R&D Credit Tax Court Case Highlights Funded Research and Compensation Rules

Last week, the U.S. Tax Court issued its opinion in a case arising from the IRS’s denial of an architecture firm’s R&D tax credits claims.

The case, Smith v. Commissioner (T.C. Memo 2026-50), is one of the most notable R&D tax credit cases in recent history. The court weighed whether research completed under a client contract is funded research, and whether the firm’s partners were too highly compensated to be considered “reasonable” research expenses. Insights from the determinations can help taxpayers bolster their R&D tax credit claims.

Background 

The case takes us back to the late 2000s, when architecture firm Adrian Smith + Gordon Gill Architecture (AS+GG) claimed R&D tax credits for research conducted in connection with several large-scale client projects — some for supertall buildings and others for complexes in luxury locales. AS+GG also included portions of the firm’s three partners’ multi-million-dollar salaries as qualified research expenses.

In 2017, the IRS denied many of the firm’s R&D tax credits. In court, the IRS argued that AS+GG’s work performed under client contracts amounted to “funded research,” which the statute specifically denies an R&D tax credit. The agency also challenged the reasonableness of the partners’ substantial compensation; the statute also requires that qualified research expenses be “reasonable.”

Funded Research

To qualify for an R&D tax credit, a taxpayer needs to have spent money on qualified research. The Internal Revenue Code (IRC) specifically states that funded research does not constitute qualified research, but it does not define “funded.” In this case, the Tax Court turned to the Treasury regulations, finding that research is funded when both these factors are present:

• The parties agree that payment is not contingent on the success of the research.
• The taxpayer agrees to perform research for another person without retaining “substantial rights” to its research.

The court reviewed six sample AS+GG project contracts signed between 2008 and 2010. It found that no payment under the six contracts was contingent on the success of the research. However, it also found that four contracts met the “substantial rights” requirement because they conferred on AS+GG the right to use some aspect of their research in the future.

The determination may allow AS+GG to claim R&D tax credits for these projects to the extent that qualified research expenses exceed client payments received. The other two projects transferred full rights to the client, making the associated research ineligible for R&D tax credits.

Note: AS+GG also attempted to invalidate the Treasury regulations by invoking Loper Bright, a landmark Supreme Court case from 2024 that barred courts from relying solely on agencies’ statutory interpretations. The Tax Court rejected AS+GG’s challenge. Therefore, these regulations defining funded research remain valid.

Reasonable R&D Expenses

A now-removed paragraph in the IRC required that qualified research be “reasonable.” The Tax Court evaluated AS+GG partners’ compensation using the independent investor test, which, in the words of the court, “[I]f investors obtain returns above what they should reasonably expect, a manager’s salary is presumptively reasonable.”

The IRS’s expert on reasonable compensation conducted the independent investor test and found that the firm produced a 939% return on equity — sufficient for the Tax Court to conclude that the partners’ compensation was reasonable. Therefore, AS+GG rightfully claimed portions of their wages as qualified research expenses for the R&D tax credits. 

3 Takeaways for R&D Tax Credit Claims

The Tax Court’s determinations in Smith v. Commissioner teach us these three lessons: 

• Client-funded research may still qualify for an R&D tax credit, but be careful when negotiating your rights. When you give up “substantial rights” to your client, you risk your research being treated as funded research, which is not credit-eligible. Ask your R&D tax advisor to review the contemplated contract language.
• When claiming wages for the R&D tax credit, evaluate reasonableness. The Tax Court’s analysis relied heavily on the independent investor test, developed in the Seventh Circuit. Your R&D tax advisor can perform this analysis to help bolster your R&D tax credit claim.
• R&D tax credit regulations remain authoritative. AS+GG tried to invalidate the R&D tax credit regulations under Loper Bright, but the Tax Court found that the regulations faithfully interpret the IRC. Therefore, we should continue to rely on the regulations for guidance in this area.

Smith + Howard: Your R&D Tax Credit Advisor

Navigating the complexities of R&D tax credit claims, especially when client contracts and compensation issues are involved, requires specialized knowledge and experience. In Smith v. Commissioner, nuanced contract wording may have made the difference in whether AS+GG’s research was eligible for the R&D tax credit. It is essential to seek expert guidance when interpreting the rules governing funded research and reasonable wage requirements.

If your business is considering or currently pursuing R&D tax credits under circumstances similar to those discussed in this case, working with a qualified R&D tax advisor is essential. The right advisor can help you assess contract language, analyze compensation, and maximize your credit while staying compliant with the latest regulations.

For guidance tailored to your situation, reach out to Jackson Moore.