The federal research and development (R&D) tax credit under Internal Revenue Code (IRC) Section 41 encourages investment in qualified research. Established by the Economic Recovery Tax Act of 1981, it has developed through legislation, regulations, and judicial decisions. Fairchild Industries, Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995), modified February 23, 1996, is an important authority on the funded research exclusion. That exclusion affects whether a researcher may include customer-related research costs in its credit calculation. Avoiding the exclusion does not by itself establish eligibility: the other requirements of Section 41 must also be met.

The Legislative Architecture and the Funded Research Doctrine

Congress enacted the research credit to encourage businesses to undertake the costs of research, including qualified staffing, supplies, and certain computer charges. Section 44F, a predecessor to Section 41, excluded research to the extent funded by another person or governmental entity. The statutory distinction is between research funded by another party and research merely performed for another party; customer involvement alone does not disqualify research.

IRC Section 41(d)(4)(H) excludes research to the extent funded by a grant, contract, or otherwise by another person or governmental entity. Treasury Regulation Section 1.41-4A(d), applied through Section 1.41-4(c)(9), addresses payment risk and substantial rights. Payments contingent on research success are not treated as funding. A researcher that retains no substantial rights is treated as fully funded. Where substantial rights are retained but some costs are funded, the regulation can permit otherwise qualifying expenses above the funding amount; therefore, the analysis is not always an all-or-nothing two-pronged test.

The regulations address the researcher and customer through complementary rules. Under Treasury Regulation Section 1.41-2(e), a customer’s contract research expenses generally require an agreement made before the research, research performed on its behalf, and an obligation to pay even if the research fails. Payment solely for a successful product or result does not meet that rule. Each party must independently satisfy all applicable credit requirements; the funded research analysis does not automatically award either party a credit.

Fairchild Industries, Inc. v. United States: The Factual Nexus

The dispute in Fairchild centered on a July 1982 contract between Fairchild Industries and the United States Air Force for the development of the T-46A aircraft, also known as the “Next Generation Trainer” (NGT). This trainer was intended to be the primary vehicle for training new pilots, replacing aging fleets with a more sophisticated, modern system. The contract was structured as a fixed-price incentive (FPI) agreement, encompassing both a full-scale development (FSD) phase and a subsequent production phase. The tax credits in question related exclusively to the FSD phase, where Fairchild was required to design, develop, and deliver two prototype aircraft along with all supporting documentation and systems.

The T-46A contract was a massive undertaking, characterized by over 1,000 pages of rigorous technical specifications and performance standards. One of the most critical provisions was the “Total System Responsibility” clause. Under this mandate, Fairchild accepted full responsibility for the installation and integration of all NGT system elements—including subsystems, components, support equipment, and software—to ensure the total system met all performance requirements, regardless of whether elements were fabricated by Fairchild or its subcontractors.

The financing of this research was accomplished through “progress payments.” In accordance with the Defense Acquisition Regulations (DAR) 7-104.35, the Air Force provided bimonthly refundable advances based on a percentage of the expenditures Fairchild actually incurred. However, these payments were strictly “liquidated” only upon the formal delivery and acceptance of specific contract line items. If Fairchild failed to meet the technical benchmarks, the Air Force maintained the right to reject the work, demand corrections at Fairchild’s sole expense, or accept the work at a reduced price. Furthermore, if the contract was terminated for default, Fairchild was legally obligated to return all unliquidated progress payments.

The Financial Burden and Risk Allocation

Fairchild spent approximately $216.1 million on full-scale development during 1982–1986, against an amended FSD ceiling price of approximately $133.5 million. At cancellation in late 1986, the Air Force had paid $53.0 million for accepted work and $60.8 million in unliquidated advances. Under the termination-for-convenience settlement, an audit established that 90% of FSD work was successfully completed, entitling Fairchild to $120.6 million in total. The previous payments were credited toward that amount and another $6.8 million was paid.

Fairchild claimed $109.4 million of FSD qualified research expenses on its 1982–1985 returns. After disallowances unrelated to the appeal, the IRS treated 55.8% of the remaining $89.8 million as funded, based on the ratio of government payments to total FSD costs. This resulted in a $5.8 million credit disallowance affecting the 1983 and 1984 tax years because of carryover and carryback effects. The Court of Federal Claims upheld the funding determination, emphasizing the progress payments and Fairchild’s expectation of payment.

The Federal Circuit’s Reversal: Establishing the Risk Standard

The Federal Circuit reversed the funded research determination and remanded for further proceedings to determine the amount of qualified research expenses. Its analysis focused on contractual liability for unsuccessful research, rather than expected payment or the project’s eventual outcome. The parties agreed that Fairchild retained substantial rights, so that issue was not decided on appeal.

The contract made Fairchild’s entitlement to payment depend on successful completion and acceptance of the relevant line item. Unaccepted work could be rejected or corrected at Fairchild’s expense, and unliquidated advances were repayable on termination for default. Acceptance reduced Fairchild’s exposure for completed line items; failure on one item did not automatically require repayment for unrelated work already accepted.

Fairchild distinguishes interim financing from funding for research-credit purposes. Refundable advances did not remove the contractor’s risk before acceptance of each line item. The holding depends on the agreement’s allocation of payment obligations, rather than the label attached to the payments.

Core Legal Principles from the Fairchild Decision

The Federal Circuit’s opinion articulated several principles that continue to govern R&D tax credit applications:

Contractual Allocation: Examine all relevant agreements in effect when the research is performed, including payment, acceptance, termination, and intellectual property provisions. The assessment is not limited to a single document labeled a research contract.

Financial Burden of Failure: Risk is assessed by identifying which party would suffer the financial loss if the research activities failed to produce the desired result.

Nature of Payment: Fixed-price contracts that utilize progress payments are not inherently “funded” if those payments are subject to technical acceptance and refundability.

Legislative Purpose: The credit encourages investment in research. Fairchild’s unrecovered costs illustrated its exposure, but cost overruns or an unprofitable project alone do not establish that payment was contingent on research success.

The Evolution of Judicial Interpretation: Post-Fairchild Developments

Later cases apply the funding rules to defense, construction, architecture, and engineering contracts. They illustrate the importance of the actual payment obligations and retained research rights. Professional services are not categorically excluded from qualified research, and technical complexity alone does not establish eligibility.

The Geosyntec Distinction: Fixed-Price vs. Capped Contracts

In Geosyntec Consultants, Inc. v. United States, the Eleventh Circuit addressed the application of Fairchild to environmental engineering projects. The court reaffirmed that the “sole focus” when assigning financial risk is which party bears the loss in the event of failure, rather than the project’s profitability.

Geosyntec Consultants, Inc. v. United States, 776 F.3d 1330 (11th Cir. 2015), concerned two capped cost-plus contracts on appeal. The district court had separately found three fixed-price contracts unfunded, and those claims were settled. The Eleventh Circuit affirmed the adverse ruling on the two capped contracts because payment was for services and was not contingent on research success. Exposure to costs above a ceiling did not alone establish the necessary contingency. The decision does not create an automatic safe harbor for every fixed-price contract.

Populous Holdings and the Standard for Design Firms

In Populous Holdings, Inc. v. Commissioner, Docket No. 405-17, order dated December 6, 2019, the Tax Court granted the taxpayer summary judgment on the funded research issue for the contracts considered. The order addressed both payment risk and substantial rights. It is a fact-specific Tax Court order, not an appellate rule that all architectural design contracts qualify.

The court considered the fixed fees, the firm’s obligation to bear additional research costs, client review and approval provisions, and invoice-dispute rights. It also concluded that the firm retained substantial rights notwithstanding client ownership provisions. These features must be assessed together; a duty to correct errors without extra compensation does not by itself settle the funding question for every design firm.

Meyer, Borgman & Johnson (MBJ): A Modern Pivot

On May 6, 2024, the Eighth Circuit affirmed the denial of research credits in Meyer, Borgman & Johnson, Inc. v. Commissioner. The structural engineering firm argued that its design contracts placed payment at risk through inspection, acceptance, and quality requirements. The court applied the funded research framework to the particular agreements; it did not overrule Fairchild or Geosyntec.

The court concluded that the agreements did not expressly or by clear implication condition payment on research success. General professional-care obligations and compliance with building requirements did not establish the specific success contingencies present in Fairchild. Refund provisions can be relevant evidence, but the decision does not impose a universal requirement that every qualifying contract contain an express refund clause.

The Substantial Rights Standard: Retaining the Benefit of Discovery

The second prong of the funded research test—the Substantial Rights Standard—is often as contentious as the Risk Standard. For research to be considered unfunded, the taxpayer must not only bear the financial risk but also retain the right to use the research results in its own business.

Lockheed Martin and the Right to Use

The Federal Circuit’s decision in Lockheed Martin Corp. v. United States remains the seminal case on this issue. The IRS had argued that Lockheed Martin did not retain substantial rights in its government research because the government acquired “unlimited rights” to use and disclose the technical data, thereby destroying Lockheed’s competitive advantage.

Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000), establishes that substantial rights need not be exclusive. Government rights to use or disclose the results did not automatically eliminate the contractor’s substantial rights. The inquiry concerns the researcher’s meaningful right to use the results in its business, considered under the governing agreements and restrictions. Having to pay for the right to use the results weighs against substantial rights; legal title and competitive exclusivity are not themselves required.

The Grigsby Setback and Incidental Benefits

United States v. Grigsby, 85 F.4th 258 (5th Cir. 2023), affirmed an adverse judgment involving credits claimed through Cajun Industries. The court identified failures to establish qualifying business components and also addressed funding. Three representative contracts failed the substantial-rights analysis because of their rights-transfer terms; a fourth, the East Bank project, failed the payment-contingency analysis. It is inaccurate to say that every contract failed both tests.

The regulation distinguishes meaningful rights in research results from incidental benefits such as increased experience. Grigsby rejected unsupported assertions that Cajun could reuse unspecified methods on later projects. Dynetics, Inc. v. United States, 121 Fed. Cl. 492 (2015), also illustrates the need to examine the actual contractual rights. General experience alone is insufficient, but identifiable reusable know-how should not automatically be equated with incidental experience. The taxpayer must show what results it may use and the legal basis for that use.

Implications for Future R&D Tax Credit Applications

The legacy of Fairchild and its progeny has created a demanding environment for taxpayers, particularly those in the government contracting and professional services sectors. Future applications for the R&D tax credit must be built upon a foundation of contractual precision and contemporaneous technical documentation.

Strategic Contract Drafting in a Post-MBJ Era

MBJ highlights the limits of relying on general professional-care terms. Contract drafting should accurately reflect the commercial agreement and its genuine allocation of research risk and rights. The following provisions can clarify that allocation, but none guarantees a credit or substitutes for actual qualified research:

Technical Milestones: Where commercially appropriate, specify the required technical results and explain whether entitlement to payment depends on achieving them. Examples might include thermal efficiency, structural performance, or software latency requirements. Simply adding technical language without changing the underlying obligation to pay is insufficient.

Rights of Rejection and Correction: Contracts should clearly articulate the customer’s right to reject deliverables that fail to meet technical specifications and require the contractor to remedy those failures at their own cost.

Refundability of Advances: Explain when interim payments become earned, which deliverables or line items they relate to, and when repayment is required. Fairchild involved acceptance by line item, not necessarily acceptance of the entire project. Refundability is relevant evidence rather than a mandatory clause for every unfunded arrangement.

IP Reservation Clauses: Rather than using boilerplate “Work Made for Hire” clauses that transfer all rights to the client, contracts should explicitly reserve for the researcher the right to use the underlying research, processes, and technology in its business.

The Documentation Mandate: IRS Form 6765 and Beyond

The IRS’s 2021 Chief Counsel memorandum 20214101F and subsequent administrative guidance addressed the information needed for research-credit refund claims. Effective June 18, 2024, the IRS waived submission at filing of individual researchers’ names and the information each individual sought to discover. Claimants must still identify the relevant business components and research activities and provide the required expense totals. The waived information may still be requested during examination.

Under the December 2025 instructions for Form 6765, Section G is optional for tax years beginning before 2026 and generally required for tax years beginning after 2025, subject to exceptions. Exceptions cover qualifying payroll-credit small businesses and certain original-return filers meeting both the $1.5 million QRE and $50 million average-gross-receipts limits. The instructions also limit detailed component disclosure to the prescribed coverage and component-count rules. Section G does not categorically prohibit cost-center allocations or mandate a particular accounting system. Taxpayers still need reliable records supporting the activities, expenses, and allocation methods claimed.

Technical and Mathematical Rigor in R&D Claims

Under IRC Section 41(d), “qualified research” must satisfy a four-part test. The fourth part—the “Process of Experimentation” test—has become a focal point of recent litigation, such as Little Sandy Coal Co. v. Commissioner.

The 80 Percent “Substantially All” Threshold

Treasury Regulation Section 1.41-4(a)(6) generally requires at least 80% of the research activities for a business component to constitute elements of a process of experimentation for a qualified purpose, measured by cost or another consistently applied reasonable basis. This is not an 80% newness test or a requirement that 80% of the entire finished product be experimental. The separate shrinking-back rule may apply where the overall business component does not qualify.

Little Sandy Coal Co. v. Commissioner, 62 F.4th 287 (7th Cir. 2023), rejected arbitrary allocations and reliance on the novelty of vessels without adequate proof of research activities. The court required a reasoned basis for determining the experimentation portion. Contemporaneous time records can help, but the decision does not impose a univers