What Smith v. Commissioner Means for R&D Tax Credits
Most discussions about the R&D tax credit center on whether the work qualifies. Establishing technical uncertainty and a process of experimentation are essential parts of that analysis, but funding questions matter just as much and are often overlooked.
If anything, the Tax Court's June 2026 ruling in Smith v. Commissioner is a reminder of why a qualified expert is so essential to the R&D credit process. The court gave taxpayers clear guidance on funding requirements and how to read contract language, and getting that analysis right (along with proper technical interviews and documentation) is exactly the kind of work an experienced practitioner brings to the table.
What the Case Involved
Smith v. Commissioner involved research credits claimed by Adrian Smith + Gordon Gill Architecture, a firm that designs some of the tallest and most technologically demanding buildings in the world. Specifically, the firm claimed IRC §41 research credits for tax years 2008 through 2010.
By the time the case reached the court, the IRS had already conceded that the firm’s activities generally met the four-part test for qualified research, but the technical merits were not at the basis of that fight. The entire case primarily came down to single question: was the research funded by the firm itself, or was it funded by the clients, and therefore excluded from the credit? To make the analysis workable, the parties examined six sample projects for review.
The court’s findings and how it got there can serve as a roadmap for how the funded research exclusion operates, as well as serve as a warning for any business that does research on behalf of the people who pay it.
What Funded Research Really Means
IRC §41(d)(4)(H) excludes from qualified research any research funded by a grant, contract, or otherwise by another person. The principle is straightforward: if another party bore the cost and risk of the research, that party is treated as the investor, and the credit is designed to reward whomever put its own capital at risk. The exclusion exists to prevent two separate taxpayers from claiming the benefit for the same research dollar.
The statute does not define funded research, so the court turned to Treas. Reg. 1.41-4A(d), which sets a two-part test. Research is treated as funded unless the taxpayer clears both hurdles:
1) Payment for the research must be contingent on its success, which is to say: the taxpayer, not the client, bears the financial risk.
2) The taxpayer must retain substantial rights in the results of the research.
While failing to clear the first hurdle is a significant obstacle toward claiming a credit, it does not entirely prevent the taxpayer for claiming a credit on the research performed. As long as the second hurdle is cleared, the taxpayer can potentially claim a partial credit, as long as the qualified research expenses for each examined project exceed the payments the taxpayer received from its client. In that scenario, only the excess amount, if any, is eligible for the credit.
Prong One: Financial Risk, and Why the Firm Lost It
On the question of financial risk, the firm lost on all six projects, and the reasoning is important for service providers.
The firm argued that its payments were contingent on success because clients signed off on each design phase before releasing the next payment. While that sounds like financial risk on its face, the court did not agree, and it drew a distinction that every firm conducting contract research should internalize.
The court cited Meyer, Borgman & Johnson, Inc. v. Commissioner to highlight the difference between successful performance and proper performance. Successful performance means hitting detailed, objective technical benchmarks that function as a real measuring stick of the success of the research. Proper performance means delivering competent work that meets a professional standard of care. Successful performance puts risk on the researcher, while proper performance does not.
Because the firm was paid for meeting a professional standard rather than for achieving a defined technical result, the risk of research failure sat with the clients. The court also rejected the argument that a client’s right to terminate the contract created meaningful risk. Losing the chance to earn future profit is not the kind of financial risk that Treas. Reg. 1.41-4A(d) contemplates. A contract that simply lets a client walk away does not put the researcher’s own money on the line in the way the rule requires it to. The court determined that all six contracts did not meet the requirements of the financial risk funding prong.
Prong Two: Substantial Rights, and Where Partial Credit Survived
This is where the case turns from a complete loss into something more nuanced. Even though every project failed the financial risk test, Treas. Reg. 1.41-4A(d) may allow for a partial credit where the taxpayer retained substantial rights in the research. In practice, a credit may be available to the extent the firm’s qualified research expenses exceeded what the client paid for the work on each project.
The court determined that the firm did not maintain substantial rights in the research performed for two of the six projects. The contracts for these two projects gave the clients absolute ownership and copyright in the work product, and the firm would have needed the clients’ permission to reuse its own research, with nothing limiting the clients’ ability to refuse. Handing over that control was fatal to the credit on these two projects.
On the other four projects, however, the firm either kept copyrights or negotiated licenses that let it market and reuse underlying research. The court then confirmed an important principle: the right to use research results, even in a non-exclusive capacity, is a substantial right. That distinction potentially preserved partial credits on four projects that otherwise would’ve been entirely lost.
A Pattern, not a One-off
Smith sits at the end of a line of decisions in which courts have steadily clarified how the funded research exclusion is applied. In a 2024 decision in Meyer, Borgman, & Johnson v. Commissioner, the Eighth Circuit held that a structural engineering firm’s research was funded because its contracts did not make payment contingent on the success of the research.
The substantial rights prong has its own body of law. In Lockheed Martin v. United States, the U.S. Court of Appeals for the Federal Circuit established that transferring shared rights in research documents, even along with exclusive rights to the intellectual property in them, is not the same as giving up all substantial rights.
On the other side, Tangel v. Commissioner denied substantial rights where the taxpayer was broadly prohibited from using the technical information it developed and was bound by work-for-hire obligations. Dynetics v. United States reached a comparable funded research conclusion years earlier. Read together, these cases show that the two questions Smith raised about financial risk and substantial rights are the same two questions the courts continue returning to. Smith is not a new rule; it is the clearest recent illustration of a rule that has been developing for more than a decade.
Why This Matters for Taxpayers Claiming the Credit
Strip away the specifics and Smith delivers a message that reaches past architecture firms: qualifying activity is necessary but is not sufficient on its own. You can conduct a process of experimentation, resolve technological uncertainty, and provide documentation on all of it, and still lose the credit if your clients’ agreements hand the risk and rights to someone else. The research may get the attention, but the contract often makes the final decision.
The Importance of Contracts
If Smith has a practical lesson, it is that the outcome was decided by contractual language, and that language is something that you can influence before the research is performed. Here are three areas that deserve attention:
1. Contractual Language. Warranty, inspection and acceptance, guarantees, substituted performance, and limitation of liability clauses may help place the risk of failure on your business, which points towards non-funded research. Specifically, clauses like these are crucial to claim the credit on research performed under contract.
2. The ownership and use of results. This is where partial credits are won or lost. A contract that assigns all rights, data, and copyrights to the clients and/or requires their permission before using the results of that research on future projects can strip away substantial rights. A contract that lets you keep your copyrights or grants you a license to use and market the underlying research preserves them. Even non-exclusive rights to use the results count, which means small changes in drafting can make a large difference.
3. An interaction between the two of these. Smith is a reminder that questions are answered separately. A careful review looks at both the payment mechanics and the intellectual property terms. For taxpayers who want to claim the research credit, they must pass both the risk and rights test.
Common Questions
Does performing research under a client contract automatically disqualify the credit?
No. Research performed under contract can still qualify. The question is whether your payment was contingent on the success of the research and whether you retained substantial rights in the results. If both are true, the research is not funded, even though a client paid for the work.
Can you still claim a credit if you fail the financial risk test?
Sometimes. If you retained substantial rights in the research, Treas. Reg. 1.41-4A(d) allows a partial credit to the extent your qualified research expenses exceed the payments you received for the work. Smith potentially preserved credits on four of six projects on exactly this basis. Taxpayers are also allowed to allocated funding between qualified and non-qualified activities.
What counts as retaining substantial rights?
Keeping the right to use the results of your research, even without an exclusive right to them, is enough. Assigning all ownership and copyrights to the client and needing the client's permission to reuse what you learned, is not.
In Summary
At RK Partners, we have experienced attorneys with a combined 40 years of experience in reviewing research contracts who will perform a detailed analysis of your contracts to determine which party is at risk and has rights in the technology. This analysis is a critical part of any research tax credit study. RK can also work with your firm to appropriately structure your research contracts while you are negotiation with your clients/customers. Smith makes clear that the IRS and the courts are reading them closely, and a short review now can protect a credit that is far harder to defend later.
