In Smith v. Commissioner, T.C. Memo. 2026-50, the Tax Court further clarified the analysis under section 41 regarding funded research. The court rejected a challenge to the validity of the "funded research" regulations under section 41 and held that the taxpayers are eligible for reduced research credits based on its finding that they retained substantial rights in the research. This case is particularly relevant for taxpayers that perform research activities in connection with customer contracts, such as those in the construction or defense industries.

The taxpayers in Smith were three partners in an architectural firm (AS+GG), which was organized as a partnership for federal income tax purposes, and their spouses. AS+GG reported research credits under section 41 for the 2008, 2009, and 2010 tax years based on 48 architectural projects. The IRS conceded that each of the projects met the four-part test and are qualified under section 41(d). It contested the taxpayers' eligibility for the credit on the basis that the research activities with respect to the projects were funded research under section 41(d)(4)(H). After the court rejected the government's motion for summary judgment, finding the existence of genuine issues of material fact regarding the funded research question, the parties stipulated that the scope of trial would be limited to six sample projects (the Sample Projects).

Under section 41(d)(4)(H), research that is otherwise qualified under section 41 does not include "[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)." While section 41 does not define "funded research," the court looked to the regulations and prior case law to divine a two-pronged approach to determining when research is funded. The most important factor is whether "a taxpayer performing research for another person retains no substantial rights in research under the agreement providing for the research." Treas. Reg. § 1.41-4A(d)(2). A taxpayer that retains no substantial rights in research is ineligible for the research and experimentation (R&E) credit with respect to that research. The other factor is whether "[a]mounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research… are not treated as funding." Treas. Reg. § 1.41-4A(d)(1). 

The Tax Court first rejected the taxpayers' challenge to Treas. Reg. § 1.41-4A(d) under Loper Bright v. Raimondo, 603 U.S. 369 (2024). The taxpayers argued that Treas. Reg. § 1.41-4A(d) was not the best reading of section 41's funded research exclusion and that "funded research" should instead be defined as "a sum of money set apart for a specific objective." The court rejected that argument and upheld Treas. Reg. § 1.41-4A(d) based on pre-Loper Bright decisions of the Court of Appeals for the Federal Circuit and Court of Federal Claims (COFC) and its determination that Treas. Reg. § 1.41-4A(d) was deserving of Skidmore deference based on its longevity and clarity. After upholding the validity of Treas. Reg. § 1.41-4A(d), the Tax Court analyzed the Sample Projects based on that regulation's interpretation of the funded research exclusion.

First, the court found that none of the contracts for the Sample Projects provided that payments to AS+GG were contingent on the success of the research. The taxpayers' primary contention was that payments for the Sample Projects were contingent on success because they required approval after each phase or milestone, like the contracts at issue in Fairchild Indus., Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995). The court rejected that argument based on its review of approval clauses, payment clauses, termination clauses, and other provisions from the research agreements for each of the Sample Projects. Rather, the court found that the taxpayers' approval requirements were "not the type of clearly detailed specifications that required approval before payment would be made" like the "1,000 pages of detailed specifications" in the Fairchild contracts and concluded that none of the Sample Projects was contingent on the success of the research.

Next, the court found that AS+GG retained "substantial rights" in research for four of the Sample Projects. The court reviewed the language of the research agreements for each Sample Project. For the four Sample Projects in which the court found that AS+GG retained substantial rights, the court pointed to AS+GG's retention of copyrights and/or entrance into license agreements with respect to the research. For the other two Sample Projects, the court found that the language of the agreements indicated that AS+GG did not retain any property rights in the research because AS+GG was required to obtain written consent from the client to use the research going forward. With respect to the four Sample Projects in which AS+GG retained substantial rights, the court held that the taxpayers may be eligible to claim R&E credits "to the extent the total amount of research expenses exceeded the payments received."

While a mixed decision, Smith provides valuable additional clarity to the funded research analysis. We will watch for further disputes related to the computation of a partial R&E credit in accordance with the court's holdings and, once the court issues its decision, any appeal to the Seventh Circuit. Given the fact-intensive nature of the funded research (and all R&E) cases and the IRS's longstanding enforcement focus on the R&E credit, we anticipate additional litigation on these issues. 

For more information, please contact: 

George A. Hani, ghani@milchev.com, 202-626-5953

Robert J. Kovacev, rkovacev@milchev.com, 202-626-5857

Samuel A. Lapin, slapin@milchev.com, 202-626-5807

Tyler C. Jackson, tjackson@milchev.com, 202-626-5820

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