Meyer, Borgman & Johnson, Inc. v. Commissioner of Internal Revenue

 May 6, 2024 | Benton, United States Court of Appeals for the Eighth Circuit Judge | Docket No. 23-1523

Short Summary

In the case of Meyer, Borgman & Johnson, Inc. v. Commissioner of Internal Revenue, the United States Court of Appeals for the Eighth Circuit upheld a decision from the Tax Court, denying the appellant, MBJ, a structural engineering firm, approximately $190,000 in research tax credits. The Court affirmed the Tax Court’s ruling that MBJ’s research expenses were “funded” under the criteria of 26 U.S.C. § 41(d)(4)(H), thereby disqualifying them from the credits. The case underscores the critical examination of contract terms in determining the eligibility for research tax credits, particularly the criteria surrounding “funded” research.

Key Issue

The central issue in this case was whether MBJ’s research expenses were “funded” by another party, as specified under 26 U.S.C. § 41(d)(4)(H), which would disqualify them from being eligible for research tax credits. The interpretation of MBJ’s contractual arrangements—whether the payment for their research was contingent solely upon the success of the research, and thus not “funded”—was pivotal. The Court reviewed the contract terms and other provisions relating to MBJ’s obligations and rights to payment, which determined the outcome of their claim for the research tax credits.

Primary Holding of the Appeals Court

The primary holding was that MBJ’s research expenses were indeed “funded” within the meaning of the statutory provision, as the payments were not contingent on the success of the research. The Court elaborated that the contracts required MBJ to adhere to professional standards rather than to achieve specific research outcomes. Therefore, despite MBJ’s argument that the payments were contingent on research success due to detailed performance requirements, the Court found that these were typical professional obligations and did not place the financial risk of research failure on the payer. Consequently, MBJ was not entitled to the claimed research tax credits, and the Tax Court’s judgment was affirmed. This decision illustrates the strict scrutiny applied to contract terms in claims for research tax credits and highlights the importance of clearly defining the contingency of payment in relation to the research’s success.

Specific Issues and Rulings

1. Definition and Interpretation of “Funded” Research:
   • Ruling: The court ruled that MBJ’s research expenses were “funded” as defined under 26 U.S.C. § 41(d)(4)(H).
   • Reasoning: The court’s reasoning was based on the statutory and regulatory definitions which exclude from qualification any research expenses funded by another party. The court examined whether the contracts transferred the financial risk of the research to another party. The judgment hinged on the interpretation that if the payment obligations were not dependent on the success of the research, the research was considered funded.

2. Contingency of Payment on Research Success:
   • Ruling: The court found that the payments were not contingent on the success of the research.
   • Reasoning: The court delved into the specifics of MBJ’s contracts, highlighting that although the contracts required compliance with various performance standards, these requirements did not make the payments contingent solely on the success of the research. Instead, they reflected standard professional obligations to deliver services up to a certain standard of care rather than success in research terms.

3. Contractual Provisions Related to Inspection, Acceptance, and Quality Assurance:
   • Ruling: The court concluded that these provisions did not make payment contingent on research success.
   • Reasoning: The analysis pointed out that while the contracts had inspection and acceptance clauses, these did not specifically link payment to the achievement of research outcomes. The provisions were interpreted as typical of professional services contracts, ensuring adherence to standards rather than conditioning payment on the success of innovative research.

4. Comparison with Relevant Case Law:
   • Ruling: The court distinguished MBJ’s situation from precedent cases that MBJ argued supported their position.
   • Reasoning: The court compared the contractual terms in MBJ’s case with those in cases like Fairchild Industries, noting key differences in the risk and payment structures. It highlighted that, unlike in Fairchild, MBJ’s contracts did not place the economic risk of failing to achieve research outcomes on the client. The court emphasized the need for explicit contractual language making payment contingent on research success to qualify for the credit, which was absent in MBJ’s contracts.

5. Interpretation of Professional Obligations Versus Research Outcomes:
   • Ruling: The court ruled that MBJ’s obligations under the contracts were typical professional obligations, not contingent on the success of research.
   • Reasoning: The court differentiated between “successful performance”—achieving specific research outcomes—and “proper performance”—meeting professional standards and contractual requirements. It reasoned that MBJ’s contracts required the latter, which does not satisfy the conditions for research credit eligibility under the tax code.

How this Case Differs From Previous Rulings on Funded Research

In the Meyer, Borgman & Johnson, Inc. v. Commissioner of Internal Revenue case, the Eighth Circuit’s interpretation of fixed fee contracts deviates from prior interpretations seen in cases like Populous Holdings, Inc. v. Commissioner and Geosyntec Consultants, Inc. v. United States. Historically, fixed fee contracts have often been viewed favorably for R&D tax credits on the premise that they place maximum economic risk on the contractor, who must bear the cost of research failure. Such contracts were generally considered “unfunded” because the contractor’s payment was contingent on successful research outcomes, thus qualifying for the credit. However, in the MBJ case, the court determined that while MBJ’s fixed fee contracts did impose general business risks, these risks were not specifically tied to the success of the research; rather, they were linked to fulfilling professional service standards. This ruling underscores a more stringent interpretation where merely having a fixed fee structure does not automatically imply eligibility for the R&D tax credit; explicit contingency of payment on the specific success of research is required. This stands in contrast to the broader application of the principle seen in Populous, and closer to the scrutiny applied in Geosyntec, signaling a shift towards more specific requirements for demonstrating that payment risks are directly tied to research outcomes.