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Ruling highlights need to evaluate funded research

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Tax Hot Topics newsletter The Tax Court held in Edward J. Tangel and Beatrice C. Tangel, et al. v. Commissioner (T.C. Memo 2021-1), that Enercon Engineering, Inc. (Enercon), an S corporation, was not entitled to claim a credit for increasing research activities under Section 41 for research performed under contract.

The IRS previously disallowed Section 41 research credits of $929,668 for the 2018-2010 tax years and requested partial summary judgment for one of the 142 different projects included in Enercon’s research credit claims.

Enercon designs and produces integrated controls and switchgears for custom applications in the power generation industry. It was hired by Vericor Power Systems LLC (Vericor) to develop a new enclosure for turbine power generation. Under the terms of the agreement, Enercon was not permitted to use the results of the research for any purpose outside of the agreed-upon services without prior written consent from Vericor.

To prevent double claiming qualified research expenditures, Section 41(d)(4)(H) states that qualified research shall not include “[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).” To determine whether the research is funded, the regulations require taxpayers consider all agreements entered into between the parties and if a taxpayer: 1) bears the economic risk of failure and 2) retains substantial rights in the research. The Tax Court focused on the second requirement.

Enercon took the position that it “retained the right to use, on its own future projects, the ‘institutional knowledge it glean[ed] from research’ performed for Vericor” and that Enercon met the requirements in the Regulations. The Tax Court stated that the provisions of the agreement were hostile to Enercon’s claim. The Tax Court granted partial summary judgment and concluded that, under the terms of the contract, Enercon did not retain any substantial rights to the research.

The Tangel decision emphasizes the requirement that taxpayers must evaluate all terms and conditions of an agreement to determine which taxpayer is funding the research and eligible to claim the related costs in a research credit claim.

Contacts:
Sharon Kay
Partner
Washington National Tax Office
T +1 202 861 4140

Kevin Benton
Director
Dallas Office
T +1 704 632 3893

Pinky Shodhan
Senior Associate
Washington National Tax Office
T +1 202 521 1596

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