Research credit denied for capped cost-plus contract work
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In response to an appeal from a U.S. district court, the 11th Circuit Court of Appeals found that certain research contracts containing a cost-plus fee arrangement subject to a cap were funded research, disqualifying costs associated with work performed under such contracts from treatment as qualified research expenditures. While this appeals decision in Geosyntec1 is taxpayer-unfriendly, it further clarifies the definition of funded research by differentiating the facts from those addressed in Fairchild Industries.2
In the district court case, Geosyntec, an environmental and geological infrastructure consulting and engineering firm, sought a refund for research credits related to numerous consulting projects it was engaged to perform by unrelated third parties. The specific refund claims involved three types of contracts: fixed-price, cost-plus, and cost-plus subject to a ceiling (capped cost-plus contracts). The underlying issue revolved around a determination as to whether each contract was considered funded research3 and, thus, not qualified for the research credit. The court sided with Geosyntec on fixed-price contracts, and while Geosyntec conceded that cost-plus contracts were nonqualified funded research, the district court also found that capped cost-plus contracts were nonqualified funded research. Geosyntec disagreed and appealed the decision.
Funded research and Fairchild
Generally, expenses associated with research funded by a grant, contract or third party are considered nonqualified research expenses to the researcher or contractor unless the amounts payable under the agreement are contingent on the success of the underlying research.4 This rule is based on the underlying concept that in order for an expense to be a qualified research expenditure, a taxpayer must bear the expense of the research, regardless of the outcome.
Fairchild Industries is the seminal case addressing the concept of funded research. In Fairchild Industries, the taxpayer was contracted by the U.S. Air Force to design a new type of aircraft. The contract contained numerous technical specifications listed as separately priced contract line items, and the Air Force was only obligated to pay for research that met each line-item specification. The Air Force was also entitled to reject work that was not up to its specifications, at which point Fairchild could continue research at its own expense or a reduced fee. Due to these factors, the court held that Fairchild clearly bore the risk of failure under the contract since payment was contingent on the acceptance of each contract line item, which was in turn contingent on the underlying success of each technical specification. Ultimately, Fairchild had to succeed on each item to obtain payment. Fairchild Industries has been held as precedent since the Federal Circuit Court’s 1995 decision.
Upon appeal to the 11th Circuit Court of Appeals, two specific capped cost-plus contracts between Geosyntec and its clients were reviewed by the court. Pursuant to both contracts, Geosyntec was to perform services on a cost reimbursement basis, with amounts not to exceed an agreed-upon dollar amount (i.e., the cap). A provision allowed Geosyntec to recover additional dollar amounts if certain circumstances occurred (primarily related to government regulations changing). These contracts had specific pricing for separately identifiable line item tasks. Geosyntec would provide invoices for each item as the task was completed, and the client would have to approve each item before issuing payment to Geosyntec. The contracts required Geosyntec to perform the duties to a degree of professional care at which a licensed professional engineering firm would perform comparable services.
Geosyntec argued that it faced substantial economic risk under these contracts because payment would only cover incurred expenses, preventing Geosyntec from making a profit if the expenses were in excess of the capped fee. Furthermore, Geosyntec argued that the totality of the contract provisions placed financial risk on itself, even though successful product completion was not specified in the terms of the contract.
The appellate court found against Geosyntec’s arguments for both contracts, essentially ruling that cost-plus contracts subject to a cap or ceiling are funded contracts and, thus, ineligible as qualified research for the contract research provider. It should be noted that the court did not opine on the qualified status for Geosyntec’s clients. The court took a three-pronged approach in making this determination.
First, the court opined that Geosyntec did not face substantial financial risk under the contracts because cost-of-performance contracts focus on the amount being paid subject to a contract, not the success or failure of the research. Additionally, Geosyntec was entitled to certain excess payments if undue situations arose, which essentially raised the ceiling of each contract and pointed to a lack of economic or financial risk.
Second, the court ruled that fulfillment of the contracts did not truly depend on the success of Geosyntec’s work and only required that Geosyntec complete such work to industry standards. In Fairchild, the taxpayer had to succeed in order to receive payment. In Geosyntec, the clients engaged Geosyntec to perform research, not to obtain a specific result.
Finally, the court found that the totality of the contracts’ provisions did not mandate a successful product outcome, and therefore, the risk of failed research was not borne by Geosyntec.
Capped cost-plus contracts are commonly used by engineering firms in practice. While such firms attempt to claim research credits on these types of contracts, the Geosyntec ruling severely limits the qualification of such contracts for the contractor. Taxpayers should be careful to adhere to the Fairchild standards when drafting contract arrangements if they expect to qualify such contracts for the research credit.
1 Geosyntec Consultants, Inc. v. U.S., 115 AFTR 2d 2015, (CA11), 01/29/2015.
2 Fairchild Industries, Inc. v. U.S., 76 AFTR 2d 95-7707 (71 F3d 868), 11/29/1995.
3 Section 41(d)(4)(H).
4 Reg. section 1.41-4A(d).