Meyer, Borgman & Johnson, Inc. v. Commissioner

The federal research and development tax credit, established under $\S 41$ of the Internal Revenue Code, serves as a cornerstone of the United States' strategy to foster technological innovation and domestic economic competitiveness. Since its inception, the credit has been designed to incentivize taxpayers to undertake the financial risks inherent in developing new or improved business components. However, the eligibility for this credit is strictly bounded by several statutory exclusions, most notably the "funded research" provision under $\S 41(d)(4)(H)$, which denies the credit to any research to the extent it is funded by any grant, contract, or otherwise by another person or governmental entity. The recent adjudication of Meyer, Borgman & Johnson, Inc. v. Commissioner (hereafter "MBJ v. Commissioner") has emerged as a pivotal development in this legal area, clarifying the rigorous standards required to prove that a researcher bears the economic risk of failure. By examining the nuances of contractual language, professional standards of care, and the allocation of intellectual property rights, this case provides a definitive guide for future R&D tax credit applications, particularly within the architecture, engineering, and construction (AEC) sectors.

The Statutory Architecture and Legislative Intent of the Research Credit

To appreciate the significance of the MBJ decision, one must first understand the legislative purpose behind the research credit. Congress regarded research as the lifeblood of economic progress and viewed effective tax incentives as a fundamental element of America's competitiveness strategy. The credit is intended to offset the costs of research that might not otherwise be performed due to high risk and uncertain outcomes. Consequently, the law mandates that the credit should follow the risk; the entity that stands to lose money if the research fails is the entity entitled to the tax benefit.

The statutory framework defines "qualified research" through a four-part test: the research must be intended to develop a new or improved business component, be technological in nature, involve the elimination of uncertainty, and follow a process of experimentation. Even if these criteria are met, the research is excluded from the credit if it is "funded". Under Treasury Regulation $\S 1.41-4A(d)$, research is considered funded unless the taxpayer can demonstrate that (1) the payments for the research are contingent upon its success, and (2) the taxpayer retains substantial rights in the research results. This two-pronged test ensures that the taxpayer is truly at risk and has a meaningful commercial interest in the innovation.

Factual Underpinnings of Meyer, Borgman & Johnson, Inc. v. Commissioner

Meyer, Borgman & Johnson, Inc. (MBJ) is a specialized structural engineering firm headquartered in Minnesota. The firm provides engineering designs for building projects, often involving complex structural challenges that require customized solutions beyond standard industry practices. For the tax years 2010, 2011, and 2013, MBJ claimed approximately $190,000 in research tax credits for the costs incurred in developing these designs. The Commissioner of Internal Revenue denied these credits, asserting that the engineering work was performed under contracts that constituted funded research.

During the litigation, the parties agreed to analyze a sample of 14 projects to determine the firm's eligibility for the credit. These projects were governed by contracts that were primarily fixed-fee or capped-price arrangements. MBJ argued that because the fees were fixed, any failure in the research process—such as a design failing a simulation or model test—would require the firm to perform additional work at its own expense. In MBJ's view, this inherent economic risk meant the research was not funded.

The Contractual Evidence

The 14 sample contracts included both signed agreements and unsigned proposals that the court deemed representative of the firm's business practices. MBJ highlighted several specific terms to support its claim of risk:

• Standard of Care Provisions: The contracts required MBJ to perform services as expeditiously as consistent with "professional skill and care".
• Compliance Clauses: MBJ was obligated to comply with all pertinent local, state, and federal codes and regulations.
• Termination for Non-Performance: Clients had the right to terminate the agreements if MBJ failed "substantially to perform" its obligations.
• Approval Phases: Many projects were divided into discrete phases, with the client's approval required before MBJ could proceed to the next stage or receive payment.

Despite these arguments, the Tax Court granted summary judgment in favor of the Commissioner, a decision that was later reviewed de novo and affirmed by the Eighth Circuit Court of Appeals.

Judicial Analysis: Distinguishing Success from Proper Performance

The central legal issue in MBJ v. Commissioner was whether the firm's right to payment was contingent on the "success of the research" or merely on the "proper performance" of professional services. This distinction is critical for practitioners because it separates the general economic risks of running a business from the specific technological risks targeted by $\S 41$.

The Rejection of General Professional Standards

MBJ argued that its obligation to meet building codes and professional standards of care meant that its payment was contingent on the success of its design. However, the Eighth Circuit rejected this, drawing a sharp line between "successful performance"—which involves meeting detailed, objective technical barometers of success—and "proper performance"—which involves providing deliverables according to a general standard of care free from negligence.

The court observed that a structural engineer could perform its duties with the utmost professional skill and care and still have a design fail to achieve a specific technological result, or conversely, succeed in a design despite a lack of specific research success. Because the contracts did not explicitly state that the clients would withhold payment if specific research goals were not met, the court found that the risk of failure remained with the client who was paying for the professional expertise, not the researcher. The court noted that requirements to comply with codes or to perform without error are "unavailing" in the funding analysis because they do not mandate the success of the research itself.

The Inherent Risk of Fixed-Price Contracts

A significant portion of MBJ's defense rested on the idea that fixed-price contracts are "inherently risky". The firm contended that if it underestimated the time or labor needed to solve a technical challenge, it would suffer a financial loss. While the court acknowledged this possibility, it ruled that such risk constitutes "general economic risk" rather than a "contingency on the success of research".

The court aligned its reasoning with the Fifth Circuit's decision in United States v. Grigsby, which held that taxpayers often improperly conflate "contracts for products or services" with "amounts payable contingent on the success of research". To be considered unfunded, a contract must place the risk of failure for specific "line items" or technological milestones on the researcher. In MBJ's case, the absence of provisions requiring the refund of payments for research failure indicated that the firm was being paid for its time and effort, regardless of the ultimate success of the research process.

Insight: The "Mirror Image" Metaphor and the Tax Vacuum

A profound second-order insight from the MBJ Tax Court order involves the rejection of the "mirror image" metaphor. Historically, many tax practitioners operated under the assumption that the R&D credit must reside with either the client or the researcher—that the rules for identifying funded research and the rules for identifying who can claim the credit are perfect mirror images. MBJ argued that since its clients were not in the business of structural engineering and thus could not claim the credit, the credit should naturally default to the firm performing the work.

The Tax Court explicitly rejected this view, stating that the metaphor "distorts the meaning of the regulation". The court highlighted that Treasury Regulation $\S 1.41-4A(d)(2)$ creates scenarios where research is not creditable by either party. If a researcher fails the economic risk test (because payment is not contingent on success) and the client fails the qualified research test (perhaps because the research is not in their trade or business), the credit simply disappears. This "tax vacuum" occurs when contracts are drafted purely for commercial or professional liability purposes without regard for the specific requirements of the research credit. This highlights a causal relationship between boilerplate contract drafting and the permanent loss of valuable tax incentives.

Comparative Jurisprudence: The Fairchild Standard vs. Modern Rulings

The MBJ decision reinforces Fairchild Industries, Inc. v. United States (1996) as the baseline for what constitutes unfunded research. In Fairchild, the taxpayer developed an aircraft for the U.S. Air Force under a contract that contained over 1,000 pages of technical specifications. The Air Force was only obligated to pay if Fairchild met every specific design, construction, and performance standard. If Fairchild failed, the Air Force could reject the work, require correction at the company's expense, or demand an equitable price reduction.

Modern courts have contrasted MBJ's situation with Fairchild to emphasize the lack of "successful performance" criteria in contemporary professional service agreements. While MBJ and Grigsby have narrowed the path for AEC firms, the case of Populous Holdings, Inc. v. Commissioner (2019) remains a notable outlier. In Populous, an architectural firm was granted summary judgment because the court found that its fixed-price contracts required the firm to remedy failed research at its own cost, which the court deemed sufficient to prove economic risk.

The MBJ court effectively limited Populous by noting that Populous was a non-precedential order and that the MBJ contracts lacked even the modest rejection or limitation-of-payment provisions present in the Populous sample. This suggests a trend where courts are moving away from the "inherent risk of fixed prices" argument and toward a requirement for explicit "contingency on success" clauses.

The Substantial Rights Test: Beyond Institutional Knowledge

While the MBJ court did not reach a detailed analysis of substantial rights because the lack of contingency was dispositive, the issue remains a critical barrier for AEC firms. Treasury Regulation $\S 1.41-4A(d)(2)$ stipulates that a researcher must retain "substantial rights" to be entitled to the credit. If a firm transfers all intellectual property, patent rights, and copyrights to the client, the research is considered funded even if the researcher bore the economic risk.

Institutional Knowledge vs. Substantial Rights

A key tension in recent litigation is the definition of "rights". In cases like Dynetics and Smith, taxpayers argued that they retained rights because they gained "institutional knowledge," "skills," and "advancements" during the performance of the research that could be used on future projects. The courts have consistently rejected this, characterizing such gains as "incidental benefits" rather than "substantial rights".

A substantial right must be a legal right to use the results of the research without restriction or payment to the client. In Lockheed Martin Corp. v. United States, the court clarified that this right does not have to be exclusive; a researcher can share rights with the client and still qualify for the credit. However, if a contract includes "Work Made for Hire" language or broad IP transfer clauses that divest the researcher of all ownership and use rights, the credit will be denied.

IRS Administrative Response and Field Impacts

The MBJ decision did not occur in a vacuum; it has been accompanied by a shift in IRS audit strategy. On November 12, 2021, the IRS issued Field Attorney Advice (FAA) 20223401F, which established a more rigid framework for evaluating research credit claims in contractual contexts.

Impact of FAA 20223401F

The issuance of this FAA has effectively halted field-level negotiations on the funded research issue. Reports from the industry indicate that IRS managers now cite this guidance as a reason to disallow claims entirely if contracts do not meet the Fairchild level of specificity. Furthermore, the IRS has introduced a new "Classifier" review system designed to deny refund claims before they even reach an examiner if they lack bulletproof documentation of technological uncertainty and the process of experimentation.

This administrative hardening means that AEC firms can no longer rely on "handshake deals" or "standard industry practice" to justify their credits. The IRS and the courts are now focused strictly on the "four corners" of the contract, ignoring oral understandings or "course of dealings" evidence that contradicts the written terms.

Emerging Resilience: The 2025 Rulings and the Role of Choice-of-Law

Despite the strictness of the MBJ decision, a new avenue for R&D credit defense has emerged through two 2025 cases: Smith et al. v. Commissioner and System Technologies, Inc. v. Commissioner. These cases demonstrate that "choice-of-law" provisions can be used to override the silence of a contract on the issue of research contingency or intellectual property rights.

System Technologies and the UCC

In System Technologies, the taxpayer developed custom finishing systems for the automotive industry. The purchase orders for the projects were governed by Indiana state law. The IRS argued that because the contracts lacked explicit contingency-on-success language, the research was funded.

However, the Tax Court ruled that under the Indiana Uniform Commercial Code (UCC), a buyer has statutory remedies for a total breach of contract. The court reasoned that if the research failed and the product was not delivered, Indiana law would mandate a refund of payments. Therefore, by incorporating Indiana law through a choice-of-law provision, the parties had implicitly made payment contingent on the success of the research. This ruling suggests that "traditional contract analysis" can satisfy the R&D credit requirements even where "tax-specific" language is missing.

Smith and International Intellectual Property Law

In Smith, the Tax Court considered a Chicago-based architectural firm with projects governed by the laws of Dubai and the UAE. The taxpayer argued that under these foreign jurisdictions, copyright and reproduction rights are automatically granted to the creator of a design unless explicitly forfeited in the contract. The court denied the IRS's motion for summary judgment, ruling that a factual dispute existed over whether these foreign laws divested the firm of "substantial rights". This confirms that local governing law—whether state or international—is a relevant and powerful tool for substantiating R&D tax credit claims.

Future Implications and Strategy for AEC R&D Applications

The implications of MBJ v. Commissioner for the future of R&D tax credits in the USA are twofold: it represents a significant narrowing of the definition of "risk" for professional service providers, yet it also provides a clear blueprint for how to structure future agreements to ensure eligibility. Firms that continue to use "one-off" contracts without revising their terms face a "nail in the coffin" for their R&D claims.

Contractual Reform Strategies

To survive IRS scrutiny post-MBJ, future R&D tax credit applications must be supported by contracts that explicitly address both economic risk and substantial rights. Specifically, agreements should:

• Link Milestones to Success: Tie payment milestones not to the calendar or general phases, but to the successful achievement of objective technical benchmarks.
• Include Refund Provisions: Explicitly state that the researcher is liable for a refund if the research results do not meet contract specifications.
• Explicitly Reserve Use Rights: Include a clause stating that the "Researcher retains a perpetual, non-exclusive right to use the underlying technological processes, methods, and innovations for its own business purposes without additional compensation to the Client".
• Utilize Favorable Choice-of-Law: Select governing jurisdictions (like Indiana) where the UCC or local statutes provide strong remedies for total breach or automatically protect creator rights.

Substantive Documentation and the Scientific Method

Beyond the contract, firms must improve their technical substantiation. The MBJ and Phoenix Design Group cases highlight that treating an entire building as a single "business component" is a failing strategy. Instead, firms should apply the "shrink-back" rule to focus on specific, innovative subsystems—such as a custom HVAC integration or a novel load-bearing assembly—where technical uncertainty and experimentation are clearly present.

Documentation must evolve to mirror the scientific method, recording hypotheses, the testing of multiple alternatives through BIM or simulations, and the iteration of designs based on results. Vague time logs using terms like "design" must be replaced with activity-based logs like "tested vibration response in structural supports" to satisfy the "process of experimentation" requirement.

Legislative Context: Section 174 and the OBBBA

Finally, the 2024-2025 legislative environment adds a layer of urgency. The restoration of immediate expensing for domestic R&D costs under the OBBBA means that identifying "unfunded research" can lead to immediate deductions and significant tax savings. Small businesses with average gross receipts under $31 million have a unique window to amend prior returns (2022-2024) and claim refunds for taxes paid during the mandatory amortization period. This makes the legal standards established in MBJ not just a matter of compliance, but a central component of cash-flow strategy for innovative firms.

Synthesis and Conclusion

The adjudication of Meyer, Borgman & Johnson, Inc. v. Commissioner clarifies that the federal government will strictly enforce the "funded research" exclusion, particularly against professional service providers who rely on general professional standards of care. The case serves as a definitive rejection of the idea that fixed-price engineering work is inherently risky enough to qualify for the R&D tax credit. By distinguishing between the delivery of a professional service and the success of a research process, the Eighth Circuit has established a high evidentiary bar for future applications.

However, the broader landscape—including the Populous precedent and the recent 2025 victories in Smith and System Technologies—indicates that this bar is not insurmountable. The path forward for AEC firms requires a sophisticated integration of contract law and tax compliance. By proactively drafting contracts to include explicit technical benchmarks and strategically selecting favorable governing laws, firms can ensure their innovations remain "unfunded" and thus eligible for the credit. Ultimately, the MBJ decision marks the end of "boilerplate R&D" and the beginning of a more rigorous, legally nuanced era for the research tax credit in the United States.