Opinion provides insight on funded research exclusion

The U.S. District Court for the Middle District of Louisiana recently ruled in favor of the IRS in Leonard L. Grigsby et al. v. The United States (No. 19-00596-BAJ-SDJ), disallowing a taxpayer’s research tax credit on the basis that the research activities constituted funded research within the meaning of Section 41(d)(4)(H).

As background, Treas. Reg. Sec. 1.41-4A(d) provides that research is not “qualified research” for purposes of the research tax credit to the extent the research is funded by any grant, contract, or otherwise by another person, including any government entity. In defining funded research, the regulations provide two standards under which taxpayers must evaluate their research activities: 

• The “Risk Standard,” which states that amounts payable under an agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research are not treated as funding
• The “Substantial Rights Standard,” which provides that a taxpayer must retain substantial rights in the research to qualify for the research tax credit

The taxpayer addressed by Grigsby was a shareholder of Cajun Industries LLC (“Cajun”), a construction company taxed as an S Corporation that claimed the research credit for work it performed under contractual agreements with its clients. During the proceedings, the court evaluated four sample projects. Two of the sample projects consisted of contracts that were subject to an agreed-upon maximum price (i.e., “capped” contracts), while the other two projects consisted of fixed-price agreements.

The first item at issue in Grigsby relates to the definition of Cajun’s business components in accordance with Section 41(d)(2)(B). The taxpayer argued that the business components associated with the sample projects are construction processes that Cajun used when constructing items for its clients. The court rejected the taxpayer’s argument, as the taxpayer had previously claimed during the discovery process of the proceedings that it developed a product rather than a construction process. In its ruling, the court found that the taxpayer failed to provide evidence supporting its claim because the taxpayer did not identify any new or improved construction processes.

The second item at issue in Grigsby is the funded research exclusion. The court found that three of Cajun’s four sample projects did not meet the Substantial Rights Standard because language in each of the three contracts expressly stated that all of Cajun’s work product transferred to its client. Citing prior case law, including Lockheed Martin Corporation v. United States, 210 F.3d 1366, 1374-75 (Fed. Cir. 2000) and Dynetics, Inc. & Subsidiaries v. United States, 121 Fed. Cl. 492, 523 (2015), the court found the contract language provided convincing evidence that the taxpayer did not retain substantial rights to the research. With respect to the fourth sample project, the court referenced specific contract terms which provided for monthly payments that include “full compensation for all loss…” in its ruling that the research performed during this sample project was funded because the project did not meet the Risk Standard.

The Grigsby case provides taxpayers with insight into recent interpretations of relevant guidance associated with the funded research exclusion, including prior case law. Notably, the government’s ruling in this case suggests recent interpretations of the Substantial Rights Standard are broad and are not limited to rights in the intellectual property but may encompass other aspects of the work product (e.g., data, drawings, calculations, etc.).

The funded research exclusion continues to be a highly contentious and evolving provision of the research tax credit, and taxpayers should consider current and prior case law when evaluating all agreements related to the qualified research and the funded research exclusion.

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