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The impact of the Populous court case on the R&D credit, fixed price contracts and funded research

May 28, 2020

Many taxpayers engage in research activities where contracts are executed with their clients. Research activities that would otherwise qualify for the Research and Development (R&D) tax credit become ineligible if the research is funded by another. As such, funded research has been a hot topic in the R&D tax credit realm for many years. 

In fact, there are a myriad of prior court cases that the Tax Court (Court) relied upon in evaluating Populous Holdings, Inc.’s (Populous) facts and circumstances, and ultimately granting summary judgement to Populous. 

How the court case got started

Populous is an architecture firm that filed an R&D credit in 2010 and 2011 related to the architectural design services it provides to its clients. The credits were denied by the IRS. The focus of the IRS denial related to the contracts Populous held with its clients. The IRS stating the contracts resulted in funded research.  

The IRS and Populous agreed to review five fixed price contracts during the trial to determine a resolution. The funded research exclusion has two determining factors: 1) the payment must be contingent upon success of the research, and 2) the taxpayer must retain substantial rights to the research being conducted. The five fixed price contracts were reviewed for language related to these two factors.

Contingent upon success

This factor is concerned with who bears the economic risk of payment if the research is found to be unsuccessful. The five contracts reviewed did not include statements referring to research as a part of the contract scope. Rather, the contracts provided that Populous’ client was paying for a work product (design documents).

Language from the five contracts reviewed provided that Populous’ clients were able to review and approve the design documents created, Populous’ clients had the ability to approve at each phase prior to payment and/or that Populous’ clients had a right to challenge invoices.  

Additional language provided that Populous would be required to remedy issues (if the research failed), at its own expense. The Court focused on these contract provisions to determine whether or not this factor was satisfied. These provisions are in line with Geosyntec,[1] the Court cited — that, in general, fixed price contracts meet this factor because fixed price contracts require the taxpayer conducting the research to remedy failed research at their own expense.  

The Court, in reviewing the contracts, agreed with Populous that this factor is satisfied and that the terms of the five contracts reviewed include that payment is contingent upon the success of the research.

Retains substantial rights

The term “substantial rights” is not defined in Section 41, relying on taxpayer facts and circumstances as the determining mark. 

Lockheed Martin[2] successfully argued that a taxpayer has substantial rights to the research if the taxpayer retains the right to use the research without paying for that right. 

For Populous, the IRS argued that three of the five contracts did not meet the substantial rights factor because the contract language included provisions that transferred the ownership of the design document to Populous’ client. 

The Court provided, that “ownership of documents does not dictate the right to use technology-related research results or mean that the clients had exclusive right to research… [In addition, Populous] retained copies of the documents for its use.” The Court focused on the following: that none of the contracts included provisions that Populous pay for the right to use the research, there was no exclusivity rights language included, and none of the contracts incorporated language that restricted Populous’ from using the research it performed in its business.  

In conclusion, the Court found Populous retained substantial rights related to the contracts. The Court here confirms that substantial rights to the research can be retained by the taxpayer even if the taxpayer does not retain ownership of the work product (design documents).

Court widens R&D tax credit eligibility

The Court’s decision reverses the IRS position that the credits claimed by Populous are funded research.  Alternatively, the Court concluded that the research conducted by Populous was not funded, as both factors above are met. As a result, the research is eligible for inclusion in the Section 41 research credit.  

This is a great win for taxpayers. In conjunction with other tax court case decisions referenced, the Populous case paves a path for taxpayers to use as a reference in applying the funded research exclusion factors to their own activities and fixed price contract terms.

[1] Geosyntec Consultants, Inc. vs United States, 776 F.3d 1130

[2] Lockheed Martin Corp. v United States, 210 F.3d 1366


Christina Schultz, CPA
Senior Manager, Tax
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