A recent Tax Court case has given architecture firms more ammunition in substantiating R&D Tax Credit claims. In Populous Holdings, Inc. (“Populous”) v. Commissioner of Internal Revenue, the Court ruled in support of the taxpayer’s R&D Credit Claim for building design projects. In recent years, the architecture industry has been increasingly accessing this credit. However, no Tax Court precedent has existed specifically addressing whether or not work done by most architecture firms meets the standards of the Internal Revenue Code, leading to disputes between the IRS and taxpayers. The Populous case remedies this problem, paving the way for R&D Credit that can be backed up by legal regulations and court precedent.
A key issue in this case was whether or not Populous had a right to claim R&D Credits for research performed under contract. The IRS argued that the fixed-price contract fell into the funded research exclusion of 26 CFR § 1.41-4(c)(9), since Populous was paid for work under the contract and turned over the drawings to the building owner upon completion of the project. The Court, however, ruled that this research was not funded because if the research failed, the petitioner would be required to incur additional expenses without additional compensation. The Court also ruled that on all the contracts examined, Populous retained the right to retain or exploit the research on future projects. These two lines of reasoning shot down IRS claims that architects do not perform qualified research.
1- The IRS discarded Populous’ credit by reasoning that design work performed under contract constituted funded research.
2- The Tax Court relied on precedent from previous court cases to find that the fixed-price contract structure put the financial risk of failed research on the architect.
3- Even though the architect was required to turn over documents to the client, the firm retained the rights to use any technical know-how or techniques on future projects.
4- The Tax Court rejected IRS arguments and ruled that Populous was entitled to the tax credit.
This ruling provides further clarity on two key issues that contractors face when claiming the R&D Credit:
1- Is payment contingent on the success of the research?
2- Does the taxpayer retain rights to the research?
Let us further explore each issue and examine how they apply to the typical architecture firm.
Payment Contingent on Success
The tax code requires the taxpayer claiming the R&D Credit to prove that they are not being paid to perform the research but rather to successfully produce an end result. The fixed-price contract structures that most architect firms work under require the company to produce a work product (construction documents) that is deficiency free. To produce a successful work product, an architect firm must perform the research and testing necessary to discover the building drawings, systems, and technologies that meet both the design intent and technical requirements of the contract. Since there is a fixed amount of money that the firm will be paid, it is responsible for bearing all costs necessary to produce a successful outcome. Thus, according to the precedent set forth in Populous, the architect is paid for the result of the research. Warranty clauses within contracts further prove that the financial risk for success or failure is on the architect.
ATS Guidance: If a contract to provide architecture service has a fixed-price or a cap on all expenses and gives the client the right to review and approve designs, as well as dispute invoices, the work to produce a final set of drawings will qualify for the R&D Credit. Firms that use an iterative process of design to take drawings from concept to completion (usually following the SD, DD, & CD format) can pass the tests required to claim R&D Credits.
Substantial Rights Retained
Whether or not the taxpayer retained the rights to its research was a central dispute in the previous Fairchild and Dynetics court cases. Generally, taxpayers are required to retain the rights to any proprietary information that arises as a result of the research. In Populous, the IRS argued that because the firm turned over documents to the client, it did not own the research. However, the Court found that none of the contracts denied Populous the ability to use the means, methods, or technologies accessed to produce the drawings on future projects and that no licensing fee was required to do so. Thus, the IRS claim was rejected.
ATS Guidance: Retention of intellectual property was a key issue in prior court cases since the projects examined required creation of technology that was proprietary in nature. In the architecture world, however, designs themselves are not proprietary. It is the means, methods, and technical know-how used to create the drawings that are proprietary. Prior to Populous, there was no guidance on whether or not physical drawings should be classified as proprietary in nature. This ruling clarifies the fact that even if a contract requires an architect to turn over final documents, as long as the architect is not prohibited from using the means and methods to exploit the results of the research on future projects, the design work can qualify as R&D.
The precedent set forth in this case dispels the IRS belief that the work performed by architects is of a nature that does not constitute qualified research. Now more than ever, architecture firms should seek reward for the risks that they take in providing designs for clients. The R&D Tax Credit is designed to do just that.