Contractor costs — amounts paid to outside firms, engineers, developers, laboratories, or consultants — may, in certain circumstances, be taken into account as qualified research expenses (QREs) for the federal R&D tax credit under Section 41. But not every payment to an outside party qualifies. This page explains the general rules and what the analysis emphasizes.
Contract Research in Plain English
Under Section 41(b)(3), "contract research expenses" generally means 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee) for qualified research. In other words, when a taxpayer pays an outside party to perform qualified research on its behalf, a defined portion of that payment may be taken into account — not the full amount. The reduced inclusion reflects that the taxpayer is not performing the research itself. (Separate percentages apply to certain payments to qualified research consortia and energy research consortia under the statute.)
When Contractor Costs May Be Relevant
Contractor costs may be relevant when a taxpayer engages an outside party to perform qualified research relating to the development or improvement of a business component. As with all QREs, the underlying activity must constitute qualified research under the four-part test, and the cost must meet the applicable requirements. For more on qualified research, see our pages on qualified research and the four-part test.
Research Performed on Behalf of the Taxpayer
The Treasury Regulations under Section 41 (§1.41-2) address contract research, including the requirement that the research be performed on behalf of the taxpayer. The regulations provide that qualified research is performed on behalf of a taxpayer if the taxpayer has a right to the research results. Where the taxpayer performs research on behalf of another person and retains no substantial rights in the research, that research generally is not taken into account for the taxpayer. For more on the funded-research concept, see our page on funded research.
Economic Risk and Payment Structure
The regulations address the economic-risk-of-loss requirement. The general principle is that the taxpayer must bear the financial risk of the research. Where the taxpayer is paid or reimbursed regardless of the outcome of the research — so that another party bears the economic risk — the costs generally may not qualify as contract research for the taxpayer. The payment structure matters: a fixed-fee arrangement where the outside party bears the risk of failure may indicate that the taxpayer does not bear the economic risk, while an arrangement where the taxpayer pays for research regardless of success may support the taxpayer's position. The specific facts control.
Rights to Research Results
The regulations also address rights to the research results. The taxpayer generally must retain substantial rights in the research results for the costs to be taken into account. Where the taxpayer retains no substantial rights — for example, where the rights are transferred to another party in return for license or royalty payments and the taxpayer does not use the product of the research in its trade or business — the costs generally may not qualify. Exclusive versus non-exclusive rights can be relevant, and the analysis depends on the specific contractual arrangement.
U.S. Research Considerations
Section 41 excludes research conducted outside the United States and its territories from qualified research. This means that contract research performed abroad generally may not be taken into account, even if the other requirements are met. The location of the research is therefore a relevant consideration in evaluating contractor costs. For more, see our page on research outside the United States.
Determining the Potentially Relevant Portion of an Invoice
An invoice from an outside firm is not, by itself, evidence that the amount qualifies as contract research. Several questions generally need to be addressed:
- Did the work constitute qualified research under the four-part test?
- Was the research performed on behalf of the taxpayer?
- Does the taxpayer bear the economic risk of the research?
- Does the taxpayer retain substantial rights to the results?
- Was the research performed in the United States?
- What portion of the invoice relates to qualified research versus other services?
Only the portion of the payment that satisfies these requirements may be taken into account, and only 65 percent of that portion is generally included (with different percentages for certain consortia). Allocation between qualified research and non-qualified services is often required.
Documentation That May Help
Records that can help support contract research claims include the engagement agreements, statements of work, invoices tied to specific projects, records of the research performed, and records establishing the taxpayer's rights to the results and its economic risk. The IRS has noted that studies which fail to connect specific projects and activities to the underlying costs can fail to establish the required nexus. For more, see our page on R&D tax credit documentation.
Common Contractor-Cost Mistakes
A few mistakes arise often:
- Treating every payment to an outside engineer, developer, or consultant as automatically qualifying.
- Including the full invoice amount rather than the reduced percentage that applies to contract research.
- Overlooking whether the taxpayer retains substantial rights to the results.
- Overlooking whether the taxpayer bears the economic risk of failure.
- Including research performed outside the United States.
Key Takeaway
Certain contractor costs may be taken into account as qualified research expenses when the outside party performs qualified research on behalf of the taxpayer, the taxpayer bears the economic risk, and the taxpayer retains substantial rights to the results. The reduced inclusion percentage reflects that the taxpayer is not performing the research itself, and an invoice alone does not establish qualified treatment. Because these determinations are fact-specific, professional review is appropriate. For the broader cost framework, see our page on qualified research expenses.