Posted by Jeffrey Feingold on 09.23.13
S. District Court Rules on Whether Research was "Funded" or "Not Funded" for Research & Experimentation Tax Credit Purposes
As set forth in the pivotal case of Geosyntec Consultants, Inc. v. United States, No. 9:12-cv-80334 (S.D. Fla. 2013), the United States District Court for the Southern District of Florida ruled that engineering work conducted under select customer contracts was "not funded" and consequently eligible for the Research and Experimentation Tax Credit (hereinafter "Research Tax Credit") pursuant to I.R.C. § 41, while other contracts were deemed "funded" and not eligible for the Research Tax Credit.
Geosyntec Consultants Inc. (hereinafter "Geosyntec") is an engineering firm that specializes in matters involving the environment, natural resources and geologic infrastructure. Geosyntec's core business is to develop innovative and sustainable solutions to environmental problems that are less expensive and disruptive than conventional remediation approaches.
Geosyntec sought a refund of $1,677,432 for Research Tax Credits resulting from 370 client projects on which it worked from 2002 through 2005. At issue before the court in cross-motions for summary judgment motion was whether the services rendered by Geosyntec on those projects should be classified as "funded research" under I.R.C. § 41(d)(4)(H) and thus not eligible for the Research Tax Credit.
Pursuant to Treas. Reg. § 1.41-4A(d) there are two requirements for determining whether research and experimentation analysis rendered for a third party is considered "not funded" and therefore not excluded from the Research Tax Credit under I.R.C. § 41(d)(4)(H):
1) The taxpayer must retain substantially all of the rights to the research (e.g., although exclusive rights to the research is not required); and
2) The amounts payable to the taxpayer under the contract must be contingent on the success of the research (i.e., it should be duly noted that the taxpayer must bear the economic risk of loss).
The ruling in this case dealt only with the second requirement and focused on whether Geosyntec had in fact had the economic risk of loss for the projects in question.
In its ruling, the court relied heavily on Fairchild Industries v. U.S., 71 F.3d 868 (Fed. Cir. 1995), a fundamental case that dealt with this specific issue. The district court assessed Geosyntec's contract terms in connection to the Fairchild decision, as well as under the administrative authority provided within the treasury regulations, to determine if Geosyntec's clients had to pay for the services rendered even if it was unsuccessful.
Geosyntec entered into different types of contracts with its customers including "lump sum" contracts, where it was paid under a firm fixed price contract for the services rendered; "cost plus contracts subject to a maximum", where it was paid for labor and other expenses, plus a mark-up, subject to an agreed-upon maximum price; and "cost plus" contracts, where it was paid for all time and material costs incurred for the project. Both the Internal Revenue Service and Geosyntec agreed that the "cost plus" contracts were funded, so the court focused on the other two contract types. The parties also agreed to present the court with six representative contracts: three firm fixed price contracts and three capped contracts.
The court agreed with Geosyntec that each of the firm fixed price contracts in question was not funded, noting that the nature of firm fixed-price contracts makes them inherently risky for the contractor. To the extent Geosyntec's performance under these contracts was unsuccessful; Geosyntec had to remedy the performance without additional compensation, the court said. The noteworthy contract provisions under these firm fixed-price contracts included the client's right to withhold payment if a project milestone was not properly completed, warranty provisions requiring Geosyntec to replace or repair defects at its expense, and inspection and acceptance clauses that shifted risk to Geosyntec. Conversely, the court found that the capped contracts in question were funded because "each one obligates the client to reimburse [Geosyntec] for predefined tasks at predefined rates in accordance with a detailed project budget," and that ultimately, Geosyntec did not bear the entire risk of any failed research. Of note, one of the capped contracts allowed Geosyntec to submit change orders if needed to address price or work adjustments. Another provision in a capped contract indicated that Geosyntec did not guarantee results; only compliance with professional standards of care was required.
In conclusion, the court granted in part and denied in part both the government and Geosyntec's motions for summary judgment, scheduling a trial for Nov. 18, 2013 and indicating that a settlement conference would likely occur before the trial date.