Most companies developing products under customer contracts assume they cannot claim Section 41 research credits. If someone else is paying for the work, the reasoning goes, the research is funded and funded research is excluded from the credit. That assumption, applied without analysis, costs companies credits they legitimately earned.
In early 2025, the Tax Court denied the IRS’s motion for partial summary judgment in System Technologies, Inc. v. Commissioner. The court found that System Technologies’s research was not funded. Payment under its customer contracts was contingent on successful delivery, meaning the company bore the financial risk of failed research and was entitled to claim the credit.
The case carries a direct message for any manufacturer or specialty contractor developing custom products under customer agreements.
System Technologies engineers and manufactures industrial finishing systems for the automotive industry, including pre-treatment solutions, ultraviolet curing systems, and robotic paint application systems. These are custom-engineered products developed through genuine design experimentation.
For tax year 2016, the company filed amended returns claiming Section 41 credits of $99,304 across six development projects. Each project began with a customer proposal incorporating terms and conditions and a choice of law provision specifying Indiana law as controlling.
The IRS disallowed the credits in full and moved for partial summary judgment on one ground: the research was funded under Section 41(d)(4)(H) and therefore ineligible regardless of whether it otherwise qualified.
Section 41 excludes research that is funded by another party. In practical terms, the rule turns on payment structure:
The IRS argued that System Technologies’s purchase agreements contained no express language conditioning payment on successful completion. The warranty provisions limited remedies to repair or replacement of defective parts.
Because the contracts did not explicitly address failure to deliver a completed product, the IRS contended customers had no right to recover payments and the company therefore bore no financial risk.
The Tax Court’s analysis turned on the choice of law provisions in every proposal. Those provisions made Indiana law controlling, so the court examined what remedies existed under state law if delivery failed.
Indiana’s Uniform Commercial Code allows buyers to recover payments made when a seller fails to deliver. That statutory remedy exists even when contracts contain warranty limitations.
Indiana courts do not allow remedy limitations to eliminate all buyer recourse in the event of total breach. Where a limited remedy fails its essential purpose, statutory remedies become available.
If System Technologies failed to deliver a functioning product, repair or replacement would not be sufficient. Customers could recover payments. That created contingency and therefore financial risk.
The court’s reasoning followed a clear sequence:
The decision reflects a broader principle. Funded research is interpreted economically rather than literally. Contract wording informs the analysis, but it does not end it.
The IRS also argued delivery failure was unrealistic. The court declined to accept that argument at summary judgment and noted that it relates to whether research is qualified, not whether it is funded.
System Technologies did not prevail because its contracts referenced Section 41. It prevailed because the court evaluated economic risk allocation using governing law.
What makes this decision significant is not the specific contract language. It is the analytical approach. Funded research is an economic question before it is a drafting question. Many claims are excluded because contracts do not explicitly reference contingency, even when governing law already places real financial risk on the taxpayer. System Technologies reinforces that funded analysis evaluates how risk operates in practice, not whether contingency language appears on the page.
For manufacturers and specialty contractors, the case reinforces several boundaries:
Eligibility for contract-based claims depends on evaluating agreements before documentation begins. The governing law, remedy structure, and economic risk allocation determine whether a position is defensible.
National Tax Group evaluates eligibility through contract review, choice of law analysis, and assessment of financial risk structure before a claim is filed. This establishes whether the funded research exclusion applies.
Once eligibility is confirmed, TaxDrone.AI provides the documentation infrastructure that supports the claim:
NTG determines whether the position holds. TaxDrone.AI preserves the evidence that explains why.
Funded status is not determined by who pays. It is determined by who bears failure risk. When contract structure, governing law, and commercial reality place the cost of failure on the taxpayer, the research may remain eligible even when agreements are silent.
Evaluating how risk operates in your contracts before filing is therefore not procedural diligence. It is eligibility analysis.
Evaluate your contract structure and documentation readiness before filing. That analysis is most effective while remediation is still possible.
