Fairchild Industries Incorporated v. United States, No. 94-5116

November 29, 1995 | Before RICH, NEWMAN, and SCHALL, Circuit Judges 

Short Summary

This case involves Fairchild Industries, Inc., an aerospace company, and the United States government. Fairchild entered into a contract with the Air Force to design and build a new training aircraft and later claimed research tax credits for the related expenses. The IRS denied a large portion of these credits, arguing that the government had “funded” the research, which would disqualify Fairchild from taking the credit. The central question was whether Fairchild truly bore the financial risk of the research, or if the contract structure meant the government had effectively paid for the work regardless of the outcome. In the end, the court sided with Fairchild, finding that because payment was only guaranteed if the work met strict requirements, Fairchild had taken on the risk and was eligible for the research tax credit. 

 

Key Issues

• Was Fairchild’s research “funded” by the government under the tax code? 

  The main legal question was whether the payments Fairchild received from the Air Force meant the government was funding the research work. If another party, like the government, funds research, the company doing the work can’t claim a research tax credit. The court had to examine whether the contract structure meant Fairchild was really spending its own money at risk or simply working with government funds with little chance of loss. 

• Do progress payments from the government count as funding for tax credit purposes? 

  Fairchild received “progress payments” from the Air Force throughout the project, rather than just a lump sum at the end. The court needed to decide if these payments meant Fairchild wasn’t really risking its own money, since it was getting paid as the work went along. The answer depended on whether Fairchild had to pay these amounts back if the work wasn’t accepted, or if the payments were truly the government covering the costs upfront. 

• Who bears the financial risk in a fixed-price incentive contract? 

  A big part of the case was figuring out which party (Fairchild or the government) would be financially responsible if the project didn’t succeed. The contract set strict standards and required the Air Force to only pay for work that met those requirements. If Fairchild failed, it would not only miss out on payment but also must return any unearned progress payments. The court needed to decide if this arrangement meant Fairchild took on real financial risk, which would allow it to claim the research tax credit under the law. 

Primary Holding 

The court decided that Fairchild Industries was entitled to claim the research tax credit for its work on the Air Force contract. The main reason was that Fairchild’s payment from the Air Force was not guaranteed. Fairchild would only get paid if its research and development met strict contract requirements and was accepted by the Air Force. The court explained that this meant Fairchild was taking on the real financial risk for the project, not the government. 

In simple terms, the court held that because Fairchild could lose money if the research didn’t succeed, the company’s research expenses were not “funded” by the government. As a result, Fairchild qualified for the tax credit. 

 

Specific Issues

 

1. Was the Research “Funded” by the Government? 

   • Ruling: The court ruled that the research and development work done by Fairchild under its Air Force contract was not “funded” by the government according to the tax credit rules.
   • Reasoning: The court looked closely at the contract and found that Fairchild only received payment if the work met the contract’s demanding requirements and was accepted by the Air Force. If Fairchild’s work didn’t measure up, not only would they miss out on payment, but they would also have to pay back any progress payments they received along the way. The court pointed out that “funded” means the company isn’t really at risk of losing money, but here, Fairchild truly was at risk. The company was spending its own money upfront and could lose it if things went wrong. Because Fairchild was the one shouldering the financial risk, the research expenses did not count as being funded by the government.

      

2. Do Progress Payments Count as Funding?  
   

   • Ruling: The court decided that progress payments from the Air Force did not mean that the research was “funded” by the government for tax credit purposes. 
   • Reasoning: Although Fairchild received regular payments from the Air Force during the project, these weren’t guaranteed earnings. The court explained that progress payments were more like temporary loans meant to help with cash flow while the project was underway. If Fairchild didn’t complete the work or if the government wasn’t satisfied, Fairchild would have to give that money back. So, these payments didn’t take away Fairchild’s risk or make the government the true funder of the research. The payments just made it easier for Fairchild to manage the costs while working toward the contract’s goals.
     
     

3. Who Bore the Financial Risk? 

   • Ruling: The court determined that Fairchild, rather than the government, carried the financial risk on the project.
   • Reasoning: Under the terms of the fixed-price incentive contract, the government only agreed to pay if Fairchild’s work met specific requirements and was accepted. If anything went wrong or if Fairchild didn’t deliver as promised, Fairchild would have to pay back the progress payments and absorb the loss. The court emphasized that this contract structure was what mattered most because Fairchild had so much at stake, it was the party bearing the financial risk. This meant Fairchild was eligible to claim the research tax credit.

      

Helpful Takeaways for Taxpayers 

 

• If you bear the risk of loss, you may qualify for the credit. 

  When a contract makes payment truly depend on your company’s successful performance, your expenses are less likely to be considered “funded” by someone else. If your business could lose its own money if the work fails, you’re in a strong position to claim research tax credits, even on government projects. 

• Progress payments don’t automatically count as disqualifying funding. 

  Receiving periodic payments during a project doesn’t necessarily mean the research is “funded” by your customer. If you have to repay those advances if the work isn’t accepted, the IRS may still see you as bearing the financial risk, making you eligible for the credit. 

• Contract details matter most. 

  The specific terms of your agreement, especially how payment, performance standards, and repayment of advances are handled, are key. Well-drafted contracts that clearly state when you get paid and what happens if you fail can help protect your right to the research credit. 

• Documentation is your best defense. 

  Keeping clear records of your contract terms, payment structure, and what happens if the project isn’t successful will help support your claim if the IRS reviews it. Solid documentation showing you took on real risk is critical. 

• Government contracts can still qualify. 

  Just because you’re working for the government doesn’t mean you’re automatically disqualified from claiming research tax credits. If the contract places the risk of failure on your business, you may still be able to benefit from the credit.