Government contractors have often asked the question, “can my R&D activities within my government contracts be included in my R&D Credit?” The common answer they hear is “no,” and this information can cost companies significant dollars to their bottom line because that answer is not accurate. If the activities performed in the contract pass the four-part test, two more boxes need to be checked to determine if the activities are qualified or not–financial risk and substantial rights.
When it comes to rights, companies don’t need to maintain 100 percent of the rights –they only need to have substantial rights. For example, the SBIR/STTR program is designed in a way to give the Government the rights to use the results, while the contractor also maintains the rights to further develop the technology, etc. By keeping some of the rights, the taxpayer has substantial rights.
When it comes to financial risk, the language used in contracts can be complex and there are generally more questions about financial risk than rights. Therefore, most government contractors want to know what type of contracts qualify for the R&D Credit. Below are the financial characteristics of three types of government contracts and the likelihood of whether they would or would not be qualified for the R&D Credit.
Firm Fixed Price Contracts
One of the key characteristics that generally makes firm fixed price contracts attractive when it comes to the R&D Credit is payments within the contract are paid upon milestones being hit. For example, this may look like the taxpayer receiving payment on a portion of the contract once a report is delivered, or a prototype is approved, or a piece of software is signed off on, etc. Since some form of acceptance is needed by the government on a milestone for payment to be received, that constitutes financial risk for the contractor.
Cost Plus Fixed Fee Contracts (CPFF)
CPFF contracts often allow for a small portion of the contract to be includable in the R&D Credit Calculation. These contracts are generally structured in a way in which the contractor receives a reimbursement for most of the work completed, but there is a final payment that is withheld until the project is signed off on. That withheld portion of the contract can be includable since that has to be completed for the contractor to be paid that specific amount. On average, what is allowable from CPFF contracts is a very small percentage of the total revenue amount of the contract, but those amounts can add up to a significant value if a taxpayer has multiple CPFFs.
Time and Materials Contracts (T&M)
T&M contracts are great for companies that are selling services with a scope that is not clear. However, these contracts have a very low likelihood of being qualified for the R&D Credit. This is due to contractors being paid based on hours worked and materials used. In other words, once an hour is completed or materials are purchased the contractor is contractually obligated to be paid. This contract structure lacks financial risk and as a result would not be includable as qualified research.