Can you still qualify for R&D credit if all of your research activities are funded or under contract?
When evaluating a client’s potential to claim the R&D credit, an understanding of the client’s business and contractual relationships is critical. For clients that design and produce goods for sale to external customers, such as a pharmaceutical company, funded research will generally not be an issue. However, for clients that provide services, such as an architecture firm, a thorough analysis and understanding of the contractual relationships of the client is necessary.
The essence of this requirement is to determine if the taxpayer claiming the credit has an adequate financial risk for the costs incurred and retains substantial rights to the research results. Most taxpayers would reply “we always have financial risk”, but the IRS is concerned with determining who bears the contractual risk. Essentially, if the project is not completed per specification or in a timely fashion, who’s left holding the bag? Generally speaking, as a payee the taxpayer must bear financial risk through a fixed-fee type contract or a success-based fee to claim the R&D credit. Cost plus and time and materials contracts will generally not qualify for inclusion in the R&D credit of the payee.
In order to qualify for the credit, each project must be assessed to determine whether the scope of work meets the Four-Part test as well as determining whether the project is “funded”, which is an exclusion promulgated in the Code. Each governing contract for a project containing qualified activity must be assessed to determine whether it meets the requirements of the Code. During this assessment a two-prong test approach should be taken. In reviewing each contract, CPA/consultant should assess whether: 1) payment was contingent upon success of the research, and 2) whether or not the Company retained substantial rights to the research. These tests are satisfied by reviewing the fee structure and other language within the confines of the contract.
Several court cases have examined funded research in relation to the R&D credit. In Dynetics, Inc. v. U.S., a recent case from 2015, the Court of Federal Claims considered whether the taxpayer’s activities were funded research. The research conducted by Dynetics, Inc., a government contractor of information technology, was found by the Court to be funded research as the payment received was not contingent on the success of the research and the company did not retain substantial rights to the results of the research. Thus, the R&D credit related to these activities was disallowed.
In the contracts reviewed by the Court, the taxpayer did not explicitly accept contractual responsibility for producing any product or result. As such, Dynetics bore no risk since they were to receive payment regardless of the outcome of the research. In determining whether or not Dynetics retained significant rights in the research, the Court reviewed the plain language of the contract included in the following provision: “All rights, title and interest in and to inventions or other intellectual property rights conceived or reduced to practice in the course of performance of the work called for by this Contract are hereby vested in the University.” As a result of this provision, and since the taxpayer could produce no additional evidence to the contrary, the Court found that the taxpayer did not retain rights in the research.
For further review, other relevant cases that concern funded research include Fairchild Industries v. U.S. (Fed. Cir. 1996), Lockheed Martin v. U.S., 210 F. 3d 1338 (Fed. Cir. 2000), Geosyntec Consultants, Inc. v. U.S., 112 AFTR2d2013-5488, 2013-2 USTC P50, 498 (2013), and Union Carbide (97 T.C.M. 1207, 1259 (2009)).