Dynetics Decision Highlights Impact of Contract Terms on Research Credit Eligibility
Author: Ashley Thompson
The research tax credit offers a lucrative incentive for companies investing in the development of new or improved technologies. This incentive often is claimed by manufacturers, software developers, technology companies, engineering firms and contractors.
Dynetics Inc. and Subsidiaries v. United States provides valuable insight into the funded research exclusion. The funded research provision can cause otherwise qualified expenditures to become nonqualified. Research performed for a customer under contract is considered funded if either of these statements is true:
- The amounts payable under the agreement aren’t contingent on the success of the research
- The taxpayer doesn’t retain substantial rights in the research
The key to avoiding the funded research exclusion is to illustrate you bear the financial risk of the research and retain substantial rights to the research results. A taxpayer has substantial rights to the research results if it can make independent use of the information or intellectual property discovered in its trade or business without having to pay for that right.
Dynetics is an engineering company headquartered in Huntsville, Alabama. In the Dynetics case, the court reviewed seven defense and aerospace contracts. These contracts served as a representative sample of the more than 100 contracts the company had engaged in over a three-year period. The contracts fell into these categories:
- Cost plus fixed fee
- Fixed-price level of effort
- Time and materials
- Cost plus fixed-fee level of effort
The court found Dynetics wasn’t financially at risk for research performed under the seven contracts reviewed. Financial risk is determined by who bears the research costs upon failure; Dynetics was unable to persuade the court that payment was contingent on success. The court reviewed inspection clauses, warranty clauses and terminology related to level of effort in examining this issue.
- Inspection clauses – The inspection clauses weren’t enough to grant Dynetics customers the right to reject work or services or to withhold payment, leading the court to find Dynetics bore no financial risk.
- Warranty clauses – Dynetics was required by the contracts to provide services free from defects in workmanship and conforming to the requirements of the contract. In addition, Dynetics was required to correct any issues at cost. The court found Dynetics still wasn’t at financial risk, as “cost” meant at labor costs without profit. The judge said, “While it is true that Dynetics would not have the opportunity to earn its full fee, the loss of an opportunity for profit is not the type of financial risk contemplated in the Treasury regulation.”
- Level of effort contracts – The court determined that payment for level of effort contracts—regardless of other contractual terms, such as time and materials, cost plus, fixed fee, etc.—was based on effort rather than the result of the research. Since payment was found to be based on effort, these contracts were determined to be funded.
The court also found that in two of the contracts, Dynetics didn’t retain rights to the research results. The clause in the UAH01 contract states, in part, that “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.” Since everything was passed to the University of Alabama (Dynetics’ customer), the court found Dynetics didn’t retain rights to the research results.
In the NT001 contract, Dynetics’ ability to use developed and discovered information was limited by government security requirements. Dynetics also was required to receive government authorization to use the results in any other projects. The court determined these limitations were restrictive enough to preclude Dynetics from retaining rights to the research results. The court further pointed to Treasury Regulation 1.41-4A(d)(2), which states “incidental benefits to the taxpayer from performance of the research (for example, increased experience in a field of research) do not constitute substantial rights in the research.”
Contracts ultimately are used to determine financial risks and ownership rights and usually are requested as documentation during IRS examinations. It should be noted the IRS didn’t challenge standard fixed-price agreements as being funded research in this case. Taxpayers should carefully review all contract agreements to determine which party bears the financial risk of the research as well as whether the taxpayer retains substantial rights to the research results.
For information on how this decision could affect you, contact your BKD advisor.