Dynetics, Inc. v. United States

| May 31, 2015 | Campbell-Smith, Chief Judge, United States Court of Federal Claims | Docket No. 12-576T

Short Summary 

The case of Dynetics, Inc. v. United States centers around the eligibility of Dynetics, Inc. to claim research tax credits under § 41 of the Internal Revenue Code. Dynetics, an engineering company, filed for a refund based on research tax credits for various contracts, which the IRS disallowed. The Court of Federal Claims was tasked with determining if the research conducted under seven sample contracts qualified for these credits, focusing primarily on whether the research was “funded” by external sources, thus disqualifying it from the credit. 

Key Issues 

1. Funded Research Exception: The main issue was whether Dynetics’ research was “funded” by contracts, making it ineligible for the tax credit. According to I.R.C. § 41(d)(4)(H), research is not qualified if funded by another entity. 

2. Financial Risk and Payment Contingency: The court needed to assess if payments for the research were contingent on the success of the research. If Dynetics bore the financial risk of the research failing, it would potentially qualify for the credit. 

3. Substantial Rights in Research: Another significant issue was whether Dynetics retained substantial rights to the research outcomes. If the taxpayer must pay to use the results or retains no substantial rights, the research is considered funded. 

4. Course of Dealing: Dynetics argued that its long-term relationships and practices with contracting partners implied a shared understanding that went beyond the written contracts, potentially affecting the interpretation of “funded” research. 

5. Contract Inspection and Warranty Clauses: The court examined whether inspection and warranty clauses in the contracts placed Dynetics at financial risk for nonconforming work, which would impact their eligibility for the credit. 

Primary Holding 

The Court of Federal Claims ruled in favor of the IRS, granting the government’s motion for partial summary judgment on the funded research question and denying Dynetics’ cross-motion. The court found: 

1. Funded Research Determination: Dynetics’ research was deemed funded under the governing regulations since payments were not contingent on the success of the research. Contractual clauses and practices did not support the argument that Dynetics bore financial risk for unsuccessful research. 

2. Inspection and Warranty Clauses: The incorporated inspection and warranty clauses in the contracts did not shift the financial risk of failure to Dynetics in a manner that would qualify the research for the tax credit. 

3. Substantial Rights: Dynetics did not retain substantial rights in the research results, particularly in cases involving highly classified information, which limited their ability to use or exploit the research outcomes. 

This case underscores the importance of clear contract terms and the need for taxpayers to demonstrate that research is both financially risky and that they retain substantial rights to qualify for the R&D tax credit. 

Specific Issues and Rulings 

1. Funded Research Question 

Court Ruling: The court ruled that the research conducted by Dynetics was “funded” under the governing regulations. 

Justification: The court found that the payments to Dynetics were not contingent on the success of the research. Since Dynetics received payment regardless of the research outcome, it was deemed funded by another entity. The governing regulation, Treas. Reg. § 1.41-4A(d)(1), specifies that amounts payable under any agreement that are not contingent on the success of the research are treated as funded. 

2. Financial Risk and Payment Contingency 

Court Ruling: The court ruled that the payments to Dynetics were not contingent on the success of the research, and thus Dynetics did not bear the financial risk. 

Justification: The court determined that under the contracts, Dynetics would be paid regardless of whether its research was successful. Therefore, the research expenses did not meet the criteria for the R&D tax credit, as the financial risk was not on Dynetics but on the funding entity. 

3. Course of Dealing 

Court Ruling: The court ruled that there was no course of dealing that altered the plain terms of the contracts to imply Dynetics needed to produce successful results to receive payment. 

Justification: The court found that Dynetics’ argument of a course of dealing was insufficient. The court emphasized that the contracts’ clear terms must be honored, and external understandings or practices could not modify those terms. The court found no evidence of a joint understanding between Dynetics and its contracting partners that would suggest an obligation beyond the written agreements. 

4. Inspection Clauses 

Court Ruling: The court ruled that the inspection clauses in the contracts did not impose financial risk on Dynetics in a way that would qualify the research for the tax credit. 

Justification: The court analyzed the inspection clauses and determined that they did not shift the financial risk of nonconforming work to Dynetics. For example, the clauses did not result in Dynetics bearing the cost of failed research outcomes but merely required correction or replacement of defective work, often at reimbursed costs. 

5. Warranty Clauses 

Court Ruling: The court ruled that the warranty clauses did not place Dynetics at significant financial risk relevant to the R&D tax credit eligibility. 

Justification: The court found that while the warranty clauses might have required Dynetics to correct defective work, these corrections did not constitute a financial risk related to the failure of the research. The clauses primarily limited Dynetics’ profit on corrections, rather than imposing unreimbursed expenses that would qualify the research as unfunded. 

6. Termination Clauses 

Court Ruling: The court ruled that the termination for convenience clauses did not place Dynetics at financial risk affecting the eligibility for the tax credit. 

Justification: The court noted that if a contract was terminated for convenience, Dynetics would still receive payment for all reimbursable costs and a portion of the fee proportional to the completed work. The loss of potential future profits did not amount to the financial risk contemplated by the Treasury regulation for the R&D tax credit. 

7. Undefinitized Contracts 

Court Ruling: The court ruled that the initially undefinitized nature of certain contracts did not place Dynetics at financial risk for the purposes of the R&D tax credit. 

Justification: The court found that the undefinitized contracts were eventually formalized with all necessary terms, including payment provisions, which ensured Dynetics would be reimbursed for its costs. The risk Dynetics cited was more about business uncertainty rather than financial risk associated with research failure. 

8. Substantial Rights in Research 

UAH01 Contract 

Court Ruling: The court ruled that Dynetics did not retain substantial rights in the results of the research under the UAH01 contract. 

Justification: The court found that under the contract terms, all rights, title, and interest in the research results vested in the University. Dynetics’ arguments about retaining rights to non-patentable technology were not persuasive, as the broad contractual language covered all intellectual property rights. 

NT001 Contract 

Court Ruling: The court ruled that Dynetics did not retain substantial rights in the results of the research under Task Order 169 of the NT001 contract. 

Justification: The court found that the security requirements and the nature of the work under the NT001 contract, involving highly classified information, restricted Dynetics’ ability to use or exploit the research results. The DD Form 254 security provisions and the need for government authorization for any use of the research results meant that Dynetics did not have substantial rights as required by the Treasury regulations. 

Deep Dive on Each Contract 

AF007 Contract Analysis 

The AF007 contract was issued by the United States Air Force Research Laboratory to develop and test tailkits for ammunition deployment. The court’s analysis and conclusion that the contract was funded involved several key steps: 

1. Nature of the Contract 

The AF007 contract was a cost-plus-fixed-fee contract. This type of contract typically reimburses the contractor for allowable costs incurred in performance of the contract, along with an additional fixed fee. 

2. Inspection Clause 

The contract incorporated FAR 52.246-8, Inspection of Research and Development—Cost-Reimbursement. The relevant clause provided that the government had the right to inspect and test all work at any time during the contract performance, including the period of performance, and in any event before acceptance. 

• Court’s Evaluation: The court found that this inspection clause did not impose financial risk on Dynetics. While it allowed the government to inspect and potentially reject nonconforming work, the cost of correction was generally reimbursed, excluding the contractor’s profit. This did not equate to financial risk from unsuccessful research, as Dynetics would still be reimbursed for its costs. 

3. Warranty Clause 

The contract also had a warranty clause that required Dynetics to correct any defective work. However, the costs associated with these corrections were also reimbursable, excluding profit. 

• Court’s Evaluation: The court determined that this clause did not impose a financial risk related to the failure of the research. Instead, it limited only the profit, not the reimbursable costs. 

4. Course of Dealing Argument 

Dynetics argued that a course of dealing with the Air Force implied that it was expected to produce successful results to receive payment. 

• Court’s Evaluation: The court found no evidence of a joint understanding between Dynetics and the Air Force that required successful results beyond the written contract terms. The clear terms of the contract indicated that Dynetics would be reimbursed for its costs regardless of the success of the research. 

5. Termination Clause 

The contract included a termination for convenience clause, which allowed the government to terminate the contract and reimburse Dynetics for all allowable costs incurred up to the termination date, plus a portion of the fee proportional to the work completed. 

• Court’s Evaluation: The court concluded that this clause did not impose financial risk as it guaranteed reimbursement for costs and a partial fee, even if the contract was terminated. 

The court concluded that the AF007 contract was funded because the payment to Dynetics was not contingent on the success of the research. The terms of the contract ensured that Dynetics would be reimbursed for its costs, excluding profit, regardless of the research outcome. As such, the financial risk of the research did not lie with Dynetics but with the funding entity, making the research expenses ineligible for the R&D tax credit under I.R.C. § 41 and the corresponding Treasury regulations. 

AMS01 Contract Analysis 

The AMS01 contract was a subcontract issued by Aviation & Missile Solutions, LLC (AMS) with the prime contract from the U.S. Army Aviation and Missile Command (AMCOM). It involved tasks such as developing missile defense systems and designing warheads. The court analyzed the contract and concluded it was funded based on the following key points: 

1. Nature of the Contract 

The AMS01 contract involved task orders issued on a fixed-price level-of-effort basis. This type of contract requires the contractor to provide a specified level of effort over a stated period, and payment is based on the effort expended rather than the results achieved. 

2. Inspection Clauses 

The AMS01 contract incorporated four different inspection clauses due to its nature, allowing for various types of task orders: 

• FAR 52.246-4 (Inspection of Services—Fixed-Price) 
• FAR 52.246-5 (Inspection of Services—Cost-Reimbursement) 
• FAR 52.246-6 (Inspection—Time-and-Material and Labor-Hour) 
• FAR 52.246-9 (Inspection of Research and Development (Short Form)) 

Despite the multiple inspection clauses, the contract primarily involved firm-fixed-price, level-of-effort task orders. 

• Court’s Evaluation: The court emphasized that a firm-fixed-price, level-of-effort contract means that the contractor is paid for the effort expended rather than the success or failure of the research. The inspection clauses did not shift financial risk to Dynetics because payment was based on the level of effort provided, not on the successful outcomes of the research. 

3. Course of Dealing Argument 

Dynetics argued that its long-term relationship with AMS and AMCOM implied an understanding that it needed to produce successful results to secure future work and payment. 

• Court’s Evaluation: The court rejected this argument, stating that extrinsic evidence of a course of dealing could not override the clear and unambiguous terms of the written contract. The contract’s terms indicated payment for the level of effort, not the success of the research. 

4. Termination Clause 

The AMS01 contract included standard termination clauses that allowed for termination for convenience by the government. In such cases, the government would pay for all allowable costs incurred up to the termination date, along with a portion of the fee proportional to the work completed. 

• Court’s Evaluation: The court found that the termination clause did not impose financial risk on Dynetics. The termination clause ensured that Dynetics would be reimbursed for its costs, even if the contract was terminated, thus removing any financial risk related to the success or failure of the research. 

The court concluded that the AMS01 contract was funded because Dynetics’ payment was not contingent on the success of the research. The terms of the contract ensured that Dynetics would be paid based on the level of effort provided, regardless of the research outcome. The financial risk of the research did not lie with Dynetics but with the funding entity, making the research expenses ineligible for the R&D tax credit under I.R.C. § 41 and the corresponding Treasury regulations. 

AR005 Contract Analysis 

The AR005 contract was issued by the U.S. Army Aviation & Missile Command and involved tasks like developing calibration shelters for Humvees. The contract included both fixed-price and cost-plus-fixed-fee line items. The court analyzed the terms and concluded that the contract was funded based on the following points: 

1. Nature of the Contract 

The AR005 contract was a mixed contract with fixed-price line items and cost-plus-fixed-fee line items. The expenses at issue were only those under the cost-plus-fixed-fee line items, which involved reimbursable costs plus a fixed fee. 

2. Inspection Clause 

The AR005 contract incorporated the inspection clause FAR 52.246-2, Inspection of Supplies—Fixed-Price, which governs the inspection of “supplies” defined as raw materials, components, intermediate assemblies, end products, and lots of supplies. However, the contract did not include an inspection clause specifically for the cost-plus-fixed-fee line items, which was an oversight. 

• Court’s Evaluation: The court determined that the fixed-price inspection clause (FAR 52.246-2) did not apply to the cost-plus-fixed-fee line items for engineering services. The absence of a relevant inspection clause for these line items was significant because it meant that the financial risk associated with nonconforming work under the cost-plus-fixed-fee line items did not shift to Dynetics. 

3. Course of Dealing Argument 

Dynetics argued that there was a course of dealing with the Army that implied it had to produce successful results to be paid. 

• Court’s Evaluation: The court rejected this argument, stating that the written contract terms were clear and unambiguous. Extrinsic evidence of a course of dealing could not override the contract’s plain language. The contract provided for reimbursement of costs plus a fixed fee, regardless of the success of the research. 

4. Rejection of Nonconforming Work 

The contract included a warranty clause that required Dynetics to correct any defective work, but the costs associated with these corrections were reimbursable, excluding profit. 

• Court’s Evaluation: The court determined that the requirement to correct defective work did not impose financial risk related to the success of the research because Dynetics would be reimbursed for its costs. The risk was limited to the potential loss of profit on the corrections, which is not the type of financial risk contemplated by the Treasury regulations. 

5. Termination Clause 

The contract included a standard termination for convenience clause, which allowed the government to terminate the contract and reimburse Dynetics for all allowable costs incurred up to the termination date, plus a portion of the fee proportional to the work completed. 

• Court’s Evaluation: The court concluded that the termination clause did not impose financial risk on Dynetics, as it guaranteed reimbursement for costs and a partial fee, even if the contract was terminated. This did not equate to the financial risk of unsuccessful research. 

The court concluded that the AR005 contract was funded because Dynetics’ payment was not contingent on the success of the research. The terms of the contract ensured that Dynetics would be reimbursed for its costs plus a fixed fee, regardless of the research outcome. The financial risk of the research did not lie with Dynetics but with the funding entity, making the research expenses ineligible for the R&D tax credit under I.R.C. § 41 and the corresponding Treasury regulations. 

BOE12 Contract Analysis 

The BOE12 contract was issued by The Boeing Company to Dynetics as a time-and-materials contract. The court analyzed the terms and concluded that the contract was funded based on the following points: 

1. Nature of the Contract 

The BOE12 contract was a time-and-materials contract, which generally involves payment based on the hours worked and materials used, rather than the successful completion of a specific deliverable. 

2. Rejection and Warranty Clauses 

The court examined the rejection and warranty clauses included in the Boeing Company General Provisions for Labor Hour/Time & Material Contracts (GP3), which were incorporated into the BOE12 contract. 

• Rejection Clause: This clause allowed Boeing to reject nonconforming services and require Dynetics to correct or replace the nonconforming services at its own expense, limited to Dynetics’ hourly rate excluding profit. 
• Court’s Evaluation: The court determined that while Dynetics was required to reperform the work at its own expense, it would still be reimbursed for the costs, excluding profit. This arrangement did not place Dynetics at financial risk for the purposes of the R&D tax credit because it was still guaranteed reimbursement for its costs. 
• Warranty for Services Clause: This clause provided that Boeing could either require Dynetics to correct or reperform any defective or nonconforming services, or make an equitable adjustment in the price of the contract. If Dynetics failed to correct or reperform, Boeing could obtain replacement services from another source at Dynetics’ expense. 
• Court’s Evaluation: The court noted that Dynetics would be at financial risk only if it failed or refused to correct or reperform the services. However, this risk was not directly related to the success of the research itself, but rather to Dynetics’ compliance with contract terms. Therefore, this did not qualify as the financial risk contemplated by the Treasury regulations. 
• Warranty for Materials Clause: This clause required Dynetics to correct or replace defective materials at its own expense. However, the court did not find this relevant to the expenses at issue, which were primarily for labor. 

3. Financial Risk 

The court analyzed whether the contract placed the financial risk on Dynetics, as required by the Treasury regulations for the R&D tax credit. 

• Court’s Conclusion: The court concluded that Dynetics was not at financial risk for the purposes of the R&D tax credit because it was reimbursed for its costs under the time-and-materials arrangement. The risk related to reperforming services or replacing materials did not equate to the financial risk of the research itself failing, as Dynetics was still guaranteed reimbursement for the initial costs incurred. 

The court concluded that the BOE12 contract was funded because Dynetics’ payment was not contingent on the success of the research. The terms of the contract ensured that Dynetics would be reimbursed for its costs, excluding profit, regardless of the outcome of the research. The financial risk associated with nonconforming work or materials did not meet the criteria for the financial risk required for the R&D tax credit under I.R.C. § 41 and the corresponding Treasury regulations. Therefore, the expenses under the BOE12 contract were deemed ineligible for the R&D tax credit. 

NT001 Contract Analysis 

The NT001 contract was issued by the Defense Intelligence Agency (DIA) Missile & Space Intelligence Center (MSIC) to Dynetics. It was a cost-plus-fixed-fee contract. The court focused specifically on Task Order 169 to analyze whether the contract was funded. Here’s how the court analyzed the terms and came to its conclusion: 

1. Nature of the Contract 

The NT001 contract involved highly classified intelligence research on foreign weapons systems. Task Order 169 specifically required Dynetics to prepare engineering drawings and describe key physical and operational characteristics of a foreign missile. 

2. DD Form 254 Security Requirements 

The court analyzed the security requirements specified in DD Form 254, which was attached to the NT001 contract. This form specified how classified intelligence information should be handled. 

• Access to Intelligence Information: Dynetics had access to Special Compartmented Information (SCI) and top-secret intelligence information. 
• Security Restrictions: DD Form 254 included several stringent security requirements, such as: 
• Prohibiting the release of intelligence material to any unauthorized person or organization without specific written authorization from DIA/MSIC. 
• Requiring all materials provided to the contractor under the contract to be used exclusively for the contract. 
• Mandating the return or destruction of all materials upon contract completion, unless written exceptions were provided. 

3. Financial Risk and Reimbursement 

The court examined whether the contract placed the financial risk on Dynetics, as required for the R&D tax credit. 

• Reimbursement Structure: Under the cost-plus-fixed-fee structure, Dynetics was reimbursed for allowable costs incurred, plus a fixed fee. This reimbursement was not contingent on the success of the research, meaning Dynetics would be paid regardless of the research outcome. 

4. Right to Use or Exploit the Results of the Research 

The court analyzed whether Dynetics retained substantial rights to use or exploit the research results, a key requirement for the R&D tax credit. 

• Security Restrictions Impact: The court found that the stringent security requirements under DD Form 254 significantly restricted Dynetics’ ability to use or exploit the research results. The classified nature of the intelligence information meant that any research results permeated by such information could not be used or shared without government authorization. 
• Authorization Requirement: Dynetics argued that it could use the research results with MSIC’s authorization. However, the court pointed out that needing government authorization to use the results did not equate to retaining substantial rights. 
• Intellectual Property Rights: Dynetics claimed it retained intellectual property rights under FAR 52.227-11 (Patent Rights—Retention by the Contractor). However, the court noted that this provision only applied to patentable inventions, and Dynetics did not argue that the engineering drawings and technical reports produced were patentable. 

The court concluded that the NT001 contract was funded for the following reasons: 

1. Reimbursement for Costs: Dynetics was reimbursed for its costs plus a fixed fee under the cost-plus-fixed-fee structure, regardless of the success of the research. This structure placed the financial risk on the government, not on Dynetics. 

2. No Substantial Rights Retained: The stringent security requirements and the need for government authorization to use any research results meant Dynetics did not retain substantial rights to exploit the results. The results were effectively controlled by the government due to the classified nature of the information. 

As a result, the expenses under the NT001 contract were deemed ineligible for the R&D tax credit because the research was considered funded under the governing Internal Revenue Code and Treasury regulations. 

UAH01 Contract Analysis 

The UAH01 contract was issued to Dynetics by the University of Alabama, Huntsville (UAH) as a subcontract under a cooperative agreement with the National Aeronautics and Space Administration (NASA)/Marshall Space Flight Center. It was a cost-plus-fixed-fee level-of-effort contract. Here’s how the court analyzed the terms and came to its conclusion that the contract was funded: 

1. Nature of the Contract 

The UAH01 contract involved providing various research and development tasks in support of the National Space Science & Technology Center. It was structured as a cost-plus-fixed-fee level-of-effort contract, meaning Dynetics was paid for its incurred costs plus a fixed fee. 

2. Patent Rights Clause 

The court analyzed the patent rights clause included in the contract: 

• Clause Content: Paragraph 24 of the UAH01 contract stated that all rights, title, and interest in inventions or other intellectual property rights conceived or reduced to practice during the performance of the work were vested in the University. 
• Detailed Examination: 
• First Sentence: The first sentence of paragraph 24 vested all rights, title, and interest in and to inventions or other intellectual property rights conceived or reduced to practice in the University. 
• Second Sentence: The second sentence required Dynetics to promptly disclose to the University any potentially patentable ideas or concepts conceived or reduced to practice. 

3. Intellectual Property and Substantial Rights 

The court considered whether Dynetics retained substantial rights in the research results: 

• Dynetics’ Argument: Dynetics argued that it retained rights to non-patentable technology developed under the contract. They cited the “NASA Grantee New Technology Summary Report” which distinguished between patentable and non-patentable new technology. 
• Court’s Evaluation: 

• Broad Intellectual Property Clause: The court noted that the first sentence of paragraph 24 was broad, covering not only patentable inventions but also any other intellectual property rights. This included any results of the research, whether patentable or not. 
• Non-Patentable Technology: Even if the research results were non-patentable, the broad language of paragraph 24 vested these rights in the University. 
• Experience and Skills: The court stated that any incidental benefits, such as increased experience in a field of research, did not constitute substantial rights in the research as per Treasury regulations. 

4. Reimbursement and Financial Risk 

The court analyzed the reimbursement structure to determine if Dynetics bore financial risk: 

• Cost-Plus-Fixed-Fee Structure: Under this structure, Dynetics was reimbursed for its costs plus a fixed fee. This meant Dynetics was paid for its efforts regardless of the research outcome. 
• Court’s Conclusion: The court concluded that Dynetics did not bear the financial risk of the research failing, as it was reimbursed for its costs. 

The court concluded that the UAH01 contract was funded for the following reasons: 

1. Broad Vesting of Intellectual Property: Paragraph 24 vested all intellectual property rights, whether patentable or not, in the University. This meant Dynetics did not retain substantial rights in the research results. 

2. Reimbursement Structure: The cost-plus-fixed-fee structure ensured Dynetics was reimbursed for its costs, placing the financial risk on the government. 

As a result, the court determined that the research under the UAH01 contract was funded according to the governing Internal Revenue Code and Treasury regulations. Therefore, the expenses under this contract were deemed ineligible for the R&D tax credit. 

AR009 Contract Analysis 

The AR009 contract was issued to Dynetics by the U.S. Army Aviation and Missile Command (AMCOM) as a cost-plus-fixed-fee contract. Here’s how the court analyzed the terms and came to its conclusion that the contract was funded: 

1. Nature of the Contract 

The AR009 contract involved providing research and development services related to missile systems. The contract specified that Dynetics would be reimbursed for its costs plus a fixed fee, typical of a cost-plus-fixed-fee arrangement. 

2. Intellectual Property Rights 

The court examined the intellectual property rights clauses within the contract: 

• Clause Content: The contract contained provisions stating that any inventions or intellectual property developed during the performance of the contract would be owned by the government. 
• Detailed Examination: 
• Rights Clause: The specific clauses in the contract vested all rights, title, and interest in inventions or other intellectual property arising from the research directly with the government. 
• Dynetics’ Obligations: Dynetics was required to disclose any inventions and assign rights to the government, reinforcing the government’s ownership over any developed technology. 

3. Retention of Substantial Rights 

The court assessed whether Dynetics retained any substantial rights in the research results: 

• Government Ownership: The court noted that the contract explicitly transferred ownership of all intellectual property to the government. 
• Dynetics’ Argument: Dynetics argued that it retained rights to non-patentable technologies developed under the contract. 
• Court’s Evaluation: 

• Broad Intellectual Property Clauses: The court emphasized that the language used in the contract was comprehensive, covering all forms of intellectual property, including non-patentable technologies. 
• Experience and Skills: The court determined that any incidental benefits to Dynetics, such as gaining experience or expertise, did not amount to retaining substantial rights in the research results. 

4. Reimbursement and Financial Risk 

The court analyzed the financial aspects to determine if Dynetics bore any financial risk: 

• Cost-Plus-Fixed-Fee Structure: The contract ensured Dynetics would be reimbursed for all incurred costs plus a fixed fee, regardless of the research outcome. 
• Financial Risk: The court concluded that Dynetics did not bear the financial risk of the research failing, as the reimbursement structure covered all costs. 

The court concluded that the AR009 contract was funded based on the following reasons: 

1. Government Ownership of Intellectual Property: The contractual clauses vested all intellectual property rights, both patentable and non-patentable, with the government. This meant Dynetics did not retain substantial rights in the research results. 

2. Reimbursement Structure: The cost-plus-fixed-fee structure ensured that Dynetics was reimbursed for its costs, placing the financial risk on the government. 

As a result, the court determined that the research under the AR009 contract was funded according to the applicable Internal Revenue Code and Treasury regulations. Consequently, the expenses incurred under this contract were deemed ineligible for the R&D tax credit. 

Key Takeaways for Taxpayers 

The Dynetics, Inc. case provides several important insights for taxpayers when reviewing contracts for R&D funding eligibility under the R&D tax credit. Here are the key takeaways: 

1. Understand Contract Types and Structures 

• Cost-Plus Contracts: Contracts structured as cost-plus-fixed-fee or cost-plus contracts generally indicate that the research is funded because the taxpayer is reimbursed for its costs regardless of the success of the research. 
• Fixed-Price Contracts: Fixed-price contracts, where the taxpayer bears the risk of cost overruns or failure to achieve the desired result, are more likely to qualify for the R&D tax credit. 

2. Examine Intellectual Property Clauses 

• Government Ownership: Clauses that vest all intellectual property rights, including patents and other intellectual property, in the government or another party typically result in the research being considered funded. This indicates the taxpayer does not retain substantial rights in the research. 
• Retention of Rights: To qualify for the R&D tax credit, the taxpayer must retain substantial rights to the research outcomes. This includes the ability to use or exploit the research results without significant restrictions. 

3. Review Reimbursement Terms 

• Reimbursement Provisions: Contracts that ensure reimbursement for costs incurred by the taxpayer, irrespective of the research’s success, suggest that the research is funded. This includes contracts that cover labor, materials, and other expenses. 
• Financial Risk: For the research to be considered unfunded, the taxpayer must bear the financial risk of the research’s failure. This means that payment should be contingent on the success of the research. 

4. Understand the Impact of Security and Confidentiality Clauses 

• Classified Information: Contracts involving classified or sensitive information may include security requirements that restrict the taxpayer’s ability to use the research results. These restrictions can indicate that the taxpayer does not retain substantial rights. 
• Authorization Requirements: If the taxpayer needs government authorization to use or disclose the research results, this can imply that the research is funded. 

5. Consider the Entire Agreement 

• Integrated Agreement: The court will consider the entire agreement, including all attachments and incorporated provisions, to determine if the research is funded. Ensure all parts of the contract are consistent with the retention of substantial rights and the bearing of financial risk by the taxpayer. 

6. Incidental Benefits Do Not Constitute Substantial Rights 

• Experience and Skills: Incidental benefits, such as increased experience or skills gained from performing the research, do not constitute substantial rights in the research results. The taxpayer must have explicit rights to use or exploit the research outcomes.