Analyzing the Lockheed and Fairchild Court Cases

Governmentally funded programs have spawned a significant amount of research in the private sector. During the 1980s, many companies enjoyed the benefits of federal programs such as the SBIR, STTR and BAA that placed the financial risk of private research on the federal government while assigning the intellectual rights to the private researcher. Much to the chagrin of the companies that benefited from these contracts, the government began shifting the financial risk to the contracted researcher. While this may make the money more risky, it generates other financial opportunities.

Internal Revenue Code §41(d)(4)(H) exempts funded research from the Federal Research Tax Credit but the code fails to define “funded research”.  Companies that perform contract research for the Federal Government and private industry often incorrectly assume these contracts constitute funded research.  These assumptions are based on preconceived definitions of “funded”.  Two landmark Tax Court cases, Fairchild Industries, Inc. vs. The United States[1] and Lockheed Martin Corporation vs. The United States[2], challenged these presumptions.

Fairchild Industries entered into a contract with the United States Air Force to develop the “Next Generation Trainer” to replace the Cessna T-37.  The contract required a significant amount of research and development to reach milestones that were set by the Air Force.  Fairchild Industries claimed the research activities related to this contract qualified for the research and experimentation tax credit because:

  • the fixed-price contract with the Air Force transferred the financial risk to Fairchild Industries
  • the contract granted Fairchild substantial rights to the design resulting from the research

The district federal court concluded that the correct research activities were disallowed by the IRS, they recognized “the government’s test (reason for disallowing the credit) is essentially tautological” and should be scrutinized.  The court autonomously decided the government’s bi-monthly payments to Fairchild financed the research which meant the government’s money was used to conduct the research.  In addition, “the contract called for payments, …, from the government to the contractor even if the government were to find that some equitable adjustment in target cost was necessary.”

This judgment was appealed by Fairchild on the grounds that payment timing does not dictate assignment of risk associated with the funds for research activities.  Fairchild contended that while they were paid on a bi-monthly basis, these funds could be retrieved by the government if they defaulted on the contract.  Since Fairchild incurred research expenses in accordance with legislative intent and maintained financial risk, the court of appeals ruled in favor of Fairchild.

The ruling refined the criteria for substantiating financial risk and established that contract research may qualify for the research tax credit.

Lockheed Martin Corporation vs. the United States established a definition for substantial rights.  Prior to this court case the “government analogized substantial rights to patent rights”, which characterized Lockheed Martin’s rights as “incidental benefits”.  The court referenced treasury regulation §1.41-5(d) to contradict the government’s analogy and assert “that a taxpayer that retains the right to use the research results without paying for it has ‘substantial rights in the research.’”  As a result, the court set precedent stating that the taxpayer does not need to maintain patent rights to maintain substantial rights.

While the court cases generated landmark rulings related to the research tax credit, the results have gone largely unnoticed.  Many small, medium, and large companies conducting contract research still do not take advantage of the credit even though these court case rulings delineate qualified contract research from “funded research”.

By breaking down the results of the court cases into standard contract clauses a tax provider or a taxpayer can determine if a contract relegates the activities defined in the scope of work as “funded research”.  Government contract outlines follow Federal Acquisition Regulations (FAR) and Defense Federal Acquisition Regulations (DFAR).  These regulations contain default, and rights retention clauses that reflect legislative intent, financial risk, and substantial rights.  As a result, these clauses can be used to differentiate “funded research” from qualified research for the taxpayer.

Contract types dictate default clauses contained in government contracts.  As a result, the court indicated that financial risk is not reflected in the contract type but rather the contract clauses.  Therefore, financial risk must be designated in the contract with:

  • a default clause that indicates payments to the contractor may be withheld in part or in full if milestones are not adequately obtained
  • language that the contractor needs to demonstrate adequate progress
  • language indicating the amount of the contract will not be adjusted unless there is a change in the scope of work

Substantial rights of research results are explicitly awarded by rights retention clauses or a lack there-of.  The Lockheed Martin case laid the groundwork that substantial rights are maintained by the entity conducting the research as long as that entity does not have to pay for use of the resulting knowledge.  Most contracts will contain rights retention clauses that indicate where the rights lie.  In the event that rights are not explicitly granted, those rights stay with the entity conducting the research.

By evaluating the criteria that delineate funded research from qualified research, companies can also identify activities that are conducted tangentially to contract research that may qualify for the credit.  These activities include proposal development, and independent research and development.

The presumptions that government contracts automatically indicate funded research have limited the research credit claims of many companies.  This information should not only be used for qualifying research expenditures for tax credits but it should also be used to structure contracts.  Understanding the ramifications of your contract language will result in better allocation of research resources.

[1] Fairchild Industries, Incorporated, Plaintiff-appellant, v. the United States, Defendant-appellee United States Court of Appeals, Federal Circuit. – 71 F.3d 868

[2] Lockheed Martin Corporation, as successor to Martin Marietta Corporation and Martin Marietta Technologies, Inc. and affiliated corporations, Plaintiff-Appellant v. United States, Defendant-Appellee  , Refund suits: Research and, (Apr. 26, 2000)  [2000-1 USTC ¶50,401]