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VideoHow Contract Language Affects Funded Research and Research Tax Credit Claims
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Companies claiming the Research Tax Credit (RTC) often focus on whether their activities qualify while overlooking a critical factor: contract language. The Tax Court’s decision in Smith v. Commissioner, T.C. Memo 2026-50 reinforces that contract structure can directly determine whether research is considered “funded” and therefore is ineligible for the credit.
This case provides clarity on how courts evaluate fixed-fee and milestone-based contracts, particularly for organizations in design, engineering, construction and consulting. It also highlights how jurisdiction affects the standard for reasonable compensation under Section 174(e).
Key Questions to Consider About Funded Research and RTC Eligibility
If your organization claims the RTC for work performed under contract, this decision provides additional insight into how contract terms may affect eligibility:
- Do your contracts preserve substantial rights to research results?
Retaining copyright or ownership or avoiding a blanket requirement to obtain client consent before using research results can support the substantial rights requirement. - Are payments contingent on the success of the research?
Milestone-based payments or client approvals alone may not establish that payment depends on research success. - Could termination or settlement agreements affect your RTC analysis?
Early termination agreements or settlements may influence whether research is considered funded.
Case Background and Issues
In Smith v. Commissioner, the Tax Court addressed how the RTC funded research exclusion under Internal Revenue Code (IRC) Section 41(d)(4)(H) applies to fixed-fee, milestone-based service contracts. These structures are commonly used by design, architecture, engineering and construction organizations. The court also clarified which reasonable compensation standard applies under Section 174(e) for research and experimental (R&E) expenditures.
The taxpayers were three partners of Adrian Smith+Gordon Gill Architecture (AS+GG), an internationally recognized architecture firm that designs large-scale, highly sustainable, technically complex buildings, including several of the world’s tallest towers. They claimed RTCs for tax years 2008-2010 related to work performed under client contracts.
The IRS disallowed the credits on the grounds that the research was funded by the firm’s clients and therefore ineligible for the credit. However, the IRS did not dispute that the underlying activities satisfied the four-part test for qualified research.
The outcome depended on contract language, making the case directly relevant to organizations that perform research under third-party contracts. The decision shows that the treatment of client-funded research can vary from project to project based on the specific terms of the agreement, particularly provisions addressing payment terms, ownership of work product and the taxpayer’s rights to use research results.
What Issues Did the Court Consider?
The case focused on two primary issues:
- Whether the research was funded under Section 41(d)(4)(H)
- Whether the partners’ 2008 compensation was reasonable under Section 174(e)
Issue 1: Was the research funded under Section 41(d)(4)(H)?
Research is excluded from the RTC if another party funds it. Treasury regulations establish two independent tests, and both must be satisfied to claim the RTC:
- Contingent on the success of the research: The taxpayer’s right to payment must depend on whether the research succeeds, not merely on successfully performing the work.
- Retention of substantial rights to the research: The taxpayer must retain the right to use the results of the research without being required to pay or otherwise seek permission to do so. The provision of exclusive rights to the client, standing alone, does not necessarily defeat this.
The court then applied these two tests to the six AS+GG contracts at issue. Before doing so, it considered the taxpayers’ argument that the Supreme Court’s Loper Bright decision affected the funded research analysis.
How did the court address the Loper Bright argument? The taxpayers argued that the Supreme Court’s Loper Bright decision eliminated the two-part regulatory test and therefore, the definition of “funded” should be read narrowly using its dictionary meaning. The Tax Court rejected this argument, holding that the regulations independently reflect the best reading of the statute. Practitioners should not expect Loper Bright to reopen this issue.
When is payment contingent on the success of the research? The court held that none of AS+GG’s six contracts under review made payment contingent on the success of the research. Common protective contract features did not meet the requirements.
The court concluded that several commonly used contract provisions did not satisfy the contingent-on-success requirement. General standards-of-care provisions, such as requirements to perform services in accordance with sound professional standards or industry practices, were treated as ordinary performance obligations rather than measures of research success. Similarly, milestone-based and percentage-of-completion payment structures did not make payment contingent on research success because they generally reflected progress in performing the work rather than successful research outcomes.
The court also found that termination-for-convenience provisions did not create the type of financial risk contemplated by the regulations, viewing them instead as a lost opportunity for future profit. In addition, the court rejected arguments that foreign law should alter its analysis where the cited foreign-law provisions were not incorporated into the contracts or did not override the contracts’ express terms.
What does it mean to retain substantial rights in research? By contrast, the substantial rights requirement produced a split result. The court sided with the taxpayers on four of the six contracts reviewed. The court focused on how each contract addressed ownership of research results and the firm’s ability to reuse the work product.
The court reached different conclusions depending on how the contracts addressed ownership and use of the research results. Contracts that vested ownership and copyright in the client and required AS+GG to obtain express written approval before using the research results did not preserve substantial rights. By contrast, contracts that allowed AS+GG to retain copyright or other rights to use the research results, even while granting the client a license to use them, preserved substantial rights.
The court also considered whether subsequent settlement agreements modified the original contracts. Where a settlement agreement directly overrode an original contractual provision, the court considered the modified terms in determining whether AS+GG retained substantial rights. In the Atrium City Tower project, for example, the settlement agreement replaced the original restriction with terms under which AS+GG retained copyright and granted the client a license to market the project documents.
What was the outcome? For the four projects where AS+GG retained substantial rights, the RTC was not eliminated entirely. Because payments under all six contracts were not contingent on the success of the research, the court held that AS+GG could claim research credits for the four projects to the extent the qualified research expenses exceeded the payments received. The court left the precise calculation of the allowable credits to the parties.
Issue 2: Reasonable compensation under Section 174(e)
The IRS separately challenged the reasonableness of the partners’ 2008 compensation under Section 174(e), which requires R&E expenditures, including wages, to be reasonable.
Because these cases are appealable to the Seventh Circuit, the court applied the taxpayer-favorable independent investor test rather than the multifactor test advocated by the IRS. Under that standard, compensation is presumptively reasonable if investors receive an outsized return on equity.
Therefore, the court held that the partners’ aggregate 2008 compensation was reasonable. The decision also underscores that the applicable reasonable compensation standard may vary depending on the circuit that governs the appeal. The independent investor test is not applied uniformly across all jurisdictions, making venue an important consideration when evaluating compensation-related challenges under Section 174(e). As a result, businesses in Seventh Circuit jurisdictions, including Illinois, Indiana and Wisconsin, may have a more favorable standard for defending owner compensation tied to R&E expenditures.
Weaver Can Help
The Smith v. Commissioner decision highlights the importance of reviewing contract language when claiming the RTC. Payment terms, intellectual property ownership and rights to research results can all influence whether research is considered funded under Section 41.
Weaver’s tax credits and incentives team regularly reviews client contracts to assess RTC qualification. Our professionals can also help structure new client agreements that support a defensible credit position. Contact us today.
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