Tax Court revisits funded research rules in design credit dispute

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In a recent memorandum opinion, Smith et al. v. Commissioner, T.C. Memo 2026-50, the U.S. Tax Court concluded that the taxpayer may claim research credits only to the extent its research expenses exceeded the payments received.

This ruling reinforces that the funded research analysis is highly fact-specific and increasingly focused on payment mechanics and intellectual property rights.

The court also addressed the taxpayer’s challenge to the validity of the funded research regulations following Loper Bright v. Raimondo and considered whether the firm’s partners’ compensation was reasonable under Section 174(e). For additional background, see our prior story on the U.S. Tax Court’s denial of summary judgment.

The taxpayers were partners of Adrian Smith + Gordon Gill Architecture, LLP (AS+GG), an Illinois-based architectural design firm focused on large-scale building projects. AS+GG claimed research credits under Section 41 for certain design projects for tax years 2008 through 2010. The IRS disallowed the credits, asserting that the research was excluded as funded research under Section 41(d)(4)(H).

The Tax Court analyzed six sample projects under the criteria set forth in Treas. Reg. Section 1.41-4A(d), evaluating whether payment was contingent on the success of the research and whether AS+GG retained substantial rights. In assessing whether payment was contingent on success, the Tax Court reviewed various contract provisions and concluded that payment for each project was not contingent on success because AS+GG did not bear the financial risk of failure.

The court distinguished the approval and payment provisions from those in Fairchild Indus., Inc. v. United States, 71 F.3d 868, 870 (Fed. Cir. 1995), in which the Federal Circuit found payment to be contingent on the success of the research. The Tax Court further found that, although AS+GG’s contracts included milestone-based progress payments, they more closely resembled the contracts in Meyer, Borgman & Johnson, Inc. v. Commissioner, 100 F.4^th 986, 988 (8^th Cir. 2024), as they generally lacked the detailed technical specifications and performance standards present in Fairchild Indus., Inc.

In assessing whether AS+GG retained substantial rights, the Tax Court examined the contract terms to determine whether the firm could use the research results without payment. Citing Lockheed Martin Corp. v. United States, 210 F.3d 1366, 1374-75 (Fed. Cir. 2000), in which the Federal Circuit held that a non-exclusive right to use research results is a substantial right and must be determined from the research agreements, the Tax Court concluded that AS+GG retained substantial rights for four of the six sample projects because rights generally vested with AS+GG under the contract terms.

It determined that AS+GG did not retain substantial rights for the remaining two projects, as the contracts provided that all project data was the “absolute property” of the client and required AS+GG to obtain “express written approval” before using any project information for other purposes.

The Tax Court also addressed the validity of the funded research regulations following Loper Bright. It noted that prior decisions have upheld the regulations and, applying principles of stare decisis, concluded that they remain in effect. The court separately considered whether the partners’ compensation was reasonable under Section 174(e). Applying the independent investor test, the court relied on the Seventh Circuit’s ruling in Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 838 (7^th Cir. 1999) and noted that Congress intended the reasonableness requirement under Section 174 to parallel the reasonable allowance standard under Section 162(a)(1).

The court also concluded that the partners’ compensation was reasonable, as the parties did not dispute that the results of the independent investor test supported that conclusion. 

By the time of the trial, the IRS had already conceded the four-part test under Section 41(d), the Section 41(d)(4)(A) through (G) exclusions, and the asserted penalties.