Technical Risk v. Economic Risk

With the IRS placing more scrutiny on the R&D Tax Credit, it is important to be aware of common myths of the credit as well as areas of exposure when building a claim. To dispel some of these misconceptions and provide clear guidance for CPA firms and businesses that may qualify for the R&D Credit, read this week’s blog exploring Technical Risk versus Economic Risk and the application of these concepts when preparing an R&D Credit Claim.

For a successful R&D Credit claim, a taxpayer must demonstrate that it bears two types of risk for each qualified project. First is the technical risk of developing an appropriate solution for the project and second is the economic risk of successfully delivering a completed solution. Understanding the substance of each concept and the correct application when reviewing potentially qualified research projects is essential to proper claim preparation.

Technical risk relates to the vulnerability of successfully completing a project as prescribed by internal goals or customer specifications. This assessment is directly linked to the “Technical Uncertainty” test of the four-part test defined in Section 41 to qualify R&D projects. The business must establish that it has the design or engineering responsibilities for a project and that there are technical challenges to be resolved. Even if a company and its employees are confident in their expertise and capability of successfully completing a project, if there is risk associated with the potential failure of the technical solution(s) developed that satisfies the technical risk assessment.

In addition to technical risk, the business must also bear the economic risk of the project. This requirement is related to the Funded Research Exclusion as set forth in Sec. 41(d)(4)(H). In order to pass the economic risk assessment, a business needs to be “on the hook” for successfully completing the project or as specified in Reg. 1.41-4A(d)(1): “payment must be contingent upon success”. When reviewing a contract of a client-driven project, the payment structure should generally be fixed-fee, lump-sum, or otherwise structured in a way that the business incurs the costs to resolve any failure to demonstrate the taxpayer is bearing the economic risk. The logic being that the taxpayer must be at risk of going over budget and is not obligated to receive additional compensation for any extra time and effort required to develop a successful solution.

This falls in line with tax court decisions such as Fairchild Industries, and more recently Populous Holdings, that reinforce fixed-fee contracts generally meeting the requirements of the funded research exclusion. If a project is internally generated or otherwise not associated with a particular client contract, then the business is almost certainly bearing the economic risk of the project as it is not receiving direct compensation for conducting the research activities. It is also important to note that the risk of failure or going over budget is the requirement and not that a project must fail or go over budget to qualify.

When preparing a R&D Tax Credit claim, it is imperative that each potential qualifying project or business component is thoroughly evaluated via the four-part test and all applicable exclusions. By conducting an initial assessment to determine which projects ostensibly bear both technical and economic risk, R&D Credit claim preparers and business owners can quickly eliminate many projects that likely do not qualify. While not a full encompassing test to determine the validity of a project’s qualifications, understanding the concepts and application of technical risk and economic risk assessments is foundational to building a defensible R&D Credit claim.

If you have any questions about the R&D Tax Credit qualifications or McGuire Sponsel’s approach to R&D claims, do not hesitate to reach out.