Businesses engaged in research and development (R&D) or software development activities have the potential to qualify for the R&D Tax Credit — a federal tax benefit designed to incentivize innovation and reward organizations for investing in R&D. This credit enables businesses to offset their income taxes and, in some cases, their payroll taxes, resulting in substantial tax savings. Some individual states also offer R&D tax benefits.
With increasing pressure to limit government spending, many government contractors are seeing their clients tighten budgets and reduce discretionary spending, leaving them to seek ways to improve cash flow without compromising operations. The R&D Tax Credit offers government contractors a strategic opportunity to lower tax liabilities, increase liquidity and reinvest in their businesses.
Can Government Contactors Qualify for the R&D Tax Credit?
Yes. However, in order to receive the R&D Tax Credit, government contractors must perform qualifying R&D or software development activities and must retain the rights and financial risks of the development. Qualifying R&D activities may encompass a wide range of efforts, including, but not limited to, the development of systems, products for government sale and government system development.
Some more specific examples in the context of government contracting include:
- Defense Contracting: A contractor is being paid by the government to design or develop aircraft, submarines, analytical platforms or assist with the design of integrated bridge systems on ships.
- Medical Contracting: During the pandemic, a contractor was being paid by the government to develop COVID-19 vaccines.
- Government System Development: A contractor is being paid to perform custom development on government systems, such as providing new functionality on existing systems, writing custom code to integrate disparate systems, improving the scalability and performance of back end systems.
But keep in mind, the critical aspects of contract R&D for government contractors revolve around the concepts of rights and risks.
Rights and Risks for Contract R&D Activities
The rights and risks associated with contract R&D activities are vital considerations for qualifying for the R&D Tax Credit. These concepts evaluate whether the taxpayer has the right to exploit the R&D and whether they retain the financial risks of the development.
When determining R&D Tax Credit eligibility, it is crucial for a company to consider contract requirements and clauses, including FAR clauses. These provisions can establish which party retains the rights and bears the financial risks of development. Understanding these clauses is essential, as specific clawback or warranty clauses may indicate whether a taxpayer is at risk for successfully performing the R&D project.
For taxpayers that hire third-party contractors or subcontractors to perform R&D, the same rights and risks analysis should be done to determine eligibility for the R&D Tax Credit.
Capitalization Requirements Through TCJA’s Section 174
It is also important to note that the Tax Cuts and Jobs Act (TCJA) has introduced mandatory capitalization of research and experimental expenditures (SREs) under Section 174 costs for tax years beginning after December 31, 2021. This new requirement has implications for the tax treatment of your R&D expenses, both domestically and internationally, affecting the taxable income of government contractors engaged in R&D and software development activities.
Under Section 174 of the tax code, government contractors are required to capitalize and amortize costs related to R&D, including software development expenditures. This provision entails the capitalization and amortization of all costs incidental to R&D and software development, such as planning, upgrades, enhancements, designing, building, writing source code and testing software. Activities that are not considered software development include training employees, tech support, data conversion, straightforward installation, production implementation, configuration and maintenance activities.
Guidance released by the IRS in September 2023 provides further insight into R&D capitalization requirements for research performed under contracts. To the extent contractors retain rights to the development or financial risks, the contractor is required to capitalize the research and experimentation costs.
Government Contractor R&D Tax Credit Opportunities
Government contractors could take advantage of the following tax credits, depending on their eligible R&D activities:
Federal R&D Tax Credit: Tax Saving Opportunities
The federal R&D Tax Credit rewards businesses for developing new or improved products, processes or software, activities that many government contractors perform daily. By claiming the tax credit, government contractors can reduce their federal tax obligations, allocating more cash to business operations. Even small projects, like enhancing internal systems or developing prototypes for government clients, may qualify.
Payroll Tax Offset: Small Business Tax Credit for R&D
Qualified small businesses with less than $5 million in gross receipts and less than five years of reporting gross receipts can use the federal R&D Tax Credit to offset up to $500,000 in payroll taxes each year. This option allows early-stage contractors or businesses without significant income tax liability to benefit from the tax credit, turning innovation into cash flow even when profits are low.
State R&D Tax Credit Refunds: Cash Back in Your Pocket
Several states offer refundable R&D Tax Credits that can put cash directly back into a contractor’s business, regardless of income tax liability. In fact, more than 35 states offer their own R&D Tax Credit regimes, including Florida, Georgia, Maryland, Texas and Virginia.
Virginia’s refundable R&D tax credit allows small businesses to receive cash refunds for qualifying research expenses, while Maryland offers refundable tax credits to both small and large businesses performing R&D activities. These programs offer an immediate cash flow boost, making them especially valuable during periods of reduced client spending.
It is essential to evaluate each state's credit regime based on the specific company's fact pattern and the states they operate in. Notably, government contractors based in the Washington, DC metro region — the epicenter for government contracting — should pay attention to R&D Tax Credit legislation in Virginia.
Recommendations for Government Contractors Involved in Research & Development
If you’re planning on using R&D tax credits for your organizations, make sure to consider the following recommendations:
Get Tax Involved in Contract Negotiations
Government contractors should involve tax professionals in contract negotiations because the terms of the contract can significantly impact their eligibility for the R&D Tax Credit and the capitalization and amortization of R&D costs under Section 174.
Tax professionals are well-versed in identifying the specific R&D activities that qualify for the tax credit and can see to it that the contract terms align with the requirements for claiming the credit. Additionally, they can help navigate the complex rules regarding the capitalization and amortization of Section 174 costs.
Set Up or Use Existing Project Accounting
While it’s not a requirement for the R&D Tax Credit, government contractors are uniquely positioned to capture the necessary project accounting details due to their often-required detailed time tracking system. That said, businesses with clear and comprehensive documentation for all R&D activities are seen as favorable in establishing the nexus between qualifying research activities and qualifying research expenditures.
Along with implementing a robust time tracking system that provides a comprehensive record of the time and resources allocated to qualifying R&D activities, government contractors should also set up efficient tracking mechanisms and task names to better capture contemporaneous data for R&D credit calculation and Section 174 calculations. With these setups in place, government contractors can also reduce the need for frequent interruptions or additional reporting from the development team, allowing them to focus on their core responsibilities and maximizing the capture of R&D activities.
Your Guide Forward
The R&D Tax Credit can provide significant tax savings for government contractors engaged in R&D activities. However, navigating the complexities of federal and state tax laws can be complex. Additionally, a quantitative and qualitative aspect is necessary to ensure that the activities rise to the threshold of the four-part test, and this requires the knowledge and expertise of a multidisciplinary team of CPAs, lawyers and engineering/development teams to navigate successfully.
Cherry Bekaert’s Tax Credit & Incentives Advisory team not only has significant experience in R&D credits and Section 174 analysis but also in working within the government contracting industry. If you have any questions or concerns, our consultants are available to discuss your unique situation.
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