Research Tax Credit & Funded Research

The Research Tax Credit & the Risk Test

By Kreig D. Mitchell

© 2017 - All Rights Reserved - www.empoweredtax.com

The Research Tax Credit

● The research tax credit is one of the most significant tax incentives available today.

● There are a number of rules that define what activities and expenses qualify for the credit.

● There are also several exclusionary rules, such as the funded

research rule.


The Funded Research Exclusion

● The exclusion is for funded research can apply when one party pays another to perform research.

● It can prevent the researcher or the researcher’s client from being able to take the credit.

● It is believed that the purpose of the exclusion is to prevent more than one taxpayer from taking the credit for the same research activity.


The Code

The funded research rule is found in I.R.C. § 41(d)(4)(H), which says:

“Any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity),” is not qualified.


The Regulations

● The regulations include two sets of rules for the funded research exclusion; one applies to the researcher and one applies to the researcher’s client.

● These sets of rules have been referred to mirror image rules even though they do not use the same language.

● These sets of rules create two tests, namely, the rights test and the risk test. This presentation only addresses the risk test.


The Risk Test for the Researcher

The language in the regulations that sets out the risk test for the researcher is as follows:

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 agreements) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded. Amounts payable under any agreement contingent on the success of the research and thus considered to be paid for the product or result of the research (see § 1.41-2(e)(2)) are not treated as funding.


The Risk Test for the Client

The language in the regulations for the risk test for the researcher’s client are as follows:

If an expense is paid or incurred pursuant to an agreement under which payment is contingent on the success of the research, then the expense is considered paid for the product or result rather than the performance of the research, and the payment is not a contract research expense. The previous sentence applies only to that portion of a payment which is contingent on the success of the research.


What Does the Language in the Regulations Mean?

● Given these rules, the researcher satisfies the risk test if payment is contingent on success of the research and the client satisfies this test if payment is not contingent.

● There have been several court cases involving credits taken by the party performing the research that expand on these concepts.


The Court Cases that Address the Risk Test

● Fairchild Industries, Inc. v. United States, 71 F.3d 868 (1995), rev’g 30 Fed. Cl. 839 (1994)

● Geosyntec Consultants, Inc. v. United States, 2013-2 USTC ¶50,498 (2015), aff’d 776 F.3d 1330 (11th Cir. 2015)

● Dynetics, Inc. v. United States, 121 Fed. Cl. 492 (2015)


Fairchild Industries, Inc. v. United States

● Considered the seminal case on point.

● Trial court concluded that the research was funded, but this was reversed on appeal.

● Involved fixed-price type contracts with upfront milestone or periodic payments.

● The appeals court concluded that the periodic payments were more akin to loans that would have to be repaid rather than final payment.

● The appeals court based its decision on the inspection and acceptance terms in the parties contract.


Geosyntec Consultants, Inc. v. United States

● The trial court concluded that the fixed price contracts were not funded, but that the cost-plus capped contracts were funded. The decision was affirmed on appeal.

● For the cost-plus capped contracts, the trial court concluded that the other parties were required to reimburse the taxpayer based on hourly rates based on pre-defined budgets regardless of whether the research failed.


Geosyntec Consultants, Inc. v. United States

● The appeals court concluded that the taxpayer was not subject to performance requirements for these contracts as the taxpayer was only obligated to perform using the standard of care applicable to professionals performing comparable services and there were no quality assurance procedures included in the contracts


Dynetics, Inc. v. United States

● The trial court concluded that the research was funded.

● Involved a refund claim and the government’s motion for summary judgment based on the funded research exclusion.

● The court considered fixed-price, cost-plus, and time-and-materials contracts.

● The court's conclusions are highly-fact specific and difficult to apply to other cases.


How Do We Apply the Risk Test?

The Code, regulations, and court cases can be distilled down to the following rule to apply the risk test:

The type of risk that is to be considered is the financial risk for non-payment. This risk is identified by asking the hypothetical question, viewed from the outset of the contract, as to whether, based on the terms in the party’s contract, the researcher would be paid or the client would not have to pay the researcher if the research failed due to a technical aspect of the research at some point in the future.


Difficulties in Applying the Risk Test

● What agreements can be considered?

● What contract terms can be considered?

● How are contract ambiguities dealt with?

● How are conflicting risk terms dealt with?


Research Tax Credit & Funded Research

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