The federal research and development tax credit under Section 41 of the Internal Revenue Code encourages qualifying research activities. Introduced in 1981 and made permanent in 2015, the credit includes a funded research exclusion that is especially relevant to companies performing research under customer or government contracts. Eligibility requires analysis of both contractual payment terms and the rights retained in the research results.

Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000), is an important decision on the substantial-rights element of this exclusion. It explains why a contractor can retain substantial rights even when the government also holds broad rights. The decision also addresses the separate procedural limits on expanding a tax refund claim during litigation. It does not establish automatic credit eligibility for government contractors or determine the modern treatment of research deductions.

The Statutory Architecture and the Funded Research Obstacle

Section 41 requires research to satisfy several conditions, commonly described as a four-part test. These address the character of the research expenditures, the technological nature of the information sought, a qualifying purpose involving a business component, and a process of experimentation. Qualifying purposes concern improvements in function, performance, reliability, or quality. Business components include products, processes, computer software, techniques, formulas, and inventions. For tax years beginning after December 31, 2024, the expenditure requirement refers to Section 174A; earlier years must be evaluated under the law applicable to those years.

Research may still be excluded even if it meets those requirements. Exclusions include research after commercial production, certain adaptations, foreign research, and research funded by another person or governmental entity. Section 41(d)(4)(H), Treasury Regulation Section 1.41-4(c)(9), and the incorporated rules in Section 1.41-4A(d) govern the funding analysis.

The regulations distinguish payment contingent on research success from payment for research regardless of success. They separately examine whether the researcher retains substantial rights. If no substantial rights are retained, the research is treated as fully funded even when the contractor bears costs. If substantial rights are retained, noncontingent payments generally reduce otherwise eligible research expenses under the funding-allocation rules; an eligible excess may remain. Contract labels alone do not resolve either question.

Historical Context and the Genesis of the Lockheed Martin Dispute

The refund claims concerned tax years 1982 through 1988 and research performed by Martin Marietta predecessor companies under approximately 300 fixed-price government contracts. Lockheed Martin appeared as successor in interest. The litigation focused on representative contracts involving the Small Intercontinental Ballistic Missile (SICBM), Titan IV launch vehicle, Supersonic Low-Altitude Target (SLAT), and Low Altitude Navigation and Targeting Infrared for Night (LANTIRN) programs.

The IRS disputed eligibility on funding grounds, including payment contingency and retained rights. The contracts gave the government broad rights in technical data and computer software and included patent provisions and nonrecurring-cost recoupment clauses. Payment contingency was not an issue decided in the Federal Circuit appeal; the appellate substantial-rights ruling should not be read as a determination of that separate requirement.

The Court of Federal Claims held that the contractor lacked substantial rights. Its reasoning relied on government access to the research, restrictions associated with patents and exports, and the obligation to reimburse certain government costs on commercial transactions. The Federal Circuit rejected that substantial-rights analysis.

Comparative Contractual Profiles in the Lockheed Martin Litigation

The representative programs shared broad government data rights and commercial cost-recoupment provisions. The following table preserves the program comparison without suggesting that the listed clauses were unique to one program.

The Federal Circuit Decision: Redefining Substantial Rights

The Federal Circuit held that substantial rights need not be exclusive. The government’s ability to use or disclose research results did not eliminate the contractor’s own right to use them in its business. The substantial-rights question concerned the rights retained under the research agreements.

The court distinguished the contractual recoupment obligation from a charge for permission to use research. Recoupment applied to specified commercial sales or licensing transactions; it did not prevent internal use of the technology without payment. The court therefore ruled for Lockheed Martin on substantial rights. It reversed that portion of the judgment and remanded for further proceedings, while affirming the separate procedural ruling.

The practical lesson is that shared rights may be substantial. A contractor must nevertheless establish its own rights under the applicable agreement and satisfy the remaining credit requirements. Neither government ownership interests nor nonexclusive contractor rights produce a universal result.

The Procedural Pitfall: The Variance Doctrine and the “Green Books”

The case applied the established substantial-variance doctrine; it did not create that doctrine. During litigation concerning LANTIRN, Lockheed Martin sought to expand the expenses supporting its refund claim beyond the schedules supplied during the administrative examination, including additional employee-related costs.

The parties called those expense schedules the Green Books. Although the refund forms stated broad expense categories, the schedules supplied the factual basis examined by the IRS. The court rejected the attempt to introduce materially different expense claims through a motion described as clarifying the complaint.

The ruling illustrates why a refund claim must adequately identify its grounds and supporting facts. A refund suit generally cannot rest on substantially different grounds that the IRS lacked a fair opportunity to examine. Whether a later submission is a permissible clarification or an impermissible new claim depends on the facts and applicable procedural rules; the case does not mean every later correction is automatically barred.

Comparative Case Law: Financial Risk and Retained Rights

Fairchild Industries, Lockheed Martin, and Dynetics illustrate different aspects of the funded research exclusion. Their outcomes depend on the agreements and issues presented, rather than a simple distinction between government and private-sector projects.

Fairchild Industries and the Financial Risk Pillar

In Fairchild Industries, Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995), the court examined the financial risk of developing the T-46A trainer aircraft under a fixed-price incentive contract. Progress payments did not by themselves establish funding. The inspection, acceptance, and repayment terms placed the relevant risk of unsuccessful performance on the contractor. This makes the agreement’s actual allocation of research-failure costs more significant than the timing of interim payments.

Dynetics and the Boundary of Incidental Benefits

Dynetics, Inc. and Subsidiaries v. United States, 121 Fed. Cl. 492 (2015), addressed seven sample contracts involving several payment structures, including cost reimbursement, time and materials, and fixed-price level of effort. The court granted the government partial summary judgment on funded research. It considered both payment contingency and retained rights. General experience and institutional knowledge do not, without more, establish substantial rights in research results, and the taxpayer must substantiate the rights on which it relies.

The following table compares the legal frameworks across these landmark cases.

Implications for Software and AEC Businesses

Software developers and architecture, engineering, and construction businesses can face the same funding issues as aerospace contractors. Customer ownership of a deliverable does not, by itself, answer whether the provider may reuse the underlying research. Payment rights, acceptance conditions, intellectual property assignments, licenses, and use restrictions must be read together.

The AEC Industry: Contract-Specific Outcomes

The December 2019 order in Populous Holdings, Inc. v. Commissioner illustrates how a design firm can retain substantial rights despite customer ownership of project documents. The contracts permitted use of underlying research in the firm’s business without a separate payment obligation. That outcome depends on the agreements reviewed and does not establish an industry-wide exemption from the funding exclusion.

The Smith litigation involving Adrian Smith + Gordon Gill Architecture also demonstrates the importance of distinguishing a procedural ruling from a final eligibility decision. An earlier denial of IRS summary judgment allowed disputed contract issues to proceed; it was not a final award of credits. A June 2026 decision found that payments under the six sample contracts were not contingent on research success. Substantial rights were retained in four projects, allowing consideration of otherwise qualifying expenses exceeding funding, but were absent in two. Design milestones alone therefore should not be presented as proof of an unfunded arrangement.

The Software Industry: Fixed-Price vs. Time-and-Materials

A fixed-price arrangement may support financial risk when entitlement to payment depends on successful research. A cost overrun, payment cap, warranty, or obligation to meet professional standards is not automatically sufficient. Time-and-materials arrangements often provide payment for effort regardless of research success, but the actual terms and allocation of payments remain controlling. Retaining substantial rights is a separate inquiry, and all other Section 41 requirements still apply.

Research Deductions Under Sections 174 and 174A

Research-credit eligibility and the treatment of research expenditures as deductions are distinct questions. The Tax Cuts and Jobs Act required capitalization of specified research or experimental expenditures for tax years beginning after December 31, 2021, with five-year amortization for domestic research and fifteen-year amortization for foreign research, using a midpoint convention. The 2025 legislation changed the domestic rules for later tax years and supplied transition options.

The “Right to Exploit” Framework

Notice 2023-63 describes an interim framework for research providers under the TCJA version of Section 174. Financial risk or a qualifying right to use or exploit the resulting research product can cause provider costs to be specified research or experimental expenditures. Notice 2024-12 modifies that framework, including exceptions for separately bargained-for rights and rights limited to performing research for the recipient. These notices are not a restatement of the Section 41 funded research test. Their scope, reliance conditions, and applicable tax years must be considered separately.

The One Big Beautiful Bill Act (OBBBA)

Public Law 119-21, commonly known as the One Big Beautiful Bill Act, was enacted on July 4, 2025. New Section 174A generally permits current deductions for domestic research or experimental expenditures paid or incurred in tax years beginning after December 31, 2024. Taxpayers may instead elect capitalization and amortization over at least 60 months under Section 174A(c). Foreign research remains subject to fifteen-year amortization under Section 174. Transition provisions address previously capitalized domestic costs and eligible small-business retroactive elections; Revenue Procedure 2025-28 sets out implementation procedures. Section 174A does not enact Lockheed Martin’s substantial-rights holding as a new deduction test.

The following table distinguishes the expenditure regimes. These rules concern deduction timing and do not replace Section 41’s separate eligibility analysis.

Best Practices for Contract Drafting and Compliance

Contract review and research documentation should address the requirements actually relevant to the claim. Contract language should accurately reflect the commercial arrangement, and favorable wording cannot substitute for qualifying research or supporting evidence.

Avoiding the “Work Made for Hire” Trap

Broad intellectual property assignments or work-made-for-hire provisions can limit a provider’s ability to use research results. Cases such as Tangel v. Commissioner and Grigsby v. United States illustrate the risks of surrendering rights or relying on reuse subject to unrestricted customer approval. Review all reservations and licenses rather than treating the phrase work made for hire as automatically decisive. Where commercially appropriate, an express nonexclusive right to reuse underlying technical information can help establish the rights retained.

Documenting Financial Risk

Review the consequences of unsuccessful research, including acceptance, rejection, correction, termination, and repayment provisions. Records should explain when payment becomes legally due and who bears costs if the technical objective is not achieved. An obligation to correct ordinary defects or comply with a professional standard does not necessarily make payment contingent on research success.

Mitigating Variance Doctrine Risk

A refund claim should clearly state the factual and legal grounds supporting the amount requested. The Lockheed Martin procedural ruling makes careful preparation of expense schedules and supporting records particularly relevant. Administrative filing requirements and substantive eligibility are separate issues.

A robust compliance strategy must include:

Expense nexus: Maintain records supporting the claimed wages, supplies, and eligible contract research expenses and linking them to the research activities and relevant business components.

Research evidence: Retain engineering notes, design alternatives, testing results, and other records showing the uncertainty and experimentation. Contemporaneous evidence is useful, but no single narrative format universally establishes qualification.

Complete claims: Reconcile the expense population before filing and identify the grounds and facts supporting the refund. Assess any amendments within the applicable procedural rules and limitation periods.

IRS Audit Techniques Post-Lockheed Martin

IRS examination guidance directs attention to contracts, research records, expense substantiation, and refund-claim scope. The Aerospace Industry Audit Techniques Guide discusses the substantial-variance issue in Lockheed Martin. Such guides assist examiners but are not binding legal authority and do not make every post-filing clarification invalid.

Review relevant agreements at both prime-contractor and subcontractor levels. Payment obligations and retained rights can differ between those levels. Identify the FAR, DFARS, or historical procurement clauses actually incorporated, including their versions and negotiated changes, rather than assuming one modern patent or data-rights clause applies to every contract.

For research-credit refund claims, current IRS guidance calls for identification of the relevant business components, the research activities for each, and total qualified expense categories. Since June 18, 2024, the IRS has waived the upfront requirement to name each researcher and specify what each individual sought to discover, although examiners may request that information. The IRS has extended the transition period allowing 45 days to perfect eligible deficient claims through January 10, 2027. Taxpayers should follow the instructions applicable to the claim and filing date.

Final Thoughts

Lockheed Martin confirms that substantial research rights can be shared with a customer or the government. The contractor’s retained ability to use research results matters, even without exclusive control. The ruling does not dispense with financial-risk analysis, expense substantiation, or the other requirements of Section 41.

The case also demonstrates the need to present refund claims with sufficient factual specificity before litigation. A defensible study should address contract rights, payment contingency, qualifying activities, and expense support separately. Modern deduction rules under Sections 174 and 174A require their own analysis and should not be conflated with the research-credit holding.

The intersection of financial risk, intellectual property, and statutory compliance is where the future of American innovation is decided. For the government contractor, the Lockheed Martin decision is more than just a case study; it is the essential roadmap for securing the tax benefits that drive technological progress in the 21st century.