Smith v. Commissioner (T.C. Memo. 2026-50): Tax Court Clarifies Funded Research Rules for R&D Tax Credits

Tax Court Issues Important R&D Tax Credit Decision

In Smith, et al. v. Commissioner, T.C. Memo. 2026-50, the U.S. Tax Court addressed two significant issues affecting taxpayers claiming the federal R&D tax credit under Internal Revenue Code Section 41:

• When research performed under a customer contract constitutes “funded research.”
• Whether shareholder or partner compensation included in qualified research expenditures (QREs) is reasonable under Section 174.

The case involved Adrian Smith and Gordon Gill Architecture (AS+GG), an architecture firm that claimed R&D tax credits related to innovative design projects performed between 2008 and 2010.

Court Clarifies Funded Research Requirements

The IRS argued that the firm’s research activities were funded by customers and therefore ineligible for the R&D tax credit.

The Tax Court applied the long-standing two-part funded research test found in Treasury Regulation §1.41-4A(d). Research is considered funded when:

1. Payment is not contingent on the success of the research; and
2. The taxpayer does not retain substantial rights in the research results.

The court determined that four of the six representative projects met the substantial rights requirement because AS+GG retained meaningful rights to use, market, or leverage the research results in future work.

As a result, those projects remained eligible for R&D tax credits to the extent qualified research expenses exceeded customer reimbursements.

However, two projects granted clients exclusive ownership of all research results. The court concluded those projects were fully funded and therefore ineligible for the credit.

Tax Court Upholds Existing Funded Research Regulations

The taxpayers also challenged the validity of the funded research regulations following the U.S. Supreme Court’s decision in Loper Bright v. Raimondo.

The Tax Court rejected that argument and upheld the existing funded research framework. The decision confirms that taxpayers and advisors should continue relying on the traditional two-prong funded research analysis when evaluating eligibility for R&D tax credits.

Reasonable Compensation Challenge Rejected

The IRS also challenged the amount of compensation paid to the firm’s partners and included in qualified research expenditures.

Applying the Seventh Circuit’s “independent investor” test, the court found the compensation was reasonable. Notably, the IRS’s own expert acknowledged that the compensation levels still produced an extraordinary return on equity for a hypothetical independent investor.

Because the compensation was reasonable under Section 174, the court allowed the wage expenses to remain included in the R&D tax credit calculation.

Key Takeaways for Taxpayers Claiming R&D Tax Credits

The Smith decision provides several important lessons for taxpayers:

• Contract language remains critical when evaluating funded research issues.
• Retaining substantial rights in research results can preserve R&D tax credit eligibility.
• Customer-funded projects may still qualify for credits when the taxpayer bears unreimbursed research costs and retains meaningful rights.
• Challenges to the existing funded research regulations remain difficult despite recent administrative law developments.
• Reasonable compensation analyses continue to play an important role when wage expenses are included in qualified research expenditures.

What This Means for R&D Tax Credit Claims

Smith v. Commissioner reinforces the importance of reviewing customer contracts, intellectual property provisions, and compensation structures when preparing or defending an R&D tax credit claim.

Taxpayers performing research under customer agreements should carefully evaluate whether they retain substantial rights in the research results and whether qualified research expenditures exceed amounts reimbursed by customers. Those factors may determine whether valuable R&D tax credits survive IRS examination.

Jason Massie, CPA, Esq.

As the Founder and President of MASSIE R&D Tax Credits, Jason is responsible for the quality, consistency, and integrity of our services. His strategic vision and leadership drive innovation within the company, encouraging collaboration and ne...