A common question is how customer-funded research affects the R&D tax credit. This is a higher-risk area because it involves the funded-research exclusion under Section 41. The short answer is that customer-funded research may be excluded from qualified research if the taxpayer is not at economic risk or does not retain substantial rights to the results. The analysis turns on the contract terms and facts, not on labels, and no blanket conclusion applies. This page explains the framework in general terms. It is educational and is not individualized advice or a legal conclusion about any particular contract. For the foundational framework, see our page on funded research.
The Funded-Research Exclusion
Under Section 41(d)(4)(H), research is excluded from qualified research to the extent it is funded by another person (or governmental entity). The Treasury Regulations address when research is considered funded. In general terms, research is funded to the extent the taxpayer performing it is not at economic risk or does not retain substantial rights in the results. For more, see our page on funded research.
Substantial Rights
The taxpayer generally must retain substantial rights in the research results for the research to not be funded. Where the customer retains all rights and the taxpayer must pay for the right to use the results, the taxpayer may not retain substantial rights. Exclusive versus non-exclusive rights can be relevant, and the analysis depends on the specific contractual arrangement.
Economic Risk
The taxpayer must bear the economic risk of the research. A taxpayer is at economic risk only if it is not entitled to be paid (or to receive property of value) regardless of the success of the research. If the taxpayer is paid by the customer regardless of whether the research succeeds, the taxpayer may not bear the economic risk, and the research may be funded.
Contract Facts Matter
The analysis turns on the actual contract terms and facts, not on labels. A "fixed-fee" contract can still leave the taxpayer at economic risk or with substantial rights, or not, depending on the actual terms — for example, whether payment is contingent on success, who bears cost overruns, and who controls the results. Similarly, a "cost-plus" contract does not automatically mean the taxpayer bears no risk. For more on specific contract structures, see our pages on fixed-price contracts and time-and-materials contracts.
No Blanket Conclusion
It is important not to apply a blanket conclusion to customer-funded research. Some customer-funded research may be excluded (where the taxpayer is not at risk or does not retain rights), and some may not be excluded (where the taxpayer bears the risk and retains rights). The determination depends on the specific contract terms and facts. Professional review of the actual contract is appropriate.
Hypothetical Example
Consider a manufacturer that performs development for a customer under a contract. If the contract provides that the manufacturer is paid a fixed amount regardless of success, and the customer retains all rights to the results, the research may be funded and excluded from the manufacturer's qualified research.
By contrast, if the contract provides that the manufacturer is paid only if the development succeeds, and the manufacturer retains exclusive rights to the results, the research may not be funded and may warrant review as qualified research.
These examples are illustrative only and do not provide legal conclusions about any particular contract.
Documentation That May Help
Records that can help support the funded-research analysis include the engagement agreements, statements of work, payment terms (showing who bears the economic risk), provisions allocating rights to the results, and any project communications clarifying the parties' understanding. For more, see our page on R&D tax credit documentation.
Key Takeaway
Customer-funded research may be excluded from qualified research under the funded-research rules if the taxpayer is not at economic risk or does not retain substantial rights. The analysis turns on the contract terms and facts, not on labels, and no blanket conclusion applies. Because the funded-research analysis is fact-specific, professional review is appropriate.