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Tangel, et al. v. Commissioner (T.C. Memo. 2021-1)

On January 11, 2021, the Tax Court issued a Memorandum Opinion in the case of Tangel, et al. v. Commissioner (T.C. Memo. 2021-1). The issue presented in the consolidated Tangle cases was whether the petitioners were entitled to qualified research expense credits under IRC § 41.

Background

The petitioners’ S corporation, Enercon, designs and produces integrated controls and switchgears for the power generation industry.  It was hired in 2009 to develop a new enclosure for turbine power generation.  The parties executed a “Terms and Conditions” agreement, and the third-party sent a $950k purchase order for the work.  As a part of the Terms and Conditions, Enercon agreed that any information, equipment, etc. created by it was a work made for hire, and the third-party was irrevocably assigned all right, title, and interest in such work.  Thus, Enercon sold the project’s soul to the third party for valuable consideration.

Enercon filed forms 1120S for 2008 through 2010, claiming $930k in research credits under IRC § 41(b).  The IRS determined that Enercon was full of it, disallowing all flow-through research credits that the petitioners claimed and determining that they had not provided sufficient documentation to establish that the requirements of IRC § 41 had been met.

Procedural Posture

The IRS moved for partial summary judgment with respect to a project that Enercon undertook for a third-party company.  The definition of “qualified research” excludes “[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).” IRC § 41(d)(4)(H). The IRS contended that Enercon’s research was 100% funded by a third-party because, under the agreement executed by the parties, Enercon retained no “substantial rights” in the research it performed.  See Treas. Reg. § 1.41-4A(d)(2)-(3).

O, what a Tangel-ed web the Tax Court weaves, when first it seeks to intercede…and consolidate five different cases into one 18-page memorandum opinion…using one footnote…

Statutory and Regulatory Framework

IRC § 41 allows a credit to taxpayers who increase their research expenses above a base amount. See IRC § 41(a); IRC § 41(c). “Qualified research expenses” include in-house research expenses and contract research expenses. IRC § 41(b)(1). “In-house research expenses” include wages paid to employees who engage in (or directly supervise) qualified research and amounts paid or incurred for supplies used in the conduct of qualified research. IRC § 41(b)(2). “Contract research expenses” are amounts paid by a taxpayer to a person other than an employee to perform qualified research. See IRC § 41(b)(3).

Because each party to a contract may have a possible claim to a research credit (one for in-house and one for contract research expenses), the Code provides that qualified research does not include “funded research.” See IRC § 41(d)(4)(H). “Funded research” is defined as any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity). Id.

To determine whether research is “funded,” the Treasury Regulations focus on the agreement(s) executed by the contracting parties.  Specifically, all agreements (not only research contracts) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded.  Treas. Reg. § 1.41-4A(d)(1).

Amounts payable under any agreement that are contingent on the success of the research are not treated as funding. Id. In such circumstances the party performing the research is entitled to the credit because it bears the risk of failure. See Treas. Reg. § 1.41-2(e)(2); see also Fairchild Indus., Inc. v. United States, 71 F.3d 868, 870 (Fed. Cir. 1995).  The Treasury Regulations further provide that a taxpayer is entitled to the credit only if it “retains substantial rights in the research.” Treas. Reg. § 1.41-4A(d)(3)(i). Even if the taxpayer does retain substantial rights in the work, the research is nevertheless deemed funded to the extent of the payments (and fair market value of any property) to which the taxpayer becomes entitled by performing the research. Treas. Reg. § 1.41-4A(d)(2).

Analysis of Contract

Prior Federal decisions have held that the determination whether the taxpayer had the right to use the results of its research without paying for that right must be determined by reference to the research agreements. Lockheed Martin Corp. v. United States, 210 F.3d 1366, 1376 (Fed. Cir. 2000).

The Tax Court observes that the provisions of the Terms and Conditions are “quite hostile” to the petitioners’ claim that Enercon retained any rights in the research it performed, much less “substantial rights.”  Stated differently, Enercon contracted away its rights to the project’s soul.  Unless it was a fiddle player the likes of which Georgia hadn’t seen since Johnny rosined up his bow and played that fiddle hard, it was unlikely that the Tax Court was going to find that the company had retained any substantial rights.

Unfortunately, the Treasury Regulations provide for just such an arrangement (regarding research expenses, not chickens in the bread pan picking out dough).  The Tax Court noted that this is a situation where the taxpayer performed research under an agreement that conferred on another person the exclusive right to exploit the results of the research. Treas. Reg. § 1.41-4A(d)(2). The taxpayer in these circumstances did not perform qualified research because the research is treated as fully funded. Id.

Conclusion

Having contracted away all of the rights to the research, Enercon’s claims were worthless.  The Tax Court saw through the company’s arguments that it had retained some rights, finding that an “irrevocable assignment” of all rights, even institutional knowledge, was just that.  On this day, the devil came back to Georgia, the sonofabitch wanted to try again, and as to Enercon and the Tangels, the soul of the project left with him…as did $930k in claimed research credits.

(T.C. Memo. 2021-1) Tangel v. Commissioner

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