Taxpayers win two recent research credit cases

The Tax Court has ruled in favor of the taxpayers in two recent R&D credit cases, denying the IRS summary judgment that the taxpayers’ research was funded. The cases provide valuable insight into how the court applies local law to analyze contractual agreements.

In Smith et. al. v. Commissioner (Docket Nos. 13382-17, 13385-17, and 13387-17), the Tax Court concluded that summary judgment was inappropriate because it could not determine that the taxpayers’ research was funded. Similarly, in System Technologies, Inc. v. Commissioner (Docket No. 12211-21), the Tax Court denied the IRS’s motion for partial summary judgment, finding that the taxpayer’s research did not constitute funded research.

The taxpayers in Smith were shareholders of Adrian Smith + Gordon Gill Architecture, LLP (AS+GG), a firm that provides architectural design services. AS+GG claimed research credits under Section 41 for several of its architectural design projects for tax years 2008 through 2010. Both the taxpayers and the IRS agreed to limit the scope of the research credits claimed to six of AS+GG’s projects.

The IRS, citing specific terms of the relevant contracts, argued that the research performed by AS+GG was funded. The IRS claimed that AS+GG did not retain substantial rights in its research, asserting that AS+GG only retained incidental benefits or “institutional knowledge” resulting from the research. Furthermore, the IRS argued that the research was funded because payments under the contracts were not contingent on the success of the research.

Conversely, the taxpayers claimed that the research was not funded, asserting that the IRS failed to establish how the contracts divested AS+GG of all substantial rights. Additionally, the taxpayers argued that the IRS failed to identify a contractual clause that entitled AS+GG to payment for performing research rather than entitlement to payment upon successful completion of design milestones, which implicitly implied payment for performance results.

The Tax Court denied the IRS’s motion for summary judgment, ruling that the IRS did not establish that there are no genuine issues of material fact in dispute. The contracts at issue were governed by foreign law (e.g., Dubai and UAE) and the Tax Court asserted that in such instances, there appears to be a factual dispute over the interpretation of relevant contracts and application of foreign law. The cases are currently set for trial in March 2025.

In System Technologies, Inc., the taxpayer engineered and manufactured industrial finishing systems, specializing in automotive coating designs and applications, such as pre-treatment solutions and ultraviolet curing systems. The taxpayer filed amended tax returns for its tax years 2015 through 2018 to claim research credits related to six projects. The taxpayer issued proposals for each of the six projects which incorporated a choice-of-law provision stating that the purchase order (or other relevant agreement) is governed under Indiana state law. The IRS subsequently issued a notice of deficiency disallowing the research credits for all years.

The IRS argued that, in the relevant purchase orders at issue, there were no expressed terms which conditioned payment on the successful completion of the research. The IRS asserted that the contracts’ warranty provisions overrode the general remedies provided to buyers under Indiana law, depriving the buyer of a cause of action to recover funds for non-delivery of the project. The Tax Court disagreed, finding that the scope and effect of the warranty provisions did not foreclose other remedies in the event of a total breach. It stated that, if the research failed, Indiana state law provided a remedy inclusive of refunds of payments made. The Tax Court concluded that the payments for the research were contingent on the success of the research and therefore the research was not funded. 

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