In more detail
A taxpayer may generally claim credits for up to 20% of qualified research expenses in excess of a base amount defined in section 41. Expressly excluded from the definition of qualified research in section 41 is "funded research," or any research to the extent funded by any grant, contract, or otherwise by another person or governmental entity. The Treasury regulations further explain that a taxpayer can nevertheless get the credit for research funded by another party if payment for the research is "contingent on the success of the research."
Meyer, Borgman & Johnson, Inc. (MBJ) is a structural engineering firm that creates construction documents of the structural design for building projects. MBJ sought research tax credits for its expenses incurred in creating the designs, and claimed about USD 190,000 in tax credits for its 2010, 2011, and 2013 tax years. The Commissioner of Internal Revenue denied the credits, and the US Tax Court affirmed the Commissioner's decision. On appeal to the Eighth Circuit, MBJ argued that its right to payment was contingent on the success of its research. It pointed to contract provisions allowing for termination if MBJ failed to substantially perform in accordance with the terms of the agreement. MBJ likened its contracts to the one approved in Fairchild Indus., Inc. v. United States, which "contained over 1,000 pages of technical specifications that required the taxpayer to meet specific design, construction, quality, and performance standards." In that case, the US Court of Appeals for the Federal Circuit emphasized that the taxpayer remained at risk for each line item until the research was successfully completed and the product of the research was accepted. MBJ further pointed to the inspection, acceptance, and quality assurance provisions of its contracts, which required the client's approval of design documents before the project was allowed to proceed to the next phase.
But the Court found that these provisions lacked the specificity of the contracts in Fairchild, where the taxpayer had to succeed at each step of its research to be paid. Requirements to comply with pertinent codes and regulations or to perform pursuant to a general standard of care, the Court held, do not mandate payment contingent on success. Although the Eighth Circuit acknowledged that MBJ's contracts have the general economic risk of investing resources without a commitment to be paid, the Court found that MBJ's contracts lacked the express terms or clear implication that payment was contingent upon the success of the research, and therefore affirmed the Tax Court's ruling.
Further, MBJ pointed to the fact that its contracts have a fixed price and noted that fixed price contracts are generally considered unfunded research. But the Court disagreed, stating that it is the fact that fixed price contracts may not fully compensate researchers if their research is unsuccessful that makes these contracts more likely to be unfunded research.
For taxpayers seeking the section 41 research credit for funded research, looking to the terms of their contracts will be instructive for determining their eligibility. Based on the Eighth Circuit's opinion (and on the underlying Tax Court opinion), contract provisions must expressly provide or clearly imply that the taxpayer remained at risk until the research was successfully completed and the product of the research was accepted (like the contract at issue in Fairchild). Contracts that have only a general economic risk of non-payment do not necessarily carry the risk that payment is contingent on the success of the research for purposes of the section 41 credit.
