U.S. Tax Court: Architectural partnership largely denied R&D credits but partner compensation was reasonable under section 174(e)
The court rejected a Loper Bright challenge to regulations under section 41.
Today, the U.S. Tax Court issued a significant memorandum decision in Smith v. Commissioner, providing a detailed analysis of the “funded research” exclusion under section 41(d)(4)(H). The decision solidifies the recent judicial trend seen in Meyer, Borgman & Johnson, Inc. v. Commissioner, 100 F.4th 986 (8th Cir. 2024), which as in this case, establishes a high bar for taxpayers in professional services to prove their research is not funded by their clients, shifting the baseline analysis away from older, more taxpayer-favorable interpretations of the issue.
The case is: Smith, et al. v. Commissioner, T.C. Memo. 2026-50 (June 16, 2026). Read the Tax Court’s opinion.
Summary
The IRS disallowed research credits claimed by an architectural firm, arguing the research was funded. In its analysis of six sample projects, the court applied a clear, two-step framework. The first and most critical test is whether the taxpayer retains “substantial rights” in the research. For two of the six projects, the court found the firm failed this test. The contracts for these projects contained language that transferred the copyright and made all project data the “absolute property” of the client, while requiring the firm to obtain “express prior written approval” before using any project information for another purpose. Citing logic consistent with Lockheed Martin, Tangel, and Dynetics,* the court held that because the firm had relinquished control and ownership of its research results, the taxpayer lacked substantial rights.
For the four projects where the firm did retain substantial rights, the court proceeded to the second test: analyzing whether payment was contingent on the success of the research. Here, the court found that the firm did not bear the economic risk of failure. It reasoned that contractual terms tying payment to monthly progress or the completion of phases—not the successful outcome of the innovation—do not constitute contingent payment. In so finding, the court repeatedly cited Meyer, Borgman & Johnson, which held that for research to be contingent upon success, that success must be measurable with specific and detailed criteria included in the contract.
Because the firm retained substantial rights but had no financial risk in these four projects, the court concluded the research was “partially funded.” It is critical to note the court did not award partial credits. Instead, it provided a framework for possible credits where the firm is now tasked with proving that its qualified research expenses for each project exceeded the payments it received from the client. Only the excess amount, if any, is eligible for the credit.
As secondary matters, the court also addressed two other issues. It held that the compensation paid to the partners was reasonable under the "independent investor test" applicable in the Seventh Circuit. Finally, the court rejected the taxpayer's challenge to the validity of the long-standing funded research regulations (Treas. Reg. § 1.41-4A(d)) under the Supreme Court's recent decision in Loper Bright Enters. v. Raimondo, 144 S. Ct. 2244 (2024), affirming the regulations' continued authority.
* See Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000); Tangel v. Commissioner, T.C. Memo. 2020-155, aff'd, No. 21-1405, 2022 WL 1111003 (2d Cir. Apr. 14, 2022); and Dynetics, Inc. v. United States, 121 Fed. Cl. 129 (2015), aff'd, 613 F. App'x 933 (Fed. Cir. 2015).