Many government contractors engage in sophisticated research and development activities that push the boundaries of science and technology. These contractors rightfully wonder whether they can claim valuable research tax credits for this work. The answer hinges on a critical question: Is the research considered “funded” by the government under the tax code? If it is, those expenses don’t qualify for the research tax credit, potentially leaving millions of dollars in tax savings unclaimed.
A recent Court of Federal Claims case, Dynetics, Inc. and Subsidiaries v. United States, 121 Fed.Cl. 492, provides an opportunity to consider when government contractors can claim research tax credits and when they cannot.
Facts & Procedural History
Dynetics is an engineering company headquartered in Huntsville, Alabama that performs research and development for various government entities. For three tax periods, Dynetics filed amended tax returns seeking refunds based on research tax credits it claimed under Section 41 of the Internal Revenue Code for work performed under government contracts.
The IRS conducted Tax Audits of these returns and ultimately disallowed Dynetics’ refund claims. This led Dynetics to file a Tax Litigation case in the U.S. Court of Federal Claims.
Although Dynetics performed work under more than 100 contracts, the parties selected seven representative “sample contracts” for the court to evaluate. These contracts included agreements with the Air Force, Army, NASA, Defense Intelligence Agency, and Boeing (as a government contractor).
The contracts encompassed various types of arrangements, including cost-plus-fixed-fee contracts, fixed-price level-of-effort contracts, and time-and-materials agreements.
For example, under the AF007 contract with the Air Force Research Laboratory, Dynetics was tasked “to develop and test 14 tailkits capable of carrying 21,600 pound of ammunition for deployment at a specified target.” Under the AMS01 contract, Dynetics “develop[ed] models and simulations to evaluate the effectiveness of missile defense systems” and designed hardware for the integration of devices onto various platforms. The AR005 contract required Dynetics to develop “calibration shelters for Humvees” to help soldiers calibrate equipment in the field.
The central question in the case was whether Dynetics’ research was “funded” by the government under I.R.C. § 41(d)(4)(H), which would make it ineligible for the research tax credit.
Section 41 Research Tax Credits
What Are Research Tax Credits?
Section 41 of the Internal Revenue Code provides a valuable credit for businesses that increase their qualified research expenses. This credit serves as a powerful incentive for companies to invest in innovation and technological advancement. The Research Tax Credit can significantly reduce a company’s tax liability, making it an important consideration for research-intensive businesses.
However, Section 41(d)(4)(H) specifically excludes research “to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).” This “funded research exception” prevents taxpayers from claiming credits for research expenses that are effectively borne by others.
When Is Research Considered “Funded”?
Treasury Regulation § 1.41-4A(d) further explains when research is considered “funded” under either of two circumstances:
- When payment is not “contingent on the success of the research”
- When the taxpayer “retains no substantial rights” in the research
If either condition exists, the research is deemed funded and therefore ineligible for the credit. The regulations specify that “Amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research… are not treated as funding.”
The Financial Risk Requirement
In the landmark case Fairchild Industries v. United States, the Federal Circuit established that “the inquiry turns on who bears the research costs upon failure, not on whether the researcher is likely to succeed in performing the project.”
For research to be eligible for tax credits, the contractor must bear genuine financial risk that it won’t be paid if the research fails. As the court noted, “When payment is contingent on performance, such as the successful research and development of a new product or process, the researcher bears the risk of failure.”
Contract Payment Terms and Financial Risk
How Do Inspection Clauses Affect Financial Risk?
For the AF007 contract with the Air Force, Dynetics argued that the inspection clause (FAR 52.246-8) created financial risk similar to that in Fairchild. However, the court found critical differences in how these clauses operated.
In Fairchild, the contract explicitly placed responsibility on the contractor to produce specific products and limited payment to “work delivered or rendered and accepted.” By contrast, the AF007 contract’s inspection clause merely provided that if work needed correction, Dynetics would not earn additional profit on the corrective work but would still be paid its costs.
The court determined this arrangement didn’t create the type of financial risk contemplated by the Accuracy-Related Penalties regulations. Since Dynetics would be paid regardless of whether its research was successful, it didn’t bear the financial risk of failed research.
What About Fixed-Price Level-of-Effort Contracts?
For the AR009 and AMS01 contracts, which were fixed-price level-of-effort agreements, Dynetics argued they functioned as traditional fixed-price contracts requiring delivery of specified items as a condition for payment.
The court rejected this argument, citing FAR 16.207-2, which states that for such contracts, “payment is based on the effort expended rather than on the results achieved.” This definition directly contradicts the contingency requirement for research tax credits.
The court concluded that Dynetics needed only to provide a certain level of effort to be paid for its work on these contracts, regardless of whether that work produced successful research outcomes. Without a payment structure truly contingent on research success, these contracts didn’t create the financial risk necessary for tax credit eligibility.
Do Warranty Provisions Create Financial Risk?
Under the BOE12 contract with Boeing, Dynetics pointed to warranty clauses requiring correction of defective work at “Seller’s expense.” The court closely analyzed these provisions and found they didn’t create the required financial risk.
The court determined that “Seller’s expense” meant Dynetics would be paid its costs but not an additional profit for corrective work. Furthermore, Boeing could only charge Dynetics for replacement services if Dynetics “fails or refuses to correct or reperform” – a risk tied to responsiveness, not research failure.
These contractual provisions didn’t make payment contingent on successful research outcomes in the way the tax credit regulations require. Instead, they simply limited additional profit on corrective work, which doesn’t constitute the financial risk of failed research.
Substantial Rights in Research Results
What Constitutes “Substantial Rights”?
The second way research can be “funded” is if the taxpayer retains no substantial rights in the research. The Treasury regulations state that “[i]f a taxpayer performing research for another person retains no substantial rights in research under the agreement providing for the research, the research is treated as fully funded.”
A taxpayer that cannot use the research results without paying for them, or that cannot prohibit others from using the results, has not retained substantial rights. For research to qualify for the tax credit, the contractor must not only bear financial risk but also retain meaningful rights to use or exploit the research results.
Intellectual Property Provisions and Rights
The UAH01 contract with the University of Alabama/NASA included a provision stating: “All rights, title, and interest in and to inventions or other intellectual property rights conceived or reduced to practice in the course of performance of the work called for by this Contract are hereby vested in the University.”
Dynetics argued it retained rights in “non-patentable technology,” but the court found that the contract language encompassed all intellectual property rights, including copyrights in computer code and other deliverables, not just patent rights.
The court concluded that this provision effectively transferred all intellectual property rights to the University, leaving Dynetics without substantial rights in the research results. This finding alone would make the research “funded” and ineligible for the research tax credit.
Security Restrictions and Research Rights
The NT001 contract with the Defense Intelligence Agency involved highly classified intelligence research on foreign weapons systems. Security requirements in the DD Form 254 attached to the contract severely restricted Dynetics’ ability to use or exploit the research results.
These restrictions included provisions preventing release of intelligence material without specific authorization and requiring all materials to be used exclusively for the contract. The court found these security restrictions effectively eliminated any substantial rights Dynetics might otherwise have had in the research results.
Despite Dynetics’ arguments about separability of certain components from classified information, the court found the research results were so permeated with classified intelligence that Dynetics couldn’t meaningfully use or exploit them outside the government contract context.
Patent Rights vs. Broader Research Rights
Dynetics pointed to a patent rights clause (FAR 52.227-11) incorporated into some contracts, which allowed the contractor to “retain the entire right, title, and interest throughout the world to each subject invention.”
However, the court noted this clause only covered “inventions” that are “patentable,” not all research results. Since Dynetics made no argument that its deliverables (such as engineering drawings and technical reports) were patentable, these patent rights provisions weren’t relevant to the substantial rights analysis.
The court emphasized that substantial rights in research must be evaluated based on the entire scope of research results, not just potentially patentable inventions that might arise during the research process.
The Court’s Ruling
Based on its analysis of both payment contingency and substantial rights, the Court of Federal Claims granted the government’s motion for summary judgment. The court concluded that:
- None of Dynetics’ contracts made payment contingent on successful research outcomes
- For at least two contracts, Dynetics did not retain substantial rights in the research results
Therefore, Dynetics’ research was “funded” by the government and ineligible for the Research Tax Credit.
The Takeaway
Government contractors seeking research tax credits must carefully analyze their contracts to determine whether their research is truly “unfunded” under the tax code. The analysis should focus on two critical questions:
- Is payment genuinely contingent on successful research outcomes, with the contractor bearing the financial risk of failure?
- Does the contractor retain substantial rights to use and exploit the research results?
Standard government contract clauses requiring correction of defective work typically don’t create sufficient contingency if the contractor will still be paid its costs. Similarly, intellectual property provisions and security restrictions can eliminate a contractor’s rights in research results.
For contractors hoping to preserve tax credit eligibility, contract terms should explicitly place financial risk of research failure on the contractor and preserve rights to use research results for other purposes. Without such provisions, contractors may lose valuable tax benefits despite performing innovative and challenging R&D work.
