R&D Tax Credits & Government Contractors: Discerning IP & Financial Risk
Government contractors play a key role in advancing research and development (R&D) across the aerospace, defense, technology, and healthcare industries. While the R&D Tax Credit is a valuable tax incentive for companies investing in research and development, contractors performing government-funded research face unique eligibility challenges. The structure of government contracts, ownership of intellectual property (IP), and who bears the project’s financial risk all impact the ability to claim this credit.
How Funded Research Affects Eligibility
The primary challenges with government contracts are due to the differences between “qualified” and “non-qualified” research. These differences are based on IP ownership and financial risk allocation. Contractors must have both “substantial rights” to the research and financial risk to include associated expenses in the R&D Tax Credit.
- Non-qualified Research: Research is typically non-qualified when the funding agency retains control over the IP and/or assumes the financial risk. When a contractor is reimbursed regardless of the success of the research, they don’t bear financial risk. As a result, related expenses don’t qualify for the R&D Tax Credit.
- Qualified Research: Research may be eligible if the contractor retains “substantial rights” to the research outcomes and bears the financial risk. For instance, if the contract specifies that payments are contingent on research success and the contractor can exploit the IP generated, these factors can contribute to R&D credit eligibility.
Examples of Government Contracts
Government contracts differ in terms, and each contract type affects credit eligibility differently. The following are the most common contract types:
- Cost-reimbursable Contracts: Under these contracts, the government reimburses all allowable costs associated with the R&D, with the contractor guaranteed payment. This structure makes the contractor ineligible for the R&D credit for related expenses because the government bears the financial risk of the research.
- Fixed-price Contracts: In these agreements, contractors assume financial risk by committing to complete the research for a set amount. If costs exceed this amount, the contractor absorbs the loss, which may allow them to claim the R&D credit. These contracts are favorable for R&D credit eligibility since they demonstrate the contractor’s financial risk.
- Milestone-based Contracts: Payments in milestone-based contracts are contingent upon the completion of specified phases or goals. Because the contractor may not be paid if milestones aren’t achieved, this structure may meet the financial risk requirement, making the R&D expenses potentially eligible.
Intellectual Property Considerations
A critical eligibility requirement for government contractors seeking the R&D credit is the ownership of IP developed through the contract. The IRS requires that the taxpayer maintain “substantial rights” to the research, meaning that if the government retains exclusive rights to the IP being developed, the contractor is ineligible for the credit for the related expenses.
In many cases, contractors retain non-exclusive rights to IP, allowing them to commercialize the technology outside the government. For example, a contractor developing software under a government contract may be able to use the software in commercial applications if they retain non-exclusive rights. This scenario often supports R&D Tax Credit eligibility.
Steps for Government Contractors to Maximize the R&D Tax Credit
- Review Contract Terms: Government contractors should closely examine contract terms, especially those related to IP rights and payment structures. Securing substantial rights and agreeing to performance-based payments increases the potential for eligibility.
- Document Activities & Costs: Detailed documentation of qualified research activities, expenses, and contractual evidence of the financial risk strengthens the case for credit eligibility.
- Seek Expertise: Government contracts are complex, and navigating tax credit regulations requires specialized knowledge. Consulting with tax advisors familiar with government contracting and the R&D Tax Credit can help optimize eligibility.
The R&D Tax Credit offers significant incentives for companies undertaking research and development, yet government contractors must carefully navigate contract terms and IP stipulations to qualify. Understanding the nuances of funded research in government contracts is essential for maximizing tax benefits. By securing substantial rights, structuring contracts to assume financial risk, and consulting with knowledgeable advisors, government contractors can leverage the R&D tax credit while advancing critical innovations.
If you have any questions about the R&D Tax Credit, government contractor eligibility, or McGuire Sponsel’s approach to R&D Tax Credit claims, please do not hesitate to reach out.
Garrett Duffy is a Relationship Manager specializing in R&D Tax Credits and in the Northeast markets. He focuses on leading projects across multiple clients and industries, leading the proposal process for potential new clients, and mentoring new employees.
Garrett combines his chemical engineering background and R&D tax credit expertise to provide a tailored approach to each client engagement.
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