Whether the R&D activities a company performs under contract are eligible for federal R&D tax credits comes down, ultimately, to whether taxing authorities consider the research “funded.” That determination is often a matter of some debate, as court cases have illustrated time and again.

In the latest case on this issue, Dynetics Inc. and Subsidiaries v. United States, Chief Judge Campbell-Smith of the US Court of Federal Claims issued a nearly 50-page opinion that centered on whether the R&D performed by Dynetics, an engineering company, was considered funded research under the relevant tax code and regulation sections. After reviewing each contract in great detail, the court determined that all the contracts were funded and therefore ineligible for R&D credits.

The decision could have broad implications for engineering and other companies that claim R&D credits in connection with work performed under contract with government agencies, universities, and commercial enterprises, and it underscores once again the importance of analyzing R&D contracts in detail before claiming the credit.

Funded Research

In general there are two requirements that a taxpayer must meet for work to be considered not funded and therefore eligible for the credit. First, the taxpayer must bear financial risk of failure—in other words, the contract must be such that the taxpayer will not receive payment from its customers unless the research is successful. Second, the taxpayer must have substantial rights to the results of the research, which means it must be able to use the intellectual property or information discovered in its trade or business without having to pay for that right. Prior case law has established that taxpayers don't need to retain exclusive rights to the results of the research to meet this requirement.

At issue in Dynetics were seven defense and aerospace contracts, which were intended to serve as a representative sample of the more than 100 contracts the company had engaged in over a three-year period. Each of the contracts the court reviewed fell into one of the following categories:

• Cost plus fixed fee
• Cost plus fixed fee and level of effort
• Fixed price and level of effort
• Time and materials

Note that standard fixed-price agreements weren't challenged by the IRS as being funded research.

Dynetics maintained that its customers could withhold payment under each agreement if the customer didn't accept its performance or deliverables upon inspection, staking its argument on what happens in practice. Whereas Dynetics cited how its relationships with customers operate, the IRS and the court focused on the fine print of each contract, including any standard template language and general contract provisions incorporated through federal acquisition regulations common in the industry.

Additionally, the court found that Dynetics didn't meet its burden of proof in demonstrating substantial rights in two of the contracts it reviewed.

Know the Terms of Your Contracts

Less than six months ago, the US Court of Appeals came to a similar decision in Geosyntec Consultants Inc. v. United States, which concerned research performed under cost-plus-fixed-fee agreements (that is, capped contracts).

Due to these recent developments, it's imperative that engineering and other companies review and understand the terms of the agreements they enter into with customers, including any general terms and conditions that are incorporated by reference. Any positions with respect to financial risk and intellectual property rights must be carefully considered and thoroughly documented for R&D tax credit purposes.

Here are some of the key takeaways on specific contract clauses from the judge's opinion in Dynetics:

• Inspection clauses. An inspection clause alone didn't grant Dynetics's customers the right to reject work or services (labor) or to refuse payment based on the terms of the specific provisions reviewed. Therefore, the court found that Dynetics bore no financial risk.
• Warranty clauses. Even though Dynetics was required under its contracts to correct or replace any nonconforming services at cost—that is, labor costs without profit—the court found this still didn't constitute financial risk. This held true even if the customer paid a third party for replacement services and billed Dynetics. The court ruled that this situation wasn't a failure of research but rather a failure to deliver on the contract terms.
• Patent rights. A contract provision that granted patent rights to the researcher didn't create R&D eligibility because nothing patentable had been created.
• State laws. The state laws that governed Dynetics's contracts were deemed irrelevant to federal R&D credit eligibility because they weren't explicitly incorporated in its contracts.
• Level-of-effort contracts. In cases where payment was based on level of effort (such as work hours) rather than the result of the research, Dynetics's R&D was considered funded. This was determined to be true of agreements of any type (cost plus fixed fee, time and materials, etc.) that also contained a level-of-effort payment arrangement.

We're Here to Help

If your company performs R&D, review the terms of your agreements carefully before proceeding to claim the R&D credit. Moss Adams can help you determine your eligibility and document both your transactions with clients and your R&D expenses. To learn more, contact your Moss Adams professional.