The research credit: Funded research

Editor: Alexander J. Brosseau, CPA

Two recent court cases involving the research credit, Perficient Inc., No. 15467-17 (Tax Ct. 7/11/22) (response to motion for partial summary judgment), and Grigsby, No. 19-00596-BAJ-SDJ (M.D. La. 10/19/22), examine the Sec. 41(d)(4)(H) funded-research exclusion. These cases demonstrate the complexity of the funded-research exclusion rules, which continue to be a point of contention between taxpayers and the IRS. Discussion in Perficient and Grigsby provides taxpayers with recent interpretations of relevant guidance, including preceding case law.

Regs. Sec. 1.41-4A(d) provides a general exclusion for funded research, stating that research funded by any grant, contract, or otherwise by another person, including any governmental entity, does not constitute qualified research for purposes of the research credit. Furthermore, all agreements entered into between the taxpayer performing the research and other persons must be considered in determining the extent to which the research is funded — not only research contracts. In defining funded research, the regulations provide two standards under which taxpayers must evaluate their research activities:

1. Amounts payable under an agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research are not treated as funding (“risk standard”).
2. If a taxpayer retains no substantial rights in the research, then the research is considered to be funded (“substantial-rights standard”).

The application of these standards continues to be litigated, and awareness of prior case law provides helpful context to the discussion in Perficient and Grigsby.

Funded-research case law and the risk standard

The foundational case regarding the funded-research exclusion and the risk standard is Fairchild Industries, Inc., 71 F.3d 868 (Fed. Cir. 1995). Fairchild Industries, an aerospace manufacturer, entered into a fixed-price incentive contract to design and produce the T-46A aircraft, a “next generation trainer,” for use in training new pilots. Under the contract, the U.S. Air Force was obligated to pay for the research only if Fairchild produced results that met the contract specifications. If it deemed Fairchild’s work was not acceptable, the Air Force could either (1) reject the work, (2) require Fairchild to correct the work at its own expense, or (3) accept the work subject to an equitable price reduction. Additionally, the contract’s financing provisions provided that if Fairchild was making satisfactory progress, the Air Force would pay bimonthly refundable advances, termed “progress payments,” calculated as a percentage of the expenditures Fairchild actually incurred.

On appeal, the Federal Circuit reversed the U.S. Claims Court decision that Fairchild’s research was funded research. It found that the sole inquiry in evaluating financial risk is who bears the research costs upon failure, not the likelihood of a project’s success or failure. The court determined the inspection and acceptance clauses clearly placed financial risk on Fairchild, as it had no right to payment until it fully succeeded in each phase of the project. Additionally, the court determined the “advances” or “progress payments” distributed during performance did not shift financial risk away from Fairchild, as Fairchild was not entitled to retain any such payments if it did not successfully produce the product to which the payment related.

Another instructive case as it pertains to the risk standard is Geosyntec Consultants, Inc., 776 F.3d 1330 (11th Cir. 2015), aff ’g No. 12-80334-Civ (S.D. Fla. 4/15/13). Geosyntec Consultants, a consulting and engineering firm, claimed the research credit for work performed pursuant to certain contractual agreements. Geosyntec and the government agreed to have the issue decided based on six sample contracts to expedite the examination process. Three of the sample contracts were fixed-price agreements, under which Geosyntec performed the contracted work for a fixed total price, and the remaining three sample contracts were “capped” contracts, under which Geosyntec billed its clients for labor and other expenses incurred up to an agreed-upon maximum price.

Citing Fairchild, the court determined that the fixed-price agreements did not constitute funded research, referencing the inspection and acceptance clauses, which permitted clients to withhold payment to Geosyntec until each milestone was completed and accepted. In contrast, the court concluded that the capped contracts constituted funded research. Geosyntec argued, in part, that its risk of not receiving the full maximum price or, conversely, of exceeding its own budget resulted in its retaining financial risk over the contracts.

The court disagreed, contending that the sole focus when assigning financial risk is which party bears the financial loss in the event of failure, not the underlying profitability of a given agreement. Relevant to current developments in the Perficient case, the court indicated that the capped contracts contained no inspection or acceptance criteria or method for rejection that expressly made payment contingent on the success of Geosyntec’s research. This distinguished Geosyntec from the contract in Fairchild, which contained detailed contract specifications approval requirements and became the cornerstone of the court’s decision.

Funded-research case law

A prominent case that addresses the substantial-rights standard of the funded-research exclusion is Lockheed Martin Corporation, 210 F.3d 1366 (Fed. Cir. 2000). Lockheed Martin Corp., a defense contractor for the federal government, entered into multiple contracts for a variety of defense technology development programs. During litigation, contracts associated with a total of four programs were evaluated. The contracts included regulatory clauses that detailed patent rights, technical data, and computer software rights; security classification guidelines; and provisions regarding the government’s recovery of nonrecurring costs on commercial sales (cost recovery). Under the cost-recovery provision, Lockheed Martin was required to reimburse the government a proportionate share for the sale or license of similar technology and products that the company sold to consumers, subject to any patent or technology software restrictions provided in the contracts. However, Lockheed Martin retained the right to use its research results in its business without any further payment to the government.

The Lockheed Martin case was ultimately decided on appeal, where the Federal Circuit held that the programs at issue did not constitute funded research because Lockheed Martin retained substantial rights in the research. The court cited Regs. Sec. 1.41-2(a) and rejected the government’s argument that substantial rights exist only when the taxpayer retains the right to exclude others from its research and other parties do not also have the right to use or disclose the taxpayer’s research. Important to the Perficient case, the court in Lockheed Martin concluded that “[t]he right to use the research results, even without the exclusive right, is a substantial right,” clarifying that a contractor is not required to retain all rights to retain substantial rights.

The court observed that the cost recovery recoupment provisions only applied when Lockheed Martin intended to sell products or sell or license technology developed specifically for the government to other parties. The court ruled that these provisions did not restrict Lockheed Martin’s right to manufacture the specific products, similar products, related technology, or the right to unrestricted use of the results of the research in its own business, such that Lockheed Martin retained the right to use its research without paying for that right.

The substantial-rights standard was also litigated in Dynetics, Inc., 121 Fed. Cl. 492 (2015). Dynetics, an engineering firm, filed amended tax returns for three tax periods seeking a refund resulting from research credits related to work performed on more than 100 contracts, of which seven sample contracts were reviewed

Aspects of the terms evaluated in certain of these sample contracts are relevant to the Perficient and Grigsby cases. For example, one required the attachment of a DD Form 254, Department of Defense Contract Security Classification Specification, which dictates the security level and characteristics of a specific research project. Security provisions in the Form 254 placed a variety of limitations on the use of the intelligence information contained in the results of the research. Dynetics asserted that it retained the right to use the results of the research, in part because of the skills and advancements it developed while working on the contract. Citing Regs. Sec. 1.41-4A(d)(2), the court stipulated that it was not clear how the skills and advancements Dynetics developed were anything other than incidental benefits from performance of the research rather than substantial rights in the research. Ultimately, the court concluded that Dynetics had the burden to show that it had substantial rights in the research and its arguments were not persuasive.

Another contract with a university involved research for patentable and nonpatentable technology. The government argued that Dynetics did not have substantial rights in the research due to language in the contract, stating that all the rights of the work belonged to the university. Dynetics conceded that it may not have substantial rights in all of its work for the university but argued that it had substantial rights in the nonpatentable technology. The court disagreed, citing broad language in the contract that vested “other intellectual property rights” in the university.

A more recent case, Populous Holdings, Inc., No. 405-17 (Tax Ct. 1/16/20) (stipulated decision entered), addressed the substantial-rights standard and payment for future use of the research. Populous Holdings, an architectural design service, entered into multiple contracts for design work. In each of the contracts, the client retained ownership of the documents and any models produced. Populous was free to use any design details that were repetitive but was restricted from using project-specific design details. The contracts did not require Populous to pay its clients for use of the research. Citing Lockheed Martin, the court determined on summary judgment that Populous retained substantial rights in the research because no provisions within the contracts prohibited Populous from using the related research technology in its business and the agreements did not require Populous to pay its clients to use the research in future projects.

Perficient and validity of the substantial-rights standard

In the Perficient case, Perficient Inc., a technology services company that designs, builds, and delivers software technology solutions, claimed that it was entitled to summary judgment because (1) each of its sample projects satisfied the risk standard; (2) the substantial-rights standard is procedurally invalid under the Administrative Procedure Act (APA) and substantively invalid under an analysis consistent with that in Chevron USA Inc. v. Natural Resource Defense Council, Inc., 467 U.S. 837 (1984); and (3) even if it were valid, each of the approximately 24 sample projects analyzed satisfied the substantial-rights standard.

Perficient contended that the risk standard was satisfied for the sample projects because each client paid for a product rather than for Perficient to undertake research. In support of its claim, Perficient asserted that certain provisions in the contracts — requiring the client to review and inspect the deliverables, allowing the client to test the deliverables for functionality, and allowing the client to accept or reject the deliverables — demonstrated that Perficient was delivering a solution to a client’s technical issue and not to undertake research. Perficient did not challenge the validity of the risk standard in its motion.

The IRS disputed Perficient’s characterization of its project agreements as product contracts and contended that 22 of the sample projects constituted funded research. The IRS argued that the master agreements governing Perficient’s project contracts required more than just end products. In reference to another sample project where payment depended solely on the passage of a specified amount of time, the IRS distinguished Perficient’s facts from those in Fairchild where Fairchild did not have a right to retain advance payments until after client acceptance. The IRS maintained that a taxpayer’s right to payment cannot only depend on the passage of a specified time but must also depend on a post-inspection approval and acceptance process. Further citing two of the “capped” contracts evaluated in Geosyntec and noting that Geosyntec and Dynetics considered the extent to which clients could reject work by comparing the facts against Fairchild, the IRS contended that a rejection clause in an agreement is irrelevant when there are no detailed specifications on which to measure conformity and base the rejection. Notably, Perficient and the IRS agreed that certain warranty provisions, including warranties relating to general standards of care and assurances that performance will be free from negligence, are not relevant to determining whether a payment is contingent on the success of the research.

With respect to the substantial-rights standard, Perficient cited Oakbrook Land Holdings, LLC, 154 T.C. 180 (2020), which provides that courts must generally give deference to agency regulations if the statute is ambiguous and the agency’s interpretation is “rational” or reasonable. Perficient contended that the substantial-rights standard is procedurally defective under the APA because of Treasury’s failure to discuss, address, or provide any reasoned explanation in response to all comments questioning the inclusion of the substantial-rights standard in the 1983 proposed regulations. Perficient further claimed the substantial-rights standard is substantively defective under the two-step standard for determining deference to regulations under Chevron. Concerning step one of the Chevron analysis, Perficient asserted that Congress explicitly (and unambiguously) addressed the meaning of qualified research to exclude funded research in Sec. 41, and the insertion of the substantial-rights standard in the regulations directly conflicts with congressional intent, in part because there is no evidence that demonstrates the meaning of the word “funded” requires a taxpayer to retain substantial rights to research. Regarding the second step of the Chevron analysis, Perficient asserted that the substantial-rights standard is arbitrary in substance because of Congress’s failure to include any reference or discussion of substantial rights in its directive to promulgate regulations implementing the research credit, which Perficient concluded was evidence that Congress did not intend to expand the meaning of “funded.”

The IRS disputed Perficient’s analysis and asserted that Treasury is not required to address all comments provided in response to proposed regulations, noting that one comment that Perficient referenced in its challenge of procedural validity was sent approximately six years after the close of the notice-and-comment period. With respect to the substantive validity of the substantial-rights standard, the IRS contended that Congress left it to Treasury to define funded research and did not address whether research was “funded” based on which party retains the rights in the research.

Lastly, Perficient contended that even if the substantial-rights standard is valid, each of its 24 sample projects satisfied the standard because Perficient retained the rights to use the research; knowhow; and improvements, modifications, and derivatives to preexisting intellectual property developed or refined in connection with the sample project. Perficient pointed out that Examples 1–4 in Regs. Sec. 1.41-4A(d)(6) clearly establish that the taxpayer’s retention of the right to use the results of the research is a substantial right and cited the court’s holding in Lockheed Martin that a substantial right does not require the right to exclude others from using the research and the holding in Populous that the right to use research without paying for it is a substantial right. The IRS countered that know-how is not a substantial right but rather an incidental benefit that does not constitute a substantial right in the research. The IRS’s position is aligned with Regs. Sec. 1.41-4A(d)(2), which states as an example that “increased experience in a field of research” does not constitute substantial rights in the research, and Dynetics, in which the court stipulated that skills and advancements developed while working on a contract are incidental benefits from performance of the research.

Grigsby and contract language

The recent holding in Grigsby provides further insight regarding the district court’s application of the funded-research exclusion. This case involved Cajun Industries LLC, a construction company taxed as an S corporation that had claimed the research credit for work performed under contractual agreements. In total, four sample projects were evaluated, two of which consisted of “capped” contracts subject to an agreed-upon maximum price and two of which consisted of fixed-price agreements.

The first item at issue in this case was related to the definition of Cajun’s business components in accordance with Sec. 41(d)(2)(B), which provides context for applying the funded-research exclusion. Cajun argued that its business components associated with the sample projects were construction processes that it used when constructing items for its clients. The court rejected Cajun’s position, pointing out that Cajun had previously claimed during the discovery process of the proceedings that it developed a product (rather than a construction process) for each of the sample projects and failed to supplement its discovery responses. The court also reasoned that Cajun’s assertion failed due to a lack of specificity, as Cajun did not identify any new or improved construction processes.

With respect to the funded-research exclusion item at issue, the court found that three of Cajun’s sample projects did not meet the substantial-rights standard, citing guidance provided in Lockheed Martin, which requires a taxpayer to, at a minimum, maintain the right to use its research without having to pay for it. The court referred to language in each of Cajun’s three projects’ agreements, which expressly stated that all of Cajun’s work product transferred to its client. For example, contract terms for one project defined Cajun’s work product as “work for hire” and expressly transferred all “rights, title, and interest” in the work product to the client. Contract terms for another sample project cited by the court provided that “[a]ll inventions, discoveries, and improvements (patentable and unpatentable) that are made or conceived by [Cajun] or [Cajun’s] employees in performing the Services … shall belong to Company.” Citing Dynetics, the court found such contract language to be convincing and indicated that Cajun failed to show a plausible contractual basis that it retained substantial rights to the research.

The court made no ruling on the fourth sample project regarding the substantial-rights standard, since the contract was silent on the ownership of the construction process developed during the project. However, the court concluded that the project did not meet the risk standard. Acknowledging that the contract associated with the project was a fixed-price contract, the court distinguished Cajun’s facts from those in Populous and other prior case law by referencing specific contract terms that stated monthly payments included “full compensation for all loss, damages, or risks of every description connected with or resulting from the nature of the work.” The court found such language conclusive in determining the research performed during the sample project was funded.

Importance of case law to structuring agreements

As evidenced by the developments in Perficient and Grigsby, the funded research exclusion continues to be a highly contentious and evolving provision of the research credit. In lieu of additional, much-needed guidance on the matter, taxpayers should consider prior case law when evaluating if, and to what extent, expenditures could potentially be considered funded research. It would be prudent for taxpayers to evaluate all agreements related to the qualified research and memorialize supplemental facts if elements of the funded-research exclusion rules are not specifically addressed in contemporaneous documentation.

Editor Notes

Alexander J. Brosseau, J.D., CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP. For additional information about these items, contact Mr. Brosseau at 202-661-4532 or abrosseau@deloitte.com.

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