Source: RSM US LLP.   

ARTICLE | January 24, 2021


On Jan. 11, 2021, the United States Tax Court offered insight into what constitutes ‘substantial rights’ as it relates to qualified research expenditures (QRE) for the research and development (R&D) credit under section 41. While there are typically three main types of costs considered for the research credit (wages, supplies and contract research), this case focuses on in-house wages claimed based on work performed under an agreement with a third-party contractor. The issue addressed in this case is if the taxpayer, who is working on behalf of another company, maintains substantial rights to the results of the work performed under contract and is eligible to claim the research credit for the in-house wages incurred for the project.  

Facts, issues and analysis

In this case, IRS disallowed research credits of approximately $930,000 claimed during 2008 – 2010 by Enercon Engineering, Inc. (Enercon, Company or taxpayer) where the majority of the QREs were allegedly incurred in connection with research performed in more than 100 projects. The main issue is whether substantial rights are established within the terms of the agreement between Enercon and Vericor Power Systems (a company for which Enercon was performing research under contract); other relevant cases for this topic include Lockheed Martin Corp. v. United States and Dynetics, Inc. & Subs. V United States. Generally, to determine whether a taxpayer retains the necessary substantial rights, the IRS looks to the language within the contract for the research itself, and relies on both tax law and contract law. 

The regulations specify two main factors as relevant in ascertaining whether the research is funded. First, “[a]mounts payable under any agreement that are contingent on the success of research…. are not treated as funding” Reg. section 1.41-2(e)(2). Second, the taxpayer must demonstrate it “retains substantial rights in the research” Reg. section 1.41-4A(d)(3)(i). The IRS argues that Enercon’s research was 100% funded by Vericor because, under the agreement executed by the parties, Enercon retained no substantial rights in the research performed.

On Feb. 11, 2009, Enercon sent Vericor an offer letter summarizing Enercon’s understanding of the project, including all technical specifications and legal requirements contained in the Terms and Conditions of the agreement. Under this contract, Enercon agreed to produce a new enclosure for turbine power generation. Within the agreement, Vericor included explicit language surrounding the rights to retain technical information (written, oral, etc.), tooling used as part of research, and restrictions of use on any technical knowledge gained that could be used to assist others in developing similar products and/or tooling. 

In addition, the agreement further stated the Company cannot use or disclose such information without the consent of Vericor and any such information (and copies thereof) shall be returned to Vericor at their request. Lastly, information prepared by the Company specifically in connection to the contract, including original work created by Enercon, are considered ‘works made for hire’ under the U.S. Copyright laws. If any work is not classified as such, the order is deemed as an irrevocable assignment to rights, title and interest is retained by Vericor. 

When comparing this case to Lockheed Martin Corp. v. United States (Lockheed), Enercon’s argument asks whether the “institutional knowledge it glean[ed] from research” performed for Vericor merits substantial rights where Enercon gained an “express transfer of some rights” to be used by the Company’s own future projects. In response, the court cited Treas. Reg. 1.41-4A in holding that mere “[i]ncidental benefits….from performance of the research,” such as having a more experienced or knowledgeable staff, do not constitute substantial rights. The main argument in Lockheed was that the legal requirements were unrelated to the agreement the parties executed, which differs from the conclusion reached here. 

With the facts considered in the case, the court held the parties’ agreement controls the determination of whether the taxpayer performing research has retained substantial rights. The IRS determined the results of all research Enercon performed in the course of fulfilling this contract were retained by Vericor due to the unequivocal nature of the language of the Terms and Conditions. Furthermore, Enercon was unable to re-use the results of its research without getting Vericor’s prior written consent. Lastly, in accordance with the decision reached in Dynetics Inc. & Subs. v. United States, having to secure permission to use the research, with no conditions limiting the other party’s ability to withhold consent, prevents the Company from possessing substantial rights.


Taxpayers should evaluate on a project-by-project basis the extent in which their company can demonstrate the retention of substantial rights to intellectual property (IP) or technical knowledge outside of the purview of the agreements in place with third parties, which could lead to more favorable outcomes for taxpayers. When evaluating agreements as it relates to the R&D tax credit, please consult with your tax advisor.

This article was written by Tyler Caton and originally appeared on Jan 24, 2021.
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