Four Common Myths Defense Contractors Hear about the R&D Tax Credit

The following post is the first guest blog from one of our new partners in 2024, Hull & Knarr LLP, written by Business Development Manager, John Berry. Stay tuned for more blogs from John, as well as featured guest posts from new  partners this spring and summer!

The R&D Credit is an incentive that has been around for more than 40 years, yet there remain many businesses that opt not to claim it for one reason or another. In some cases, businesses owners have a vision of what R&D is and don’t believe that what they do constitutes R&D despite the fact that the tax code rewards R&D at a much lower level of innovation than most think. In other cases, there is a lot of misinformation out there about the R&D Credit and this misinformation either prevents companies from capturing this benefit or results in paying more in tax than they should.

One of the industries most affected by R&D Credit misinformation are defense contractors. We have outlined four of the most common myths defense contractors have shared with our team at Hull & Knarr to help them determine if the R&D Credit is something that can help their business or not.

Myth 1: I can’t claim the R&D Credit because the tax code says “funded research is excluded.”

It’s true that the code states, “funded research is excluded.” However, that statement doesn’t define what “funded research” is. Upon reading further in the code, taxpayers will come to find out that every contract – government or commercial – needs to have two key characteristics to be qualified for the R&D Credit (in addition to the activity needing to pass the four-part test). Those two characteristics are financial risk and substantial rights to the IP.

Companies that have Firm Fixed-Price (FFP) contracts through the SBIR/STTR program most often meet the criteria of financial risk and substantial rights. Time and Materials contracts and CPFF contracts don’t meet the criteria due to there being no financial risk.

If you are a company that has won FFP contracts since 2019 and are unsure about whether your contracts are qualified, a Hull & Knarr expert can help.

Myth 2: I am not profitable, therefore I can’t claim the R&D Credit.

Historically, the R&D Credit was used to offset income tax for companies that were profitable. The R&D Credit became more inclusive beginning in 2016 and for companies within five years of receiving their first revenue, they have the option of using the R&D Credit against payroll tax. Note: Businesses using the R&D Credit against payroll tax are only able to use the Federal R&D Credit to offset payroll tax.

Myth 3: Accounting firms are best suited to handle my R&D Credit.

Accounting firms are very good at accounting. The R&D Credit, while filed on a tax form, is not an accounting function. What a lot of companies are unaware of is that the IRS uses degreed engineers to audit the R&D Credit. If the IRS uses degreed engineers, it makes sense for your provider to have degreed engineers. Degreed engineers can speak the same language as the technical personnel within a company and understand the ecosystem of innovation, therefore identify more qualified activities. This leads to higher R&D Credit that can be best defended from a compliance standpoint.

Myth 4: All R&D Credit providers charge contingency fees.

Contingency fees violate Circular 230 and therefore providers that charge contingency fees are unable to defend their work in front of the IRS in the event of an audit. Contingency fees are only favorable for providers, not for taxpayers. While in some cases contingency fees may end up being a lower fee than paying a provider a fixed fee, the benefit lies with the provider as they can include non-qualified expenses to drive up their fee. If non-qualified expenses are included in your study and it goes to audit, the taxpayer becomes the one at risk - not the provider. Paying a provider a fixed price for their services reduces the taxpayers risk.

CONCLUSION: The art of the R&D Credit comes down to being able to determine whether a company’s projects and/or activities meet the qualifications for the R&D Credit or not. For defense contractors, there are multiple qualifications that need to be met and companies with FFP contracts are best served by having a provider that has expertise in the relationship between the R&D Credit and FAR.

WHO IS HULL & KNARR: We are a team of engineers that help businesses by navigating the complexities of the R&D Credit for them while they focus on their business. To be clear, we are not an accounting firm, but we do support companies and their accounting firms by ensuring that their R&D Credit is maximized and documented properly to withstand the scrutiny of an IRS audit. Hull & Knarr has been the trusted provider by companies with defense contracts across the country for nearly 20 years. If you are a business and have heard any of the myths above, you are not alone and Hull & Knarr can help. Schedule a time by clicking here and a Hull & Knarr expert can answer your questions.