A common question from manufacturers is whether supplier-led product development — where a supplier develops or modifies a product component on behalf of the taxpayer — can support an R&D tax credit. This is a higher-risk area because it involves the funded-research exclusion, contract research rules, rights to results, and the foreign-research exclusion. The short answer is that supplier-led development may support a credit when the taxpayer bears the economic risk, retains substantial rights to the results, and the research is performed on behalf of the taxpayer in the United States. Funded research, lack of rights, or foreign research may limit or eliminate the credit. 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. When a supplier performs development and the taxpayer does not bear the economic risk or does not retain substantial rights, the research may be funded and excluded from the taxpayer's qualified research. For more, see our page on funded research.
Contract Research Rules
From the perspective of the taxpayer that pays a supplier to perform development, different rules apply. Under Section 41(b)(3) and the Treasury Regulations (§1.41-2), contract research expenses may be taken into account by the paying taxpayer if the research is performed on behalf of the taxpayer, the taxpayer bears the economic risk of loss, and the taxpayer retains substantial rights to the results. If the paying taxpayer does not bear the economic risk or does not retain substantial rights, the costs generally may not qualify as contract research. For more, see our page on R&D tax credit contractor costs.
Economic Risk
The regulations address economic risk. 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 pays the supplier regardless of whether the development succeeds, the taxpayer may not bear the economic risk. The payment structure matters: if the taxpayer pays for development regardless of outcome, it may bear the economic risk; if the supplier bears the risk of failure, the taxpayer may not.
Rights to Results
The taxpayer generally must retain substantial rights in the research results for the costs to be taken into account. Where the supplier 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.
U.S. vs. Foreign Research
Section 41 excludes research conducted outside the United States from qualified research. If the supplier performs the development outside the United States, the costs generally may not be taken into account for the federal credit, even if the other requirements are met. The location of the supplier's research activities is what matters, not the location of the taxpayer. For more, see our page on research outside the United States.
Hypothetical Example
Consider a U.S. manufacturer that engages a U.S.-based supplier to develop a new component for the manufacturer's product. The manufacturer pays the supplier for the development regardless of success, retains exclusive rights to the results, and the development is performed in the United States. The manufacturer is uncertain whether the component can achieve the required performance and the supplier evaluates alternatives to resolve the uncertainty. Under these facts, the development may support a credit for the manufacturer as contract research, provided the other requirements are met. The manufacturer may take into account 65 percent of the amounts paid to the supplier under Section 41(b)(3)(A).
By contrast, if the supplier performs the development at its own cost, bears the economic risk, and retains all rights to the results, the research may be funded and excluded from the manufacturer's qualified research.
This example is illustrative only and does not state that the activity definitely qualifies or that any particular contract supports a credit.
Documentation That May Help
Records that can help support supplier-led development claims include the engagement agreements, statements of work, payment terms (showing who bears the economic risk), provisions allocating rights to the results, records of the research performed and where it was performed, and invoices tied to specific projects. For more, see our page on R&D tax credit documentation.
Key Takeaway
Supplier-led product development may support an R&D tax credit when the taxpayer bears the economic risk, retains substantial rights to the results, and the research is performed on behalf of the taxpayer in the United States. Funded research, lack of rights, or foreign research may limit or eliminate the credit. Because the funded-research and contract-research analyses turn on the specific contract terms and facts, professional review is appropriate before claiming the credit.