by Geoff Garber, Partner and Justin Stone, Tax Consultant
Taxpayers claiming the federal research tax credit for work under fixed-price contracts received a significant win from the United States Tax Court (“the Court”). On December 6, 2019, the Court issued an order granting summary judgment to the taxpayer, Populous Holdings, Inc. (“Populous”), finding that the company’s architecture work performed under fixed price contracts qualified for federal research tax credits and was not excluded as funded research under IRC Section 41(d)(1)(H). Specifically, the Court held that 1) payments to Populous were contingent on the success of the research, and 2) Populous retained substantial rights in the research. The Court established a helpful framework for funding analysis by integrating guidance from both regulations and three of the cornerstone research credit cases in Geosyntec, Fairchild, and Lockheed.
Populous, an architectural design services firm, claimed R&D credits for research activities conducted in tax years 2010 and 2011. The IRS denied Populous’ claims of $132,539 for tax year 2011 and carryforward credits from 2010 of $151,494, arguing that the activities were excluded as funded research. The Service and Populous agreed to limit the Court’s analysis to the funding issue, selecting five representative fixed-price contracts from a population of over 100 that formed the basis of the research credit claims. Service contended that the Taxpayer’s activities were not contingent on the success of the research for all five projects and that three of the five projects did not meet the substantial rights requirement.
The Court analyzed the activities in light of the funded research exclusion under Section 41(d)(1)(H), focusing on whether Populous had sufficient financial risk and substantial rights under the contracts. Judge Robert Goeke explained that contract research is considered funded research unless two conditions are met: (1) payment is contingent on the success of the research and (2) the contractor retains substantial rights in the research. Additionally, payment is contingent on the success of the research when the payment is for the product or result of the research.
Judge Goeke relies on Fairchild Indus., Inc. v. United States in stating that the key is “who bears the cost of the research if [the research] is unsuccessful,” such as when “the research fails to produce the desired product or result.” The Court determined that it must examine the terms of the contract to assess financial risk, referring to Geosyntec Consultants, Inc. v. United States for specific clauses, such as:
- Payment procedures
- Quality and performance standards
- Termination clauses
- Warrant and default provisions
Judge Goeke relied heavily on Geosyntec throughout the Order, reiterating that “[i]n general, fixed priced contracts have been considered unfunded research, qualifying the contractor for the credit” because they are “inherently risky.” The Court observed that the client’s obligation to pay does not need to be conditioned on acceptance of a final product to be considered unfunded in fixed price contracts. Of particular note is Judge Goeke’s discussion of payment for research versus the research product:
None of the contracts expressly requires research; thus, none of the contracts expressly states that petitioner is being paid for research. Petitioner is paid for a work product at a fixed price. The work product included the need to perform research. If its research failed, petitioner would be required to incur additional expenses without additional compensation.
The Court evaluated other clauses in favor of Populous as well, such as:
- Right to review and approve design documents
- Invoice dispute provisions
- Revision obligations and covering related costs
In the end, the Court found that payments to Populous were contingent on the research’s success in all 5 contracts and the research satisfied the contingency requirement.
The second prong of the funding assessment is whether the taxpayer retains substantial rights to the research. The IRS argued that Populous lacked sufficient rights in three of the five contracts due to ownership of the documents. The Court disagreed with the IRS and relied heavily on Lockheed Martin Corp. v. United States in finding that there were no provisions in the contracts that prohibited petitioners from using the research it performed or that required it to pay the client for the use of the research. Additionally, Judge Goeke stressed that the right to use the research does not need to be exclusive. As such, the Court found that Populous retained sufficient rights to use or exploit the results of its research going forward.
Holdings provides a clear, concise roadmap for
taxpayers and practitioners to evaluate whether research is funded under
contract. The result is a huge win for companies predominantly engaging with
clients on a fixed price basis. Reach out to BRAYN Consulting today if you or
your clients would like to learn more about claiming R&D tax credits or
whether Populous might affect your credit claims.
 See Treas. Reg. 1.41-4A(d).
 See Treas. Reg. 1.41-2(e)(2)(iii).
 Fairchild Indus., Inc. v. United States, 71 F.3d 868, 870 (Fed. Cir. 1995).
 Geosyntec Consultants, Inc. v. United States, 76 F.3d 1330, 1339 (11th Cir. 2015); Fairchild Indus., 71 F.3d at 870
 See Geosyntec, 76 F.3d 1330; See also Fairchild Indus., 71 F.3d 868
 Contrasting with the contract in Fairchild where payment was conditioned on acceptance of work product
 Lockheed Martin Corp. v. United States, 210 F.3d 1366, 1374-1375 (Fed. Cir. 2000).
 Id. at 1375; see Treas. Reg. 1.41-. 2(e)(3).