The IRS recently released guidance (FAA 20223401F) determining that taxpayer contracts with customers were funded activity under Section 41(d)(4)(H) and therefore not allowed for the R&D credit.
In the FAA, the IRS examined five separate contracts between the taxpayer and its customers to determine whether the customer was funding the research. The IRS focused on specific elements of the contracts, including termination clauses, ownership of deliverables, payment terms, acceptances/inspections, and warranties. The FAA also referenced a proposal that was prepared related to one of the contracts that included payment terms and a termination clause.
The IRS found that in each of the contracts, the payments from the customers to the taxpayer were not contingent on the success of the research, and the taxpayer did not retain substantial rights to use or exploit the results of its research. As a result, all five contracts were determined to be funded research, which does not qualify for the Section 41 research credit.
As illustrated by this FAA and extensive case law, the funded research rules are a major focus of IRS examinations. While taxpayers have asked for additional guidance from the IRS on the issue, it is unclear when such guidance may be issued. Taxpayers should continue to carefully analyze and document customer agreements—including all subsequent changes—when applying the funded research rules and determining whether the related expenditures are allowable for the research credit.