Why Accountants and Taxpayers Should Pay Attention 

You might be thinking, “I’m not an attorney. I don’t even enjoy watching Law & Order. Why do I need to read an article about contracts and case law?”

The answer is simple. R&D Credits are being disallowed because other people didn’t read articles about contracts and case law.

The “funded research” exclusion is a complexity commonly encountered when companies employ a third-party contractor. In these cases, R&D Tax Credit eligibility often hinges on contractual language and interpretation. The right phrase – or lack thereof – can make the difference between a valuable tax offset – and a disallowance.

The tax code isn’t explicit here – there are no “magic words” that automatically indicate eligibility. As a result, professionals are turning to case law and drawing inferences from there. Fortunately, there has been an abundance of activity in contract law recently, and many lessons can be gleaned.

Let’s explore two recent cases — Meyer Borgman Johnson v. Commissioner and Smith v. Commissioner – and consider how those rulings can guide us in successfully claiming the R&D Tax Credit.

Defining “Funded” vs. “Non-Funded” Research

But first, let’s back up a moment and review the definition of funded research according to Sec. 1.41-4A(d)(1):

“In general. Research does not constitute qualified research to the extent it is funded by any grant, contract, or otherwise by another person (including any governmental entity). All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded.”

On a practical level, the status of contractual research is determined by two elements:

• Economic Risk: The entity that maintains the economic risk is the one with something to lose. Who is that?

• • It might be the parent company – if the third-party contractor gets paid no matter what, the parent company is taking the risks.
  • It might be the third-party contractor – if they will only get paid if they are successful, they’re taking the risk.
  • It all depends on the precise terms of the contract.

• Substantial Rights: The entity that retains the rights can use the results of the research – the IP or work product — for their business without restriction, and without having to pay for the privilege.

The entity that maintains the economic risk and retains the substantial rights to the research is the one who is eligible to claim the Credit. 

Risks + Rights = Credit-Eligible 

It seems pretty straightforward, but – as is so often the case – the devil is in the details. If contractual language is vague or imprecise, disaster may ensue.

Meyer Borgman Johnson (MBJ) v. Commissioner (2024)

Case Background 

Meyer Borgman Johnson (MBJ) is a structural engineering firm that entered into multiple fixed-price contracts with clients. MBJ claimed the Credit on its federal returns, confident that they maintained the economic risk and retained the substantial rights.

• MBJ argued that fixed-price contracts inherently signaled economic risk, which they certainly can — if a design required more revisions, MBJ wouldn’t get paid any more.
• They also believed they retained enough rights to the underlying research processes and know-how used across projects.

Case Analysis 

The Tax Court ruled against MBJ, stating that:

• The contracts lacked specificity: There was no explicit language tying payment to the successful development of a specific research result.

• • The contract did say that the client had to approve each stage of the design before MBJ could move forward, and MBJ argued that – in that sense – payment was contingent on success.
  • Their argument was denied – the contract needed to plainly tie “success at each step” to “compensation.”

• Boilerplate contract terms were insufficient: Generic provisions failed to clearly show that MBJ retained substantial rights or bore meaningful economic risk.
• The contract did state that MBJ’s design had to comply with all regulations, be structurally sound, and come in within budget. MBJ argued that this implied that they had to succeed in order to be compensated.
• Denied again – the contract simply mandated that MBJ deliver a decent product. The court noted that “…performing to a general standard of care does not ‘mandate success.’”
• No documentation supported MBJ’s claim of retained rights: There was no clear contractual right to use or reproduce the design work beyond the client’s project.

Case Takeaways  

• While a fixed-price contract is promising, it’s not always enough to automatically demonstrate risk. The court looked for explicit terms that linked compensation to successful project outcomes.
• Granular contract language is essential: Each word is key. And what is left out can be just as significant as what is included. 
• Documentation must spell out each party’s responsibilities and ownership in detail.

Smith v. Commissioner (2024)

Case Background 

Smith, an architectural design firm based in Chicago, provided design services to multiple international clients. They claimed the Credit, asserting that they maintained the risk and retained the rights.

Case Analysis  

The IRS zeroed in on certain aspects of the contract, including:

• A clause stating that “[a]ll inventions, discoveries, and improvements (patentable and unpatentable)… shall belong to Company.”
• Clauses suggesting clients retained full rights to the final deliverables.
• No mention of Smith being able to reuse designs or processes without permission.
• Compensation not explicitly tied to success.

Smith argued that they had developed certain skills in the course of performing the research, and as such they retained substantial rights. The Court responded that these skills were “institutional knowledge,” and did not represent substantial rights. Maybe Smith could use some generalized ideas, but ownership of the work product was clearly transferred to the clients.

Case Takeaways 

• Contracts that transfer ownership of IP/work product to the funding party disqualifies the research, even if skills were gained.
• Again, payment not tied to success – if compensation is guaranteed regardless of outcome, the risk shifts to the funding party.

What’s a Taxpayer to Do?

The MBJ and Smith cases demonstrate that IRS scrutiny is laser-focused on contract interpretation. Businesses that invest in innovation but overlook the legal nuances risk losing substantial credits.

You’re still not an attorney. But now that you’ve read this article, you recognize the importance of working with a good one.

Don’t miss out because of legalese. It’s crucial to find an advisor experienced in R&D tax law and contract interpretation. These experts can help you:

• Determine your eligibility status
• Review contract templates
• Consider potential contractual amendments in light of your business case
• Ensure contracts explicitly document who bears the risk and who retains the rights
• Establish appropriate documentation processes

At Capstan, our team of engineers, tax professionals, and attorneys are here to help. We’ve reviewed 1000s of contracts and we understand that every word matters. Let us know if we can give you a hand.

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Want more details?  We’ve got an all-new CPE webinar coming to Capstan University this summer. More case law, more contracts, a survey of common red flags, and actionable steps you can take to aid your clients. Keep your eyes on Capstan University.