The Statutory Genesis and the Doctrine of Legislative Grace

Courts describe tax deductions and credits as matters of legislative grace, and taxpayers generally bear the burden of establishing entitlement. This is a judicial principle, not a characterization stated in the Internal Revenue Code, and applicable burden-shifting rules may matter. Section 41 requires qualifying research expenditures, technological information intended to help develop a new or improved business component, and substantially all research activities to constitute elements of a process of experimentation for a permitted purpose. Relevant uncertainty concerns capability, method, or appropriate design; permitted improvements concern function, performance, reliability, or quality. The expenditure test in the historical cases referred to Section 174. The statutory version applicable to the claim year must be used.

Even when these substantive technological requirements are met, the funded research exclusion serves as a secondary, often more formidable, barrier. The Treasury Regulations delineate two primary criteria for determining if research is funded: the “financial risk” test and the “substantial rights” test. The litigation in Geosyntec focused intensely on the financial risk prong, examining whether the taxpayer bore the economic consequences of research failure or whether the client was obligated to pay for the effort regardless of the outcome.

Factual Landscape of Geosyntec Consultants, Inc. v. United States

Geosyntec Consultants, Inc. is a specialized consulting and engineering firm that provides services on complex environmental, natural resource, and geological infrastructure projects. The firm’s business model is predicated on developing innovative and sustainable solutions for public and private clients. Between the taxable years of 2002 and 2005, Geosyntec engaged in hundreds of projects and subsequently filed a lawsuit in 2012 seeking a federal income tax refund of $1,677,432, claiming it was entitled to research tax credits for qualified research expenses (QREs) incurred during those years.

The IRS disallowed Geosyntec’s refund claim, and the government argued in litigation that client funding barred the credit. The parties selected six representative contracts: three fixed-price contracts and three cost-plus contracts subject to a cap. Fixed-price contracts specified a total price, while capped contracts reimbursed labor and expenses with a markup up to an agreed maximum. The district court addressed all six, but the appeal concerned only the Delaware Solid Waste Authority and Waste Management capped contracts; Geosyntec abandoned its challenge concerning the third capped contract.

The Judicial Deconstruction of Risk and Funding

The core of the dispute in Geosyntec revolved around whether the research conducted under the capped contracts placed the “costs of research failure” squarely on the firm. Geosyntec argued that it faced substantial financial risk because if it exceeded the contract cap, it would not be reimbursed for the additional costs, and it lacked the opportunity to increase its profit margin if the work was completed under budget.

Applying the financial-risk analysis developed in Fairchild Industries, Inc. v. United States, the Eleventh Circuit distinguished the risk of an unprofitable engagement from the risk of unsuccessful research. Fairchild’s entitlement to payment depended on producing contractually acceptable results. The two Geosyntec agreements on appeal did not impose an equivalent condition, even when their provisions were considered together.

The Standard of Care vs. Technological Success

Geosyntec distinguishes achieving specified research results from properly performing professional services. The Delaware Solid Waste Authority and Waste Management contracts imposed professional standards, compliance obligations, and remedies for deficient work. Those obligations did not make payment depend on research success.

The Waste Management engagement paid Geosyntec to evaluate groundwater-remediation technology. A properly conducted evaluation could earn payment even if the technology proved unsuitable. The legal question is whether the agreement makes payment depend on successful research, expressly or by clear implication. A particular formula of words is not mandatory, and requiring competent professional work alone does not establish the necessary contingency.

Inspection, Acceptance, and Invoicing Mechanisms

The detailed inspection and acceptance benchmark discussed in the appellate opinion came from Fairchild’s aircraft-development contract, not a holding that Geosyntec’s fixed-price agreements all contained Federal Acquisition Regulation clauses. The district court found Geosyntec’s three representative fixed-price contracts unfunded, but other credit requirements remained unresolved and the parties settled. The government did not appeal that ruling.

The capped agreements used monthly invoices, with approval and dispute procedures. Waste Management had 45 days to pay undisputed amounts and could challenge charges for reasons including deficient or negligent work, not merely clerical errors. Its review and rejection rights did not make payment dependent on successful research. The court evaluated the full contractual allocation of obligations and payment rights.

The Broader Jurisprudential Shift: Dynetics and MBJ

Geosyntec was decided on January 29, 2015. Later that year, the Court of Federal Claims decided Dynetics, Inc. & Subsidiaries v. United States, 121 Fed. Cl. 492 (2015). Dynetics examined financial risk under representative contracts and separately addressed substantial rights under two agreements. These opinions apply existing statutory and regulatory standards; they do not establish a categorical exclusion for engineering services.

The Substantial Rights Threshold

Treasury Regulation Section 1.41-4A(d)(2) treats research as fully funded when the performing taxpayer retains no substantial rights in its results. Dynetics failed to establish retained rights under an agreement vesting intellectual-property rights in the University of Alabama in Huntsville and under an intelligence-related task order with restrictive contractual security provisions. The court’s analysis of the latter was specific to Task Order 169, not every task order under that contract. A patent-rights clause did not establish useful retained rights in results that the taxpayer had not shown to be patentable.

The Geosyntec appellate opinion did not decide whether the taxpayer retained substantial rights and did not announce a rule allowing parol evidence to establish them. The parties had deferred the substantial-rights issue. Rights must be evaluated under the governing agreements. Whether extrinsic evidence can assist contract interpretation depends on the applicable law and circumstances; ordinary experience gained from performing work does not itself establish substantial rights.

The Meyer, Borgman & Johnson Ruling

In Meyer, Borgman & Johnson, Inc. v. Commissioner, 100 F.4th 986 (8th Cir. 2024), the Eighth Circuit affirmed the denial of credits on funded-research grounds. MBJ argued that its obligations to deliver structurally sound, code-compliant designs and its contractual performance provisions made payment dependent on successful research. The decision does not categorically disqualify fixed-price arrangements.

The court found that the agreements did not condition payment on research success, either expressly or by clear implication. General professional obligations and inspection or acceptance provisions were insufficient in the circumstances. A fixed fee and an obligation to correct defective work can create commercial exposure without allocating the financial risk of unsuccessful research to the service provider.

Implications for Modern R&D Tax Credit Applications

The combined weight of Geosyntec, Dynetics, and MBJ has profound implications for how service providers—particularly those in the Architecture, Engineering, and Construction (AEC) industries—must structure their client engagements and document their activities.

Contractual Reform and the Success Contingency

For contracted research, the complete agreement is central to the funding analysis, but contract wording alone cannot establish credit eligibility. Research activities, retained rights, qualified expenses, and substantiation must also satisfy the applicable requirements. Prospective agreements should accurately reflect the parties’ actual commercial allocation of risk. Where appropriate to the engagement, consider the following provisions:

Technological Milestones: Define deliverables not by hours worked, but by the attainment of specific technological performance benchmarks.

Express Contingency Clauses: Include language that explicitly states payment is contingent upon the research meeting detailed, objective specifications.

Warranty and Remedy Provisions: Specify who must pay to correct nonconforming research results. A routine negligence warranty or obligation to correct design errors alone does not establish a research-success payment contingency.

Inspection and Rejection Rights: Grant the client clear rights to inspect and reject work product that fails to meet the technological specifications, with associated payment withholding.

Retaining Substantial Rights in an IP-Sensitive Economy

In addition to the financial-risk analysis, taxpayers must establish a substantial contractual right to use the research results without paying for that use. Exclusive ownership is not required, and a client’s ownership of the final deliverable does not necessarily foreclose retained rights. However, general knowledge, increased experience, or skills gained incidentally are insufficient. Confidentiality and security clauses must be evaluated for their actual effect on the taxpayer’s contractual ability to exploit the results.

The Documentation Imperative: Insights from Phoenix Design Group

Phoenix Design Group, Inc. v. Commissioner, T.C. Memo. 2024-113, addressed whether three trial projects involved qualified research. The court found none in those projects; that determination was not binding on the remaining 235 projects. The firm’s general six-stage design description did not establish the qualifying activities actually performed. The case is not a categorical prohibition on staged engineering design.

The evidence did not establish the required technical uncertainty and process of experimentation in the trial projects. Preliminary calculations and professional judgment were insufficient on that record. The possibility of later design revisions did not itself prove unresolved technical uncertainty. Using standard software does not, by itself, determine whether an activity qualifies.

The “Shrinking Back” Rule and Contemporary Records

The record also did not permit the court to identify qualifying portions under the shrinking-back rule. This supports maintaining records that identify uncertainties, alternatives evaluated, and related activities at the relevant business-component or subcomponent level. Activity records and supporting payroll information can strengthen substantiation; the decision does not prescribe one mandatory timekeeping system.

Final Thoughts

Geosyntec and the related decisions reinforce the established distinction between commercial risk and research-failure risk. They do not replace a former blanket entitlement for fixed-fee work or eliminate research credits for professional services. Each claim requires analysis of the applicable agreements, actual research activities, retained rights, and expenses.

Navigating the Funded Research Exclusion

Contract labels do not resolve the funded research exclusion. Success-based payment terms can support a finding that payments are not funding, but the financial and substantial-rights rules must be applied together. Research may also be only partly funded: where substantial rights are retained, the regulations govern the reduction of otherwise qualified expenses by funding, including applicable allocation rules. Merely exceeding a budget does not establish that all research expenses are unfunded.

Maximizing Credit Potential through Integrated Compliance

A defensible credit position combines qualifying technological experimentation, retained substantial rights, appropriate financial-risk treatment, and reliable expense substantiation. Contemporaneous records are particularly useful. Retrospective R&D studies are not categorically prohibited, but their conclusions must be supported by credible evidence of the activities and expenditures claimed.

Geosyntec and the related cases offer practical guidance for evaluating research-credit claims. Agreements should accurately allocate the economic consequences of research failure, and records should substantiate qualifying experimentation and retained rights. Engineering and other professional-service businesses can qualify when the applicable statutory and regulatory requirements are met; neither an industry label nor a fixed-price contract establishes entitlement by itself.