Architectural firms design complex structures, such as stadiums, academic buildings, and commercial structures. This work typically require extensive research into materials, structural systems, and innovative design solutions. This type of design work can qualify for the research tax credit.
One nuance is the contract or funding mechanism that pays for the design work. Architectural firms enter fixed-price contracts for this work. This begs the question, can this type of work that is paid for via a fixed-price contract qualify?
The tax court’s decision in Populous Holdings, Inc. v. Commissioner, 2019 WL 13032526 (T.C. 2019), provides guidance on this exact issue. It involves an architectural firm that reported research credits for design work performed under fixed-price service agreements.
Facts & Procedural History
Populous Holdings provides architectural design services to its clieints. It reported research credits on its 2010 and 2011 income tax returns. The credits were for work relating to over 100 contracts and subcontracts.
The IRS audited the credits and denied a research credit of $132,539 for 2011 and a general business credit carry forward from 2010 of $151,494, arguing that Populous’s research constituted “funded research” and therefore did not qualify for the credit. Litigation ensued.
The parties agreed to focus their dispute on five representative contracts: McEnery, Houston Dynamo, University of Arkansas, University of South Florida, and Pico Hall. The agreement nwas that the court’s decision on these five contracts would resolve the entire case according to their stipulated allocation.
Both Populous and the IRS filed cross-motions for summary judgment, seeking a definitive ruling on whether the research expenses qualified for the research tax credit. The tax court had to determine whether Populous’s contracts constituted “funded research,” which would disqualify the company from claiming the credit.
The Research and Development Credit Framework
Section 41 of the tax code allows taxpayers to claim a credit for qualified research expenses. This provision encourages private sector research and development by providing dollar-for-dollar tax credits for qualifying expenditures. The credit applies to both in-house research expenses and amounts paid to third parties for contract research.
In-house research expenses includes wages paid to employees and owners and supply costs. Contract research expenses represent payments made to external parties to perform research activities.
The tax code includes several limitations on what counts as a qualified expense. One of the limitations says that qualified research does not include “funded research,” which is defined as research funded by grants, contracts, or other arrangements with third parties or governmental entities. This rule prevents double benefits where one party funds research and another party performs it.
The funded research exclusion creates a potential trap for contractors. If a contractor’s research is considered funded by the client, the contractor cannot claim the research credit even though it performed the actual research work. The regulations address this issue by establishing specific conditions under which contract research avoids the funded research classification.
When Does Contract Research Avoid the Funded Research Trap?
The regulations provide that contract research escapes the funded research exclusion when two conditions are met. First, payment must be contingent on the success of the research. Second, the contractor must retain substantial rights in the research results.
These requirements, found in Treasury Regulation sections 1.41-2(e)(2)(iii) and 1.41-4A(d), are often called “mirror image rules.” They ensure that only one party—either the contractor or the client—can claim the research credit for any given research activity. This prevents the same research expenses from generating credits for both parties.
Payment is considered contingent on success when the contractor receives compensation for the product or result of the research, rather than simply for performing research activities. The focus centers on who bears the financial risk if the research fails to produce the desired outcome. When contractors bear this risk, their research typically qualifies for the credit.
Who Bears the Financial Risk Under Fixed-Price Contracts?
The tax court’s analysis in Populous focused heavily on risk allocation between the contractor and client.
Fixed-price contracts generally place the financial risk of research failure on the contractor. Under such arrangements, if research efforts fail to produce the required results, the contractor must remedy the failure at its own expense without additional compensation from the client.
Courts examine specific contract terms to determine risk allocation. Relevant provisions include payment procedures, quality and performance standards, termination clauses, warranty requirements, and default provisions. The presence of client approval rights, invoice dispute mechanisms, and revision requirements at the contractor’s expense all support a finding that payment depends on research success.
In Populous, all five contracts were fixed-price arrangements, with three also providing capped reimbursement for certain expenses. None of the contracts expressly required research or stated that Populous was being paid specifically for research activities. Instead, Populous was compensated for delivering work products that required research to complete successfully.
The contracts granted clients rights to review and approve design documents and dispute invoices. Two contracts expressly required Populous to revise documents under certain circumstances at its own expense. The court held for the taxpayer, concluding that these provisions demonstrated that Populous bore the financial risk if its research efforts failed to produce acceptable results.
What Constitutes Substantial Rights in Research Results?
The IRS also challenged the second prong, i.e., the substantial rights requirement. These rules requires that contractors retain substantial rights in their research to claim the credit. The right to use research results without paying the client represents a substantial retained right.
This right need not be exclusive—contractors can retain substantial rights even when clients also have rights to use the research. However, incidental benefits such as increased knowledge or experience do not constitute substantial rights in research. The contractor must have meaningful ongoing rights to exploit or use the research results in its business operations.
The IRS argued that Populous failed to retain substantial rights in three contracts because the clients owned the architectural documents and copyrights. Under these contracts, clients received ownership of design documents, construction documents, and related materials. Some contracts also granted clients exclusive architectural copyrights and prohibited Populous from using distinctive design features without consent.
Does Document Ownership Eliminate Research Rights?
The tax court rejected the IRS’s document ownership argument, distinguishing between ownership of final documents and rights to underlying research. Document ownership does not dictate rights to use technology-related research results or grant clients exclusive rights to the contractor’s research methodologies and knowledge.
Populous retained copies of documents for its own use, and none of the contracts prohibited the firm from using related researched technology in its business. While clients owned specific project documents and architectural copyrights, these ownership rights did not extend to the underlying research processes, methodologies, and technological knowledge that Populous developed during the projects.
The court emphasized that contractors can retain substantial research rights even when clients own the final work products. The key distinction lies between rights to specific project deliverables and rights to the research knowledge and methodologies used to create those deliverables. Thus, the court held for the taxpayer on this second requirement as well.
The Takeaway
This case shows that architectural firms and other professional service providers can successfully claim research credits. To do so they should work under fixed-price contracts or retain the financial risk of research failure and retain substantial rights to research results. The decision also clarifies that document ownership by clients does not automatically eliminate contractors’ research rights, provided the contractors retain meaningful ability to use their research knowledge and methodologies in future business activities. This ruling expands opportunities for professional service firms to claim research credits while performing client work under fixed-price arrangements. Firms should examine their contract structures and research activities to identify potential credit opportunities, recognizing that the funded research exclusion does not apply when contractors bear the financial risk and retain substantial research rights.
