Smith v. Commissioner (T.C. Memo. 2026-50)

Few firms embody innovation more visibly than the architects who design the world’s tallest buildings. When a celebrated “supertall” design practice claimed federal research credits for the engineering that makes such towers possible, on paper, the case, Smith v. Commissioner, looked like a natural fit. The U.S. Tax Court still denied the credits; not because the work lacked ingenuity, but because of what the firm’s client contracts said.

That outcome carries a lesson for any company that performs research on behalf of clients: qualifying activity is necessary but not sufficient. If a contract shifts the financial risk to the customer or signs away rights to the results, the law treats the research as “funded” by someone else, and funded research does not earn the credit.

Overview of Smith v. Commissioner and the Funded Research Challenge

The taxpayers were the partners of a prominent architecture firm that designs large-scale, highly engineered towers, drawing on deep research into thermodynamics, geotechnics, fluid dynamics and microclimates. The firm claimed substantial credits under Internal Revenue Code Section 41 for design work on a set of international projects. The IRS challenged those credits using the “funded research” exclusion, which removes from the credit any research paid for by another party through a contract.

Two Key Questions for R&D Credit Eligibility in Service Contracts

To test the question, the court examined the contracts for six representative projects and applied a clean, two-part framework.

1. Does the firm keep “substantial rights” in the research? If the contract hands ownership of the results to the client, especially if the firm needs the client’s permission to use what it learned, the firm has not retained substantial rights. In two of the six projects, the contracts made all project data the client’s “absolute property,” transferred copyright, and required written approval before the firm could reuse anything. That was fatal: no substantial rights, so the research was funded.
2. Is payment contingent on the success of the research? Only if the firm clears the first question does the court reach the second. Here, the firm kept substantial rights in the other four projects, but still lost. The contracts tied payment to progress: monthly billing, completion of phases and an hourly fee structure. The court drew a sharp line between delivering work to a general professional standard of care (“proper performance”) and being paid only if the research actually succeeds against detailed, measurable criteria (“successful performance”). Getting paid for progress means the client, not the firm, bears the risk of failure.

Because every sampled project failed one prong or the other, the court treated the research as funded. Notably, it declined to award partial credits—a reminder that a single weak contract term can put an entire project’s credit at risk.

Contract Terms That Protect or Jeopardize R&D Credits

The decision reads almost like a checklist. Here is the practical version.

Build it in (protects the credit)	Watch out for (jeopardizes the credit)
Payment tied to defined, measurable research outcomes specified in the contract	Payment tied to phases, percentage-of-completion, or hourly billing
Firm retains ownership of and rights to use its research results	Copyright or data ownership assigned to the client as “absolute property”
Firm may reuse what it develops without seeking permission	Reuse requires the client’s prior written approval, with no limits on withholding consent
Real economic exposure if the technical work does not succeed	Reliance on termination-for-convenience clauses as evidence of “risk”

What the Court’s Decision Means for Service Firms

Not everything went the IRS’s way. On a separate issue, the court found that the partners’ compensation, measured through their self-employment earnings, was reasonable and could support the wage portion of the credit. For service partnerships and self-employed individuals who perform genuine research, that part of the ruling is encouraging, even though the funding question carried the day.

Action Steps to Preserve R&D Tax Credits in Client Contracts

• Read your contracts the way the IRS will. Innovation in the work product means little if the agreement gives the results away or guarantees payment regardless of technical success.
• Tie compensation to outcomes where you can. Payment milestones built around measurable research results stand on far firmer ground than progress- or time-based billing.
• Protect your rights to reuse. Retaining ownership of, or at least an unrestricted right to use, what you develop helps preserve substantial rights.
• Don’t lean on termination clauses. The mere possibility of losing future profit is not the kind of financial risk the rules reward.
• Document contemporaneously. Strong technical records remain essential, but pair them with contract terms that keep the credit within reach.

Navigate R&D Credit Eligibility with Confidence

As the Smith decision demonstrates, contract language can play a critical role in determining R&D credit eligibility. Businesses performing research on behalf of clients should regularly evaluate how payment terms, ownership rights and financial risk are addressed in their agreements. Frazier & Deeter’s Credits & Incentives team helps organizations assess R&D credit opportunities, identify potential risks and develop strategies to support sustainable tax savings. Connect with our team to discuss your R&D credit position and contract considerations.

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