The Devil is in the Details (of the Contract): U.S. Tax Court Upholds the Current Definition of “Funded” Research

By Carli Huband, Partner-in-Charge, R&D Tax Credit Services and Maggie Crow, Senior Technical Writer

When it comes to qualifying for R&D credits, the old adage that “the devil is in the details” rings especially true. The IRS has been accelerating its attempts lately to deny taxpayers their R&D credits, so paying attention to key details can make or break a taxpayer’s defense of their credits – and those details become especially important when taxpayers are performing contract work for clients.

The tax code clearly states that qualified research must be “unfunded,” meaning that the research performed by the taxpayer cannot be funded via grants, contracts, or other such parties, including government entities. But the IRS also stipulates that any payment for qualified research conducted by the taxpayer must be contingent on a successful result and that the taxpayer retains a substantial interest in the result of the research, such as the right to reuse the research for future projects.

Historically, these stipulations have allowed contractors the ability to qualify for the credit in instances where they can prove they hold the financial risk and intellectual property rights to any work performed on a contract basis. For instance, contractors with a fixed price contract have historically been able to claim the R&D credit because fixed price contracts are inherently riskier – the contractor is financially responsible if the research is unsuccessful as they must correct the failure at their own expense.

However, this assumption was recently called into question when the IRS denied the credit to Populous Holdings, Inc. (“Populous”). The architectural design service company claimed qualified research expenses totaling nearly $300,000 for projects encompassing more than 100 client contracts throughout 2010 and 2011, but the IRS denied the credits, stating that the taxpayer’s claimed qualified research expenses were actually funded by other parties. Populous protested the denial, triggering a tax court case with potentially far-reaching ramifications.

In response to the motion for summary judgment on the case, the Court assessed a representative sample of Populous’s contracts to evaluate which party (Populous or the client) held substantial rights and financial risk. Populous and the IRS agreed that a sample of five contracts would suffice; after evaluating this sample, the Court confirmed that the entire sample consisted of fixed price contracts. Specifically, the Court concluded that each contract included language that granted the client the right to approve designs and dispute invoices, thus confirming that payment was reliant on the success of the research.

Sometimes, what is absent from the contracts is equally as important as what is present. The Court also noted in the Populous proceedings that the representative sample of contracts did not include any provisions prohibiting Populous from leveraging the research performed for future projects, nor did they require payment to the client for the use of such research. Additionally, the contracts did not require any physical work product documents, nor did the contracts provide intellectual property rights to the client. Therefore, the Court confirmed that Populous retained substantial rights to the use of the research in each contract.

With both of these considerations in mind, the Court concluded that the research performed by Populous was not funded and that they were entitled to the qualified research expenses claimed for both years in question. The Court issued an order on the motion for summary judgment to dismiss the case in its entirety. This outcome, in turn, reinforces the current definition of funded research and the limitations it places on the R&D credit.

While this case was only a summary judgment, the decision could apply to cases across the country and is significant for any taxpayer claiming the R&D Tax Credit for contract work. While other court cases have established a precedent for the ability to claim qualified expenses for contract work (such as the Geosyntec case cited several times in this Judge’s summary judgment), these cases took place in district courts and could therefore only be cited as true precedence in those districts. Now that the high tax court has issued this judgment in the Populous Holdings, Inc. v IRS case agreeing with the recent rulings at the district level, there is true federal precedence with nationally-reaching implications.

If your company is performing contract research and development work, this case might support your ability to claim the R&D Tax Credit for qualified expenses. However, deciphering these contracts and your eligibility for the credit requires a knowledgeable specialist. Aprio’s R&D Tax Credit Specialists are fully equipped to assess your unique situation and help maximize the value of your credits. Please contact Carli Huband at carli.huband@aprio.com or Meredith Kowal at meredith.kowal@aprio.com to learn more.