Architectural and engineering firms in IRS crosshairs
Which comes first, the contract for services or identification of the business component and the four part test?
The U.S. Tax Court (T.C.) issued an opinion, applicable nationwide, in Harper v. Commissioner (TC Memo 2023-57 May 10, 2023, item 53 on docket). The T.C. found that creating architectural and engineering (A&E) construction designs does indeed meet the definition of a “business component” – one of the threshold tests for qualified research.
Specifically, Harper described 24 separate services as well as five development stages: job bid, conceptual design, design development, documentation and construction. Further, Harper described research activities as follows: “Each project was undertaken to develop unique solutions to a combination of various aspects spanning the disciplines of architectural, civil, structural, mechanical, electrical and plumbing engineering, among others,” and (the taxpayer) “faced many uncertainties regarding the final design resulting from the unique combinations of all project requirements.”
Subsequently, almost one year after Harper, on May 6, 2024, the Eighth Circuit Court of Appeals (Eighth Circuit) issued an opinion in Meyer, Borgman & Johnson, Inc. (MBJ) v. Commissioner (of the IRS), No. 23-1523, May 6, 2024. MBJ is another A&E entity who filed for research and development (R&D) tax credits for development work performed under contract to create new building designs.
The Eighth Circuit, with jurisdiction in Minnesota, Iowa, Missouri, Arkansas, North Dakota, South Dakota and Nebraska, determined the contracts were for design services, were all lump sum/firm fixed price and MBJ met the rights test. Sound familiar? Not so fast, as the Eighth Circuit then looked at the contracts to see if they were indeed research contracts.
MBJ agreed to perform its services adhering to professional skill and care as well as complying with pertinent building codes and regulations. The Eighth Circuit determined that performing to a general standard of care does not equate to meeting the test of a contract being “contingent on the success of the research” and thus considered to be paid for the product or result of the research. The Eighth Circuit cited the Fairchild case which was determined to be allowable as a research contract in part because it included “over 1,000 pages of technical specifications that required Fairchild to meet specific design, construction, quality, and performance standards.” MBJ contracts did not contain similar language. As such, the Eighth Circuit determined the contracts subject to the funding exclusion, so they were not eligible for R&D tax credits.
Interestingly, MBJ failed to reference the Harper case. This opens the door to discussion on how the Harper case may have impacted MBJ’s findings. Also, structural designs, mechanical, electrical and plumbing and other designs contain a multitude of specifications – albeit outside of the “four corners of the contract” as they are contained within the deliverable business component – why were these not discussed in MBJ?
Despite potential Harper case impact, it begs the question: which comes first, the contract or the four part test and other foundational requirements? Clearly, as established in other cases on this topic, such as in Fairchild, Lockheed, Geosyntec, Populous Holdings and Grigsby for example, the contract comes first.
Note that guidance for IRC 174 Selected Research Expense (SRE) criteria have no similar reference to funded contract research. Thus, MBJ appears to be subject to 174. This may change when IRS and Treasury release a new proposed regulation later this year that may provide additional guidance.
To learn details on how this impacts you, contact your CPA or Steve Roark, CPA.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
