Taking Credit Where Its Due: The Importance of Contracts for Claiming the R & D Credit

At a glance

• The main takeaway: In a recent tax court case, an engineering firm’s research and development (R&D) tax credits were denied on the principle of funded research.
• Aprio’s take on this case: With this ruling, the IRS is once again affirmed that retaining and documenting your company’s rights and risks for contracted development work is critical for claiming and sustaining an R&D tax credit.
• Next steps: Schedule a consultation with Aprio’s R&D Tax Credit specialists to assess your company’s potential eligibility and identify any contractual risks to the research performed.

The full story:

The IRS recently denied an engineering firm’s claims for the federal R&D tax credit in the Meyer, Borgman, & Johnson, Inc. v. Comm’r of Internal Revenue case. This outcome rested on the principle of funded research under Code Sec. 41 (d)(4)(H), which states that “qualified research” does not include efforts funded by any grant, contract, or otherwise by another person (or governmental entity). The court also referenced the Geosyntec Consults, Inc. v. United States case, in which performing activities to meet a general standard of care and comply with pertinent regulations does not mandate success and thereby cannot qualify as R&D.

Why is this important?

The Internal Revenue Code (IRC) and associated guidance issued by the IRS and the Treasury define the types of activities and expenditures that a taxpayer can include in it’s R&D credit computation, as well as additional limiting qualification criteria. For example, a taxpayer must exclude any activities and associated costs for research that is performed outside of the U.S. and research that is funded by another entity.

The Section 41 Treasury Regulations[1] clarify that for purposes of the R&D Tax Credit, research is considered “funded” when two criteria are met:

• Financial risk: the taxpayer does not bear the financial or economic risk associated with performing the research; and
• Substantial rights: the taxpayer does not hold substantial rights to the work performed.

These criteria make the issue of funded research a common concern among companies that either utilize contractors or act as a contractor when performing the research activities. While the language in the tax code provides for some level of interpretation for these scenarios, the determination of whether or not a taxpayer’s research is funded must always be supported by and documented in the contracts governing the work.

For example, taxpayers may be able to qualify R&D activities performed under contract when payment for the work they were contracted for was contingent on a successful result and they retained a substantial interest in the results, such as the right to reuse the research for future projects.

In the case of Meyer, Borgman, & Johnson, Inc., the IRS evaluated the company’s contracts and determined it did not bear the financial risk of the work performed. Therefore, the company’s efforts were considered “funded research” and, ultimately, did not qualify for the R&D tax credit benefit. Cases such as this remind us of the importance in clearly documenting the granular details of agreements between taxpayers and the entities contracting their efforts, regardless of industry or size.

Financial Risk

Research activities can qualify for the R&D credit regardless of whether they result in success —however, there must be an element of financial risk to the taxpayer in the case the research fails to produce the expected result. If a company is investing its own funds into the research, there is no question that the company bears the financial risk. However, if a company has been contracted to perform the research on behalf of a separate entity, the specific terms of the contractual agreement will determine which party bears the financial risk.

The IRS proved that Meyer, Borgman, & Johnson, Inc. did not hold the financial risk of the work performed because their payment was not contingent on the success of the project. While the taxpayer was responsible for methods and means in performing its services, the taxpayer did not cite any provisions requiring it to refund payments already received it failed to meet specific benchmarks. Therefore, whether they succeeded or failed, they would receive payment, which means there was no financial risk tied to the research activities.

Taxpayers operating from a fixed price contract have historically been able to claim the R&D credit because fixed price contracts are inherently riskier, as the taxpayer is financially responsible if the research is unsuccessful as they must correct the failure at their own expense.

However, there are many variations of contractual terms that can make it tricky to determine where the risk may fall. Maintaining clear and thorough contracts is paramount as documentation of qualification for the credit. We highly advise any company pursuing R&D tax credits to work with knowledgeable R&D expert advisors who can accurately assess qualification according to each taxpayer’s specific fact patterns.

Substantial Rights

Equally important, taxpayers must ensure their contracts reinforce a substantial claim to the research’s IP rights.

The tax code specifies in T.R. Sec. 1.41-2(a)(3)(ii) that a taxpayer performing research on behalf of other entities can qualify the expenses of that research, as long as they retain “substantial rights” in the activities. Moreover, the taxpayer can retain substantial rights even when other parties do as well, meaning the taxpayer does not have to claim exclusive rights to their work.

Any company qualifying contracted research must maintain explicit documentation regarding the holder of each activity’s use rights. Careful evaluation of the contracts and documentation is crucial when making this determination.

The bottom line

This case illustrates the importance of obtaining clear contracts and quality documentation for the R&D tax credit, especially if your company works on any projects that might be considered funded research. Companies can document their rights to intellectual property and financial risk by maintaining contracts, invoices, purchase orders, and contemporaneous evidence that show your company would bear the financial risk if the development project was unsuccessful.

If you think you may qualify for the R&D tax credit, Aprio can assess your eligibility and work with you to determine which research projects may qualify. Aprio’s R&D Tax Credit specialists also have the experience to help you document research and development projects and maximize your overall benefit. If you’re interested in learning more about the R&D tax credit, schedule a consultation today to learn more.

Related Resources/Assets/Aprio.com articles/pages

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[1] Note – The standard for “qualified research expenditure” (QRE) classification under Section 41, which governs eligibility for the R&D Tax Credit, is more stringent than the standard for “specified research expenditures” (SRE) classification under Section 174.