There is often confusion about whether government or commercial contracts can qualify as expenses for purposes of the R&D Credit. The simple answer is if a contract puts a company at financial risk – meaning payments are contingent upon success of hitting milestones – and the company also retains substantial rights to the research results, then that contract would qualify. The type of contract that most often meets these criteria are Firm Fixed Price contracts (i.e., SBIR/STTR), while there are small portions of other types of contracts that meet these criteria as well. In addition to contract expenses, certain amounts of B&P are includable as well.
In helping defense contractors claim the maximum defensible amount of R&D Credit for 20 years, we often hear that what’s most important to them is they claim what’s accurate and that their study will withstand an audit. Their biggest fear defense contractors face is claiming an incorrect amount and being at risk of paying that amount back to the government considering the government is one of their clients.
For all companies claiming the R&D Credit, compliance is of the upmost importance. For defense contractors specifically, we have outlined five steps to ensure your R&D Credit is protected:
- Make sure you pay a fixed fee to your R&D Credit provider – not a contingency fee. Providers that charge a contingency fee for the R&D Credit are in violation of Circular 230 and can’t defend their clients in front of the IRS. A contingency fee not only limits a company’s ROI, but the incentive lies with the provider to identify as many activities/expenses as possible regardless of whether they are qualified or not.
- Make sure your provider is qualifying the activities. Most companies are unaware that they are the ones qualifying the activities, which puts them at risk. That would look like a provider explaining what qualifies and then asking a company, “do you perform any activities?” From there, a company would share the projects they believe meet those criteria and the provider would then use that to perform the calculation. In an audit situation, the company is the one at risk as they were the ones that determined what projects qualified. A company needs a provider that will perform interviews and ask questions so the provider can determine what is qualified or not so they can defend the activities under audit.
- Contracts MUST be analyzed. Whether the contracts are commercial or government, the contracts need to be analyzed to ensure that the proper clauses are in the contract that establish financial risk and substantial rights. If this step is not taken, then there is no way to determine if the associated activities/expenses are qualified raising red flags.
- Know what you are getting from your report. This report should have a detailed description of the company’s R&D process, examples of what was qualified/not qualified and why it was qualified or not. It should have the clauses that make certain contracts qualified, it should have the calculation and most importantly it should answer the questions the IRS would ask if an audit occurred. This is the first line of defense in the event of an audit and non-negotiable.
- Audit Defense. Companies should have audit defense, not audit support. This audit defense should be at no additional cost. If you’re hiring a provider to perform the R&D Credit study and they are the ones identifying what activities should be qualified/not qualified, it shouldn’t be a problem for them to stand by their work.
Defense contractors are smart and realize that if they can claim a R&D Credit, they want to claim the maximum defensible amount. By asking questions to ensure the five items above are part of their process will create peace of mind that their R&D Credit is maximized and protected.