Tax Court Decisions that Reinforced Key Principles in the Funded Research Analysis
By Archita Roy, Tax Staff Accountant
As per the U.S. Tax Court, two key decisions provide valuable guidance on one of the most debated issues in the Research and Development (R&D) Tax Credit: the “funded research” rules under Internal Revenue Code (IRS) Section 41.
In both Smith et al. v. Commissioner and System Technologies, Inc. v. Commissioner cases, the IRS argued that the taxpayers’ research activities were funded by their customers and therefore did not qualify for the R&D tax credit. However, the Tax Court disagreed and denied the IRS’s motions for summary judgment, concluding that there were important factual and legal issues that required a closer review.
These decisions remind businesses that determining whether research is “funded” is rarely as straightforward as reading a few contract provisions. Instead, it requires looking at the entire agreement, the governing law and the actual economic risk assumed by the taxpayer.
Understanding the Funded Research Rules
Under Section 41, research activities generally do not qualify for the R&D tax credit if they are “funded” by the government or another party, as per Treasury Regulations. Below are the two-part analysis tests to determine whether research is funded:
- Substantial Rights Test – To qualify for the credit, the taxpayer must retain substantial rights in the research results. In other words, the company must have the ability to use or benefit from the research or the underlying technology beyond the specific customer engagement. If all rights are transferred to the customer, the research may be considered funded.
- Economic Risk Test – The second requirement focuses on who bears the financial risk of the research. If a taxpayer receives payment regardless of whether the research succeeds, the work may be treated as funded. On the other hand, if payment depends on successfully completing the project or delivering agreed-upon results, the taxpayer may still be considered to have borne the economic risk.
*Failure to satisfy either of the above-mentioned tests may result in the disqualification of the credit*
Smith et al. v. Commissioner Case
Adrian Smith and Gordon Gill Architecture, LLP (AS+GG), an architectural design firm that claimed R&D tax credits for several design projects performed between 2008 and 2010.
The IRS argued that the research was funded because AS+GG did not retain substantial rights in the research and that any benefit the firm retained amounted only to general institutional knowledge. The IRS also claimed that the firm’s payments were not dependent on the success of the research activities.
The taxpayers disagreed. Also, they argued that the IRS had not shown that the contracts transferred all substantial rights to the clients. They also maintained that payments were tied to the successful completion of project milestones and deliverables rather than simply performing research activities. Because payment depended on successfully reaching those milestones, they argued that the firm continued to bear economic risk.
An interesting aspect of this case was that the contracts were governed by the laws of Dubai and the United Arab Emirates. The Tax Court explained that interpreting the contracts required analyzing foreign law, making it impossible to resolve the dispute through summary judgment alone.
As a result, the court denied the IRS’s motion, allowing the case to proceed to trial.
System Technologies, Inc. v. Commissioner
System Technologies, Inc., a company that designs and manufactures industrial finishing systems, including automotive coating and ultraviolet curing systems, claimed R&D tax credits for six projects covering tax years 2015 through 2018.
The IRS argued that the research was funded because the purchase orders did not specifically state that payment depended on successful completion of the research. The IRS also pointed to warranty provisions in the contracts, suggesting that those provisions guarantee payment regardless of project success.
The Tax Court, however, came to a different conclusion. Since the contracts were governed by Indiana law, the court evaluated not only the contract language but also the legal remedies available under Indiana law. The court determined that the warranty provisions did not eliminate the customer’s ability to pursue additional remedies if the company failed to deliver the contracted product.
In other words, if the project failed, the customer could potentially recover payments that had already been made. That meant the taxpayer continued to bear meaningful economic risk throughout the project.
Because payment was contingent upon successful performance, the court concluded that the research was not funded and denied the IRS’s motion for partial summary judgment.
Key Takeaways for Taxpayers
These decisions reinforce several important principles for taxpayers claiming R&D tax credits:
- Contract Language is important: The IRS often focuses on individual contract provisions when arguing that research is funded. However, these decisions on the cases demonstrate that courts may also consider broader legal principles that govern the agreement, including rights and remedies available under applicable state or federal law.
- Economic Risk Remains Critical: If the business remains financially responsible for delivering a successful outcome, or if payments can be withheld, refunded or recovered when a project fails, the taxpayer may still satisfy the economic risk requirement.
- Applicable Law Matters: The terms of a contract are not the only consideration. State or foreign law can significantly affect how contractual rights and obligations are interpreted, which can ultimately influence whether research is considered funded.
- Milestone-Based Payments May Support Qualification: Payments tied to the successful completion of project milestones or deliverables may help demonstrate economic risk.
- Documentation Is Essential: Documentation plays an important role in supporting an R&D tax credit claim. Businesses should keep records that clearly support both the substantial rights and economic risk requirements. Relevant documentation may include:
- Complete contracts and amendments
- Statements of work
- Purchase orders
- Evidence of milestone acceptance
- Documentation supporting retained rights in research results
These records can be critical when defending R&D credit claims during IRS examinations.
Final Thoughts
The recent Tax Court decisions in Smith and System Technologies are encouraging for taxpayers claiming the R&D tax credit. They reinforce that funded research determinations cannot be made by looking at isolated contract clauses alone. Instead, they require a careful evaluation of the contract as a whole, the governing legal framework, and the economic realities of the arrangement.
For businesses working under fixed-price contracts, milestone-based agreements or custom development arrangements, the contract language is only part of the picture. Businesses should also consider whether they retain substantial rights and remain financially at risk if the project is unsuccessful.
As the IRS continues to examine R&D tax credit claims, businesses should proactively review their customer agreements, understand how the governing law affects them, and ensure they have documentation to support their position. Taking these steps today can help reduce risk and strengthen the defensibility of future R&D tax credit claims.
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