United States

Court upholds IRS disallowance of research tax credit for funded research

Taxpayer lacked substantial rights required to qualify for the credit


Are you entitled to a research tax credit if someone else “funds” your research? The question is a threshold issue for the research tax credit–if a taxpayer’s research is funded, then the taxpayer’s research expenses cannot be used to compute a research tax credit. A variation of “funded research” was addressed by the U.S. Court of Federal Claims in Dynetics, Inc v. United States. The court determined that research conducted by the taxpayer was funded by the government and the taxpayer was not entitled to a research tax credit.

In order to qualify for the research tax credit, a taxpayer’s research must not be funded as defined under section 41(d)(4)(H) of the Internal Revenue Code. Regulations interpreting the funding issue contain two factors: (1) that the taxpayer was “at risk” on the contracts and would not get paid unless it was successful, and (2) that the taxpayer retain substantial rights to the research and any resulting intellectual property. If a taxpayer does not meet both requirements, the contract is considered funded and not eligible for inclusion in the research tax credit. Consequently, none of the research expenditures incurred by the taxpayer are eligible for the research tax credit if the project is funded.    

Dynetics, Inc. is an engineering firm located in Huntsville, Alabama that had entered into a number of contracts with the government to provide engineering services. Dynetics filed a claim for refund based on the research tax credit claiming it engaged in qualified research for work performed on over 100 contracts. The IRS disallowed the refunds claims and the taxpayer sued for a refund in the Court of Federal Claims. The case involved two issues: (1) the effect of federal regulations on contract interpretation, and (2) defining “substantial rights” for purposes of funded research.

The government and the taxpayer moved for summary judgment on the issue of “funded research”–whether the research was funded, thereby precluding eligibility for the research tax credit. The taxpayer argued that they were at risk on the contracts; therefore, they were not funded, and eligible for the research tax credit. Because there were so many contracts at issue, the court agreed to analyze seven contracts as representative of the issues in all contracts.

Of the contracts reviewed by the court, most were cost plus fixed fee or a variation thereof. A “cost plus” contract is one where the contractor gets reimbursed for all of their costs plus a fixed fee or profit level. Under a cost plus contract, the contractor is usually not at risk because their costs are reimbursed. Unique to the Dynetics’ argument was the effect of the Federal Acquisition Regulations on the terms of the contract. Government contracting is regulated by the Federal Acquisition Regulations (FAR) and the Defense Acquisition Regulations (DFARs) that define a contractor’s responsibilities and protect the government’s interests. For example, under FAR 52.246-8, the government has the right to inspect and test all work called for by the contract.   

Dynetics argued that its course of dealings with the government established an expectation that it would produce a successful result, regardless of the terms of the contract. Further various provisions of the FARs placed risk upon Dynetics beyond the provisions of the contracts themselves. Therefore, Dynetics argued that even in a cost plus contract where their expenditures would be reimbursed regardless of the deliverable, Dynetics course of dealing with the government along with applicable FAR provisions created risk that caused the contracts not to be funded for purposes of the research tax credit.        

The court in Dynetics, following the long established analysis of government contracts in Fairchild v. United States,  71 F. 3d 868 (Fed. Cir. 1995), found that the provisions of the Federal and Defense Acquisition Regulations did not alter the responsibilities of the contracting parties. DFAR provisions incorporated into the contract allowed for inspection of work and cancellation of the contract at the convenience of the parties, but the clauses did not create a substantial risk that Dynetics would not be paid for its work. Under the terms of the contract, Dynetics was paid for its work plus a profit (cost plus) no matter its perceived risks.

In addition to the funding issue, the court addressed whether Dynetics retained substantial rights in the intellectual property created under the government contracts. Treasury regulation 1.41-4A(d)(2) provides that if a taxpayer does not retain substantial rights in the research under the agreement, the research is treated as fully funded and therefore not qualified research under section 41(d)(4)(H). Incidental benefits such as increased knowledge is not sufficient to be deemed substantial rights.  

Under the applicable provisions of the FAR, all intellectual property became a deliverable to the government; Dynetics did not maintain substantial rights. Generally, Dynetics could not use the results of its research without express authorization of the government. In one specific contract, the relevant contract provision allowed Dynetics to retain all patent rights, subject to the rights obtained by the government under the contract. However, Dynetics never demonstrated that the outcome of the research would result in patentable intellectual property. In all of the contracts examined by the court, Dynetics could never demonstrate that it retained substantial rights in the research beyond any incidental benefit.    

The Dynetics case represents an important obstacle in claiming the research tax credit. As a threshold issue, if a research project is funded then none of the research expenditures qualify for the research tax credit. Consequently, taxpayers need to do a thorough analysis of research-related contracts to determine whether the contract itself will qualify for the research tax credit. Due to the complexity of these contracts, particularly government contracts, assistance in interpreting the contracts may be needed. 


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