Shami v. Comm'r

• Decision Date: 23 January 2014
• Docket Number: No. 12–60727.,12–60727.
• Citation: 741 F.3d 560
• Parties: 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.
• Court: U.S. Court of Appeals — Fifth Circuit

741 F.3d 560

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.

No. 12–60727.

United States Court of Appeals, Fifth Circuit.

Jan. 23, 2014.

Jeremy M. Fingeret, Zerbe, Fingeret, Frank & Jadav, Houston, TX, for Petitioners–Appellants.

Randolph Lyons Hutter, Esq., Jonathan S. Cohen, Kathryn Keneally, U.S. Department of Justice, William J. Wilkins, Internal Revenue Service, Washington, DC, for 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.

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

Each Petitioner was a shareholder in FSI for at least one of the tax years at issue. Because FSI is a Subchapter S corporation ⁶, 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:

$16,325,517 7

$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 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 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

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, 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

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