Navigating the Funded Research Exclusion for R&D Tax Credits: Insights from Perficient Inc. and Grigsby Cases

The Sec. 41(d)(4)(H) funded-research exclusion remains a complex issue for R&D tax credits, as demonstrated by two recent court cases: Perficient Inc. and Grigsby. These cases provide valuable interpretations of the rules governing funded research, emphasizing the importance of contract language and the risk standard and substantial-rights standard.

Understanding the Funded Research Exclusion

Under Regs. Sec. 1.41-4A(d), research funded by a grant, contract, or any third party, including government entities, is generally excluded from R&D tax credits. This regulation prevents double-dipping, ensuring only expenses genuinely borne by the taxpayer qualify.

Two standards are used to determine funded research:

1. Risk Standard – Research is not funded if payment is contingent on successful results, meaning the taxpayer bears the financial risk if the research fails.
2. Substantial-Rights Standard – Research is considered funded if the taxpayer retains no substantial rights in the research results. This means that if the taxpayer must transfer all rights to another party, the research is ineligible for the credit.

Case Analysis: Perficient Inc.

In Perficient Inc., a technology services company argued that it satisfied the risk standard because its contracts required client approval of deliverables before payment. Perficient contended that it was delivering a product, not performing research, thus bearing the financial risk.

However, the IRS argued that 22 of the sample projects constituted funded research, emphasizing that payments were tied to time-based milestones rather than project success. The IRS highlighted that merely including a rejection clause is insufficient; the contract must explicitly link payment to the research’s success.

Perficient also challenged the validity of the substantial-rights standard, arguing it was procedurally and substantively invalid under the Administrative Procedure Act (APA) and Chevron USA Inc. v. Natural Resource Defense Council, Inc. The company claimed it retained the rights to use the research, modifications, and derivatives, thereby meeting the substantial-rights standard.

The IRS countered that know-how is an incidental benefit, not a substantial right, aligning with previous rulings in Dynetics. The court’s decision in Perficient could significantly impact future interpretations of the substantial-rights standard.

Case Analysis: Grigsby

In Grigsby, Cajun Industries LLC, a construction company, claimed the research credit for work performed under four sample contracts. Two contracts were capped-price agreements, and two were fixed-price contracts.

The court ruled that three of Cajun’s projects did not meet the substantial-rights standard because the contracts explicitly transferred all rights to the client. For instance, one contract defined the work as “work for hire,” transferring all intellectual property to the client.

For the fourth project, the court did not rule on the substantial-rights standard but concluded it failed the risk standard because the contract language stated payments included “full compensation for all loss, damages, or risks,” meaning Cajun did not bear financial risk.

Lessons from Preceding Case Law

Several key cases provide context for these rulings:

• Fairchild Industries (1995) – Established that financial risk depends on who bears the cost if the project fails, not on profitability or progress payments.
• Geosyntec Consultants (2015) – Determined that capped contracts are funded research because payments were not contingent on research success.
• Lockheed Martin (2000) – Ruled that retaining the right to use research results is a substantial right, even without exclusivity.
• Dynetics (2015) – Confirmed that skills gained from performing research are incidental benefits, not substantial rights.

These cases emphasize the importance of contract details, particularly regarding payment contingencies and intellectual property rights.

Key Takeaways for Taxpayers

1. Contract Language Matters – Clearly define payment terms, inspection and acceptance clauses, and intellectual property rights. Payments tied to project milestones or success criteria support risk retention.
2. Document Substantial Rights – Retain explicit rights to use research results, including improvements and modifications. Avoid broad clauses that transfer all intellectual property to the client.
3. Review Preceding Case Law – Understanding rulings in Fairchild, Geosyntec, and Lockheed Martin helps in structuring contracts and anticipating IRS challenges.
4. Consult with Tax Experts – Navigating the funded-research exclusion is complex. Engaging tax professionals can help optimize credit claims while ensuring compliance.

Conclusion

The funded-research exclusion remains a contentious area in R&D tax credits, with recent cases like Perficient Inc. and Grigsby illustrating the nuanced interpretations of the risk and substantial-rights standards. These decisions underscore the importance of contract language in determining credit eligibility.

As the IRS continues to scrutinize funded research claims, taxpayers must carefully structure agreements and document substantial rights. By learning from preceding case law and seeking expert guidance, businesses can better navigate this evolving landscape and maximize their R&D tax benefits.

For guidance tailored to your specific situation, speak to a Swanson Reed R&D Tax Credit expert.