The Eleventh Circuit Court of Appeals took a look at what constitutes research funded by a third party in the case of Geosyntec Consultants, Inc. v. United States, CA 11, 115 AFTR 2d ¶ 2015-384.

The issue is of important because research that otherwise is qualifying research for purposes of the research credit under IRC 41 may not be counted in computing the credit if that research is funded by another party. [IRC §41(d)(4)(H)] While that definition may seem straight-forward at first, the reality of business agreements creates cases where the issue may not be crystal clear.

Both parties in this case claimed that a key opinion in this area issued by the Federal Circuit in 1995 on this issue supported their claim (Fairchild Indus., Inc. v. United States, 71 F.3d 868). However the District Court and the appellate panel found the IRS’s view of this situation and the application of the Fairchild decision the more reasonable one.

The contracts at issue were ones where a third party hired the taxpayer to perform activities that constituted qualified research. The Fairchild decision provides that merely being hired to perform research does not automatically invoke §41(d)(4)(H)—the party performing the qualified research will bear the costs upon failure of the research, that party is the one that is eligible to compute a research credit based on the costs. Conversely, if the contracting party is the one that bears such risk, the credit moves to the customer.

The panel’s opinion describes the Fairchild case in this fashion:

In Fairchild, an airplane manufacturer, Fairchild, contracted with the United States Air Force to design and produce the T-46A aircraft. See Fairchild, 71 F.3d at 870. The contract included a full-scale development (FSD) phase and a production phase, but the case focused solely on the FSD phase. Id. Fairchild’s work in the FSD phase was subdivided into eleven separately-priced contract line items, and each line item required “research, development, and testing, to meet complex contract specifications.” Id. at 871, 873. The Fairchild contract contained over 1,000 pages of technical specifications requiring Fairchild to meet specific design, construction, quality, and performance standards. Id. at 870.

Under the terms of the contract, the Air Force was obligated to pay Fairchild only if Fairchild produced results that met the contract’s specifications; equally, Fairchild was entitled to payment only for work delivered to and accepted by the Air Force. See id. at 871. “Quality assurance procedures” required the Air Force to evaluate Fairchild’s work item-by-item. See id. If Fairchild’s work was delivered and deemed unacceptable, the Air Force could reject the work, make Fairchild correct the work at its own expense, or accept the work and pay a reduced price. Id. Examining the contract, the Federal Circuit concluded that “[w]hatever risk Fairchild was bearing, the Air Force bore none of it” because the Air Force only had to pay when the work, “line item by line item, succeeded and was accepted.” Id. at 873. Since Fairchild bore the financial risk of failed research, the contract was not funded, making Fairchild eligible for the research tax credit. See id. at 874.

The situation at hand involved cost-plus contracts where Geosyntec’s revenues on the contract were subject to a maximum amount to be received. Up until Geosyntec hit that cap it would receive its costs plus an additional percentage. If the cost-plus number hit the cap, Geosyntec would end up “on the hook” for the additional expenses.

The cap wasn’t absolute—in the two example contracts used for the purposes of the litigation Geosyntec retained rights to additional compensation beyond the cap if certain situations arose.

Earlier in the litigation the District Court had ruled that for contracts there were purely fixed price contracts (where Geosyntec would be paid $X for delivering at the end of the contract), the contracts were not funded research for purposes of the research. However, the Court concluded the opposite for the cost-plus contracts despite the fact that caps existed on the amounts that Geosyntec could receive.

Geosyntec argued that because it still bore economic risk on the capped contracts (that is, it could lose money on the contract if it had underestimated the work to be done and the issues weren’t covered by clauses allowing for additional compensation), it should be treated as unfunded research.

The appellate court found that this wasn’t the issue at hand. The mere fact they could lose money wasn’t relevant—the issue was whether they bore the risk of unsuccessful research. Geosyntec could lose money simply because they had underestimated the cost of successful research, an unrelated issue. As the court stated “[c]ost-of-performance is not the financial risk with which we are concerned because ‘the only issue is whether payment was contingent on the success of the research’—that is, the financial risk of failure.”

Neither of the contracts made Geosyntec’s compensation expressly contingent on the success of Geosyntec’s research, unlike the case in Fairchild where payment would not be made unless the company succeeded at each step of the process. Both contracts in question obligated the customer to pay for the research (at least up to the maximum amount) regardless of Geosyntec’s success or failure in the research.

While Geosyntec was required under the terms of each contract to perform research in accordance with the standards of care applicable to professionals performing comparable services on the types of contracts involved, that does not mandate that the research be successful.

Thus, the appellate panel affirmed the District Court’s decision that these capped cost-plus contracts were, in fact, funded research as defined by IRC §41(d)(4)(H) and the costs incurred in such contracts could not used in computing research credit for the taxpayer.