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Client Funding Prevents Engineering Firm from Claiming Research Credit.

(Parker Tax Publishing February 16, 2015)

The Eleventh Circuit affirmed a district court ruling that, because payments to an environmental engineering firm were not contingent on the success of its contracted research, the firm was "funded" by its clients within the meaning of Code Sec. 41 and was not eligible for the research credit. Geosyntec Consultants, Inc. v. U.S., 2015 PTC 31 (11th Cir. 2015).

Background

Geosyntec is a specialized consulting and engineering firm that provides services on projects involving the environment, natural resources, and geological infrastructure. In 2012, Geosyntec filed suit in district court seeking a federal income tax refund of $1,677,432 stemming from research tax credits for qualified research expenses incurred on client projects from 2002 to 2005, including several contracts subject to a maximum payment, also known as "capped contracts." The district court was asked to decide whether Geosyntec's research was "funded" by its clients within the meaning of Code Sec. 41 such that it would not be eligible for the research credit.

The district court found the capped contracts were funded, making Geosyntec ineligible for the research tax credit. Geosyntec appealed, contending the district court erred in in its findings with respect to two of the contracts: (1) a contract with the Delaware Solid Waste Authority (DSWA) to expand the capacity of the Cherry Island Landfill in Wilmington, Delaware (the Cherry Island Contract); and (2) a contract with Waste Management, Inc. (WM) to evaluate technology for remediating groundwater beneath a warehouse in Niagara, New York (the WM Contract).

Analysis

Under Code Sec. 41, a taxpayer may claim a tax credit based on the amount of qualified research expenses incurred in the performance of qualified research, subject to certain exclusions. The funded research exclusion prevents a taxpayer from claiming a tax credit for research funded by any grant, contract, or otherwise by another person or governmental entity (Code Sec. 41(d)(4)(H)). Research is not considered funded where an agreement makes payment to the researcher contingent on the success of its research (Reg. Sec. 1.41-4A(d)).

The Eleventh Circuit identified Fairchild Indus., Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995) as the benchmark for determining whether a research contract is funded or not for purposes of the research credit. In Fairchild, an airplane manufacturer contracted with the United States Air Force to design and produce an aircraft. Under the terms of the contract, the Air Force was obligated to pay Fairchild only if Fairchild produced results that met the contract's specifications; equally, Fairchild was entitled to payment only for work delivered to and accepted by the Air Force. Since Fairchild bore the financial risk of failed research, as payment was contingent on success, the court concluded that the contract was not funded under the meaning of Code Sec. 41, making Fairchild eligible for the research tax credit.

The Eleventh Circuit examined both the Cherry Island Contract and WM Contract to determine whether Geosyntec's right to payment was contingent on the success of its research.

Geosyntec argued that both contracts fell squarely within the gambit of Fairchild. Geosyntec contended that it faced substantial financial risk under the capped contracts because it would only be paid for expenses incurred, eliminating an opportunity to make a profit on the research should it come in under budget, and it bore the risk that its expenses would exceed the ceiling price for each contract. Geosyntec further argued that it bore the financial risk of the failure of its research to produce the desired product or result, even if success was not expressly mandated by the terms of either contract.

First, the court dismissed Geosyntec's general economic risk arguments, as payment under the contracts was still not contingent on success. Geosyntec merely noted that it ran a risk of not earning the maximum stated amount, or going over budget, which was not the financial risk contemplated in Fairchild.

Second, the court noted that neither contract expressly made payment to Geosyntec contingent on the success of the research. In the WM Contract, Geosyntec was to be paid for the labor and materials, regardless of whether the tests yielded the results WM sought. In the Cherry Island contract DSWA had the right to review and comment on Geosyntec's design work, but each task was not subject to complex contract specifications, nor was the work subject to inspection and testing before acceptance. The court noted in contrast, Fairchild had to succeed at each step of the development phase in order to be paid under the explicit terms of its contract.

Third, the court further noted that the contracts did not place risk of failure on Geosyntec. Under neither contract was Geosyntec subject to quality assurance procedures akin to those in Fairchild. The WM Contract required only that all services be completed by a specified date. Under the Cherry Island Contract, certain work was subject to review by DSWA, but there was no method to measure success. Monthly invoices submitted by Geosyntec to DSWA and to WM were payable upon submission unless an item or sum shown due on the invoice was in dispute. In contrast, unless and until Fairchild fully succeeded in each phase of the project, it had no right to payment, and the Air Force was not required to pay if it deemed the work unacceptable. The court found that under neither contract did the right to dispute sums shown due on an invoice equate to a requirement that Geosyntec's work product be evaluated and accepted prior to payment.

In sum, the Eleventh Circuit found Geosyntec was entitled to payment under both contracts, regardless of the success of its research. Both DSWA and WM contracted with Geosyntec to reimburse Geosyntec for labor and costs for pre-defined tasks at pre-defined rates. Neither the Cherry Island Contract nor the WM Contract provided that DSWA or WM was obligated to reimburse Geosyntec only if Geosyntec produced results that met the contracts' specifications. Similarly, Geosyntec was not entitled to payment only for work product delivered to and accepted by its clients. Because payment to Geosyntec was not contingent on the success of its research, the Eleventh Circuit held that the contracts were funded by Geosyntec's clients under the meaning of Code Sec. 41 and, accordingly, it was not eligible for the research credit.

For a discussion of the research tax credit, see Parker Tax ¶ 104,900. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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