When are U.S. Government Contractors Eligible for the R&D Tax Credit?

November 11, 2022

At a glance

The Main Takeaway: Many government contractors can qualify for the R&D credit, despite common misconceptions around eligibility requirements.
Impact on Your Business: The R&D Tax Credit can provide a lucrative cash benefit to qualifying companies, helping boost profitability and further fund innovation.
Next Steps: Schedule a consultation with Aprio’s R&D Tax Credit specialists to assess your company’s potential eligibility.

The full story:

Many companies often incorrectly assume that any work performed as part of the scope of a government contract is disqualified from the R&D Tax Credit because it is government-funded. In actuality, many of the research and development activities involved through the performance on government contracts can qualify, meaning government contractors could be missing out on a significant cash benefit by not pursuing the credit.

It’s time to set the record straight by dispelling some of these common myths.

Myth 1: Government contractors can’t qualify for the R&D Tax Credit

Let’s bust this myth once and for all: government-funding does not immediately disqualify a company from claiming the R&D credit. In fact, many activities performed under government contract can qualify and be claimed by the contracted company.

While government contractors are held to the same qualifying requirements as any other company claiming the R&D credit, evaluating which activities can be included requires particularly careful attention to two key criteria: financial risk and substantial intellectual rights. However, there are many misconceptions around the meaning and application of these two requirements, so let’s keep myth-busting…

Myth 2: Receiving outside funding means government contractors can’t satisfy the financial risk requirement

Determining who holds the financial risk for R&D credit eligibility in a government contractor relationship is nuanced. Per the IRS, “funded” research is essentially disqualified from the credit; however, this is where much of the misunderstanding occurs, primarily from a difference in vocabulary:

Many stakeholders in the industry generally use the term “funded” to encompass any scenario where the funding comes from an external source.

For R&D Tax Credit purposes, “funded” research holds a more limited definition, as supported by tax statutes, regulations, tax court rulings, and IRS guidance, that provides eligibility for certain contractual financial arrangements.

While there are a variety of contract types, government contracts generally fall into two categories: Fixed (e.g. Firm Fixed Price) and Variable (e.g. T&M, CP, etc.). Variable contracts can be difficult to satisfy the financial risk requirement for the R&D credit due to the contract structure commonly ensuring payment for every hour worked and material purchased. Alternatively, Fixed contracts are typically more aligned with the credit’s financial risk requirements because payment is usually contingent on the success of achieving certain milestones.

Government contractors can potentially satisfy the financial risk requirement if there is contractual risk of not being paid for their efforts. Examples could include contracts with certain clawback provisions which could lead to the withholding of payment if the deliverable does not meet certain contract specifications or require the correction of contractual deviations without further compensation. Careful evaluation of the contracts and documentation is crucial when making this determination.

Myth 3: Government contractors can’t satisfy the substantial intellectual rights requirement because they’re conducting development for a third party

When determining if a government contractor satisfies the substantial rights eligibility requirement for the R&D credit, substantial is the operative word. It’s important to clarify that companies do not need to maintain 100% of the rights to the results of development in order for the activities to qualify for the credit – they only need to meet the threshold of “substantial” rights.

Determining the threshold of “substantial” rights is nuanced but generally confirmed through the absence of any agreement where the contract provides the customer with exclusive rights to the research performed. Again, carefully reviewing the available contracts is critical to determining who holds the substantial rights to development.

Myth 4: Government contractors can’t qualify if they don’t have patents

The R&D credit provides a safe harbor for patented work; however, a patent is by no means required to adequately substantiate whether a company’s activities are eligible for the credit.

Government contractors that meet the R&D credit eligibility criteria, including maintaining financial risk and substantial rights, are entitled to claim the R&D credit without ever filing for a patent.

Myth 5: R&D credits are easy to calculate without the help of a specialized tax credit advisor

Perhaps the most detrimental mistake a company can make with respect to the R&D credit is to assume they can calculate the credit independently without engaging a knowledgeable advisor. Accurately determining eligibility for the credit is only the first hurdle, followed by the tasks of calculating and documenting the credit, all of which require a thorough understanding of tax rules and legislation.

Add in the nuances associated with determining eligibility for government contractors, and it is easy to see how calculating this credit independently is a steep challenge. Rather than risking understating your credit amount and leaving money on the table – or overstating your credit and risking IRS penalties – engage the help of an R&D credit specialist.

Aprio’s R&D Tax Credit Team has deep industry experience helping government contractors assess their eligibility and maximize their credit values. Schedule a consultation today to learn more.

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