Executive involvement in research can qualify. But a title and a testimony won’t prove it.
Every year, consumer product companies, manufacturers, and technology firms overclaim R&D tax credits in one very specific way: they include the full salaries of their top executives without the documentation to support it. The logic seems reasonable. The CEO drives the product vision. The chairman is in every formulation meeting. Surely their time counts. Under IRC §41, whether it counts depends entirely on what you can prove and how credibly you can prove it. One Fifth Circuit decision, rooted in a Tax Court memorandum that practitioners still cite today, draws that line with unusual precision.
Section 41 of the Internal Revenue Code allows companies to claim a credit for qualified research expenses. Wages are among the most significant categories of QREs, and the rules around them are both expansive and demanding. An employee’s wages qualify to the extent they are paid for performing qualified services which means directly engaging in qualified research, or directly supervising or directly supporting individuals who do.
The word “directly” is doing significant work in that sentence.
Treasury Regulation §1.41-2(b) makes clear that high-level oversight and general management responsibilities do not constitute qualified services, even when an executive is deeply involved in a company’s innovation agenda. An executive who reviews research results, approves product directions, or attends development meetings is performing management not qualified research. The line between the two is exactly where the Shami case was decided.
Most companies building an R&D credit study will ask their executives how much time they spent on research activities. The executives will answer. That answer becomes a percentage. That percentage gets applied to the salary. The credit is claimed.
What almost no one asks and what the IRS absolutely will ask upon examination is this: what contemporaneous records exist to verify that allocation?
If the answer is none, the entire wage of QRE for that executive is at risk. And if the executive’s wages represent the majority of the credit, the entire credit is at risk.
The case involved Farouk Systems, Inc. (FSI), a Houston-based hair care company behind brands like BioSilk, CHI, and Deep Brilliance. FSI’s shareholders were the petitioners. The IRS challenged the company’s R&D credits for 2003, 2004, and 2005.
FSI had a real R&D operation of 18 to 27 staff, credentialed chemists, lab technicians, and a VP of R&D who ran the group. The research itself wasn’t an issue. Nobody seriously disputed that.
The issue was who FSI said was doing it.
FSI claimed wages for two individuals at the top of the organization: Farouk Shami, founder, chairman, and CEO, and John McCall, co-chairman of the board. Together, their wages made up more than 80 percent of all wage QREs claimed across the three years producing credits of $1,072,170 in 2003, $749,460 in 2004, and $261,315 in 2005.
Neither Shami nor McCall had formal training in chemistry or engineering.
At trial, both executives testified that roughly 80 percent of their time in 2003 and 2004 went to qualified research. FSI brought in two additional employees to back that up.
The court found none of it credible.
Witness testimony contradicted Shami’s account. No witnesses corroborated McCall’s at all. The supporting employees offered only general, vague statements that tied either executive to a specific qualified activity at a specific time. FSI also attempted to introduce over 4,500 pages of lab records. The court admitted a sample. The Fifth Circuit later agreed that admitting all of them would have been cumulative without adding real probative value.
FSI’s last argument: even without solid documentation, the court should estimate the qualified portion of executive wages under the Cohan rule.
The court refused. Cohan requires a reasonable basis for estimation. The court found none in the testimony, not in the records, not anywhere in the evidentiary record. Allowing an estimate, the court said, would amount to unguided largesse.
In January 2014, the Fifth Circuit upheld the wage of QRE disallowance. It vacated the decision only on a narrow side issue whether the IRS had effectively conceded FSI’s supply-cost QREs during trial. That question was remanded for recalculation. The core holding on executive wages stood.
The Shami case illustrates two failure modes that appear in R&D examinations across industries, not just beauty and personal care.
When a company’s top earners are also deeply involved in product development, the temptation is to allocate a significant portion of their compensation to QREs. The credit math can look very attractive. But without records that document specifically what each executive did, when they did it, and how those activities constitute qualified services under §41 rather than management, approval, or oversight the allocation cannot survive examination.
FSI had an active, legitimate R&D operation. It lost the lion’s share of its credit not because its research was invalid, but because the wage allocations for its two most senior figures rested entirely on self-reported time estimates that the court found unreliable.
Companies preparing for an R&D examination often rely heavily on what their executives and employees will say on the stand. The Shami case is a direct repudiation of that strategy. Courts evaluate credibility. They weigh contradictions. They distinguish between specific, verifiable accounts of qualified activity and general assertions that research happened. When testimony is the only substantiation and when that testimony conflicts internally or goes uncorroborated, the credit fails.
Both mistakes are avoidable, and the Shami decision is essentially a warning in case law form.
The Shami case also carries a specific and underappreciated lesson about when documentation must exist. The records that matter are the ones created in the ordinary course of business — project logs, lab notebooks, formulation records, internal communications that reflect the nature of each executive’s involvement not declarations assembled for the purpose of supporting an amended return.
The requirement is clear and unforgiving:
For companies with significant executive compensation included in their R&D credit claims, the strength of documentation at the activity level is just as important as the legitimacy of the research itself.
The Shami decision established where the evidentiary line sits. Building a credit position that stays on the right side of that line across multiple executives, multiple tax years, and multiple product development cycles is an operational challenge that requires the right infrastructure from the start.
What the IRS Tests for Executive Wages | Without TaxDrone.AI + NTG | With TaxDrone.AI + NTG |
Contemporaneous time records for each executive | Self-reported percentage, assembled after year-end from memory | Activity-level records linked to specific projects, captured as work is performed |
Activity-specific evidence of qualified services | General statement that executive participated in R&D | Records distinguishing direct research participation from management and oversight — project by project |
Corroboration beyond self-testimony | Colleague statements that are general and uncorroborated | Project logs, meeting records, formulation notes, and communications that independently establish the activity |
Cohan rule applicability if records are challenged | No credible basis; court will not estimate | Contemporaneous record provides the factual grounding that makes estimation, if ever needed, credible |
Where TaxDrone.AI builds the record, NTG interprets it. Together, they address the two failure points the Shami case made permanent in the case law: insufficient documentation of executive-level qualified services and unsupported wage allocations that cannot withstand scrutiny.
Most companies performing genuine R&D have no difficulty establishing that qualified research occurred. The harder question of the one that determined the outcome in Shami is whether the records show, with specificity and credibility, which employees performed which qualified services, and in what proportion.
If your company includes executive wages in its R&D credit claim, the time to build that record is now not at the point of examination. Learn how our activity-level documentation approach works here.
