Case Studies

This document explores how the definition of “funded research” affects eligibility for R&D tax credits in the US, analyzing recent Tax Court decisions that reinforce the importance of contractual clauses and applicable legislation.

• Funded research: Research financed by contracts, grants, or agreements does not qualify for R&D credit.
• Key criterion: Guaranteed payment regardless of project success characterizes funded research.
• Systems Technologies case: The Court concluded that compensation was contingent on success, making the research eligible.
• Smith et al. case: Debate on copyright retention and application of UAE law; decision favorable to taxpayers.
• Impact of the decisions: Reaffirmation of analysis based on contractual terms and choice of law, rather than a rigid approach.

Smith v. Commissioner centers on a Chicago-based architectural firm involved in complex research projects governed by international contracts. The case raised key questions about the ownership of intellectual property under foreign law and the treatment of self-employment income in partnerships for research tax credits. The Tax Court’s decision clarified important aspects of cross-border legal application and the interpretation of qualified research expenses.

• Foreign Law Application: The research contracts were governed by the laws of Dubai and the UAE, which automatically grant copyright and reproduction rights to creators—supporting Smith’s claim to substantial rights.
• Court Ruling in Favor of Smith: The Tax Court rejected the IRS’s motion for summary judgment, affirming that foreign law is relevant in determining whether research is “funded.”
• No Additional Notice Required: The court clarified that Tax Court Rule 146 does not require a separate formal notice of intent to use foreign law when the IRS is already aware of its relevance.
• Qualified Research Expenses in Partnerships: The case also addressed whether partners’ self-employment income can be considered a qualified research expense under former IRC Section 174(e).
• IRS Authority Limitations: The court emphasized that Congress did not require partners to equate self-employment income with employee wages, limiting the IRS’s ability to challenge this treatment.

System Technologies is an engineering firm that designs and manufactures custom finishing systems for the automotive industry. In this case, the Tax Court evaluated whether six research projects were “funded” under tax law, considering the contracts’ choice-of-law provisions that designated Indiana state law. The court’s decision emphasized how state-level legal protections can influence the funding analysis and reinforced the importance of contract structure in determining tax treatment.

• Indiana Law as Governing Framework: The contracts included choice-of-law clauses applying Indiana law, which favors broad remedies and interprets them strictly in favor of the buyer.
• Court Determination of Unfunded Research: The Tax Court concluded that the projects were not funded, noting that Indiana law provides statutory remedies when contracts lack sufficient recovery terms.
• Refund Rights Under State Law: If System Technologies failed to deliver, Indiana law would override contract warranties and entitle buyers to a refund—supporting the argument that the firm retained substantial rights.
• Strategic Use of Contract Provisions: Taxpayers relied on the choice-of-law clauses to argue that the protections under Indiana law excluded the projects from being considered funded.
• Judicial Willingness to Consider State Protections: The court showed openness to evaluating how governing law provisions in contracts can affect the funding status of research activities.

MBJ claimed that its payments were conditional on the success of the research, but the court concluded that the contracts did not clearly establish this condition. The judgment reinforces that, for an activity to be considered “qualified research” under Section 41, there must be financial risk, substantial rights, and adequate documentation. The case serves as a warning to companies and consultants about the care required when analyzing contracts and the eligibility of expenses for R&D credits.

Key points:

• MBJ claimed that its contracts tied payment to research success, which would qualify its expenses for the R&D tax credit (Section 41).
• The Court concluded that MBJ’s contracts did not expressly make payment contingent on research success, but rather on delivery meeting professional standards.
• The court distinguished between meeting specific technical criteria (success) and delivering services meeting professional standards (adequacy).
• The contracts did not indicate actual financial risk or substantial rights to the research results, essential elements for qualification.
• A detailed analysis of the contracts is essential to ensure compliance with the Section 41 criteria. The absence of specific terms may compromise credit eligibility.

The legal dispute between Kyocera AVX Components Corp. and the U.S. government highlights the challenges in proving R&D Tax Credits under Section 41 of the Internal Revenue Code. The case revolves around a lack of adequate documentation, the use of questionable estimates, and failures to apply the “process of experimentation” test, and may influence how companies document their innovation activities to ensure compliance and access to tax benefits. Download our content to learn more!

Case Study – Leveraging the R&D Tax Credit in Aerospace Manufacturing

Advanced Manufacturing Inc. (AMI), established in 1985 and based in Texas, is a leading aerospace components manufacturer renowned for its high-precision metal parts utilized in both commercial and military aircraft. With a commitment to innovation, AMI invests heavily in research and development (R&D) to meet the challenges posed by increasing fuel efficiency standards and competitive pressures.

The company focuses on advanced material science, such as developing lightweight, high-strength alloys, and implementing AI-driven automation to enhance manufacturing precision. AMI’s R&D projects have yielded significant benefits, including a 15% reduction in component weight, a 20% acceleration in production cycles, and an 18% decrease in material waste.

Additionally, AMI has successfully leveraged the R&D Tax Credit, claiming $1.1 million to reinvest in further innovations. Looking to the future, AMI aims to expand its AI capabilities and pioneer new materials for defense applications, ensuring its position as a preferred supplier in the aerospace industry while contributing to sustainability efforts.

To explore more about our innovative projects and initiatives, we invite you to download our detailed PDF case study. This document provides in-depth insights into our R&D efforts, the benefits of our investments, and how we leverage tax incentives to drive growth.

Recent R&D case before the U.S. Tax Court which was ruled in favor of the commissioner and disallowed 100% of SIEMER MILLING’S 2011 and 2012 Research & Development (R&D) Tax Credit under Section 41. Siemer´s claim was disallowed for not providing adequate supporting evidence to demonstrate its process of experimentation. This article summarizes and provides detail on the case involving required documentation for federal Research and Development Tax Credit. Download the full case study to read more!

Fi Group’s mission is simple: help clients with R&D tax incentives, Direct, and Indirect tax challenges, and needs, to allow them to focus on their business operations instead of wasting their limited time and resources distracted by the tax challenges they face.

Keeping up to date on current events and important court cases such as the recent court decision for Populous Holdings are some benefits that FI Group also focuses on including.

Populous Holdings (architectural design firm) vs. Commissioner summary judgment has a major impact on whether activities were “funded” vs. “non-funded” (economic risk), thus eligible for the research and development tax credit.

This article summarizes and provides detail on this important decision.

Download the full case study to read more!