- Since the permanent passage of the R&D tax credit, the 4-part test has guided what research means.
- Litigation, and not legislation, has helped to further define what qualified research means in research and development.
- If legal analysis and insight are needed, companies should feel confident when they have an attorney ontheir R&D team.
When Did the R&D Tax Credit Begin?
Established in 1981, the Credit for Increasing Research Activities was intended to provide American industries with an incentive to invest in research and development within the United States. The Credit was specifically designed to “reverse [the] decline in research spending by industry” and to sway companies “to bear the significant costs…. Which must be incurred to initiate or expand research programs in a trade or business.”
The House Report also cited that a substantial tax credit for costs associated with research and experimental expenses would help reduce the resistance of many businesses to absorb the substantial costs of staffing, supplies, and certain computer charges which are needed to initiate or expand research programs.
Renewed on a nearly annual basis until its permanency in 2015, the R&D credit, like other tax credits and deductions, “are a matter of legislative grace and the taxpayer must clearly demonstrate entitlement to the credit.” To determine whether a taxpayer can qualify for the credit, the taxpayer must determine whether it meets the statutory requirements. This involves not only careful consideration and analysis as to the qualification criteria, but also a review of the exclusions and relevant case law to determine eligibility.
What Determines Eligibility for the Tax Credit?
Specifically, the qualifications for the Credit are provided within what is now Section 41 of the Internal Revenue Code and are often referred to by individuals familiar with the incentive as the “Four-Part Test”. For purposes of the Credit, qualified research is defined as activities that are “undertaken for the purpose of discovering information… which is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer.”
Further, “substantially all of the activities of which constitute elements of a process of experimentation” The Code defines a few key elements of the Four Part Test within Section 41. For instance, a “business component” is defined as “any product, process, computer software, technique, formula, or invention which is to be… held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer.”
The Code also cites several permitted purposes for which research may be qualified under this incentive, including “a new or improved function, performance, reliability, or quality.” The Code also specifically states purposes for which research will not be considered for the credit, including “if it relates to style, taste, cosmetic, or seasonal design factors.”
In addition to the Four-Part Test qualification criteria, the Code also provides specific exclusions for which the research activities and associated expenses would never be considered qualified.
These specific exclusions include:
- Research after commercial production
- Adaptation of existing business components
- Duplication of existing business components, surveys, studies, etc., computer software, foreign research, any research in the social sciences, and funded research
When a taxpayer satisfies all of these statutory elements, the taxpayer may take a variety of associated research and development related costs, including:
- Wages paid or incurred to an employee for qualified services performed
- Amount[s] paid or incurred for supplies used in the conduct of qualified research
- Any amount paid or incurred to another person for the right to use computers in the conduct of qualified research
- Any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research
An Important Check on the Tax Credit
To truly ensure the legislative intent of incentivizing taxpayers to take on the substantial economic risk associated with incurring these costs for development activities in the United States, one critical check on the credit is the funded research provision within the exclusions in Section 41.
This check is defined as “[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).” While Section 41 does not provide an exact definition of “funded”, the Treasury Regulations have stated that R&D would not be considered funded if payment to the taxpayer is “contingent upon the success of the research and thus considered to be paid for the product or result of the research” and the taxpayer must retain “substantial rights” in the research.
These two guidelines combined ensure that the only taxpayers entitled to credit are the taxpayers that have carried the financial risk of the R&D failing and maintained the right to use the research within their businesses. Because of this, the research credit has functioned to provide an incentive for taxpayers engaging and incurring costs related to applied research, or research that is performed for the discovery of information that has commercial objectives.
This is in direct contrast to research that is traditionally funded, such as academic or basic research where the organizations or individuals engaging in such research are seeking knowledge base expansion and not commercialization of a research concept or idea. Academic or basic research is usually developed independent of commercial goals, and therefore is not usually connected to a business component, and therefore does not satisfy the Four-Part Test.
Court Cases that Shaped the Tax Credit
While the Treasury Regulations do provide some guidance as to the meaning of “funded” for purposes of exclusion from the qualification for the R&D credit, it has not fully clarified the effect of this exclusion and the application of the exclusion in practice. As with most vague statutes that have gone unclarified, the issue of what constitutes funded research has been left to the courts to decide. Over nearly the span of the last three decades, several cases have been decided that have helped to narrow down the broad meaning of “funded research” as it relates to the tax credit.
Fairchild Industries Inc. v. United States
The first of this litany of cases was Fairchild Industries Inc. v. United States in 1996. While the funded research analysis consists of a two-prong analysis, Fairchild focused exclusively on the issue of the payment terms of the contract for R&D. In Fairchild, the court focused its analysis on whether payments were contingent upon the success of the research. The Federal Circuit Court did this by reviewing a contract with a fixed price paid via progress payments that Fairchild was required to refund if the government was dissatisfied with Fairchild’s performance of the contracted work. The court here held that payment that is contingent upon success weighs on who bears the research costs upon the failure, not whether the researcher is likely to succeed in performing the project.
In summary, the court determined Fairchild bore the cost of the failed research because it was required to provide a conforming product, and the government had the right to reject the product prior to paying for Fairchild’s work. The court’s interpretation was consistent with the legislative intent and allowed the taxpayer to factor in the research credit when determining whether to take on additional investment risks.
Lockheed Martin Corp. v. United States
The issue of funded research was again litigated just a few years later in Lockheed Martin Corp. v. United States where the court this time looked at the substantial rights associated with the research, the second prong of the funded research analysis. Here, the court held that the right to use the research without paying the client is an example of a substantial right maintained by the taxpayer, and that the right to use the research does not need to be exclusive. However, incidental benefits, including increased knowledge or experience do not constitute a substantial right in research.
Geosyntec Consultants Inc. v. United States
In recent years, the funded research pendulum has continued to swing both towards and further away from the legislative intent. For instance, the 11 Circuit in Geosyntec Consultants Inc. v. United States analyzed the different types of payment types and contrasted those payment types with the ones analyzed in Fairchild. That same year, the court also issued a decision on whether it was proper to utilize the parol evidence rule for R&D contracts in Dynetics Inc. v. United States.
More recently, the United States Tax Court provided specific examples of benefits that constituted substantial rights an architecture firm retained in Populous Holdings, Inc. v. Commissioner of Internal Revenue. Finally, in 2021, the United States Tax Court again was asked to determine whether a taxpayer retained substantial rights in research it performed under contract in Tangel v. Commissioner of Internal Revenue.
Even within the last few years, legislation has passed that influenced how the tax credit is calculated, including the Employee Retention Tax Credit, the Chief Counsel Memorandum of 1/10/2022, and the Inflation Reduction Act and CHIPS Act.
You Need a Lawyer on Your Side with R&D
It is clear by the continuous influx of litigation concerning this pivotal issue that further legal analysis and insight is necessary to influence and guide legislative and administrative decisions to ensure the true legislative intent of the credit is successfully carried out. Additional legal analysis is critical for specialty tax firms. Taxpayers should feel secure that when they file their claims, they’re in compliance with the ever changing legal landscape.
As more and more litigation is undertaken by both the IRS and individual taxpayers, more often than not, the outcome is moving further and further away from the legislative intent of the credit. Claim every penny you’re owed with confidence when you work with Strike’s tax specialists. Our thorough documentation process protects your business tax credits.
In the business tax credit world, research and development (R&D) specialty tax firms must pay careful attention to relevant case law so they can calculate credits accurately for their clients (see recent changes to R&D tax law from the Tax Cuts and Jobs Act of 2017). While Congress has the privilege of making laws, it leaves the interpretation of these broader laws up to the courts or federal agencies. The scope of tax laws are narrowed down by the Internal Revenue Service or through court cases, and these laws can (and do) change over time.