Eleventh Circuit Affirms Denial of Tax Credits for Funded Research in a Fact-Sensitive Inquiry

n Geosyntec Consultants, Inc. v. United States, No. 14-11107 (Jan. 29, 2015), the Eleventh Circuit affirmed summary judgment in favor of the United States on Geosyntec’s claims that some of its research fell under 26 U.S.C. § 41 and should garner research tax credits.

Geosyntec, an environmental engineering firm, filed suit in 2012 seeking a tax refund pursuant to 26 U.S.C. § 41 for research expenditures in 2002-2005. In the district court, the parties designated six of the hundreds of contracts for review; three were fixed-price contracts and three were capped contracts. The district court found that the three capped contracts were funded and the three fixed-price contracts were not. The parties then entered into a settlement agreement, allowing Geosyntec a refund of $255,575 for the fixed-price contracts, denying a refund for the capped contracts, but also preserving the issue for appeal as to the capped contracts. Geosyntec appealed with regard to two of the capped contracts: the Cherry Island Contract with the Delaware Solid Waste Authority (DSWA) and the WM Contract with Waste Management (WM) for redesigning groundwater resevoirs.

26 U.S.C. § 41 establishes tax credits for funded research projects. However, the statute does not define “funded” so the Eleventh Circuit examined regulations implementing the statute and determined that treasury regulations “allocate the research tax credit to the entity or person that bears ‘the financial risk of failure of the research to produce the desired product or result.’” Therefore, depending on the factual situation, either the researcher or the client could claim the tax credit. The Eleventh Circuit focused its analysis on whether Geosyntec’s right to payment under the two contracts was contingent on the research’s success as outlined in those contracts.

In the Cherry Island Contract, Geosyntec contracted with DSWA to design a landfill expansion on a cost reimbursement basis that was stipulated not to exceed $9,991,578. Each specified subtask of the contract had a separate price that could not be exceeded. However, Geosyntec could receive extra compensation in some circumstances, including when required public forums increased the price. Geosyntec was required to provide an invoice each month to DSWA; if DSWA disputed anything, it could withhold payment. Geosyntec was also permitted to cure any errors in the work at its own expense.

In the WM Contract, Geosyntec agreed to provide consulting services to WM on a project-by-project basis. In 2003, Geosyntec agreed to survey a contaminated groundwater system, performing laboratory tests and reporting those results as well as potential solutions.  The price for these services was capped at $18,781, and WM was obligated to pay after the performance of each stipulated task. If WM disputed any items in the invoices, WM and Geosyntec were to clarify or remedy the dispute.

The Eleventh Circuit relied heavily on Fairchild Indus., Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995). In Fairchild, an airplane manufacturer contracted to build aircraft for the United States Air Force. The case centered on the full-scale development portion of the contract, where every item was separately priced and required Fairchild to research and meet specified standards. The Air Force was only required to pay if Fairchild’s results met the contract’s specifications, and Fairchild would only receive payment for work accepted by the Air Force. The court deemed Fairchild entitled to the research tax credit since he bore “the financial risk of failed research.”

Here, however, the Eleventh Circuit held that both the Cherry Island and WM contracts were funded by the client and so ineligible for the research tax credit. First, the Eleventh Circuit was not persuaded that Geosyntec was under substantial financial risk, since the cost-of-performance argument advanced by Geosyntec did not relate to the risk of failure central to this case. Further, in both contracts Geosyntec had opportunities for additional compensation if DSWA required additional work or if WM changed the work specified in the contract.

Second, the Eleventh Circuit noted that payment was not contingent on the research’s success. Unlike Fairchild’s dependency on meeting the Air Force’s requirements, here both DSWA and WM were obligated to pay even if Geosyntec’s research did not achieve the result they wanted.

Third, the contracts as whole documents “did not place the risk of failed research on Geosyntec.” Neither contract specified that payment would only be made upon research that was deemed successful. The Eleventh Circuit held that Geosyntec was not subject to performance requirements since the contracts did not transform “proper performance” into “successful performance.” The WM contract did not stipulate that WM’s approval was required before payment. Similarly, while the Cherry Island Contract incorporated some level of review by DSWA, Geosyntec had the option to include DSWA’s comments if it wanted to do so. Finally, the contracts did not provide for client rejection rights that overrode Geosyntec’s right of payment. Unlike in Fairchild where the Air Force must fully approve each stage of the project for payment to be remitted, here payment was tendered to Geosyntec upon submission of an item unless that item was in dispute. While both contracts provided for a dispute mechanism, those mechanisms were not tied to the success of the research steps.

Since payment was not based on the research’s actual success, Geosyntec “did not bear the financial risk of its own failure, and the two capped contracts were funded by Geosyntec’s clients.” Accordingly, the district court’s grant of summary judgment in favor of the United States on the capped contracts was affirmed.

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