Edward J. Tangel and Beatrice C. Tangel, et al. v. Commissioner of Internal Revenue

Court hammer

January 11, 2021 | Judge Lauber | United States Tax Court | Docket Nos. 27268-13, 27309-13, 27371-13, 27373-13, 27374-13, 27375-13

Short Summary

In Tangel v. Commissioner, the United States Tax Court addressed the consolidated cases of Edward J. Tangel and Beatrice C. Tangel, among others, against the Commissioner of Internal Revenue. The primary issue was the disallowance of research credits claimed under Section 41 by Enercon Engineering, Inc., an S corporation, for the years 2008-2010. The credits, totaling $929,668, were passed through to the petitioners as Enercon’s shareholders. The IRS moved for partial summary judgment on the basis that one of the projects for which Enercon claimed research credits was 100% funded by Vericor Power Systems, LLC, under an agreement that left Enercon with no substantial rights in the research. The court agreed with the IRS and granted the motion.

Key Issues

  1. Qualification of Research Expenses: The main issue was whether the research expenses incurred by Enercon for Project No. 37688 could be classified as “qualified research expenses” under Section 41 of the Internal Revenue Code. Specifically, the dispute centered on whether these expenses were funded by another party (Vericor Power Systems, LLC) and if Enercon retained any substantial rights in the research.
  2. Interpretation of “Funded Research”: According to Section 41(d)(4)(H), research funded by any grant, contract, or otherwise by another person is excluded from qualified research expenses. The court had to determine if the agreement between Enercon and Vericor constituted fully funded research, thus disqualifying the expenses from eligibility for the credit.
  3. Contractual Rights and Obligations: The case required interpretation of the contractual terms between Enercon and Vericor to establish whether Enercon had retained any substantial rights in the research results. The Terms and Conditions of their agreement were scrutinized to assess the extent of rights and restrictions imposed on Enercon.

Holding

The Tax Court held that the research performed by Enercon for Vericor Power Systems, LLC, under Project No. 37688 was fully funded by Vericor. The court found that Enercon did not retain any substantial rights in the research results due to the specific terms of the contract, which limited Enercon’s ability to use the research findings independently. As a result, the expenses incurred for this project did not qualify as “qualified research expenses” under Section 41, and the IRS’s motion for partial summary judgment was granted. This decision effectively disallowed the claimed research credits associated with Project No. 37688.

Tax Court’s Analysis of the Contract and Decision

The Tax Court needed to determine whether Enercon Engineering, Inc. was entitled to research credits under Section 41 for the years 2008-2010. The central focus was on Project No. 37688, a project Enercon undertook for Vericor Power Systems, LLC. The IRS disallowed research credits claimed by Enercon, arguing that the research was 100% funded by Vericor and that Enercon retained no substantial rights in the research, disqualifying it from credit eligibility under Section 41(d)(4)(H).

Examination of Contractual Documents

The court’s analysis centered on the contractual documents that governed the relationship and obligations between Enercon and Vericor:

  1. Terms and Conditions Document:
    • Paragraph 15(A):
      • The document defined “Information” to include technical information supplied by Vericor, designed at Vericor’s expense, or to meet Vericor’s technical requirements.
      • Enercon agreed not to use or assist others in using such Information, design funding, or tooling to develop or sell Articles without Vericor’s prior written consent. This restriction extended beyond the project to any similar items developed in the future.
      • The clause explicitly prevented Enercon from using or disclosing the Information except for fulfilling orders for Vericor. Upon Vericor’s request, all such Information and its copies were to be returned to Vericor.
      • Court’s Interpretation: This clause significantly limited Enercon’s ability to independently use the results of its research, indicating that Enercon did not retain substantial rights in the research outcomes.
    • Paragraph 15(B):
      • This paragraph designated any materials or information prepared by Enercon for the project as “works made for hire,” meaning Vericor was deemed the author.
      • In case any material was not deemed a work made for hire, the purchase order operated as an irrevocable assignment of all rights, title, and interest to Vericor.
      • Court’s Interpretation: This clause reinforced that all intellectual property and research results were owned by Vericor, further evidencing that Enercon did not retain substantial rights.
  2. Offer Letter from Enercon to Vericor (February 11, 2009):
    • The offer letter summarized Enercon’s understanding of the project and the contractual terms. It included technical specifications and acknowledged the legal requirements as laid out in the Terms and Conditions.
    • Court’s Interpretation: This letter demonstrated Enercon’s acceptance of the restrictive terms outlined by Vericor, particularly concerning the use of Information and ownership of intellectual property.
  3. General Purchase Order and Additional Purchase Orders:
    • The General Purchase Order for $951,954, along with 18 additional change orders, detailed the deliverables and incorporated the Terms and Conditions.
    • Court’s Interpretation: These documents established the financial framework of the project, showing that Vericor fully funded the research. The incorporation of the restrictive Terms and Conditions into each order maintained the consistency of the contractual limitations.

Determination of Funding

The court found that the payments from Vericor to Enercon were fixed and not contingent on the success of the research. This meant that Enercon received funding irrespective of whether the research achieved its intended goals. Under Section 41(d)(4)(H), research funded by another party is not considered “qualified research.” Since Vericor provided all necessary funding through fixed payments outlined in the purchase orders, the research was deemed fully funded by Vericor.

Retention of Substantial Rights

The court concluded that Enercon did not retain substantial rights in the research outcomes due to the following reasons:

  1. Exclusive Use Clause:
    • Paragraph 15(A) restricted Enercon from using the research results and technical information developed during the project for any purpose other than fulfilling Vericor’s orders. This clause effectively prevented Enercon from exploiting the research results independently, indicating no retention of substantial rights.
  2. Works Made for Hire and Assignment of Rights:
    • Paragraph 15(B) established that all materials and information created by Enercon for the project were owned by Vericor. Even if any material was not a work made for hire, the agreement assigned all rights to Vericor, leaving Enercon with no ownership or substantial rights in the research outcomes.
  3. Incidental Benefits:
    • The court noted that incidental benefits, such as increased experience or knowledge gained by Enercon, did not constitute substantial rights. The regulations specify that only significant rights retained in the research results would qualify, which was not the case here.
  4. Contractual Obligations:
    • The contractual terms explicitly limited Enercon’s rights and required the return of all technical information and its copies to Vericor upon request. These obligations further confirmed that Enercon retained no substantial rights.

Based on the detailed examination of the contract terms and the regulatory framework, the court concluded that the research performed by Enercon under Project No. 37688 was fully funded by Vericor. Enercon did not retain substantial rights in the research results due to the restrictive terms of the contract. Consequently, the expenses incurred for this project did not qualify as “qualified research expenses” under Section 41, leading the court to grant the IRS’s motion for partial summary judgment.

Helpful Takeaways for Taxpayers

  1. Understanding “Funded Research”:
    • Taxpayers must be aware that research fully funded by another party (e.g., through fixed payments not contingent on success) does not qualify for the R&D tax credit under Section 41. Properly structuring agreements and payment terms is crucial to determine eligibility for the credit.
  2. Importance of Retaining Substantial Rights:
    • To qualify for the R&D tax credit, taxpayers must retain substantial rights in the research results. Contracts should explicitly state that the performing entity has the right to use the research outcomes independently without requiring permission from the funding party.
  3. Contractual Clarity and Terms:
    • Clearly define terms related to intellectual property and the use of research results. Avoid terms that limit the contractor’s ability to use or benefit from the research. Clauses that designate work as “made for hire” or require the return of technical information to the funder can disqualify the research for the credit.
  4. Non-Disclosure and Use Clauses:
    • While non-disclosure agreements are common, they should not overly restrict the use of research results. Ensure that any confidentiality or non-disclosure clauses do not prevent the performing entity from retaining substantial rights.
  5. Documentation and Record Keeping:
    • Maintain thorough documentation of all agreements, including offer letters, purchase orders, and terms and conditions. Clearly document the nature of the research, the rights retained, and the funding structure. Proper documentation can support claims for the R&D tax credit and help avoid disputes with the IRS.
  6. Awareness of Incidental Benefits:
    • Understand that incidental benefits, such as gaining experience or knowledge, do not constitute substantial rights. Contracts should focus on ensuring that the performing entity retains significant rights to use and benefit from the research outcomes.

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