In part one of this two-part blog series, we discussed the differences between SBIR grants and R&D tax credits and reviewed how each can be used to fund innovative research for businesses. Now we are going to discuss how research endeavors that received the SBIR grant can also potentially qualify for the R&D credit provided that the research passes the regulations involving the funded research tax exclusion.
About the Funded Research Tax Exclusion
Research activity that would otherwise qualify for the R&D tax credit can be made ineligible by the IRS if that research is deemed as funded research. This funded research tax exclusion is often implicated by SBIR grant funding since the exclusion for “funded research” under Internal Revenue Code Section 41(d)(4)(H) provides that the credit shall not be available for qualified research to the extent funded by a contract, grant, or otherwise by another person (or governmental entity).
The funded research exclusion is a term of art with precise legal meaning and cannot be understood using general definitions of the word “funded”. What is “funded research” can be difficult to understand and can cause compliance issues if not evaluated correctly.
The exclusion can result in significant reductions to tax credits during an audit if compliance is not met. Fundamentally, the researcher wanting to take advantage of the R&D tax credit in a potential funded research scenario needs to resolve the two following issues to ensure that the researcher’s qualified research is not deemed funded and thus excluded from the R&D tax credit.
There are two tests for determining whether research is funded and therefore excluded. One test requires the researcher/taxpayer to bear the financial risk for nonpayment if, hypothetically and in the future, the research was to fail. The other test requires the researcher/taxpayer to retain substantial rights in the research. These tests are commonly referred to the risk test and the rights test. If the researcher/taxpayer can demonstrate financial risk and the retention of substantial rights, then the research is not deemed funded research and will not be excluded from the R&D tax credit for this reason.
If you pass the “funded research” exclusion after receiving an SBIR grant, you may also be eligible for the R&D tax credit. Contact Tri-Merit for your free assessment!
Considerations and Preparation
ALL agreements entered into between the taxpayer performing the research and other persons are to be considered in determining the extent to which the research is funded.
The examiner should request a complete copy of all contracts and modifications, agreements, letters of understanding or other documents where funding is discussed.
These documents will need to be reviewed to determine whether, and to what, extent the research is to be considered funded.
A team of tax credit experts and legal counsel can be helpful in securing and interpreting these agreements.
Is the Research Under an SBIR Grant Eligible for the R&D Tax Credit or Funded?
In order to determine if the research expenditures are “funded” and thus excluded, the following questions are asked:
- Is payment for the research activities “contingent upon the success of the research” under 1.41-4A(d)(1)?
- Does the contractor retain “substantial rights” in the result of the research activities within the meaning of section 1.41-4A(d)(2)? (see link above)
If the answer to either of these questions is no, then the research is treated as funded and thus excluded from the R&D tax credit.
If a contractor retains rights in the results of the research, and if payment to him is dependent on the success of the research, then the contract is not funded and the contractor is able to claim the credit.
If the contractor performing research for another party does not retain rights and if the research payments are contingent on the contractor’s success, neither party is eligible to claim the credit.
Unless you are well-versed in this, it can be hard to determine if you are eligible for the credit after receiving an SBIR grant without consulting with a team of professionals. There are many nuanced considerations that apply. For example, a taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the results of the research. You definitely do not want to claim the credit if you are not eligible as it can cause many problems in the future if you do get audited.
We can help you support, document and substantiate your case to receive an R&D tax credit in addition to your SBIR grant if you qualify.