SUMMARY
- Populous Holdings, Inc. is an architecture firm that claimed R&D tax credit for activities in 2010 and 2011.
- The IRS denied the claim of $132,539 for the 2011 tax year and $151,494 in carryforward credits from 2010.
- The IRS’ basis for this denial was that the research was funded.
- U.S. Tax Court examined the contracts between Populous and the third party involved finding that Populous had financial risk and sufficient rights to the research and results.
TAX LAW
Section 41(d)(4)(H) notes that “any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)” is not a qualified activity for purposes of the research credit.
- The regulations governing “funded research” appear in Treas. Reg. Sec. 1.41-4A(d). To determine whether research is “funded,” the regulations direct our focus to the agreement(s) executed by the contracting parties: “All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded.”
Research does not constitute qualified research to the extent it is funded by any grant, contract, or otherwise by another person (including any governmental entity). All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded. Amounts payable under any 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.
The regulations specify two main factors (Risk and Rights) as relevant in ascertaining whether research is “funded.”
RISK – payment that is contingent on the success of the research is not treated as funding, while payments that are made regardless of success are considered funded. Generally, this means that payments that are fixed-price or lump sum would be considered “at risk” while payments that are made on a time and materials or on a cost-plus basis are not “at risk”.
The Tax Court in Populus referenced the Fairchild Indus., Inc. v. U.S., 71 F.3d 868 (3d Cir. 1995) and Geosyntec Consultants, Inc. v. U.S., 76 F.3d 1330 (11th Cir. 2015), which deal with the economic risk or who bears the cost of the research. The court looked at the following clauses to determine risk:
- Payment procedures,
- Quality and performance standards,
- Termination clauses,
- Warrant and default provisions,
- Right to review and approve design documents,
- Invoice dispute provisions, and
- Revision obligations and covering related costs.
The court found that (1) none of the contracts required Populous to perform research, (2) Populous was not being paid for its research, and (3) the clients were paying fixed prices for final products. Accordingly, the court held that the payments were contingent on Populous’ successful performance of its research and that it held financial risk.
Rights – the regulations provide that a taxpayer is entitled to the credit only if it “retains substantial rights in the research.” Sec. 1.41-4A(d)(3)(i) “If a taxpayer performing research for another person retains no substantial rights in research under the agreement providing for the research, the research is treated as fully funded.”
Courts have looked to the following contract details to determine who held substantial rights:
- Restrictions from using the research it performed,
- Cost or license needed to pay for the use of research, and
- If the right to use the research was exclusive to the buyer.
In Populus, the court looked to Lockheed Martin Corp. v. U.S., 210 F.3d 1366 (Fed. Cir. 2000) to determine rights. In Lockheed Martin, the court held that the right to use the research without paying the client is a substantial right, the right to use the research need not be exclusive, and that incidental benefits such as increased knowledge or experience do not constitute a substantial right in the research.
The Tax Court reviewed the contract details to determine if Populous maintained substantial rights:
- Was the researcher restricted from using the research it performed,
- Did the researcher need to pay for the use of research, and
- Was the right to use the research exclusive to the buyer.
The IRS argued Populous didn’t have substantial rights due to the following contract details:
- Client’s sole rights to architectural copyrights
- Client owned the architectural copyrights and construction documents, models, renderings, and other work product
- Contract also prohibited petitioner from using or recreating any distinctive original, material exterior features without the client’s consent
The court found that Populous retained sufficient rights to its research and results because there were no provisions in the contracts that prohibited petitioner from using the research it performed or that required it to pay the client for use of the research.
LOOKING AHEAD
Research credit calculations often go beyond the dollars and cents of qualified activities and any contracted services that are being treated as qualified activities should be thoroughly reviewed to confirm financial risk and legal rights to the research performed. Moreover, a planning opportunity may exist to negotiate during the contracting process favorable economic risk and IP ownership rights terms where a taxpayer anticipates performing qualified research under the contract.
For additional assistance or if you have questions contact:
Matt Neuenswander, Tax Manager, Tanner LLC
801.924.5120 | mneuenswander@tannerco.com
Shawn Marchant, Tax Principal, Tanner LLC
801.990.5928 | smarchant@tannerco.com