In parts 1-3, we looked at the contract manufacturing qualifying activities (see How does contract manufacturing qualify for R&D tax credits (part 1)), potential IRS audit issues that could be a concern (see part 2) and documentation of activities (part 3).
Increasingly, contracts are becoming an item that IRS and state tax auditors want to review and understand as part of the intent and results of the taxpayer’s R&D efforts. Specifically, areas related to ownership rights, payment terms and risk are being evaluated against the research tax credit statutes and regulations. Let’s take a brief look at some of the important issues and ways to manage potential audit risk.
Standard contract language is important
Contract manufacturers build the product for their customers, typically, as specified through drawings or detailed specifications provided by the customer. Within the contracts completed by the taxpayer conducting the research and the taxpayer paying for the research, contractual terms are defined which include ownership and payment terms.
Ownership rights: Product versus Process
Tax regulations under Internal Revenue Code Section 41 direct that “research conducted where the taxpayer has no rights to the research under an agreement providing for the research, it is considered fully funded and no expenses paid or incurred by the taxpayer in performing the research are qualified research expenses (IRC Regulations 1.41-4A(d)(2)).” It is not uncommon for a company outsourcing their manufacturing to require the contract manufacturer transfer all rights of ownership to them upon completion.
So, how can a contract manufacturer still take an R&D tax credit for their efforts on a project?
Simply, contract manufacturing companies bring process expertise and knowledge that they retain after the end of the production contract. While product rights transfer, typically, HOW the product is manufactured does not transfer and can be considered as potential qualified research and development.
Payment Terms & Risk Can Make The Difference
The concept of funded research is an area where contract manufacturers must evaluate their
efforts and payment terms in order to determine if their projects will qualify for R&D tax credit. If research is conducted on behalf of another taxpayer and that research is funded by another person, the research is not considered qualified research. However, if the contract is written such that payment is contingent upon the success of the research and thus considered to be paid for the product or result of the research, these amounts are not treated as funding.(See IRC Regulations 1.41-4A(d)(1)).
If a contract manufacturer separates engineering and design fees from production or manufacturing fees, these amounts may need to offset any costs incurred that would otherwise be qualified R&D expenditures (IRC Regulation 1.41-4A(d)(3)).
As a planning note, it would make sense to consider developing contracts to produce a final product rather than separating out the various components. It might also make sense to consider language that expressly provides that any processes developed are the property of the contract manufacturer and do not transfer to the customer.
Finally, contracts are written under a cost-plus or time, and materials basis, where the taxpayer has no risk in the development effort, would be considered funded and would not be considered qualified research. In some cases, aerospace and defense contracts are written in this manner but also contain provisions that allow the government the right to withhold payment if the product produced does not meet proper specifications. This “claw-back” provision creates risk for the contract manufacturer and may allow the research project to be considered as qualified research.
What say you, my friends?
Have you reviewed your contracts lately to understand how the above information applies?
Do you routinely solve difficult manufacturing problems in order to produce products for your customers?
Are your contracts considered “funded” or will your projects qualify for research tax credits?
Other Noteworthy Articles
Is it R and D when my customer wants a new product?
How Can Management Qualify for R&D Tax Credits?
10 Reasons Not to Take R&D Tax Credits (part 2)
Free Resources
Free R&D Tax Credit Documentation Review
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Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.
