A common question is whether subcontractor research costs can count toward the R&D tax credit. The short answer is that subcontractor costs may count as contract research if the research is performed on behalf of the taxpayer, the taxpayer bears the economic risk, and the taxpayer retains substantial rights to the results. The 65% rule and the U.S. research requirement apply. 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.
Contract Research Under Section 41(b)(3)
Under Section 41(b)(3)(A), contract research expenses are 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 a subcontractor to perform qualified research on its behalf, 65 percent 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.
Research Performed on Behalf of the Taxpayer
The Treasury Regulations require 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, that research generally is not taken into account for the taxpayer. For more, see our page on funded research.
Economic Risk
The taxpayer must bear the economic risk of the research. Where the taxpayer is paid or reimbursed regardless of the outcome, the taxpayer may not bear the economic risk. The payment structure matters: if the taxpayer pays the subcontractor regardless of success, the taxpayer may bear the economic risk; if the subcontractor bears the risk of failure, the taxpayer may not.
Substantial Rights
The taxpayer generally must retain substantial rights in the research results. Where the subcontractor 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.
U.S. Research Requirement
Section 41 excludes research conducted outside the United States from qualified research. If the subcontractor performs the research 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 subcontractor's research activities is what matters. For more, see our page on research outside the United States.
Hypothetical Example
Consider a manufacturer that engages a U.S.-based subcontractor to perform research on a new process. The manufacturer pays the subcontractor for the research regardless of success, retains exclusive rights to the results, and the research is performed in the United States. Under these facts, 65 percent of the amounts paid to the subcontractor may be taken into account as contract research, provided the other requirements are met.
By contrast, if the subcontractor performs the research outside the United States, or if the subcontractor retains all rights to the results, 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 subcontractor cost claims include the engagement agreements, statements of work, payment terms, provisions allocating rights, records of where the research was performed, and invoices tied to specific projects. For more, see our page on contractor documentation.
Key Takeaway
Subcontractor research costs may count toward the R&D tax credit as contract research if the research is performed on behalf of the taxpayer, the taxpayer bears the economic risk, and the taxpayer retains substantial rights. The 65% rule and the U.S. research requirement apply. Because the contract research analysis is fact-specific, professional review is appropriate.