Contracts matter to the IRS, so it is important to take a closer look at funded research and what it means to the Research and Development Tax Credit. Research expenses are considered funded if they are compensated by grants, contracts, persons or government entities. To be eligible for the R&D tax credit, the research can’t be funded by a third party unless it meets the two-part test set out by Treasury regulations.
The Treasury Regulation Section 1.41-4A(d) outlines two requirements for determining whether research is funded and whether it will qualify for the R&D Tax Credit. The regulation states that if payments are received from others, the activities qualify only if:
- The researcher bears the financial risk for their research in the project
- The researcher retains substantial rights in the research project
Bears the Financial Risk
A researcher bears the financial risk for the research if payment is contingent on the success of the research. Payment is considered to be contingent on the success of the research if the payment is for the product to be created or result to be provided as a result of the research. The idea is that if the research were to fail, the researcher wouldn’t be able to deliver the product or result and, therefore, it wouldn’t be entitled to payment.
Retain Substantial Rights
Research is treated as fully funded if the taxpayer enters into an agreement to perform research and pursuant to the agreement doesn’t retain “substantial rights in the research”. The right to use the product of the research in the taxpayer’s trade or business without paying licensing fees or royalties has been determined to be a substantial right. Researcher retains substantial rights if it retains the know-how of the research.