Adrian D. Smith and Nancy W. Smith, et al. v. Commissioner, T.C. Memo. 2026-50 (June 16, 2026)

During the 2008, 2009, and 2010 tax years, Adrian Smith, Carlisle Gill, and Robert Forest were the sole partners of Adrian Smith + Gordon Gill Architecture, LLP (AS+GG), an Illinois limited liability partnership. AS+GG is a highly regarded architecture firm that specializes in designing large-scale, highly innovative, and sustainable "supertall" buildings, including the world's tallest structures. The firm's design process is notoriously complex, utilizing a holistic approach that integrates architecture, structure, and mechanical engineering from the project's inception, requiring significant research into thermodynamics, geotechnics, fluid dynamics, and microclimates.

AS+GG claimed substantial research credits under I.R.C. § 41 for activities related to multiple international architectural projects. These credits flowed through to the partners, who claimed them on their joint personal income tax returns. Additionally, for the 2008 tax year, AS+GG claimed wage-related qualified research expenditures (QREs) for the partners and deducted significant guaranteed payments and gross salaries.

Taxpayers' Request for Relief

The Internal Revenue Service (IRS) audited the partners' returns and disallowed the section 41 research credits for the tax years at issue, subsequently issuing Statutory Notices of Deficiency. The taxpayers petitioned the United States Tax Court for relief. Prior to trial, the parties agreed to limit the scope of the disputed credits to a sample of six massive international projects (including the Atrium City Tower and Kingdom Tower).

Following several pretrial concessions by the IRS—including an agreement that AS+GG's activities generally satisfied the four-part test for qualified research under section 41(d)—only two primary issues remained for the Court to decide: (1) whether the architectural research performed under the six sample contracts constituted excluded "funded research" within the meaning of section 41(d)(4)(H), and (2) whether the 2008 compensation paid to the partners was reasonable under section 174(e).

Court's Analysis of the Law: The Funded Research Exclusion and Loper Bright

Under I.R.C. § 41(d)(4)(H), qualified research excludes "[a]ny research to the extent funded by any grant, contract, or otherwise by another person." Because the statute does not define the term "funded," the Court turned to Treas. Reg. § 1.41-4A(d), which outlines a two-pronged inquiry. Research is considered funded unless: (1) payment to the taxpayer is "contingent on the success of the research" (meaning the taxpayer bears the financial risk of failure), and (2) the taxpayer retains "substantial rights" in the research results.

The taxpayers mounted a robust administrative law challenge, arguing that under the Supreme Court’s recent landmark decision in Loper Bright Enters. v. Raimondo, Treas. Reg. § 1.41-4A(d) should be invalidated because it is no longer the "single best reading" of the statute. The taxpayers urged the Court to adopt a plain dictionary definition of "funded" as "a sum of money set apart for a specific objective".

Judge Weiler swiftly rejected the taxpayers' Loper Bright argument, relying heavily on the doctrine of statutory stare decisis. Quoting the Supreme Court's own limiting language in Loper Bright, the Court noted: "The holdings of those cases that specific agency actions are lawful . . . are still subject to statutory stare decisis despite our change in interpretive methodology". The Court emphasized that numerous federal appellate courts have previously validated the "contingent on success" and "substantial rights" requirements of the regulation. The Court unequivocally declared, "[W]e find that the holdings in our prior cases and the aforementioned decisions of the Federal Circuit and Federal Claims continue to remain in effect". Finding the regulation offered "clarity and certainty," the Court declined to invalidate Treas. Reg. § 1.41-4A(d).

Application of the Law to the Facts: The Funded Research Exclusion

The Court meticulously analyzed the contracts for the six sample projects to determine if AS+GG bore the financial risk of failure and retained substantial rights.

Regarding the "contingent on success" element, the taxpayers argued that their contracts required client approval at various design phases before payment was released, effectively making payment contingent on the research's success. The Court rejected this, distinguishing the taxpayers' contracts from prior caselaw where contracts contained thousands of pages of rigid, technical specifications that inherently served as a barometer of success. Reviewing the AS+GG contracts, the Court stated, "There is a difference between 'successful performance'—meeting detailed, barometers of success—and 'proper performance'—providing deliverables pursuant to a general professional standard of care and promising work free from negligence, error, or defects". Because the contracts guaranteed payment based on percentage-of-completion or hourly billing rather than technical research success, the financial risk fell on the clients, not AS+GG. The Court also dismissed the argument that termination clauses put the firm at financial risk, quoting prior caselaw: "[T]he loss of an opportunity for profit is not the type of financial risk contemplated in the Treasury regulation".

Turning to the "substantial rights" element, the Court examined whether the contracts conferred exclusive exploitation rights to the clients or required AS+GG to pay for the right to use its own research results. For two of the projects (Kingdom Tower and Plot 14), the contracts vested absolute property rights and copyrights entirely with the clients. The Court ruled that AS+GG failed to retain substantial rights in these projects, noting that needing "to secure permission to use the research, with no conditions limiting the other party's ability to withhold consent, prevents [the taxpayer] from possessing substantial rights".

However, for the remaining four projects (Atrium City Tower, Masdar HQ, Atrium City Masterplan, and Plot R2), AS+GG successfully retained copyrights or negotiated licenses allowing them to market and reuse the underlying research. The Court affirmed that "[t]he right to use the research results, even without the exclusive right, is a substantial right". The Court also soundly rejected the taxpayers' attempts to apply foreign law (such as U.A.E. or U.K. copyright laws) to override express contract provisions, maintaining that "any determination of risk must be made solely on the 'research agreement' between the parties, with no consideration of any external statute not expressly incorporated in that agreement".

Court's Analysis and Application of the Law: Reasonable Compensation

The second primary issue was the deductibility of the partners' 2008 compensation under I.R.C. § 174(e), which allows research and development expenditures only to the extent the amount is "reasonable under the circumstances".

The IRS argued for a traditional "multifactor test," but the Tax Court noted that this case is appealable to the Seventh Circuit. Following the Golsen rule, the Court held it was bound by the Seventh Circuit's precedent in Exacto Spring Corp., which mandates the "independent investor test". Under this framework, a rebuttable presumption of reasonableness arises if an inactive, independent investor would receive a far higher rate of return than reasonably expected.

The Court observed: "The higher the rate of return (adjusted for risk) that a manager can generate, the greater the salary he can command. If the rate of return is extremely high, it will be difficult to prove that the manager is being overpaid . . . it would be killing the goose that lays the golden egg". Because the IRS's own expert conceded that applying the independent investor test resulted in an astronomical 939% return on equity to the partners, the mathematical results undeniably supported the taxpayers.

Conclusions of the Court

The Tax Court concluded that none of the six contracts were "contingent on the success" of the research, meaning the research was entirely funded by the clients under the first prong of the regulatory test. However, because AS+GG did retain substantial rights in four of the six projects, the taxpayers are eligible to claim partial research credits under Treas. Reg. § 1.41-4A(d)(3) to the extent that their qualified research expenses exceeded the payments received.

Furthermore, the Court ruled fully in favor of the taxpayers on the issue of section 174(e) reasonable compensation, concluding that under the Seventh Circuit's independent investor test, the substantial compensation claimed by the partners for 2008 was reasonable. The Court directed the parties to perform a pro rata calculation based on these findings to resolve the remaining unexamined projects in the firm's portfolio.

Prepared with assistance from NotebookLM.