Vague contractual language puts lucrative R&D credits at risk. Find out how to protect your claims to federal research credits.
By Mark Dunning
The federal research & development (R&D) credit is an income tax credit used to reward innovation and research in the United States. The federal tax credit is not a deduction; it is a dollar-for-dollar credit against tax liabilities for qualified wages, supplies, or outside contractor expenses. Many states have R&D credits available as well, but rules and requirements vary and need to be considered separately.
There are rules to qualifying an expense for R&D credits, including a four-part test and nexus requirements. Funded research, the focus of this article, adds another layer of analysis to determine who has the rightful claim to these lucrative credits.
Funding limitations under Section 41 restrict research credit benefits to taxpayers who bear the financial risk and retain the rights, although not exclusive–to the research. Whoever retains BOTH the financial risk and substantial rights to the research is eligible for the credit.
A company that makes a product and pays wages related to the development of that project generally has clear claim to research credits. It is when research is funded by others, “either by grant, contract, or otherwise” (Section 41(d)(4)(H)), where eligibility to claim the credit comes into question.
Funded research is often contractually assigned between a taxpayer and a third-party performing research such as a laboratory, university, or commercial enterprise. When an agreement between a taxpayer and a research firm is vague, incomplete, or there is no contract, it can be unclear who bears the risk and holds the rights to the intellectual property derived from the research. This uncertainty puts credit eligibility into question and could lead both companies to erroneously claim the same qualifying dollar when only one is eligible or possibly invalidate either taxpayer’s claim.
The taxpayer who bears the cost of failed research is the one who bears the financial risk. This funding issue was settled by the United States Court of Appeals for the Federal Circuit in Fairchild Industries v. United States, 71 F.3d 868 (1995).
In this case, the court interpreted the rules under Section 41 to provide that when retention payments to a researcher are contingent on performance, the researcher bears the risk; if the research were to fail, the researcher wouldn’t be entitled to payment. The court found that research costs are not funded when a contractor/researcher taxpayer (Fairchild) bears the risk, thereby qualifying Fairchild’s own qualifying wages for the R&D credit, while Fairchild’s revenue was generated being a contractor to the Air Force.
This determination is made based on an examination of agreements between the parties and contract law governing those agreements.
A taxpayer that obtains a patent has the exclusive right to use such intellectual property as it deems fit. Exclusive rights are not required to generate the R&D credit; however, a taxpayer must hold the substantial rights to the research to be “qualified” for R&D credits. Court precedent on this issue was set in Lockheed Martin v. United States, 210 F.3d 1366 (2000). Lockheed Martin performed research for the government, who was given unlimited right to use the data. The government also retained certain rights to use the development.
The Federal Court of Appeals ruled in favor of Lockheed Martin, holding that as long as exclusive rights are not vested in another person, the taxpayer may retain substantial rights to the research, thereby setting a standard for determining rights for research performed under contract.
Taxpayers can share substantial rights just as they can share in the use of research results in trade or business. Taxpayers that, however, pay a royalty to secure a license to use the research results do not retain substantial rights in the research. Absent substantial right, expenses are disqualified from research credits.
A funding analysis can shed light on which taxpayer holds risk and substantial right to the research and a rightful claim to the qualified research expenses (QREs) that are the basis of any R&D claim. Both risk and rights need to be evaluated based on the funding scenario, for example:
- If a taxpayer performing research for another unrelated entity retains no substantial rights in the research under contract, the research to the taxpayer is treated as fully funded and expenses paid or incurred by the taxpayer in performing the research are not eligible for the research credit.
- If a taxpayer under contract commits to making payment “contingent on the success of the research”, the taxpayer has passed the risk on to the contractor and is not eligible for research credits. The contractor, however, may be qualified for R&D credit for those research expenses themselves.
- If a taxpayer pays for the research to be performed by a contractor regardless of the success of the project, then the taxpayer bears the risk of failure. If a taxpayer also has at least substantial rights to the research, the taxpayer’s qualified research expenses are eligible for a research credit.
Follow the money
As with most economic issues, follow the money to assess qualified expenses where grants, contracts or third-party agreements are present. Expenses that underwrite risk and rights to a research project are eligible for research credits. Expenses paid for a finished product are not.
In assessing qualified expenses, keep these practitioner points in mind:
- A taxpayer must have rights and risk in research expenses. While rights can be either exclusive or shared, the taxpayer must also bear the risk of research failures to be eligible for the credit.
- A taxpayer may be eligible for an R&D credit when research expenses and experimentation are contracted out under the taxpayer’s order and at the taxpayer’s own risk (i.e. qualified research “performed on behalf of the taxpayer”). Expenses do not qualify for the credit when a research agreement is contingent upon the success of the research. In this case, the expense is payment for the project result and not for the performance of the research itself.
- Grants do not make a project entirely ineligible for R&D credits. A taxpayer can include the project expenses in a research claim if the grant funding amount is appropriately excluded from the research expenses. This can be crucial to some taxpayers as many governmental grants rarely completely cover the investment of the research project.
Funded research can be a complicated area, with traps for the unwary. Protect your right to lucrative R&D credits with clear and concise contractual language instead of giving away R&D credit to another.
INFORMATION FOR EDUCATIONAL PURPOSES ONLY. SEEK PROFESSIONAL TAX ADVICE BEFORE ACTING.
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Mark Dunning, managing partner at TaxOps Minimization, and his team implement tax saving strategies for dynamic companies.
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