R&D Credits for SBIR Work
The United States Government provides multiple incentives to encourage small businesses to invest in innovation and technology. The Small Business Innovation Research (SBIR) program provides grants to companies seeking to help government agencies push the boundaries of technological development. This program allows small businesses to engage in federal level research while retaining the potential for the commercialization of discoveries.
The research and development tax credit (R&D credit) provides a tax break for companies investing in new product or process developments and improvement or for companies performing technical services under qualified contracts with customers. Any company that can pass what is known as the four-part test can claim this credit, which acts as a dollar-for-dollar offset of federal income taxes owed. Small businesses can benefit further from these credits since they can apply R&D credits against the employer portion of their payroll taxes.
While each of these programs has its own cumbersome rules and requirements, small businesses may be able to leverage both incentives by claiming R&D tax credits for wages, supplies, and contractor expenses associated with SBIR projects. This is possible as long as the business does not violate the “funded research” exclusion of section 41(d)(4)(H) of the revenue code. To understand how companies may be eligible for both programs, it is helpful to take a deeper look at the definition of funded research.
R&D Credit Funded Research Exclusion
When claiming the R&D credit, the government has developed rules to ensure that expenses paid for or “funded” by third parties are not included as part of the credit calculation. R&D credits are designed to reward companies undertaking activities that produce both economic and technical risk. However, interpretation of paid for or “funded” work has been a cause of a great divide between taxpayers claiming R&D credits and the IRS.
This divide has manifested itself in several high-profile tax court cases that specifically addressed the definition of funded research. Therefore, the seminal cases, Fairchild v. Commissioner, Dynetics v. Commissioner, and Geosyntec Consultants v. U.S., provide us with a reference when determining whether or not a company is performing funded research. These cases establish a two-part test when analyzing research activities:
- Does the taxpayer retain rights to any of the research produced under the contract or grant?
- Does the taxpayer bear risk of not being paid should the research fail?
A closer look at each test can help explain how SBIR projects can satisfy their requirements.
Retain Substantial Rights
In general, the courts want taxpayers to show that they can leverage any discoveries made on a particular project to pursue success on future projects. One of the stated goals of the SBIR/STTR program is to allow businesses the ability to commercialize research results in the future. SBIR candidates are often required to submit a commercialization plan, and some SBIR contracts include FAR clauses that specifically allow the business to retain intellectual property.
The financial risk question is not always easily answered. The courts have ruled that the following elements may prove that the business bears financial risk on a contracted project:
- The contract or grant is a fixed-price or lump-sum.
- The contract gives the client the right to inspect results and to withhold payment if deficiencies are found.
- The contract gives the client the right to dispute invoices submitted by the business.
- The contract does not pay the business in full until certain milestones or inspections are met.
A look at the SBIR structure reveals that businesses are granted a lump-sum award to perform research on a concept in phases. If phase criteria are not met, the business will not be awarded more money. Taxpayers often incur substantial expenses to perform proof-of-concept work prior to any phase 1 award.
The definition and application of the funded research test are extremely nuanced. However, there is a clear path for businesses working on SBIR (or STTR) projects to claim R&D credits for associated eligible expenses. In order to claim R&D credits for these projects, companies must have contracts reviewed and substantiated.
Alternate Tax Solutions has been working with government contractors and small businesses for twelve years and has helped numerous companies leverage both R&D credits and SBIR funding. For more information on if you qualify for this tax incentive, please feel free to contact our team.