Recently, in Populous Holdings, Inc (“Populous”) v. Commissioner of Internal Revenue (Docket No. 405-17), United States Tax Court Judge Robert Goeke (Judge Goeke) reviewed the Commissioner’s claims that taxpayer, Populous, was not entitled to their 2010 and 2011 federal research and development (R&D) tax credit under section 41 because their research was deemed by the IRS to be “funded” by another party. The Internal Revenue Code disallows expenses for the R&D tax credit related to “research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)”. In a taxpayer-favorable ruling, Judge Goeke found in favor of Populous with a summary judgment that Populous’ research was not funded under its contractual terms.
Populous is a global architecture firm with its American Headquarters located in Kansas City, Missouri that claimed federal R&D tax credits on their 2010 and 2011 federal tax returns. In the case of Populous Holdings, Inc (“Populous”) v. Commissioner of Internal Revenue, the Court allowed over $284,000 of contested R&D tax credits between 2010 and 2011 relating to over 100 projects and sub-contracts conducted in connection to Populous’ architectural design services business.
Judge Goeke reviewed a sampling of five (5) contracts to determine if the Populous research expenses were considered “funded research”, which are excluded from the research expenses per section 41(d)(4)(H). Contract research must meet two conditions in order to not be considered funded: the payment is contingent on the success of the research and the contractor retains substantial rights in the research. In short, Populous needed to have financial risk and intellectual property rights to the research.
The research expenses in question were based on fixed-price contracts between Populous and their clients. The Commissioner argued the contracts were not contingent on the success of the research and Populous did not retain substantial rights in three (3) of the five (5) contracts. Judge Goeke stated “Fixed-priced contracts are inherently risky…fixed-priced contracts generally place maximum economic risk on contractors who ultimately bear responsibility for all costs and resulting profit or loss”. In this specific instance, the five (5) contracts granted Populous’ clients with a warranty clause which provided them “the right to review and approve design documents and dispute invoices”. The court found that this clearly reflected payment was based on the success of the research and thusly placed financial risk on Populous. Further, Judge Goeke noted, “there is no provision in the contracts the prohibits [Populous] from using the research it performed or that it required it to pay the client for the use of the research.” This reflects Populous retained substantial rights to the research, as taxpayers do not need to obtain exclusive rights to the research performed in order to have rights to use their research outside of the contract.
This summary judgment provides two key takeaways. The first key takeaway is architecture firms can perform R&D qualified activities and may be eligible for the federal R&D tax credit. Secondly, taxpayers now have more defined guidance on fixed-price contracts. The terms of fixed-priced contracts must be reviewed in detail to determine if there is risk and substantial rights before determining if the research is funded, regardless of the industry. This has the potential to allow additional companies to qualify for the R&D tax credit for performing contract research under fixed-price contracts. As a result, taxpayers should reevaluate their R&D tax credit eligibility in light of this court decision to determine if their R&D expenditures being performed on behalf of third parties may in fact be qualified for the R&D tax credit.