Federal Taxation

• Jurisdiction: United States,Federal
• Publication year: 2016
• Citation: Vol. 67 No. 4

Federal Taxation

Robert Beard

Gregory S. Lucas

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Federal Income Taxation

by Robert Beard^* and Gregory S. Lucas^**

I. Introduction

In the year 2015, the federal courts in the United States Court of Appeals for Eleventh Circuit's appellate jurisdiction addressed an issue of first impression involving tax credits for research expenditures, interpreted new Supreme Court precedent on the enforcement of summonses issued by the Internal Revenue Service (IRS), and applied state law doctrines of transferee liability in the context of "Midco" tax shelters. This Article surveys those decisions.¹

II. Geosyntec Consultants, Inc. v. United States

In Geosyntec Consultants, Inc. v. United States,² the United States Court of Appeals for the Eleventh Circuit addressed a question of first impression in the Circuit about a taxpayer's entitlement to research tax credits under § 41 of the Internal Revenue Code (Code).³ Adopting the approach of the United States Court of Appeals for the Federal Circuit in Fairchild Industries, Inc. v. United States,⁴ the Eleventh Circuit held that a taxpayer may only claim the research tax credit if the taxpayer bears the economic risk when the research fails to yield the desired

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outcome.⁵ If the taxpayer stands to be recompensed for its research even in the event of such failure, it may not claim the credit.⁶

A. Background

First introduced as part of the Economic Recovery Tax Act of 1981,⁷ the research tax credit of § 41 provides a twenty-percent tax deduction for certain "qualified research expenses."⁸ The credit is available both for expenses incurred on in-house research and for a portion of expenses paid to third parties for "contract research."⁹ To be "qualified research," the research expenses must meet three criteria.¹⁰ First, the expenses must qualify as expenses under § 174,¹¹ which means they must have been incurred within the taxable year.¹² Further, "qualified research" must be "undertaken for the purpose of discovering information—(i) which is technological in nature, and (ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer."¹³ Finally, "substantially all of the activities" of the research must "constitute elements of a process of experimentation" for the purposes of functional innovation or improvement, performance, or reliability or quality.¹⁴

A taxpayer may not claim a credit for otherwise-qualifying research if the research is "funded by any grant, contract, or otherwise by another person (or governmental entity)."¹⁵ The Treasury Regulations clarify that an expense only qualifies for the research tax credit if the taxpayer "bear[s] the expense even if the research is not successful."¹⁶ To determine the extent to which research is funded by another person, Treasury Regulation § 1.41-4A(d)¹⁷ provides that "[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

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(see § 1.41-2(e)(2)) are not treated as funding."¹⁸ Likewise, "[a]n expense is paid or incurred for the performance of qualified research only to the extent that it is paid or incurred pursuant to an agreement that . . . [r]equires the taxpayer to bear the expense even if the research is not successful."¹⁹ Therefore, "[i]f an expense is paid or incurred pursuant to an agreement under which payment is contingent on the success of the research, then the expense is considered paid for the product or result rather than the performance of the research, and the payment is not a [qualified] research expense . . . ."²⁰

In Fairchild Industries, the Federal Circuit summarized the § 41 rules on entitlement to the tax credit when the research is performed pursuant to a contract with another party:

The regulations contain "mirror image" rules for determining when the customer for the research, rather than the researcher, is entitled to claim the tax credit. In accordance with Treasury Regulation § 1.41-2(e)(2) the contractual arrangement is the factor that determines who is entitled to the tax benefit, for the customer may claim the credit only if the agreement requires the customer to pay for the research even if it is unsuccessful. If, however, the customer need not pay unless the research is successful, the customer has "paid for the product or result rather than the performance of the research" and can not claim the tax credit because it has assumed no risk. Thus, the regulations implement allocation of the tax credit to the person that bears the financial risk of failure of the research to produce the desired product or result.²¹

The court in Fairchild Industries applied the above rule to a fixed-price incentive contract under which the taxpayer, Fairchild Industries, Inc. (Fairchild), would design and produce a training aircraft for the Air Force.²² The taxpayer's dispute with the IRS centered on whether expenses incurred by Fairchild in producing prototype aircraft were borne by Fairchild (and therefore eligible for the research tax credit) or whether the Air Force's payments under its contract with Fairchild should be treated as reimbursements of those expenses.²³

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The United States Court of Federal Claims held Fairchild was not the at-risk party for the failure of the research because it received advances and progress payments during the course of the contract.²⁴ The United States Court of Appeals for the Federal Circuit, however, reversed.²⁵ Because the contract was clear that Fairchild could only keep the progress payments if the research was successful, Fairchild bore the burden of failure.²⁶ The fact that the Air Force's advances financed the research was not determinative because Fairchild would have had to reimburse the Air Force in the case of failure. Under these facts, the research was funded by Fairchild within the meaning of § 41.²⁷

B. The Geosyntec Opinion

In Geosyntec Consultants, the Eleventh Circuit applied the holding of Fairchild Industries.²⁸ The taxpayer, Geosyntec Consultants, Inc. (Geosyntec), was an environmental consulting and engineering firm that carried out research activities pursuant to hundreds of different contracts with clients. Mercifully, the parties were able to identify six representative contracts for detailed review by the court. Some of the contracts were fixed-price contracts, pursuant to which Geosyntec was paid an agreed price for a specified scope of work. The district court found, and the IRS ultimately conceded, expenses incurred pursuant to these agreements constituted qualifying research expenses. Three of the contracts were "capped contracts," under which Geosyntec would be reimbursed for labor costs and expenses actually incurred, plus a markup, subject to a maximum price cap. As in Fairchild Industries, the question was whether the research performed pursuant to these capped contracts was "funded" by a third party within the meaning of § 41. The district court found that capped-contract research was funded by the client and therefore was not eligible for the research tax credit. The taxpayer appealed with respect to two of the capped contracts.²⁹

The Eleventh Circuit first summarized the two contracts Geosyntec presented on the appeal.³⁰ Under the "Cherry Island Contract," Geosyntec was to design and engineer the expansion of the Cherry Island Landfill. Geosyntec's total payments under the Cherry Island Contract were capped at approximately $10 million, and payments for

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different aspects of the project were subject to additional, separate caps. Geosyntec received monthly payments based on its incurred costs.³¹

Under the second contract, the "WM Contract," Geosyntec was to "evaluate technology for remediating groundwater beneath a warehouse in Niagara, New York" for Waste Management, Inc (WM).³² The contract required Geosyntec to "(1) perform laboratory bench tests to evaluate the feasibility and performance of enhanced in situ bioremediation (EISB) for groundwater cleanup and (2) prepare a report describing its methodology, tabulating the results, interpreting the data collected, and discussing site conditions and potential pilot-test designs."³³ The WM Contract was capped at approximately $19,000.³⁴ The WM Contract, like the Cherry Island Contract, required Geosyntec to submit monthly invoices for which it would be reimbursed "upon proper performance of each task at fixed unit prices as set forth in Geosyntec's estimated budget."³⁵ The WM Contract provided for some modifications of the fixed unit prices as well as of the tasks Geosyntec was required to perform.³⁶

In evaluating these agreements, the Eleventh Circuit applied the reasoning of Fairchild Industries:

If Geosyntec was entitled to payment under both or either contract regardless of the success of its research, it is not eligible to claim the research tax credit; conversely, if payment to Geosyntec under both or either contract was contingent on Geosyntec's successful research or development of a product or process, Geosyntec is eligible to claim the research tax credit.³⁷

Relying on a comparison with the fixed-price incentive contract in Fairchild Industries, the Eleventh Circuit ultimately determined both contracts were "funded" within the meaning of § 41.³⁸ The court first rejected Geosyntec's argument that, because its compensation under the contracts was capped and its billing was tied to its costs, "it ran the risk of not receiving the full ceiling price or, conversely, of exceeding its own budget"³⁹ This, the court noted was the wrong sense of "risk" for § 41 purposes: "[c]ost-of-performance is not the financial risk with which we

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are concerned because 'the only issue is whether payment was contingent on the success of the research'—that is, the financial risk of failure."⁴⁰ The court further noted on this point that, under certain circumstances, additional...