Federal tax ownership depends on the substance of a transaction as well as its legal form. Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981), collected eight factors from earlier decisions for determining whether the benefits and burdens of ownership passed to a purported buyer. The case concerned cattle investments, not the research credit. Its economic-substance reasoning offers a useful comparison with contract research, but it did not establish the funded-research rules or serve as their controlling eight-factor test. Section 41(d)(4)(H), Treasury Regulations Sections 1.41-4(c)(9) and 1.41-4A(d), and research-credit decisions such as Fairchild and Lockheed Martin supply the governing standards for that inquiry.

The Historical and Legal Genesis of Grodt & McKay Realty, Inc. v. Commissioner

Grodt & McKay involved tax-oriented cattle-breeding investments by Grodt & McKay Realty, Inc., a real estate corporation, and Davis Equipment Corp. The program was offered by T. R. Land & Cattle Co., Inc., not a company called McKay Breeding Co. Each unit consisted of five breeding cows at a stated price of $30,000, or $6,000 per animal. Grodt & McKay acquired two purported units. The Tax Court found the cattle worth approximately $600 per head, far below the stated purchase price.

Grodt & McKay paid $2,000 initially and issued a $58,000 nonrecourse note. Davis Equipment paid $1,500 initially and issued a $28,500 nonrecourse note. Cattle Co. retained practical possession and control through the related management arrangements. The investors claimed tax benefits that included investment credit, depreciation, management-fee deductions, and interest deductions. Nonrecourse borrowing and third-party management are not inherently invalid; the court examined their operation together with the inflated price and other facts.

The issue was whether the arrangements effected genuine sales for federal income tax purposes. The court treated the transfer of benefits and burdens as a factual question evaluated from the agreements and surrounding circumstances. It identified eight relevant guideposts drawn from earlier cases, rather than a mandatory checklist in which each item independently determines ownership.

The court concluded that the arrangements were not sales for federal tax purposes. The investors lacked meaningful equity, practical control, and ordinary ownership risks; their only realistic expectation of profit rested on anticipated tax benefits. The challenged credits and deductions were disallowed. The holding does not mean that every transaction using nonrecourse financing is a sham.

Extending the Doctrine: The Challenges of Intangible and Fungible Assets

Courts have also used benefits-and-burdens reasoning for stock transactions and contract manufacturing. The relevance of individual factors depends on the asset and the governing statutory provision. Possession and disposition of publicly traded shares present different questions from management of livestock; a factor such as property-tax responsibility may have little relevance to a securities transaction.

In Calloway v. Commissioner, 135 T.C. 26 (2010), affirmed, 691 F.3d 1315 (11th Cir. 2012), the taxpayer transferred IBM shares under a Derivium arrangement described as a nonrecourse loan equal to 90 percent of the shares’ value. The arrangement had a three-year term and restricted early repayment. Derivium could sell the shares and did so. The courts treated the transfer as a sale rather than a genuine loan secured by stock.

The Calloway majority applied the Grodt & McKay factors to the stock transfer. Judge Holmes concurred in the result but questioned the usefulness of applying a broad ownership checklist to fungible securities, emphasizing title and the power to dispose of the property. This disagreement illustrates that benefits-and-burdens analysis is sensitive to the property and transaction, even when judges reach the same tax result.

In Anschutz Co. v. Commissioner, 664 F.3d 313 (10th Cir. 2011), affirming 135 T.C. 78 (2010), the court considered prepaid variable forward contracts together with related share-lending arrangements and sustained sale treatment. The decision addressed the integrated arrangement and the ownership benefits transferred; it does not establish that every prepaid variable forward contract, standing alone, is a taxable sale.

The Nexus of Tax Ownership and the Section 41 Research Credit

Section 41(d)(4)(H) excludes research to the extent funded by a grant, contract, or otherwise by another person, including a governmental entity. The funded-research rules determine the performing taxpayer’s eligible research expenses by examining payment contingencies, retained rights, and the extent of funding. A customer contract does not automatically eliminate every possible credit.

The regulations address two related issues: whether payments depend on successful research and whether the researcher retains substantial rights in the results. These standards should not be described as a judicial division of Grodt & McKay’s eight factors. Full tax ownership, exclusive patent ownership, and physical possession of deliverables are not synonymous with substantial rights under Section 41. All relevant agreements must be considered.

The Risk Standard: Allocating Economic Loss

Under Treasury Regulation Section 1.41-4A(d)(1), amounts payable contingent on successful research are treated as payment for its product or result rather than funding. In Fairchild Industries, Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995), modified in 1996, the decisive inquiry was which party would bear research costs if the effort failed. The probability of success was not the test. Inspection, acceptance, repayment, and correction provisions may establish the relevant allocation.

In a typical contract research arrangement, the allocation of risk is determined by the payment structure:

Contingent Payment: A researcher required to deliver a successful result before becoming entitled to payment may bear the financial risk. Refundable progress payments do not necessarily shift that risk. The researcher must also retain substantial rights, substantiate qualifying activities and costs, and satisfy the other Section 41 requirements before claiming a credit.

Noncontingent Payment: Reimbursement owed regardless of research success generally constitutes funding to that extent. Time-and-materials arrangements commonly have this feature, but the complete agreement controls. A client may separately qualify for contract research expenses under Section 41(b)(3) and Treasury Regulation Section 1.41-2(e). If the provider retains substantial rights and research expenses exceed funding, the regulations may permit a credit on eligible unfunded expenses; noncontingent payment does not always mean that every provider expense is excluded.

In Geosyntec Consultants, Inc. v. United States, 776 F.3d 1330 (11th Cir. 2015), the district court distinguished fixed-price contracts from capped cost-plus contracts. Only two capped contracts were at issue on appeal, and the Eleventh Circuit affirmed that the research under them was funded. Their payment terms did not make entitlement to compensation depend on successful research. Ordinary budget-overrun risk, professional-care obligations, and invoice-dispute rights did not establish the necessary contingency. Fixed-price or milestone labels alone are therefore insufficient.

The Substantial Rights Standard: Identifying the Right to Exploit

Under Treasury Regulation Section 1.41-4A(d)(2), research is treated as fully funded from the provider’s perspective when the provider retains no substantial rights in the research, even if payment depends on success. The regulation expressly excludes incidental experience gained from performing the work. The comparison with economic ownership is conceptual; the operative rule is the research-credit regulation.

Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000), establishes that substantial rights need not be exclusive. A meaningful right to use research results in the taxpayer’s business can qualify even where the customer also has extensive rights. A taxpayer required to pay for the right to use the results does not retain substantial rights under the regulation. However, a license can itself preserve substantial rights, and some restrictions on sales to third parties do not necessarily eliminate a retained business-use right. The entire rights arrangement must be examined.

In Dynetics, Inc. v. United States, 121 Fed. Cl. 492 (2015), the court examined contractual restrictions and rejected reliance on generalized skills and advancements as proof of substantial rights. The practical question is whether the provider retained meaningful rights in the research results, not merely greater professional experience. A patent is not required, and the Section 41 inquiry should not be replaced by the separate SRE-product-right definitions in Section 174 administrative guidance.

Modern Litigation Trends and the Shift Toward Local Law Interpretation

Research-credit disputes involving architecture, engineering, and software services frequently turn on payment and intellectual-property clauses. These cases apply Section 41 and its regulations, rather than a free-standing Grodt & McKay ownership test. Procedural decisions must be distinguished from final determinations that particular expenses qualify for the credit.

In the Smith litigation involving architectural services, an early summary-judgment ruling discussed in January 2025 commentary left contract-interpretation issues unresolved, including questions under governing foreign law. That procedural result was not a final allowance of the credits. The later opinion, Smith v. Commissioner, T.C. Memo. 2026-50, addressed payment contingencies and retained rights, with different consequences among the projects. Retained rights could preserve consideration of qualifying expenses exceeding customer funding; they did not make all customer payments contingent on successful research.

In System Technologies, Inc. v. Commissioner, Docket No. 12211-21, a summary-judgment ruling discussed in January 2025 considered remedies available under Indiana law. The court concluded that the warranty terms did not rule out refunds following a total breach and rejected the IRS’s funded-research argument on the agreements considered. This was a ruling on the funding issue, not proof that every project or expense satisfied all research-credit requirements.

These developments show why contract interpretation must include applicable law and enforceable remedies. They do not establish a universal rule that ordinary breach-of-contract remedies make customer work unfunded. The relevant considerations include:

Governing Jurisdiction: Identify the law that governs each agreement and determine how it affects entitlement to payment, refunds, acceptance, and use of research results.

Implied Warranties and Remedies: Determine whether applicable law actually makes payment dependent on the relevant result. A general duty of competent professional performance does not by itself establish a research-success contingency.

Actual Performance Conduct: Preserve evidence of rejected deliverables, repayment demands, milestone acceptance, and corrective work. Such evidence may help explain the agreements and allocation of risk, but does not automatically override enforceable terms.

Section 174 Amortization and the Enacted Section 174A Rules

The Tax Cuts and Jobs Act required capitalization of specified research or experimental expenditures for tax years beginning after December 31, 2021. For tax years beginning in 2022–2024, domestic costs generally had five-year recovery and foreign costs fifteen-year recovery, both starting at the midpoint of the year. Public Law 119-21, enacted July 4, 2025, changed this framework: Section 174A generally permits current deduction of domestic research or experimental expenditures for tax years beginning after December 31, 2024. Section 174 continues fifteen-year amortization for foreign research.

Contract research still requires separate deduction and credit analyses. Section 41’s substantial-rights test is not identical to the research-provider rules in Notice 2023-63, as modified by Notice 2024-12. Those notices addressed the TCJA capitalization regime; they cannot override the subsequently enacted domestic deduction under Section 174A. Retaining research rights does not, by itself, force five-year capitalization of all domestic costs incurred in 2025 or later.

The Research-Provider Rules in Notices 2023-63 and 2024-12

For the TCJA regime addressed by the interim guidance, costs incident to contracted SRE activities are generally SRE expenditures of a provider when either of the following applies:

The provider bears financial risk under the research contract; or

The provider has a qualifying right to use or exploit a resulting SRE product. Notice 2024-12 excludes certain separately bargained-for rights and rights limited to performing research for the recipient. A right available only with approval from an unrelated party to the research arrangement is also restricted under the guidance. The table describes the historical TCJA framework, subject to those definitions and applicable elections.

Under the historical domestic capitalization rules, a provider’s financial risk or retained product rights could cause deduction deferral even where the Section 41 credit was unavailable. A five-year recovery period beginning at midyear generally spreads deductions across six annual returns for a calendar-year taxpayer. The resulting timing difference could affect cash flow, but its size depended on taxable income, credit utilization, and the taxpayer’s facts.

For domestic expenditures in tax years beginning after 2024, Section 174A materially changes that timing comparison. Eligible domestic R&E costs are generally deductible unless an applicable capitalization election is made, while foreign R&E remains subject to Section 174. Ownership analogies cannot substitute for applying the correct statute, tax year, expenditure classification, and election.

Documentation and Substantiation: The Contemporary Enforcement Environment

Siemer Milling Co. v. Commissioner, T.C. Memo. 2019-37, illustrates the need to substantiate the Section 41 requirements for each business component. The court denied the disputed research credits for the years at issue because the evidence did not establish qualifying research, including the requisite process of experimentation. Technical novelty and project descriptions alone did not establish the claimed activities. The decision should not be reduced to an unsupported uniform annual dollar amount.

Betz v. Commissioner, T.C. Memo. 2023-84, involved shareholders of Catalytic Products International, Inc., which designed and supplied air-pollution-control systems; it was not an architectural firm. The disputed 2014 net research credit was $501,531. The court found failures of proof concerning qualifying research and claimed costs, and found that the taxpayers had not established substantial rights for five projects. Unreliable retrospective estimates were insufficient on that record. The case does not create a universal requirement for one particular time-tracking system.

Treasury Regulation Section 1.41-4(d) requires records sufficiently usable and detailed to substantiate eligibilit