A company can perform work that satisfies every element of the four-part test and still be barred from claiming the research credit for it. The funded research exclusion removes research from the credit to the extent it is paid for by another person under a contract or grant. For engineering firms, contract manufacturers, software developers and design practices, this is the most common reason an otherwise strong claim fails, and the answer usually sits in the customer agreement rather than in the technical work.
What Is Funded Research Under Section 41?
Funded research is research paid for by another party through a contract, grant or similar arrangement. Under Section 41, the company performing the work may be unable to claim the R&D tax credit if it does not bear the economic risk of failure or retain substantial rights to the research results. Eligibility must generally be evaluated project by project based on the agreement’s payment, ownership and reuse provisions.
The Funded Research Exclusion in Plain Language
Research is excluded to the extent it is funded by any grant, contract or other arrangement with another person. The phrase that carries the weight is “to the extent.” This is not always an all-or-nothing determination. Where a company’s research spending exceeds what the customer paid for it, the excess can remain creditable.
The analysis is applied project by project, which in practice usually means reviewing the contracts governing each project. One agreement can cover several projects, and a firm may find that some of its work is funded and some is not. The four-part test is a separate hurdle that still has to be cleared on its own. Our guide to the four-part test covers that side.
The Two-Part Test: Economic Risk and Substantial Rights
The analysis asks two related questions: which payments count as funding, and what rights the performer retained. They do not operate as a simple pass or fail.
Substantial rights. If the performer retains no substantial rights in the results, the research is fully funded and none of it is creditable. Rights do not have to be exclusive. What matters is whether the performer can use the research in its own business without paying for the privilege or asking permission it might not be given.
Economic risk, and the amount of funding. Where substantial rights are retained, the research is funded to the extent of the payments the performer becomes entitled to, and those amounts reduce the qualified research expenses it would otherwise have. Payments contingent on the success of the research are not treated as funding at all. So a performer with substantial rights that spends more on qualifying research than it receives in noncontingent payments can still have creditable expenses on the excess.
The Tax Court’s 2026 decision in Smith v. Commissioner shows how the second limb tends to dominate. The court worked through six sample projects for an architecture firm and found the substantial rights test failed on two of them, where contracts transferred copyright, made project data the absolute property of the client, and required express prior written approval before the firm could use project information for any other purpose. Needing permission that the other party can withhold without conditions is not consistent with retaining substantial rights. Retaining substantial rights does not end the inquiry, though: noncontingent payments can still constitute funding, and the credit is limited to qualifying expenses remaining once the funding rules are applied. Our post on what Smith v. Commissioner teaches businesses claiming R&D tax credits covers the decision in detail.
How Contract Language Determines the Answer
The commercial structure of a contract usually signals the risk answer before anyone reads the intellectual property clauses.
| Contract feature | Effect on the analysis |
| Fixed price for a defined deliverable that must perform | Points toward the performer bearing economic risk |
| Cost-plus or time-and-materials billing | Points toward the customer bearing the risk, since payment does not depend on success |
| Payment milestones tied to acceptance testing | Supports risk retention by the performer |
| Payment due on invoice regardless of outcome | Undermines risk retention |
| Customer owns all work product, data and IP outright | Undermines substantial rights |
| Performer retains the right to use methods and know-how developed | Supports substantial rights |
| Reuse permitted only with the customer’s prior written consent | Undermines substantial rights, particularly with no limit on withholding consent |
Two further points come out of recent litigation. Inspection and acceptance provisions matter, because a right to reject non-conforming work shifts risk back to the performer. And the governing law clause is not boilerplate: where a contract designates a particular jurisdiction, the rights analysis may turn on how that jurisdiction’s law treats ownership and reuse.
Common Scenarios in Manufacturing, Engineering, and Software
Contract manufacturers developing tooling, fixtures or process improvements at a customer’s request often have the strongest position on rights and the weakest on risk, since much of the work is billed at cost. Where the manufacturer funds process development itself and keeps the resulting know-how, the position improves considerably.
Engineering and design firms typically face the opposite problem. The work is plainly technical and the risk position is often defensible on a fixed-fee basis, while the client agreement hands over every drawing, model and calculation.
Software developers building to customer specification sit between the two. The question is usually whether the developer retains the right to reuse frameworks, libraries and architectural approaches on other engagements, or has assigned everything.
Grant-funded work is caught by the same rule. A grant that pays for the research regardless of outcome funds it.
What to Review in Your Customer Agreements
Before a claim is prepared, five clauses are worth pulling out of every material contract:
- Payment terms. Is any part of the payment contingent on the work performing as intended?
- Inspection and acceptance. Can the customer reject work that does not conform, and what happens to payment if it does?
- Intellectual property assignment. What transfers, and when?
- Reuse and license-back. Does the performer keep a right to use what it developed, and is that right conditional on consent?
- Governing law. Which jurisdiction’s rules apply to the ownership questions?
Contracts are usually negotiated by people who are not thinking about section 41. A clause added to reassure a customer about confidentiality can remove a credit worth more than the contract’s margin, and the fix is often a narrow carve-out for the performer’s underlying methods rather than a change to the commercial deal. Because most companies operate on standard forms, an amendment made once tends to protect every future engagement.
If you perform research under customer contracts and have never had the funding position reviewed, that is worth doing before the next claim is filed. You can see if you qualify at no cost, estimate the credit with our R&D tax credit calculator, or read more about our R&D tax credit services.
Frequently Asked Questions
If my customer pays me to develop something, can I still claim the credit?
Sometimes. If you retain no substantial rights, the research is fully funded and none of it is creditable. If you do retain substantial rights, the noncontingent payments you become entitled to reduce your qualifying expenses, and anything you spend above that amount can still qualify. Payments contingent on the research succeeding are not treated as funding.
What does “substantial rights” actually mean?
The right to use the results of the research in your own business without paying for that right and without needing permission the other party could refuse. Rights do not need to be exclusive. A contract that assigns everything to the customer and permits reuse only with prior written consent generally defeats the test.
Does a cost-plus contract automatically disqualify the research?
Not automatically, but it is difficult ground. Payments that do not depend on the success of the research count as funding, so they reduce your qualifying expenses dollar for dollar. Where the billing recovers substantially all of the cost, there is often little left above the funded amount even if substantial rights were retained.
Can the customer and the supplier both claim the credit for the same work?
Potentially, though not for the same dollars. A customer that bears the expense whether or not the research succeeds, and has rights to the results, may have qualifying contract research expenses, generally 65% of the payment. A performer that retains substantial rights may separately have qualifying expenses to the extent its own spending exceeds the amount treated as funding. Each side is tested under its own rules.
What if my contracts are already signed?
The analysis applies to the contracts as written for work already performed. Going forward, most companies operate from a standard template, so amending the reuse and payment provisions once protects future engagements. This is worth raising with counsel before the next renewal cycle.
This article provides general information about federal tax rules and is not tax advice. Speak with your tax adviser about your specific circumstances.
