Government contracting has a very specific issue we have to address with regards to how research is funded, and it’s an added level of due diligence for anyone who has government contracting as a business component.
However, we’ve seen this due diligence missed in government contracting tax compliance, and it creates serious risks with claiming the R&D Tax Credit and potential IRS examination down the road.
Challenges Regarding Funded Contracts
The topic of Funded Research stems from this portion of the revenue code:
IRC section 41(d)(4)(H) provides that qualified research excludes “[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).” Research is considered to be funded if either of the following two circumstances are met as set forth in Reg. Sec. 1.41-4A(d):
But what does it truly mean for the research to be “funded by” another person? Courts have held that the issue can be broken down into two components – Risk and Rights.
Risk – In order for research to be considered unfunded and therefore eligible for the research credit, the taxpayer must bear the financial risk of failure. Payment from the customer must be contingent on successful research.
If a contract stipulates that the taxpayer is required to succeed or return the funds, or incur additional costs beyond what the client is paying, the taxpayer is at financial risk. The research process typically begins in the pre-award (or bid and proposal) phase. As pre-award work is typically self-funded, research expenses associated with these efforts may qualify towards the research credit. Along the same lines, internal R&D (IR&D) efforts may also qualify. Contract types generally excluded from the research credit are:
- Cost plus
- Cost reimbursable
- Time and materials
- Hourly
- Cost plus fixed fee
Rights – The other component of determining whether or not research is funded is Rights. The taxpayer must retain substantial rights to the results of the research and be able to use them in future business in order for the research to be considered unfunded, and therefore eligible for the R&D credit.
If your tax advisor is unfamiliar with the R&D Tax Credit as it applies to research funded by government agencies and the world of government contracting, it is important to address the due diligence of assessing whether certain R&D expenses qualify for the credit and who retains the rights to use them. If you have any questions about your specific contract terms and eligible expenses, contact Jeremy Mosteller, CPA, CGMA or Christopher Cook, CPA, to assist you.
You may also be interested in our blog post about incurred cost submissions.