate
even though such an estimate, if made, might have been affirmed.”29 This was
so because “the basic requirement is that there be sufficient evidence to satisfy
the trier that at least the amount allowed in the estimate was in fact spent or
25
Id. (emphasis added)
26
McFerrin, 570 F.3d at 675, 679.
27
245 F.2d 559 (5th Cir. 1957).
28
Williams, 245 F.2d at 560.
29
Id.
11
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incurred for the stated purpose,” and “[u]ntil the trier has that assurance from
the record, relief to the taxpayer would be unguided largesse.”30
Neither Williams nor any other exception to the Cohan rule was before the
court in McFerrin, and we do not read McFerrin to hold that Cohan is
untempered by any exceptions. Petitioners also make no attempt to explain why
Williams would not apply to their case. Even assuming that there were some
conflict between Williams and McFerrin, Williams is our earlier precedent.
“When panel opinions appear to conflict, we are bound to follow the earlier
opinion.”31 Therefore, the Tax Court was entitled to decline to make an estimate
if it found that Petitioners had not provided a reasonable basis on which to make
one.
The Tax Court’s finding that the record did not contain a reasonable basis
on which to make an estimate is not clearly erroneous.32 The documentary
evidence submitted by Petitioners is silent about the amount of time Shami and
McCall spent performing qualified services. Even though they and two FSI
employees testified regarding the amount of time, the Tax Court, per its
prerogative,33 disregarded this testimony as contradictory, self-serving, and
noncredible. When the Tax Court’s finding depends on the assessment of
credibility, “we will not depart from such assessment except in the very rarest
of circumstances.”34 This case does not provide occasion to depart from the Tax
30
Id.
31
H&D Tire & Automotive-Hardware, Inc. v. Pitney Bowes Inc., 227 F.3d 326, 330 (5th
Cir. 2000).
32
See Williams, 245 F.2d at 560-61 (reviewing for clear error the trial court’s
determination that the record contained a dearth of evidence upon which to base an estimate).
33
E.g., Durrett v. Commissioner, 71 F.3d 515, 517 (5th Cir. 1996).
34
See id. (quoting Chamberlain v. Commissioner, 66 F.3d 729, 732 (5th Cir. 1995))
(internal quotation marks omitted).
12
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Court’s finding. Accordingly, the Tax Court did not err in refusing to estimate
the amount of credit due Petitioners for the qualified services performed, if any,
by Shami and McCall.
V
Petitioners argue that the Tax Court failed to consider that direct
supervision of qualified research is a qualified service under § 41 and, in any
event, ignored the evidence, rendering its factual findings clearly erroneous.
These arguments fail.
A
Petitioners first contend that the Tax Court failed to heed that “direct
supervision” of qualified research is a qualified service under § 41. Petitioners
observe that the Commissioner conceded that it would not challenge the § 41
credit claimed with respect to FSI employees other than Shami, McCall, and two
other highly compensated employees. Because Shami supervised employees that
the Commissioner conceded were engaged in qualified research, Petitioners
assert that Shami, by definition, performed qualified services, i.e., direct
supervision of qualified research.
As the Tax Court recognized, § 41(b)(2)(B) provides that “qualified
services” for the purposes of determining the amount of qualified in-house
research expenses under the statute “means services consisting of (I) engaging
in qualified research, or (ii) engaging in the direct supervision or direct support
of research activities which constitute qualified research.”35 Regulations
promulgated under § 41 elaborate that “direct supervision” means
the immediate supervision (first-line management) of qualified
research (as in the case of a research scientist who directly
supervises laboratory experiments, but who may not actually
perform experiments). “Direct supervision’’ does not include
35
26 U.S.C. § 41(b)(2)(B).
13
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supervision by a higher-level manager to whom first-line managers
report, even if that manager is a qualified research scientist.36
In short, the supervisor of the direct supervisor of employees who conduct
qualified research is not himself engaged in qualified research.
Petitioners allege that the stipulations and concessions at trial
conclusively demonstrate that Shami engaged in direct supervision. We reject
this argument. First, even accepting Petitioners’ claims regarding the effect of
the stipulations, Petitioners also had to prove the amount of Shami’s wages that
could be allocated to qualified services37—or at least provide a reasonable basis
upon which the court could make an estimate under Cohan. The stipulations
and concessions say nothing about the time Shami spent, if any, directly
supervising FSI employees engaged in qualified research. As discussed above,
our precedent does not require the Tax Court to estimate that amount of time.38
Second, it is far from clear that the stipulations and concessions indicate
that Shami directly supervised FSI employees actually conducting qualified
research as opposed to merely acting as an upper-level manager. Only one
stipulation addresses his supervisory role, and it is inconclusive:
Beginning April 26, 2004, and continuing throughout 2005, Ali
Ghannad was vice president of R&D for [FSI]. His duties included
without limitation; developing new products, managing the
laboratory, managing quality control and managing quality
assurance. Ali Ghannad reported to . . . Shami.
36
Treas. Reg. § 1.41-2(c)(2) (as amended in 2001) (emphasis added).
37
E.g., Treas. Reg. § 1.41-2(d)(2) (“Wages paid to or incurred for an employee constitute
in-house research expenses only to the extent the wages were paid or incurred for qualified
services performed by the employee. If an employee has performed both qualified services and
nonqualified services, only the amount of wages allocated to the performance of qualified
services constitutes an in-house research expense.”).
38
See supra notes 27-31 and accompanying text.
14
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Since Ali Ghannad was involved in developing new products, this stipulation
offers some support for the contention that Shami engaged in some direct
supervision of some qualified research. However, the stipulation also provides
that Ghannad was FSI’s R&D manager. As such, the stipulation suggests that
Shami was an upper-level manager who supervised the FSI employees who, in
turn, supervised the performance of qualified research. Indeed, two other
stipulations state that laboratory technicians reported to FSI employees other
than Shami.
The concession made by the Commissioner at trial likewise says nothing
about whether Shami directly supervised FSI employees who actually conducted
research. The record reflects that, on the second day of trial, counsel for the
Commissioner advised the court that it could “see that experimentation [was]
taking place,” so “instead of challenging . . . all of the production of everyone,
[the Commissioner would] focus in on the highly compensated employees.”
Petitioners imply that, given this concession, Shami, as the head of FSI,
necessarily performed qualified services since he supervised FSI employees.
The Commissioner’s concession cannot bear the weight placed on it by
Petitioners. Even if we were to read the concession as conceding the validity of
the QREs, the concession was not that all of FSI’s other employees were
themselves actually conducting qualified research: rather, the concession was
general and could encompass QREs based on direct supervision. Accordingly,
the concession could be entirely consistent with the conclusion that Shami—as
the head supervisor at FSI—was not performing qualifying services. As the
regulation makes clear, second-tier supervision—supervising supervisors—does
not qualify as direct supervision for the purposes of § 41(b)(2)(B).
In short, the concessions made by the Commissioner do not compel the
conclusion that Shami directly supervised the actual performance of qualified
15
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services. On this record, the Tax Court’s implicit conclusion that Petitioners had
not proven that Shami engaged in direct supervision was not clearly erroneous.
B
Petitioners also contend that, even assuming the Tax Court applied the
correct legal standard, its conclusion that they had not proven the amount of
time, if any, Shami and McCall spent performing qualified services was clearly
erroneous. We disagree.
First, the documentation in the record says little about whether Shami
performed any qualified services and nothing with respect to McCall.
Petitioners submitted a number of internal memoranda and e-mails reporting
the results of product tests to Shami and other employees of FSI. Although
Petitioners assert that “each one of these documents was sent to . . . Shami to
relay technical and testing information he needed to continue the chemical
development of the product at issue therein,” the memoranda do not facially
support that claim. Notably, Petitioners submitted no responsive memoranda
or e-mails sent by Shami.
The only other evidence proffered by Petitioners was testimonial.
Petitioners presented three witnesses to substantiate Shami’s research
activities: Shami himself; Jason Yates, FSI’s creative director during the tax
years at issue; and Tai Pham, a chemist at FSI. Petitioners presented only
McCall himself to substantiate the credit claimed based on his activities. To be
sure, this testimony, if credited, could lead to the conclusion that Shami and, to
a lesser extent, McCall, worked almost exclusively on R&D at FSI. However, the
Tax Court explicitly refused to credit the testimony offered by Petitioners,
having found it “general, vague, conclusory, . . . self-serving[,] and unreliable.”
When the Tax Court’s finding depends on the assessment of credibility,
“we will not depart from such assessment except in the very rarest of
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circumstances.”39 This case does not pose such a circumstance. The testimony
proffered by Petitioners was general, at times inconsistent, and contradicted by
the testimony of James Sie and Ali Ghannad, former FSI employees who
testified on the Commissioner’s behalf. Additionally, all of Petitioners’ witnesses
had an incentive to mislead: as the principal shareholders in FSI, Shami and
McCall would be hurt if the deficiency were upheld, and Yates and Pham both
were employees of FSI at the time of trial. The Tax Court did not clearly err in
finding that Petitioners had not proven whether Shami and McCall had engaged
in qualified research and, if so, how much of their time was spent on such
activities.
C
Petitioners next allege that the Tax Court’s finding was clearly erroneous
because it ignored the fact that Shami was credited as an inventor on certain
patents. They assert that “the sheer fact that Farouk Shami sought and
obtained patents for many of the technologies developed during 2003, 2004 and
2005 indisputably signifies that he is not only ‘involved’ in research conducted
at [FSI], but in control of every element.” This argument is waived and, in any
event, fails on the merits.
In their opening brief, Petitioners make the bare unsupported by
argument or any authority—that Shami’s patents conclusively establish that he
was in control of “every element” of research conducted at FSI. Although
Petitioners offer slightly more support in their reply brief, issues not raised in
39
E.g., Durrett, 71 F.3d at 517 (quoting Chamberlain, 66 F.3d at 732) (internal
quotation marks omitted).
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a party’s opening brief are waived.40 Petitioners’ inadequate briefing constitutes
waiver of the issue.41
In the alternative, Petitioners’ argument fails on the merits. We first note
that, although Petitioners refer to multiple patents issued to Shami, only one in
which is he is listed as coinventor, appears to relate to research conducted
during the tax years at issue in this case. Regardless, issuance of a patent does
not conclusively prove that a taxpayer has engaged in qualified research.
Although issuance of a patent is conclusive evidence that some of the
requirements of § 41’s qualified research test are satisfied,42 a taxpayer still
must prove that the expenditures are of the type deductible under § 174 of the
Code—in other words, that they were reasonable R&D expenditures under the
circumstances43—as well as that “substantially all” of the research activities
constituted a “process of experimentation.”44 Furthermore, the taxpayer must
tie the research underlying the patent to the “business component,” i.e., the
particular product, process, software, technique, formula, or invention to be held
for sale, lease, or license, or used by the taxpayer in its trade or business,45 that
is affected by the patent.46 The issuance of a patent with respect to a discrete
40
Tex. Democratic Party v. Benkiser, 459 F.3d 582, 594 (5th Cir. 2006).
41
See, e.g., Coury v. Moss, 529 F.3d 579, 587 (5th Cir. 2008) (citing Nichols v. Enterasys
Networks, Inc., 495 F.3d 185, 190 (5th Cir. 2007)).
42
Treas. Reg. § 1.41-4(a)(3)(iii) (as amended in 2004) (“[T]he issuance of a patent . . . is
conclusive evidence that a taxpayer has discovered information that is technological in nature
that is intended to eliminate uncertainty concerning the development or improvement of a
business component.”).
43
26 U.S.C. § 174(e).
44
Treas. Reg. § 1.41-4(a)(2).
45
26 U.S.C. § 41(d)(2)(B).
46
See Treas. Reg. § 1.41-4(b)(1).
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business component does not mean that all research conducted by the taxpayer
is qualified.
Here, Petitioners make no attempt to explain how much of Shami’s wages
may be attributed to the invention described in the patent or that such amount
was reasonable. They do not explain how Shami’s alleged activities constituted
a process of experimentation or how the patent credited to Shami relates to the
variety of FSI products that they assert were developed by him during the tax
years in question. Therefore, even assuming that this argument was not waived,
the issuance of the patent crediting Shami does not prove that his wages were
QREs.
VI
Petitioners last assert that the Tax Court’s final orders erroneously
concluded that Petitioners had not proven FSI’s entitlement to QREs related to
supply costs. Although the Commissioner asserted a deficiency as to such QREs,
Petitioners contend that the Commissioner conceded the issue at trial. They
claim that the Tax Court’s inclusion of the supply costs in the deficiency was
clearly erroneous. The Commissioner contends that Petitioners misread the
record and that any concession dealt only with wage-based QREs. We agree
with Petitioners and vacate the Tax Court’s judgment as to each Petitioner in
this narrow respect.
Tax Court Rule 91 requires that the parties stipulate in writing “to the
fullest extent to which complete or qualified agreement can or fairly should be
reached, all matters” of law or fact relevant to the case.47 The Tax Court is not
permitted to allow a party to a stipulation to qualify or contradict its stipulation
unless “justice requires.”48 “This stipulation process has been called ‘the bedrock
47
TAX CT. R. 91(a).
48
TAX CT. R. 91(e).
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of Tax Court practice . . . .’”49 The Tax Court must enforce the plain meaning of
language in a stipulation,50 and “even where the stipulation creates a windfall
for the taxpayer, the stipulation is nonetheless binding on the government.”51
As an initial matter, we observe that Rule 91 does not refer to oral
stipulations or concessions at trial. Both parties assume that an oral concession
is binding, which is consistent with existing precedent in the Tax Court.52 For
the purposes of this appeal, we assume without deciding that an oral, on-record
concession is equivalent to a stipulation.
With respect to the effect of the concession, although the Commissioner
may have intended the concession to encompass only the wage QREs, the plain
meaning of the Commissioner’s counsel’s statements at trial is that the
Commissioner would not challenge FSI’s claimed QREs except for those related
to the wages of FSI’s highly compensated employees. Counsel for the
Commissioner conceded that “experimentation is taking place” and stated that
the Commissioner would therefore “focus in on” the production of FSI’s highly
compensated employees. Later, when the Commissioner’s counsel clarified
“what [the Commissioner] perceive[d] to be the issues in th[e] case that [were]
remaining,” counsel identified only the QREs related to Shami and McCall. The
49
Farrell v. Commissioner, 136 F.3d 889, 893 (2d Cir. 1998) (quoting Branerton Corp.
v. Commissioner, 61 T.C. 691, 692 (1974)).
50
Id. at 895 (citing Gridley v. Commissioner, 73 T.C.M. 2727 (1997)); see also
Meyer’s Estate v. Commissioner, 200 F.2d 592, 596 (5th Cir. 1952) (“The Tax Court erred . . .
in failing to give effect to the plain meaning and import of the stipulation between the
parties.”).
51
Farrell, 136 F.3d at 894 (citing Kampel v. Commissioner, 634 F.2d 708, 710 n.3 (2d
Cir. 1980)).
52
Hill v. Commissioner, 57 T.C.M. 1250 (1989); Church of Scientology of Cal. v.
Commissioner, 83 T.C. 381, 524 (1984) (“Respondent’s concession in open court not to seek an
increase in the notice of deficiency was the equivalent of a stipulation.” (citing Mass. Ave.
Heights Citizens Assoc. v. Embassy Corp., 433 F.2d 513, 515 (D.C. Cir. 1970) (per curiam))).
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Commissioner’s counsel also indicated his agreement with Petitioners’ counsel’s
statement that “the only question” remaining for trial was the QREs related to
Shami and McCall. The Commissioner’s post-trial brief stated that “only the
qualified research expenses claimed for Farouk Shami and John McCall [were]
at issue.” Finally, the Tax Court itself—at least at one point—understood the
case to be limited to the QREs related to Shami and McCall. Viewed together
and in context, the series of statements made by the Commissioner’s counsel
indicate that the Commissioner conceded that the IRS would not challenge FSI’s
claimed QREs except for those related to highly compensated employees.
Although the Tax Court has discretion to provide relief from a
stipulation,53 that discretion is limited by Rule 91,54 which provides that the Tax
Court must enforce stipulations unless “justice requires.” Here, by implicitly
granting relief to the Commissioner without considering whether such relief was
warranted, the Tax Court abused its discretion.55 The Commissioner’s
concession should have been given binding effect. The Tax Court’s failure to
include the supply costs as proper QREs when calculating each Petitioner’s
deficiency therefore was clearly erroneous. Accordingly, we vacate the Tax
Court’s judgments as to each Petitioner and remand for recalculation of the
deficiencies in light of the Commissioner’s concession.
53
See Henry v. Commissioner, 362 F.2d 640, 643 (5th Cir. 1966); see also Graham v.
Commissioner, 134 F. App’x 704, 706 (5th Cir. 2005) (citing Henry, 362 F.2d at 643).
54
TAX CT. R. 91(e); see also Farrell v. Commissioner, 136 F.3d 889, 897 (2d Cir. 1998).
55
See Farrell, 136 F.3d at 897 (“We hold that under these circumstances, in the absence
of an examination by the Tax Court of the factors provided by Tax Court Rule 91(e) for relief
from a stipulation, the First Stipulation should have been given binding effect . . . .”).
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* * *
For the foregoing reasons, the Tax Court’s judgments are AFFIRMED IN
PART and VACATED IN PART, and the cases consolidated herein are
REMANDED for recalculation of the deficiencies consistent with this opinion.
22