Overview:
In general, contract research expenses are those paid to third parties for qualifying research. IRC Section 41(b)(3) defines qualifying contractor research expenses as “65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research”. Note that all contractor expenses must be domestically based.
In the event any contract research expense is related to qualified research and is to be conducted after the close of the taxpayer’s taxable year end, the expense shall be attributed to the period when the qualified research is conducted. Therefore, the prepayment of contract expenses are not qualifying expenses until the qualifying research is conducted.
IRS Treasury Regulations Section 1.41-2(e)(2) provides a three-part test for determining if the payment is for the performance of qualified research where a third party performs the research for the taxpayer. “An expense is paid or incurred for the performance of qualified research only to the extent that it is paid or incurred pursuant to an agreement that: (1) is entered into prior to the performance of the qualified research, (2) provide that research is to be performed on behalf of the taxpayer, and (3) requires the taxpayer to bear the expense even if the research is not successful. If the expense is paid or incurred pursuant to an agreement under which payment is contingent on the success of the research, then the expense is considered paid for the product or result, rather than the performance of the research and the payment is not a qualified research expense.”
Ultimately, the party that bears financial risk related to qualifying research and retains significant rights to the research is entitled to the R&D credit. Based on this, it is important to review each underlying contract in order to verify that the expense can be properly included in QRE.