When does payment from a client disqualify an architectural firm from claiming research tax credits? Do fixed-price contracts for architectural services create “funded research” that makes the firm ineligible for these credits?
The Tax Court case Populous Holdings, Inc. v. Commissioner of Internal Revenue, 2019 WL 13032526 (U.S. Tax Ct. Dec. 6, 2019), provides an opportunity to examine this issue for architectural firms and other design professionals.
Facts & Procedural History
Populous Holdings, Inc. is an architectural design firm that provides services under fixed-price contracts. For tax years 2010 and 2011, Populous claimed research tax credits under Section 41 relating to over 100 contracts and subcontracts.
The IRS audited Populous’s tax returns and disallowed the research credits, determining that Populous was not entitled to a research credit of $132,539 for 2011 or a general business credit carry forward from 2010 of $151,494. The IRS contended that Populous’s research constituted “funded research” under Section 41(d)(4)(H), making it ineligible for the research credit.
Populous disagreed with the IRS’s determination and petitioned the Tax Court for redetermination of the deficiencies. The parties identified five representative contracts for the court to review: McEnery, Houston Dynamo, University of Arkansas (UA), University of South Florida (USF), and Pico Hall. They agreed that the court’s decision on these five contracts would resolve the issue for all contracts according to their stipulation of settled issues.
Both Populous and the IRS filed cross-motions for summary judgment on whether Populous was entitled to claim the research credit for its architectural design work.
Section 41 Research Credit Basics
Section 41 of the tax code provides a credit for qualified research expenses. Congress created this credit to encourage innovation by reducing the financial burden associated with research and development activities.
Qualified research expenses include both in-house expenses (such as wages paid to employees conducting research) and contract research expenses (amounts paid to third parties to perform research). However, Section 41(d)(4)(H) specifically excludes “funded research” from qualifying for the credit.
The tax code defines funded research as “any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).” This exclusion prevents both the client paying for research and the contractor performing the research from claiming tax credits for the same research activities.
What Makes Research “Funded” Under Treasury Regulations?
Treasury Regulation § 1.41-4A(d) provides that research performed by a contractor is considered funded if either:
- The payment to the contractor is not contingent on the success of the research, or
- The contractor does not retain substantial rights in the research.
Conversely, if both conditions are not met (i.e., payment is contingent on success and the contractor retains substantial rights), then the research is not funded, and the contractor may claim the credit.
What Does “Contingent on Success” Mean for Architectural Firms?
Treasury Regulation § 1.41-2(e)(2)(iii) explains that payment is contingent on the success of the research when payment is for the product or result of the research, rather than for the performance of the research itself.
The key question is: Who bears the financial risk if the research is unsuccessful? If the contractor bears this risk, then the payment is contingent on success.
Fixed-price contracts typically place the financial risk of research failure on the contractor. If the research does not produce the desired result, the contractor must remedy the failure at its own expense, without additional compensation from the client.
In Fairchild Industries, Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995), the Federal Circuit established that the inquiry “turns on who bears the research costs upon failure.” The court found that a fixed-price contract placed the financial risk of research failure on the contractor because the contractor would need to conduct additional research without additional compensation if the initial research failed.
The Eleventh Circuit further developed this analysis in Geosyntec Consultants, Inc. v. United States, 776 F.3d 1330 (11th Cir. 2015), distinguishing between fixed-price contracts (where the contractor bears the risk of research failure) and cost-plus contracts (where the client pays for the performance of research regardless of outcome).
What Are “Substantial Rights” in Architectural Research?
Treasury Regulation § 1.41-4A(d)(2) states that a taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the research results.
Courts have interpreted this to mean that a contractor’s right to use the research results without paying the client constitutes a substantial retained right. Importantly, the right to use the research need not be exclusive—both the contractor and client can have rights to use the research.
In Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000), the Federal Circuit held that a contractor retained substantial rights when it could use the technology developed during the contract in its business without paying the client, even though the client also had rights to use the technology.
Were Populous’s Contracts “Contingent on Success”?
The Tax Court examined the five representative contracts to determine whether payments to Populous were contingent on the success of its research. All five were fixed-price contracts, with three (McEnery, Houston Dynamo, and UA) also providing for capped reimbursement of certain expenses.
Although none of the contracts expressly required “research,” the court recognized that the architectural design services Populous was contracted to provide inherently required research. The court identified several features of the contracts that placed the financial risk of research failure on Populous:
- All five contracts granted clients the right to review and approve design documents and to dispute invoices
- The Houston Dynamo and Pico Hall contracts expressly required Populous to revise documents under certain circumstances at its own expense
- The USF contract required payment “upon approval of each phase and/or deliverable of work for services performed”
- The McEnery contract contained provisions defining when Populous was entitled to additional compensation
- The UA contract provided for review and revisions but did not expressly state the revisions were at Populous’s expense
The court concluded that under all five contracts, if Populous’s research failed to produce the desired result, Populous would be required to incur additional expenses without additional compensation. Therefore, Populous bore the financial risk of failed research, and the payments were contingent on the success of the research.
Did Populous Retain “Substantial Rights” in Its Architectural Research?
For three of the contracts (McEnery, Pico Hall, and Houston Dynamo), the IRS argued that Populous did not retain substantial rights in the research.
The IRS focused on provisions stating that clients owned the documents produced by Populous, including design documents, construction documents, and architectural copyrights. However, the court found that ownership of documents does not necessarily mean the clients had exclusive rights to the underlying research.
The court noted that:
- Populous retained copies of the documents for its use
- There were no provisions in the contracts prohibiting Populous from using the related researched technology in its business
- None of the contracts required Populous to pay the clients for use of the research
While the contracts did restrict Populous from reusing certain client-specific elements (such as distinctive exterior features), these limitations did not prevent Populous from using the underlying technological research in future projects.
The court held that Populous retained substantial rights to use or exploit the results of its research under all three contested contracts.
How Do Architectural Contracts Qualify for Research Credits?
The Tax Court’s analysis provides valuable guidance on when architectural research under fixed-price contracts can qualify for research credits:
Fixed-Price Contracts vs. Cost-Plus Contracts
Fixed-price contracts generally place the financial risk of research failure on the architectural firm. If the firm’s research doesn’t produce the desired result, it must perform additional work without additional compensation. This risk allocation makes the payment contingent on the success of the research.
In contrast, cost-plus contracts typically place the financial risk on the client, as the client pays for the performance of the research regardless of its success. Under such contracts, research is more likely to be considered “funded” and ineligible for the credit.
Client Approval and Revision Requirements
When clients have the right to review and approve design documents, and the architectural firm must make revisions without additional compensation, this supports the conclusion that payment is contingent on the success of the research.
The Tax Court specifically noted that all five of Populous’s contracts granted clients the right to review and approve design documents and to dispute invoices. Two contracts expressly required Populous to revise documents under certain circumstances at its own expense.
Ownership of Documents vs. Rights to Research
The Tax Court distinguished between ownership of design documents and rights to the underlying research. Even when clients own the design documents, architectural firms may retain substantial rights in the underlying research if they can use that research in future projects without paying the clients.
In Populous’s case, the contracts specified that clients owned the project documents and certain architectural copyrights. However, there were no provisions prohibiting Populous from using the related researched technology in its business or requiring it to pay the clients for such use.
The Court’s Decision: Populous Qualifies for Research Credits
After examining the five representative contracts, the Tax Court concluded that Populous’s research was not “funded” within the meaning of Section 41(d)(4)(H). The payments under all five contracts were contingent on the success of the research, and Populous retained substantial rights in the research under the three contested contracts.
Therefore, Populous was entitled to claim the research tax credit for its architectural design work under these fixed-price contracts. The court granted Populous’s motion for summary judgment and denied the IRS’s motion.
The Takeaway
The Populous decision offers architectural firms guidance on qualifying their design work for research tax credits. Fixed-price contracts that place the financial risk of research failure on the firm and allow the firm to use its research results in future projects may enable the firm to claim these credits. This case demonstrates that innovative architectural design work can qualify as “unfunded” research despite being performed for paying clients. Architectural firms should review their contracts and research activities in light of this decision to determine whether they may be entitled to research tax credits that could significantly reduce their tax burden.
