"Funded" Research Precludes Engineering Firm from Taking Research Tax Credits

(Parker Tax Publishing June 2024)

The Eighth Circuit affirmed the Tax Court and held that a structural engineering firm was not entitled to tax credits for research expenses incurred in creating documents for certain building projects because the research was considered "funded" within the meaning of Code Sec. 41(d)(4)(H). In so holding, the Eighth Circuit rejected the firm's arguments that it was entitled to the credits because (1) its right to payment was contingent on the success of its research, and (2) its contracts had inspection, acceptance, and quality assurance provisions. Meyer, Borgman & Johnson, Inc. v. Comm'r, 2024 PTC 143 (8th Cir. 2024).

Background

Meyer, Borgman, & Johnson, Inc. (MBJ) is a structural engineering firm that creates construction documents for building projects. MBJ sought research tax credits of about $190,000 under Code Sec. 41 for expenses incurred in creating designs during its tax years ending September 30, 2010, September 30, 2011, and September 30, 2013.

The Code Sec. 41 research credit is limited to expenses for qualified research. Code Sec. 41(d)(1)(B) defines qualified research as research undertaken for the purpose of discovering information that is (1) technological in nature, and (2) intended to be useful in the development of a new or improved business component of the taxpayer. Code Sec. 41(d)(4)(H) expressly excludes from the definition of qualified research any research to the extent funded by any grant, contract, or otherwise by another person or government entity. Reg. Sec. 1.41-4(c)(9) provides that Reg. Sec. 1.41-4A(d) applies in determining the extent to which research is so funded. Under Reg. Sec. 1.41-4A(d)(1), a taxpayer is eligible for the research credit if the payment for the research is contingent on the success of the research. Reg. Sec. 1.41-4A(d)(1) provides that research is funded if: (1) the researcher retains no substantial rights in its research; or (2) payment is not contingent upon the research's success.

The IRS determined that MBJ was not entitled to the research credits and the Tax Court affirmed. In granting the IRS summary judgment, the Tax Court held that MBJ's research was "funded" within the meaning of Code Sec. 41(d)(4)(H) and thus did not qualify for the research credits. The Tax Court also found that none of MBJ's contracts expressly or by clear implication made the payments to MBJ contingent on the success of MBJ's research.

MBJ appealed to the Eighth Circuit, arguing that it qualified for the research credit because (1) as required by Reg. Sec. 1.41-4(d), its right to the payments received was contingent on the success of its research, and (2) its contracts had inspection, acceptance, and quality assurance provisions and thus were similar to the contract in Fairchild Industries, Inc. v. U.S., 71 F.3d 868 (Fed. Cir. 1996), which was approved as qualifying for the research tax credit.

According to MBJ, its payments were contingent on the success of its research because under each of its contracts, it was required to create a design that included all of the items the owner required and MBJ complied with all of the pertinent codes and regulations that would result in a structurally sound building without being so over-engineered as to compromise the construction budget, and each building construction contract was sufficiently detailed so that a contractor could follow it and successfully construct the building. MBJ highlighted provisions that allowed termination for not substantially performing and stressed that its contracts were not only fixed price arrangements but had inspection, acceptance, and quality assurance provisions.

Analysis

The Eighth Circuit held that the Tax Court correctly ruled that MBJ's research expenses did not qualify for the research tax credit. The court rejected MBJ's comparison of its contracts to the contract in Fairchild after noting that the Fairchild contract contained over 1,000 pages of technical specifications that required Fairchild to meet specific design, construction, quality, and performance standards while also remaining at risk for each line item until the research was successfully completed and the product of the research was accepted. The court contrasted that to MBJ's contracts which had the general economic risk of investing resources without a commitment to be paid. However, the court noted that the risk was not contingent on the success of the research itself as none of the contracts expressly or by clear implication made payment contingent on the success of MBJ's research. According to the court, there is a difference between "successful performance" - meeting detailed, barometers of success - and "proper performance" - providing deliverables pursuant to a general professional standard of care and promising work free from negligence, error, or defects.

The Eighth Circuit also cited the Eleventh Circuit's decision in Geosyntec Consultants, Inc. v. U.S., 2015 PTC 31 (11th Cir. 2015), where that court held that the contracts at issue were funded and thus did not qualify for the credit. For one of the Geosyntec contracts, the court noted, the design was left almost entirely to Geosyntec's professional expertise, informed by Geosyntec's own research, and subject to general (and, at times, passive) requirements. As the Eighth Circuit observed, many of MBJ's contracts were similar, with MBJ being responsible for the methods and means used in performing its services consistent with the general standard of care. Further, the court noted that MBJ did not cite any provisions requiring it to refund payments already received if it failed to meet specific benchmarks.

The court found that, while MBJ's contracts had the general economic risk of investing resources without a commitment to be paid, this risk was not contingent on the success of the research itself. None of the contracts, the court pointed out, expressly or by clear implication made payment contingent on the success of MBJ's research. MBJ's clients contracted for design services and MBJ agreed to adhere to professional standards. Requirements to comply with pertinent codes and regulations or to perform pursuant to a general standard of care, the court observed, does not mandate success.

The Eighth Circuit also cited a Fifth Circuit case, U.S. v. Grigsby, 2023 PTC 301 (5th Cir. 2023), in which the taxpayer argued that research was not funded because payments were contingent on delivering a "result or product." The Fifth Circuit disagreed and found that the taxpayer improperly conflated "contracts for products or services" with "amounts payable under any agreement that are contingent on the success of the research." The Fifth Circuit also rejected the taxpayer's argument that the "inherently risky" nature of fixed price contracts made them per se not funded. Because the payments under the contract were not contingent on the success of research, the research relating to the contract was funded and did not qualify for the credit.

For a discussion of expenses that qualify for the Code Sec. 41 research tax credit, see Parker Tax ¶104,905.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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