R&D Tax Credits for Government Contractors: Understanding the Funded Research Rules
Businesses that perform research and development under government or commercial contracts often assume that receiving payments from a customer automatically prevents them from claiming the R&D tax credit. That assumption can be costly.
The federal R&D tax credit is intended to encourage businesses to invest in qualified research activities. However, Section 41 contains specific rules concerning research that is considered “funded.” Understanding these rules is particularly important for government contractors, aerospace companies, defense manufacturers, engineering firms, software developers, and other businesses performing technical work for customers.
The Fairchild Industries case provides an important foundation for understanding how financial risk, contract terms, payment conditions, and rights in research can affect whether contract research qualifies for the R&D tax credit.
For a detailed explanation of the case, see Funded Research vs. R&D Tax Credits: The Fairchild Case Explained.
What Is Funded Research?
Under the federal R&D tax credit rules, certain research expenses may be excluded when the research is considered funded by another party. The basic concept is that the tax incentive is intended to reward taxpayers that bear the economic risk associated with conducting qualified research.
This creates an important distinction for companies working under contracts.
A company may receive payments from a customer while still bearing meaningful financial risk if the customer does not ultimately have to pay for unsuccessful work or if the contractor must repay certain amounts when contractual requirements are not satisfied.
Therefore, the existence of customer payments alone does not necessarily answer the question of whether research is funded.
The specific terms of the contract and the economic relationship between the parties need to be examined.
The Fairchild Industries Case
The Fairchild case involved an aerospace company performing work for the U.S. Air Force under a fixed-price incentive contract relating to the development and construction of the T-46A aircraft.
The IRS challenged Fairchild's treatment of certain research expenses and argued that a portion of the research was funded because the government had provided progress payments during the project.
The dispute ultimately reached the U.S. Court of Appeals for the Federal Circuit. The court examined the structure of the contract and the financial risk Fairchild actually faced during the research and development process. The court concluded that the lower court had interpreted the funded-research provisions incorrectly.
The case became important because it demonstrated that simply receiving payments from a customer does not automatically mean that the underlying research is “funded” for purposes of the R&D credit.
Financial Risk Is a Critical Consideration
One of the most important lessons from Fairchild is the role of financial risk.
When evaluating whether research is funded, businesses should examine who bears the risk if the research does not produce an acceptable result.
For example, suppose a contractor agrees to develop a new technical system under a fixed-price contract. The customer may make progress payments during development, but the contractor could still face significant financial exposure if the final product fails contractual acceptance requirements.
In that situation, the contractor may have substantial economic risk associated with the research.
This is different from an arrangement where a customer is obligated to reimburse the contractor for research expenses regardless of the outcome.
The difference can be significant when determining whether research expenses are eligible for the federal R&D tax credit.
Why Contract Language Matters
Companies performing contract research should never overlook the importance of their agreements.
A contract can contain provisions that help demonstrate who bears financial risk, who owns or can use the resulting research, what happens when a project fails, and whether payments are contingent on successful performance.
These provisions can become important evidence when an R&D tax credit claim is reviewed.
Government contractors should therefore preserve complete copies of contracts, amendments, statements of work, technical specifications, acceptance requirements, change orders, and related correspondence.
These documents can provide valuable support for an R&D tax credit study because they help establish the commercial and financial circumstances surrounding the research.
Progress Payments Do Not Automatically Eliminate R&D Credit Eligibility
Another important lesson from Fairchild is that progress payments should not automatically be treated as proof that research is funded.
Government and commercial contracts frequently involve milestone payments, advance payments, progress payments, or other forms of periodic compensation.
The existence of these payments does not necessarily establish that the customer bears all of the economic risk.
Instead, businesses should evaluate the entire contractual arrangement.
Questions may include whether the contractor must satisfy acceptance requirements, whether payments can be withheld, whether amounts must be repaid, whether the contractor absorbs cost overruns, and what happens when research does not produce the expected result.
A detailed contract review can therefore be essential before excluding potentially qualifying research expenses.
Retained Rights Can Also Matter
Financial risk is not the only consideration in a funded research analysis.
The rights that a contractor retains in the research can also be relevant. Businesses should examine whether they retain meaningful rights to use the technology, processes, designs, methods, or other research results they develop.
This issue is particularly important for engineering, aerospace, defense, software, and manufacturing companies that perform research for customers.
A contract that transfers or restricts rights may create a different tax analysis from one that allows the contractor to retain substantial rights to the underlying research.
For this reason, R&D tax credit compliance should include a review of relevant intellectual property and contractual provisions rather than focusing only on payroll and expense calculations.
Government Contractors Should Review Each Contract Separately
Businesses sometimes make the mistake of applying the same R&D tax credit conclusion to every customer contract.
That can create unnecessary risk.
Two contracts may involve similar technical work but contain completely different payment terms, acceptance requirements, financial-risk provisions, and intellectual-property clauses.
One project may create substantial financial risk for the contractor, while another may provide guaranteed reimbursement regardless of the research outcome.
Therefore, the funded-research analysis should be performed at the appropriate contract and project level.
This contract-by-contract approach can help businesses identify potentially qualifying research that might otherwise be incorrectly excluded.
Documentation Is Essential for an Audit-Ready R&D Claim
A strong R&D tax credit claim should be supported by more than a final calculation.
Businesses should maintain documentation showing what research was performed, which employees participated, what technical uncertainties existed, how experimentation was conducted, and how qualified research expenses were determined.
For contract research, the supporting documentation should also demonstrate the contractual relationship between the parties.
Contracts, project records, engineering documentation, testing results, employee records, invoices, payment information, and project communications can all contribute to a more complete record.
The purpose is to create a clear connection between the research activity, the financial risk, the contract terms, and the expenses included in the credit calculation.
Avoid Automatically Excluding Contract Research
Because of the complexity surrounding funded research, some businesses may take an overly conservative approach and exclude all contract-related research from their R&D tax credit calculations.
That can result in missed tax opportunities.
A company that performs qualified research under a government or commercial contract should evaluate the actual terms of the arrangement before deciding that the research is ineligible.
The Fairchild decision demonstrates why the analysis should focus on the substance of the contractual relationship rather than simply asking whether another party provided payments.
A careful review may reveal that the contractor retained meaningful financial risk and therefore may have a stronger basis for claiming the credit.
How Businesses Can Strengthen Their R&D Tax Credit Strategy
The best approach is to evaluate potential R&D activities and contract arrangements before the tax return is prepared.
Technical teams can identify the research activities and uncertainties involved, while finance teams can track wages and other potentially qualified expenses. Legal or contract teams can review payment terms, acceptance requirements, intellectual-property provisions, and financial-risk clauses.
Bringing these perspectives together can produce a more complete R&D tax credit analysis.
Technology can also make the process more efficient by organizing project information and supporting documentation in a centralized system.
The objective should be to identify the maximum defensible credit while maintaining records that explain exactly why the claimed activities and expenses qualify.
Final Thoughts
The Fairchild Industries case remains an important lesson for companies performing research under government and commercial contracts.
The fact that a business receives payments from a customer does not automatically mean that its research is funded for purposes of the R&D tax credit. The more important questions involve who bears the financial risk, what the contract requires, what happens if the research fails, and what rights the contractor retains in the research.
For government contractors, aerospace companies, defense businesses, engineering firms, manufacturers, and technology companies, these issues can have a significant impact on the availability of valuable R&D tax incentives.
Businesses should therefore review contracts carefully, maintain strong documentation, and evaluate each research arrangement based on its actual terms.
A well-prepared R&D tax credit study should tell a consistent story: what the company researched, why the research involved technical uncertainty, how the company experimented to resolve that uncertainty, what expenses were incurred, and why the contractor—not simply the customer—bore the relevant economic risk.
