Contract Research QRE: General Guidance to Determining Eligibility
A contract research expense is 65 percent of any expense paid or incurred in carrying on a trade or business to any person, other than an employee of the taxpayer, for the performance on behalf of the taxpayer of qualified research, or services which, if performed by employees of the taxpayer, would constitute qualified services within the meaning of section 41(b)(2)(B).
Three Part Test for Determining Contract Research QRE:
Treasury Regulation section 1.41-2(e) provides a three-part test for determining if the payment is for the performance of qualified research where a third party performs the research for the taxpayer. An expense is paid or incurred for the performance of qualified research only to the extent that it is paid or incurred pursuant to an agreement (usually in writing, but not required) that:
Is entered into prior to the performance of the qualified research,
Provides that research be performed on behalf of the taxpayer, and
Requires the taxpayer to bear the expense even if the research is not successful.
Qualified Research:
Qualified research is performed on behalf of the taxpayer if the taxpayer has a right to the research results. Qualified research can be performed on behalf of the taxpayer notwithstanding the fact that the taxpayer does not have exclusive rights to the results. Also, if the expense is paid or incurred pursuant to an agreement under which payment is contingent on the success of the research, then the expense is considered paid for the product or result, rather than the performance of research, and the payment is not a qualified contract research expense.
Under Treasury Regulation section 1.41-2(e), a contract research expense is 65 percent of any expense paid or incurred in carrying on a trade or business to any person other than an employee of the taxpayer for the performance on behalf of the taxpayer of:
(i) qualified research, or
(ii) services which, if performed by employees of the taxpayer, would constitute qualified services within the meaning of section 41(b)(2)(B).
Where the contract calls for services other than services described above, only 65 percent of the portion of the amount paid or incurred, that is attributable to the services described above is a contract research expense.
Sometimes the activities to be performed by the contractor are more clearly defined in contractually-referenced work orders or statements of work rather than the body of the main contract. As such, these kinds of documents can be helpful in making your determinations. Note: such documents would likely be requested as part of R&D tax credit examination by federal or state taxing authorities.
A service contract differs from a research contract in calculating what amounts will be allowable contract research expenses.
For example, in a service contract, the vendor may be paid by the hour and the research is not specified. In this case, you must look at the work done. Only the amounts paid for qualified research work would be included in QREs (subject to the 65% limitation).
In a research contract where there is an agreed fixed price amount to perform qualified research, the entire amount would be subject to the 65% limitation and included as a QRE.
Please refer to the IRS Audit Techniques Guide for more information on how the IRS suggests their agents approach examination of contract research QRE claims. This is helpful to get a sense for how they would approach and thus what considerations you should be making with you are determining qualifying contract research QRE to begin with!
