What is considered “Funded” Research under the Research Credit Provisions (Section 41)

If an activity is “Funded” the taxpayer does not have financial risk and cannot claim the research credit for the project’s costs.

However, if the payment is contingent upon successful completion of the work, then the taxpayer/contractor is at risk and the activity can qualify for the research credit.

This depends on the facts of each project and a review of each contract.  The taxpayer must be at financial risk during the development stage of the project, so we examine the following factors to determine eligibility for the research credit:

  •   Is the taxpayer developing a product or system for the client (as opposed to performing system integration or other work-for-hire activities)?
  •   Are there warranties/guarantees in the contract ensuring that the product developed by the taxpayer will work and meet specifications?
  •   Is the product/system/ software subject to acceptance testing?
  •   Is the taxpayer the party obligated to correct any problems uncovered during the testing to ensure that the product meets the specifications? Do they have to fix problems on their nickel?

If these factors are met, then the taxpayer is likely considered “at risk” during the development and is the party entitled to claim the research credit.

In addition to meeting the “at risk” requirement, the taxpayer  must also retain some rights in the product developed, although this does not have to be exclusive rights but can share in the rights with the client.  The following factors are helpful in making this determination:

  •   Does the taxpayer retain intellectual property rights under the contract?
  •   Does the taxpayer retain joint licensing/marketing rights?
  •   Can the taxpayer take some results of the research with them to use in subsequent projects with other clients?  Or does the client obtain exclusive rights in anything developed during the project?
  •   Does the taxpayer retain any right that has economic value?
  •   Is the taxpayer required to pay royalties to the client to use any components of the system on other projects?  Or can they use the results of the research in its business without paying for that right?

Note, that both the rights and risk components have to be met to determine which party can claim the research credit. There are even cases where neither party can claim the research credit in that neither party meets both of the criteria.


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