Government contractors play a vital role in national security and public infrastructure, often working on the cutting edge of technology and innovation. From defense systems to aerospace engineering and cybersecurity, said firms frequently develop or improve products, processes, and software under strict performance and compliance standards. Given the technical complexity and expertise required, government contractors are great candidates to leverage the R&D tax credit. However, many companies fall victim to common misconceptions related to government funding. Savvy contractors understand that a careful analysis of activities and agreement terms may lead to the realization of significant tax savings.

Contracts and credit eligibility

Government contractors must avoid identifiable pitfalls while evaluating tax positions and the monetization of potential R&D tax credits. The concept of “funded research” has a history of being challenging for government contractors. The IRS generally disqualifies research expenses funded by third parties unless the taxpayer provides an analysis of the intellectual rights and financial risks governing the related expenses. If a contractor retains substantial rights to the research results and, also, bears the financial risk of failure, research costs subject to compensation may still qualify. Misclassifying said contracts may ultimately result in incorrect claims or overlooked credits.

Key issues and considerations include:

• Common contract types:
• Firm-fixed-price (FFP): Generally favorable for R&D credits, as the contractor may assume financial risk
• Cost-plus-fixed-fee (CPFF): May disqualify activities depending on whether the contractor retains rights and bears financial risk, but often may exclude portions of the research
• Time-and-materials (T&M): Generally unfavorable for the contractor since time and expenses are generally reimbursed and not customarily subject to economic risk
• Impactful R&D credit cases:
• Fairchild Industries, Inc. v. U.S.: Evaluates the issue of payment contingent upon success
• Lockheed Martin Corp. v. U.S.: Clarifies that projects where the government retains substantial rights to research may not qualify
• Geosyntec Consultants, Inc. v. U.S.: Highlights the importance of record retention and funding analysis to support a successful claim

These cases underscore the importance of analyzing contract structure and language while evaluating R&D tax credits for government contractors.

Case study

A manufacturer (the Company) specializing in next-generation surveillance systems for the Department of Defense identified qualified R&D expenses of $3.4 million on its 2024 tax return for the following categories:

• Qualified wages from a dedicated engineering team of 40 employees conducting research
• Prototype materials, raw materials and consumables, and testing supply expenses
• Cloud hosting expenses

After completing an R&D tax credit study, the Company claimed federal R&D tax credits of $300,000. The Company recognized that a significant portion of its work met the “qualified research” criteria by conducting a detailed analysis of its CPFF and FFP contracts. Key to the success of the claim was the Company’s ability to distinguish funded research from unfunded research. The Company reviewed contract language to assess intellectual property rights and financial risk. Specifically, the Company was engaged for a contract that was governed by Federal Acquisitions Regulation 52-227-14,which, in essence, did not forfeit the Company’s substantial rights to the intellectual property gained throughout the project. Additionally, the CPFF contract included a risk-shifting, termination for convenience clause that allowed the government to terminate the contract at any time, introducing the risk that the Company might not recover all costs or earn its full fee for its work. By demonstrating that the Company maintained comprehensive documentation (i.e., project records, engineering notes, payroll records), the Company claimed and substantiated its R&D tax credit, which resulted in a meaningful tax offset and, also, improved cash flow.

What does CohnReznick think?

Maximizing the R&D credit requires more than just technical expertise – it demands deep knowledge of tax law and industry-specific nuances. As the IRS prepares to implement expanded reporting requirements on Form 6765 for 2024 and 2025 filings, government contractors must be more precise than ever. Importantly, the potential R&D credit benefits discussed in this article are not impacted by the recent changes to the rules around the amortization of research and experimental (R&E) expenditures.  Partnering with a trusted advisor who understands both the tax code and the unique aspects of government contracts is critical to claiming the credit with confidence and compliance.