Taxpayers Notch Victories Against IRS

In recent years, the IRS has tried several different angles of attack when it comes to auditing R&D Tax Credit claims. One of the biggest areas of litigation has been whether firms performing R&D or developing designs under contract are entitled to  the tax credit. Recent Tax Court rulings have paved a clearer path for contractors to claim the R&D Tax Credit.

In early 2025, the Tax Court sided with taxpayers in Smith et. al. v Commissioner and System Technologies Inc v Commissioner.  Both cases dealt with the question of funded research. As a primer, for a business to claim R&D Credits for work performed under contract, it must show the work is not “funded.” To prove work is not funded, a contract must 1) place financial risk on the taxpayer if it fails to produce a successful result, 2) allow the taxpayer to retain ownership over any intellectual property produced under the contract.

Milestone payments are proof of R&D

In previous cases, the Courts had disallowed R&D Credits since the “four corners of the contract” were silent on such matters. This presented a challenge since, in the real world, most contracts are not written with the particular requirements of the R&D Credit in mind. In Smith the Court ruled that the taxpayer did face financial risk since it would be paid only upon reaching certain milestones. The Court also acknowledged other typical contract structures such as firm fixed pricing, performance standards, termination clauses, and warranty provisions as proof that a contract must bear the cost of unsuccessful research.

ATS Takeaway: This is great news for companies working on contracts that are not specifically identified as research in development. Having read contracts across all industries, we know that most contracts do not contain direct language on payment contingent on success of research. However, many contracts do require the contractor to pass some sort of milestone before payment is initiated and will subject their work to inspection or testing. The Smith case is a tool for these instances.

Leeway given on Intellectual Property Clauses

In Smith, the IRS tried to take advantage of the fact that architectural contracts are often silent on assignment of intellectual property rights. The agency argued that since Smith was developing designs under contract on behalf of a client and would transfer those documents to the client, it retained no rights. The Court disagreed, ruling that transfer of documents with shared rights alone does not divest the taxpayer of substantial rights. The Court turned to local governing law and default rules to say that the IP may remain with the creator of the designs unless explicitly forfeited in the contract.

Local Law Considered

In System Technologies the IRS argued that the taxpayer’s purchase orders did not explicitly condition payment upon successful completion of research. This is common with purchase order However, the Court noted that local jurisdiction could be used by the client to seek financial remedy for breach of contract if the taxpayer was not successful. It ruled that state law allowed the client to pursue a refund from the taxpayer if it failed or there was a breach. Thus, the R&D was found to be contingent on success of the research and unfunded.

ATS Takeaway: This is another win for taxpayers since contracts will not have to be written with the R&D Credit in mind to satisfy the requirements. Deferring to choice of law provisions in the contract allows more real-world contracts and purchase orders to be considered non-funded.

These cases provide much needed clarity on what taxpayers should do if their contracts do not specifically address the elements required by the R&D Credit. They further emphasize the need to evaluate contracts and purchase orders considering the dozens of tax court cases that deal with the “funded research” issue to build the best legal case for claiming R&D Credits.

If you would like help in analyzing your contracts and building a case for claiming the R&D Credit, contact the tax experts at Alternate Tax Solutions.