A common question is whether outside engineering firm costs can count toward the R&D tax credit. The short answer is that engineering firm costs may count as contract research if the firm performs qualified research on behalf of the taxpayer, the taxpayer bears the economic risk, and the taxpayer retains substantial rights. Location and documentation matter. This page explains the framework in general terms. It is educational and is not individualized advice. For the contract research framework, see our page on contractor costs.
When Engineering Firm Costs May Warrant Review
Outside engineering firm costs may warrant review when the firm performs qualified research on behalf of the taxpayer. Under the four-part test, the work performed by the firm must be for a permitted purpose, be technological in nature, be intended to eliminate uncertainty, and be conducted through a process of experimentation. Not all engineering services constitute qualified research; the work must meet the four-part test.
Contract Research Rules
Where the engineering firm costs may qualify, they are taken into account as contract research under Section 41(b)(3). This means 65 percent of the amounts paid to the firm may be taken into account, not the full amount. The research must be performed on behalf of the taxpayer, the taxpayer must bear the economic risk, and the taxpayer must retain substantial rights. For more, see our page on contractor costs.
Qualified Activities
Not all engineering services constitute qualified research. Routine engineering services — applying known engineering principles to known problems without a technical uncertainty — generally are not qualified research. Engineering services that involve evaluating alternatives to resolve a technical uncertainty about a business component may warrant review. The distinction turns on whether there is a genuine technical uncertainty and a process of experimentation.
Location
Section 41 excludes research conducted outside the United States from qualified research. If the engineering firm performs the research outside the United States, the costs generally may not be taken into account for the federal credit. The location of the firm's research activities is what matters. For more, see our page on research outside the United States.
Rights and Risk
The taxpayer must bear the economic risk and retain substantial rights to the results. Where the firm retains all rights or bears the economic risk, the costs generally may not qualify. The contract provisions allocating rights and risk are relevant.
Hypothetical Example
Consider a manufacturer that engages a U.S.-based engineering firm to develop a new component for the manufacturer's product. The manufacturer pays the firm for the development regardless of success, retains exclusive rights to the results, and the development is performed in the United States. The firm evaluates alternative designs to resolve a technical uncertainty about the component. Under these facts, 65 percent of the amounts paid to the firm may be taken into account as contract research, provided the other elements are met.
By contrast, if the firm simply applies known engineering principles to a known problem without a technical uncertainty, or if the firm performs the work outside the United States, the costs generally may not qualify.
This example is illustrative only and does not state that the costs definitely qualify.
Documentation That May Help
Records that can help support engineering firm cost claims include the engagement agreements, statements of work, records of the qualified activities performed, provisions allocating rights and risk, records of where the work was performed, and invoices tied to specific projects. For more, see our page on contractor documentation.
Key Takeaway
Outside engineering firm costs may count toward the R&D tax credit as contract research if the firm performs qualified research on behalf of the taxpayer, the taxpayer bears the economic risk, and the taxpayer retains substantial rights. Location and documentation matter. Because the analysis is fact-specific, professional review is appropriate.