Key insights
- In Smith v. Commissioner, the Tax Court delivered an important reminder for organizations interested in the R&D credit: Performing innovative work, standing alone, is not enough to support an R&D tax credit claim.
- Common language found in design-related contracts can make or break the funded research analysis.
- The court also weighed in on reasonable compensation, offering taxpayer-friendly guidance for owner-employees in professional service firms.
A recent U.S. Tax Court decision, Smith v. Commissioner, gives architecture, engineering, and construction (AEC) firms a practical reminder: Qualifying activities are only part of an R&D credit claim.
Contract language, rights to research results, payment terms, and reasonable compensation support can also play a major role in whether a tax credit claim withstands scrutiny.
Prepare stronger support for your R&D credit claim.
The case involved a well-known international architecture firm that claimed research credits for innovative, sustainable, supertall building projects.
Although the taxpayer did not prevail on every issue, the ruling provides helpful guidance on two areas AEC firms should review early:
- Whether research may be considered funded by clients
- Whether owner or partner compensation is adequately supported under former Section 174(e)
What was at issue with the R&D tax credits?
The taxpayer designed some of the world’s most complex sustainable structures, including record-setting towers in Dubai and Saudi Arabia.
The IRS challenged the firm’s R&D tax credits on two fronts:
- Whether the research was “funded” by clients — and therefore ineligible
- Whether the millions of dollars in compensation paid to the firm’s three founding partners in 2008 was reasonable under former Section 174(e), a required condition for including those wages in the R&D credit calculation
Key takeaways from Smith v. Commissioner
Research funding: Contract language is everything
Construction firms: Review contract terms before claiming R&D credits
Fixed-price and milestone-based construction contracts may not show research risk by themselves.
Review performance obligations, payment terms, acceptance standards, retainage, change order language, and ownership or reuse rights before relying on project costs for an R&D credit claim.
The IRS challenged R&D credits the taxpayer claimed on six international projects for tax years 2008 – 2010. Under Treasury regulations, research is funded (and ineligible for the credit) unless the taxpayer:
- Is paid contingent on the success of the research project
- Retains substantial rights in the results
Contingent on success: Taxpayer loss
The court held that none of the six contracts made payment contingent on successful research.
Fixed-price, milestone-based invoicing tied to “percentage complete” — coupled with only a general professional standard of care — lacked the technical, rejection-driven payment clauses at issue in the 1995 seminal case, Fairchild Industries.
Substantial rights: Taxpayer win on four of six
The taxpayer retained substantial rights (and therefore partial credit eligibility) on four contracts, where the firm kept copyright in its designs even while granting the client a license. The two remaining contracts, however, vested all intellectual property (IP) in the client and required written client consent before the taxpayer could reuse the work — a fatal defect in the court’s eyes.
The court also rejected the taxpayers’ Loper Bright challenge to Treasury Regulation Section 1.41-4A(d), reaffirming that the two-part test based on contingent payments and substantial rights remains valid.
Reasonable compensation: Independent investor test wins
The IRS argued the partners’ 2008 compensation — roughly $30.2 million, $11.8 million, and $9.3 million for the three owner-employees — was unreasonable, urging use of the multi-factor test set forth in Mayson Manufacturing Co. Because the case is appealable to the Seventh Circuit, the Tax Court instead applied the “independent investor” test from Exacto Spring Corp., which creates a rebuttable presumption that owner-employee compensation is reasonable if investors obtain a “far higher return than they had any reason to expect.”
Given the taxpayer’s extraordinary return on equity, the partners’ compensation was presumptively reasonable — and the court held it reasonable in full under former Section 174(e).
Research funding tips for architecture, engineering, and construction companies
Research funding should be viewed as a gating issue for AEC companies claiming the R&D credit, especially as the R&D tax credit rules continue to evolve. Without a proper funding analysis, a credit claim may be at risk from day one.
Summary of key contract clauses affecting R&D tax credit eligibility
Review the clauses below to help determine whether your firm bears the research risk and retains sufficient rights in the results — two factors that can affect whether project costs support an R&D credit claim.
| Contract Clause | Why It Matters | Potential Favorable Indicators | Common Red Flags |
|---|---|---|---|
| Payment contingency | Determines whether the company is paid only if the research succeeds or simply for performing services. | Payment tied to objective technical success criteria, acceptance testing, or achievement of defined performance requirements. | Monthly billings, fixed milestones, or percent-complete payments payable upon submission or ordinary progress. |
| Ownership of work product and IP | Determines whether the company retains substantial rights in the research results. | Contractor retains rights to underlying methods, tools, processes, know-how, models, or non-project-specific innovations. | Client owns all rights, title, and interest in all deliverables, concepts, calculations, models, inventions, and related work product. |
| License-back or reuse rights | May preserve substantial rights even where the customer receives broad project rights. | Non-exclusive right to reuse methodologies, design approaches, building information modeling workflows, templates, specifications, or technical learnings in future projects. | Contractor must obtain customer permission before using any results, data, documents, or technical concepts developed during the project. |
| Acceptance and rejection rights | Helps determine whether payment is truly contingent on technical success. | Defined acceptance criteria tied to measurable performance results, with payment at risk if criteria are not met. | Routine owner approvals, design signoffs, or phase authorizations without objective technical success standards. |
| Retainage, warranty, and liquidated damages | These provisions may create business risk, but not necessarily research risk. | Amounts specifically tied to failure to meet technical design objectives or validated performance metrics. | General retainage, delay damages, warranty obligations, cost overruns, or punch-list exposure unrelated to research success. |
| Performance obligations | Speaks to the nature of the research to be performed and technical risk inherent in the contract. | Detailed technical specifications outlining project requirements, performance standards, and measurements for successful completion. | Nonexistent, vague, or boilerplate performance/technical standards. |
Reasonable compensation for partners
While reasonable compensation is not a new issue in the R&D credit arena, Smith is notable in that it addresses partner compensation — an issue rarely litigated under former Section 174(e). While Section 174(e) has been repealed, the IRS has not issued guidance explaining what that means for taxpayers. As such, supporting the reasonableness of owner-employee compensation may still be important even after the provision’s repeal.
The independent investor test applied in Smith can be highly advantageous to owner-employees in professional service firms — at least in the Seventh Circuit — where courts appear deferential to strong organizational returns paid out to owners.
This assumes, of course, that the other requirements for a valid R&D credit claim (e.g., favorable funding terms and qualification of the underlying activities) are also met.
How CLA can help with R&D tax credit claims
The Smith decision highlights why R&D credit reviews often require more than evaluating technical activities. Contract terms, intellectual property provisions, payment structures, and compensation support can all affect eligibility and documentation requirements.
CLA’s dedicated team of R&D professionals can help your organization review R&D credit claims, contract terms, research funding, and compensation support so your team understands where documentation may need more attention before filing or responding to questions.
Contact your CLA professional to learn more.
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