A common question is how time-and-materials (T&M) contracts affect the R&D tax credit. The short answer is that a "time-and-materials" label does not automatically determine whether research is funded. The analysis examines the actual funding, reimbursement, risk, and rights. The distinction from fixed-price structures is in the details, not the label. 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 Analysis
Under Section 41(d)(4)(H), research is excluded from qualified research to the extent it is funded by another person. 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.
Funding and Reimbursement
A T&M contract — where the taxpayer is reimbursed for time and materials — can have different implications depending on the actual terms:
- If the taxpayer is reimbursed for all time and materials regardless of whether the research succeeds, the taxpayer may not bear the economic risk.
- If the reimbursement is contingent on achieving specified results, the taxpayer may bear the economic risk.
- If the taxpayer bears the risk of cost overruns or unsuccessful efforts, that may indicate economic risk.
- If the customer bears all cost risk, that may indicate the taxpayer does not bear economic risk.
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. A T&M contract where the taxpayer is reimbursed for all time and materials regardless of outcome may indicate the taxpayer does not bear economic risk. A T&M contract where reimbursement is contingent on success may indicate the taxpayer bears economic risk.
Research Rights
The taxpayer generally must retain substantial rights in the research results. 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. The contract provisions allocating intellectual-property rights are relevant.
Distinction From Fixed-Price Structures
The distinction between T&M and fixed-price structures is in the details, not the label. Both structures can leave the taxpayer at economic risk or not, depending on the actual terms. A T&M contract with reimbursement contingent on success may leave the taxpayer at economic risk, while a fixed-price contract with payment guaranteed regardless of outcome may not. The analysis looks at the economic substance, not the contract heading. For more on fixed-price contracts, see our page on fixed-price contracts.
No Automatic Conclusion
It is important not to apply an automatic conclusion to T&M contracts. Some T&M contracts may leave the taxpayer at economic risk with substantial rights (not funded), and some may not (funded). The determination depends on the specific contract terms and facts.
Hypothetical Example
Consider a manufacturer that performs development for a customer under a T&M contract. If the contract provides that the manufacturer is reimbursed for all time and materials 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 reimbursement is contingent on achieving specified performance targets, 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 for T&M contracts include the contract, reimbursement terms, provisions allocating rights and cost risk, and any project communications clarifying the parties' understanding. For more, see our page on R&D tax credit documentation.
Key Takeaway
Time-and-materials contracts do not automatically determine whether research is funded. The analysis examines the actual funding, reimbursement, risk, and rights. The distinction from fixed-price structures is in the details, not the label. Because the funded-research analysis is fact-specific, professional review is appropriate.