Government Contractors & the R&D Tax Credit: What CPAs Should Look Out For

Government contractors face unique challenges when evaluating opportunities for the Section 41 R&D Tax Credit. A contractor may be developing novel products, improving manufacturing processes, modernizing federal IT systems, or solving agency-defined technical needs. Still, qualification depends on more than the fact that the customer is the government. CPAs must evaluate the contract language, fee structure, research rights, and whether the activities satisfy the requirements of the four-part test outlined in Section 41.

Contractors that bear technical or financial risk, retain rights to research results, or perform experimentation needed to deliver a product or solution are prime candidates for the credit. McGuire Sponsel’s years of experience across a wide array of industries can help CPAs evaluate the credit opportunities available to their clients that are performing work under contract for the U.S. government.

Why Government Contracts Can Still Qualify

Government contractors take on many types of projects, varying widely in scope, sector, and structure. People often assume these projects can’t qualify for the Section 41 R&D Tax Credit because the government funds the research. However, depending on the language in prime contracts, funding agreements, statements of work, and other key documents, these projects can meet both the “financial risk test” and the “research rights test.”

The key to successfully identifying a qualifying credit opportunity for a government contractor is detailed review of these documents. Qualifying projects can exist across a variety of contractor types, including providers of physical products, providers of services, and SBIR/STTR researchers.

Common Qualifying Activities for Government Contractors

When evaluating opportunities for government contractors, CPAs must first identify what type of contractor their client is. Some of the key activity types that can qualify for the Section 41 R&D Credit include:

• Designing/manufacturing novel products with government applications
• Build-to-print manufacturing services of government designs
• Designing/manufacturing a solution to a specific government specification
• Developing software/modernizations for government use
• SBIR/STTR research activities

Identifying QREs Across Government Contractor Projects

Government contractors can see Qualified Research Expenses (QREs) in all four categories eligible for the credit: wages, supplies, computer leasing, and contract research. Employees of the company contribute wage QREs to the R&D Credit calculation by spending time performing qualified activities, including engineering, design, and prototype development.

Physical materials used to reach a finished product, such as prototypes, scrap, and models for destructive testing, can be eligible for inclusion in QREs as supplies. When developing software for government applications or embedded use in physical products, computer leasing expenses may exist as cloud computing costs associated with a dev environment.

Amounts paid to eligible subcontractors performing research on behalf of the company may also be QREs if the proper tests are met. CPAs need to evaluate all potential sources of qualified expenses to maximize the benefit for their clients.

Don’t Assume Government Work Is Off the Table

CPAs should not assume that work performed for the government is automatically excluded from the Section 41 R&D Tax Credit. McGuire Sponsel can help identify meaningful opportunities by reviewing contract language, financial risk, research rights, qualifying activities, and the full range of potential QREs, including wages, supplies, computer leasing, and contract research. A detailed project-by-project review is essential to determine whether the client’s government work supports a defensible credit position.

McGuire Sponsel’s R&D tax credit team specializes in government contractor studies and works directly with CPA firms to identify, document, and defend qualifying expenses. To discuss whether your client may qualify, contact us today.

Frequently Asked Questions

1. What is a government contractor?

Someone performing services for the U.S. government, where funding comes from the government.

2. What types of costs are eligible?

Wages, supplies, cloud computing, and contract research costs associated with research and development on qualified projects.

3. What steps can identify a potentially qualified contractor?

Detailed contract review and discussions with technical personnel can determine if the R&D credit is worth pursuing.

4. Does the government always retain sole rights to the research?

While the government usually retains rights to the research, it often shares those rights with the contractor, which can allow the contractor to claim the R&D credit for those projects.

5. Can projects funded by SBIR/STTR grants be eligible?

Potentially, depending on the funding schedule and nature of the project.

6. Do I have to prepare additional supporting documentation to claim a credit on a project?

Usually, existing project files combined with employee testimonials are sufficient to support an R&D credit claim.

7. Our contracts specify that the government is the sole owner of the work product. Can we still qualify?

Potentially, if the contract language allows for shared rights to the research IP.

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