Tax Court Denies Full Research Credits for Architectural Firm Due to Funded Research Exclusion

Architectural Firm Faces $5M+ Tax Hit Over Research Credit Dispute

A Chicago-based architectural firm just lost its battle to claim more than $3.1 million in research credits for 2008 alone—with additional exposure for 2009 and 2010—after the U.S. Tax Court ruled that while the firm could claim partial credits for four of six disputed projects, it must pro-rate expenses under Treasury Regulation §1.41-4A(d)(3). The court rejected the IRS’s attempt to fully disallow the credits but also rejected the taxpayers’ argument that the Supreme Court’s 2024 decision in Loper Bright Enterprises v. Raimondo invalidated the funded research regulations under Section 41(d)(4)(H). In a rare display of judicial authority, the Tax Court exercised its power to interpret the statute independently, signaling a new era of aggressive judicial review over IRS regulations in research credit disputes.

From Supertall Sky­scrapers to Tax Court: The Story of AS+GG’s Research Credits

The skyline of Dubai’s Atrium City District was never meant to be ordinary. In 2008, Adrian Smith + Gordon Gill (AS+GG), a fledgling Chicago architecture firm founded by three former Skidmore, Owings & Merrill (SOM) partners, signed a $298 million contract to design three interconnected towers rising over 1,000 meters—taller than anything then standing. The Atrium City Tower would not just scrape the sky; it would redefine it, with solar-optimized facades, wind-tunnel-tested bridges, and a design so radical that AS+GG spent months studying whether the tower’s corners should be articulated or straight, solid or cable-supported. The contract required Meraas Developments to approve every phase of the design before AS+GG could proceed, from the initial concept sketches to the final construction documents. Intellectual property clauses made it clear: once paid, Meraas owned the design, and AS+GG could only display it with permission.

This was not AS+GG’s first foray into the extraordinary. The firm’s partners—Adrian Smith, Gordon Gill, and Robert Forest—had spent decades at SOM shaping some of the world’s most iconic structures. Smith had worked on the Burj Khalifa, the 828-meter tower that held the world record for height, while Gill had contributed to the Pearl River Tower in Guangzhou, the first net-zero energy supertall building. Forest, the firm’s management partner, had negotiated the Nanjing Tower deal for SOM before joining AS+GG in 2006 to help build what the partners envisioned as a firm where innovation wasn’t just encouraged but demanded.

By 2008, AS+GG had secured six high-profile projects that would test the boundaries of sustainable design. The Kingdom Tower in Saudi Arabia, contracted in 2010, was to be the world’s tallest building at over 1,001 meters, requiring AS+GG to resolve complex structural issues posed by its sandy foundation through wind tunnel testing and load-bearing research. The Masdar Headquarters in Abu Dhabi, designed to achieve zero carbon emissions, involved studies in thermodynamics, fluid dynamics, and microclimates—research so specialized that AS+GG’s contract with Masdar explicitly required performance evaluations after each phase to confirm the design met its ambitious sustainability goals. Plot 14 in Dubai, inspired by Rockefeller Center, demanded a mixed-use tower with Islamic architectural elements, while Plot R2, a 40-story residential tower, incorporated wind turbines to reduce energy demand.

AS+GG’s contracts with clients like Meraas, Jeddah Economic Co., Abu Dhabi Future Energy, Emaar Properties, and ETA Star Property were not mere service agreements. They were research-intensive collaborations. The Atrium City Masterplan contract, for example, required AS+GG to design a sustainable district with retail, residential, and transit hubs, while the Kingdom Tower contract involved months of experimentation to determine whether a 15-degree rotation or a stepped design would better withstand wind forces. The Masdar HQ contract mandated zero carbon emissions and minimal energy usage, pushing AS+GG’s team to pioneer new approaches in passive cooling and renewable energy integration.

AS+GG’s approach to design was itself a form of research. Unlike traditional architecture firms that delegated engineering and sustainability concerns to specialists, AS+GG integrated these disciplines from the outset. The firm’s holistic method required architects, engineers, and sustainability experts to collaborate in real time, iterating on solutions that balanced aesthetics, functionality, and environmental performance. This iterative process—where multiple design alternatives were tested and refined—was not just a business strategy; it was the essence of qualified research under Section 41, which allows a credit for expenses incurred in the development of new or improved business components through a process of experimentation.

For tax years 2008 through 2010, AS+GG claimed research credits under Section 41, arguing that its design work for these six projects qualified as research activities. The firm engaged tax consultants alliantgroup and Warner Robinson to identify and calculate the credits, which flowed through to the partners’ personal tax returns. The IRS, however, would later argue that AS+GG’s work was not research at all—at least not the kind that qualified for the credit. The agency contended that AS+GG’s designs were merely the application of existing architectural knowledge, not the resolution of technological uncertainty through experimentation. The dispute would hinge on whether AS+GG’s work met the four-part test under Section 41(d)(1)—a question that would force the Tax Court to grapple with the boundaries of qualified research in an industry where innovation is often indistinguishable from art.

The Battle Over Funded Research: Taxpayers vs. IRS

The dispute between AS+GG and the IRS over the funded research exclusion under § 41(d)(4)(H) boiled down to a fundamental disagreement over the nature of the firm’s contracts and the allocation of risk. At its core, the case forced the court to confront whether architectural research—often a blend of artistry and engineering—could satisfy the stringent requirements of the Research & Development (R&D) Tax Credit when funded by third parties.

The IRS took a hardline position, arguing that AS+GG’s contracts with clients effectively stripped the firm of any claim to the credit. The agency contended that payments under the contracts were not contingent on success, as invoices were submitted and paid regardless of whether the research yielded tangible technological advancements. In the IRS’s view, the contracts provided for fixed or cost-reimbursable payments, leaving AS+GG with no meaningful economic risk—a key factor in determining whether research qualifies for the credit. The agency further asserted that AS+GG did not retain substantial rights to its research, as most contracts vested intellectual property rights in the clients, leaving the firm with little more than a license to use the designs for its own purposes.

AS+GG, by contrast, framed its research as a high-stakes gamble where each phase of development required explicit client approval before proceeding. The firm argued that payments were contingent on success, as clients only funded further research if the prior phase met predefined technical milestones. This, AS+GG maintained, placed the financial burden of failure squarely on the firm—a critical distinction under the funded research exclusion. The firm also pointed to the retained rights in its contracts, noting that in most agreements, it secured copyrights or licenses that allowed it to reuse research methodologies and designs across multiple projects. These retained rights, AS+GG argued, demonstrated that it had not ceded control over its intellectual output, a requirement under Treas. Reg. § 1.41-4A(d).

The battle lines were drawn: the IRS saw AS+GG’s contracts as pre-paid research services, while the firm viewed them as high-risk, milestone-driven collaborations. The outcome would hinge on whether the court accepted the IRS’s interpretation of § 41(d)(4)(H)—a provision designed to prevent taxpayers from double-dipping on research funded by others—or AS+GG’s argument that its contracts preserved the necessary elements of risk and control.

Loper Bright and the Future of Funded Research: Court Rejects Both Sides' Extremes

The Tax Court’s ruling in AS+GG marks a pivotal moment in the post-Loper Bright landscape, rejecting both the petitioners’ radical statutory interpretation and the IRS’s attempt to expand its regulatory authority. The court’s analysis hinges on § 41(d)(4)(H), which excludes from qualified research any activity "to the extent funded by any grant, contract, or otherwise by another person," and Treasury Regulation § 1.41-4A(d), which implements a two-part test to determine whether research is funded. The court’s holding—while grounded in precedent—asserts its own interpretive authority, signaling a new era where judicial power over tax regulations is ascendant.

The petitioners’ argument that Loper Bright invalidated Treasury Regulation § 1.41-4A(d) was swiftly dispatched. The court emphasized that Loper Bright did not retroactively undermine prior decisions interpreting the funded research exclusion, nor did it strip the regulation of its persuasive force under Skidmore v. Swift & Co., 323 U.S. 134 (1944). The regulation’s longevity—first proposed in 1983 and finalized in 1989—lent it significant weight, as the court noted that its consistent application over 35 years provided clarity and certainty to taxpayers. The IRS’s reliance on Skidmore’s "power to persuade" factors was particularly compelling, with the court citing the regulation’s thorough consideration, reasoned analysis, and consistency with congressional intent. The court’s refusal to invalidate the regulation outright underscores its deference to longstanding administrative guidance, even in the absence of Chevron deference.

The court then applied the two-part test under Treasury Regulation § 1.41-4A(d) to the contracts at issue, rejecting the petitioners’ contention that the "contingent on success" prong was superfluous. The regulation’s framework—requiring either payment contingent on research success or retention of substantial rights—was deemed a reasonable construction of § 41(d)(4)(H). The court’s analysis of the "contingent on success" element was particularly rigorous. It examined each of the six contracts and found that none made payment contingent on the success of the research. The contracts’ payment structures—monthly invoices based on percentage completion, fixed-price lump sums, and reimbursable expenses—were deemed insufficient to shift economic risk to the client. The court distinguished Fairchild Industries, Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995), where the taxpayer bore the risk of nonpayment until full success, from the contracts here, which lacked such stringent performance standards. The court’s rejection of the petitioners’ argument that termination clauses or approval requirements created contingency was equally decisive, holding that the loss of opportunity for full profit did not constitute the type of financial risk contemplated by the regulation.

The court’s application of the "substantial rights" prong was more nuanced but no less consequential. It found that AS+GG retained substantial rights in four of the six projects—Atrium City Tower, Masdar HQ, Atrium City Masterplan, and Plot R2—where the contracts either vested copyright in AS+GG or granted it unrestricted use of the research results. The court relied heavily on Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000), which held that the right to use research results in one’s business, even without exclusivity, constitutes a substantial right. The court distinguished the remaining two contracts—Kingdom Tower and Plot 14—where AS+GG’s rights were limited by clauses requiring prior written approval for use of the research, rendering the research fully funded under the regulation.

The court’s conclusion—that AS+GG could claim partial research credits for the four projects where substantial rights were retained, subject to pro-rata allocation under Treasury Regulation § 1.41-4A(d)(3)—was a compromise that rejected both parties’ extremes. The petitioners’ attempt to claim full credits for all projects was rejected, while the IRS’s position that none of the projects qualified was equally untenable. The court’s reasoning reflects a judicial middle ground, where statutory text and regulatory interpretation are balanced to achieve a fair result. The decision’s emphasis on contractual terms as the sole determinant of funded research—rejecting arguments based on foreign law or extrinsic evidence—further solidifies the Tax Court’s authority to police the boundaries of the IRS’s regulatory power.

The court’s analysis also implicitly reaffirms the precedential value of prior cases interpreting the funded research exclusion, including Fairchild Industries, Lockheed Martin, and Geosyntec Consultants, Inc. v. United States, 776 F.3d 1330 (11th Cir. 2015). These cases, which the court cited extensively, provide a consistent framework for evaluating funded research, and the Tax Court’s adherence to them signals continuity in the law despite the seismic shift in administrative law wrought by Loper Bright. The court’s refusal to invalidate the regulation or adopt the petitioners’ dictionary-based definition of "funded" underscores its commitment to preserving the regulatory status quo where it aligns with congressional intent.

For future taxpayers, the decision offers both clarity and caution. The two-part test under Treasury Regulation § 1.41-4A(d) remains the gold standard for evaluating funded research, and contracts must be drafted with precision to avoid disqualification. The court’s strict interpretation of the "contingent on success" prong suggests that mere risk of loss—such as the possibility of project termination—is insufficient; payment must be explicitly tied to successful outcomes. Meanwhile, the "substantial rights" analysis highlights the importance of retaining ownership or unrestricted use of research results, as even broad licensing restrictions can trigger the exclusion. The Tax Court’s assertive stance in this case—rejecting statutory challenges while policing the boundaries of regulatory authority—demonstrates that the judiciary is poised to play a more active role in shaping tax policy in the post-Loper Bright era.

Reasonable Compensation: Court Applies Independent Investor Test to § 174(e)

The Tax Court’s ruling in AS+GG marks a decisive shift in how reasonable compensation disputes under § 174(e) will be resolved, particularly in cases appealable to the Seventh Circuit. At stake was whether the Partners’ $5 million-plus in claimed compensation for 2008 would survive IRS scrutiny—a sum that, if disallowed, could have triggered a cascading tax liability for the architectural firm. The stakes were amplified by the broader context of § 174(e), which requires research expenses to be “reasonable under the circumstances,” a standard Congress explicitly tied to § 162(a)(1)’s allowance for “reasonable salaries or other compensation for personal services actually rendered.” The court’s embrace of the independent investor test—rather than the IRS’s preferred multifactor approach—demonstrates its willingness to assert judicial authority over tax policy, even in the face of statutory ambiguity.

The dispute centered on the methodology for evaluating reasonableness. The IRS argued that the multifactor test from Mayson Manufacturing Co. v. Commissioner—which considers factors like employee qualifications, nature of work, and prevailing rates—should govern § 174(e) cases. The Partners countered that the Seventh Circuit’s independent investor test, articulated in Exacto Spring Corp. v. Commissioner, was the correct standard. The court sided with the Partners, holding that the independent investor test applies when cases are appealable to the Seventh Circuit, as they were here. This was not a mere procedural footnote: the court explicitly grounded its decision in Golsen v. Commissioner, which requires it to follow the law of the circuit to which an appeal lies. The IRS’s attempt to distinguish Exacto Spring failed, as the court noted that the Seventh Circuit had already “expressly told us” the independent investor test is the standard for reasonable compensation.

The independent investor test operates on a straightforward premise: if an independent investor, with no personal stake in the company, would approve the compensation, it is presumptively reasonable. The test creates a rebuttable presumption that an owner-employee’s salary is reasonable if investors obtain a “far higher return than they had any reason to expect.” The rationale is economic: investors pay managers to “work[] to increase the value of the assets entrusted to [their] management.” The higher the rate of return (adjusted for risk), the greater the salary a manager can command. If the return is extremely high, it becomes implausible to argue the manager is overpaid, as cutting their salary would likely reduce returns. The presumption is rebutted only if the high return stems from an extraneous event, not the manager’s efforts.

The court’s application of the test here was decisive. The parties stipulated that the mathematical results under the independent investor test supported the Partners’ total compensation as reasonable. The IRS did not contest the underlying profitability or industry benchmarks; instead, it clung to the argument that the test was inapplicable to § 174(e). The court rejected this, relying on the House report accompanying the Omnibus Budget Reconciliation Act of 1989, which added § 174(e) to the Code. The report explicitly states that the reasonableness requirement under § 174 should “parallel” the standard under § 162(a)(1), where the independent investor test has long been applied. This legislative history provided the court with a textual anchor to justify its departure from the IRS’s preferred multifactor approach.

The court’s holding carries significant implications for future taxpayers, particularly in industries where owner-employees play a central role in research activities. By adopting the independent investor test, the Tax Court has signaled that it will defer to appellate precedent even when the IRS resists, reinforcing its role as an arbiter of tax policy in the post-Loper Bright era. The decision also underscores the importance of structuring compensation arrangements with an eye toward third-party validation. Taxpayers who can demonstrate that their salaries align with what an independent investor would approve—through profitability metrics, industry comparables, and risk-adjusted returns—now have a powerful tool to defend against IRS challenges. For firms in sectors like architecture, engineering, and technology, where owner-employees often drive innovation, this ruling provides clarity and a roadmap for future § 174(e) compliance.

Partial Victory: What This Means for Architectural Firms and Beyond

The Tax Court’s ruling in AS+GG v. Commissioner delivers a partial but consequential victory for architectural firms and other professional service providers claiming research credits under Section 41. While the IRS sought to fully disallow the credits for all six projects at issue, the court allowed pro-rated research credits for four of the six—Atrium City Tower, Masdar HQ, Atrium City Masterplan, and Plot R2—on the grounds that AS+GG retained substantial rights under Treasury Regulation § 1.41-4A(d)(3). This decision rejects the IRS’s sweeping interpretation of the funded research exclusion while clarifying the contours of contractual risk allocation and intellectual property rights in client-driven projects.

The court’s ruling hinges on the funded research exclusion under Section 41(d)(4)(H), which denies credits for research funded by a third party unless the taxpayer retains substantial rights to the results. The IRS argued that all six projects were funded because AS+GG’s contracts with clients did not shift economic risk to the firm—payments were not contingent on the success of the research. The court disagreed, finding that while the contracts did not place economic risk on AS+GG, the firm retained substantial rights to the research results in four of the six projects. This distinction is critical: the funded research exclusion applies only when a taxpayer lacks both economic risk and substantial rights. By allowing partial credits where substantial rights were retained, the court reaffirmed that the exclusion is not a blanket bar but a targeted tool for assessing contractual arrangements.

The decision also rejects both parties’ extreme positions on the implications of Loper Bright Enterprises v. Raimondo, the Supreme Court’s 2024 decision overturning Chevron deference. The IRS had argued that Loper Bright weakened Treasury’s authority to issue binding regulations under Section 41, while AS+GG contended that the decision invalidated the funded research regulations entirely. The court sided with neither, instead applying a textualist interpretation of Section 41(d)(4)(H) and Treasury Regulation § 1.41-4A(d). This ruling provides clarity for future cases: the funded research exclusion remains valid, but its application turns on the specific facts of each contract, not judicial deference to agency interpretations.

For architectural firms, the decision underscores the importance of contractual drafting in preserving research credits. The court’s analysis highlights three key factors that future taxpayers should prioritize:

1. Retention of substantial rights: Firms must ensure contracts explicitly grant them ownership or licensing rights to research results, even if payment is fixed or contingent on deliverables rather than success.
2. Payment contingency: While the court did not require economic risk to qualify for credits, it distinguished between contracts where payment was tied to success (which may preserve credits) and those where it was not (which may trigger the funded research exclusion).
3. Documentation of intellectual property: Firms should memorialize in contracts how research results will be used, licensed, or commercialized to demonstrate retained rights.

The court’s application of the independent investor test to Section 174(e)—reasonable compensation—further signals a shift in how courts may evaluate owner-employee salaries in research-intensive industries. By upholding the reasonableness of AS+GG’s compensation arrangements, the court reinforced that salaries aligned with third-party validation (e.g., industry comparables, profitability metrics) can withstand IRS scrutiny. This ruling provides a roadmap for firms in architecture, engineering, and technology, where owner-employees often drive innovation but face heightened IRS scrutiny under Section 174(e).

The broader implications are significant. For architectural firms, the decision validates partial credit claims for client-driven projects where substantial rights are retained, even if payments are not performance-based. It also signals that the IRS’s aggressive stance on funded research exclusions may face judicial pushback unless contracts are structured to avoid the exclusion’s reach. However, the court’s refusal to quantify the partial credits leaves open questions for future disputes, particularly for the 42 remaining projects not addressed in this opinion. Taxpayers should anticipate further litigation or IRS guidance on how to allocate credits across multiple projects under Treasury Regulation § 1.41-4A(d)(3).

Looking ahead, the Tax Court’s ruling may embolden firms to challenge IRS disallowances of research credits in audits, particularly where contracts are ambiguous or the agency overreaches in applying the funded research exclusion. Yet the decision also serves as a caution: the line between funded and unfunded research remains thin, and firms must tread carefully in drafting contracts to preserve credits. With the IRS likely to double down on audits of Section 41 claims—especially in industries like architecture where research is often client-funded—the need for precise contractual language and robust documentation has never been greater. The stage is set for further disputes, and the IRS’s next move may well be to issue clarifying guidance on the funded research exclusion’s application in professional service contracts.