Introduction
Under IRC §41(b)(3), not all research expenses paid to third parties qualify equally for the R&D Tax Credit. The IRS allows taxpayers to claim a partial percentage of payments made to outside contractors performing qualified research.
These percentages — 65%, 75%, or 100% — depend on who performs, who pays, and who retains rights to the research results. Understanding these distinctions is essential for maximizing allowable Contract Research credits while staying compliant.
Relevant Tax Codes and Forms
- IRC §41(b)(3): Defines contract research and applicable percentage limits.
- Treas. Reg. §1.41-2(e): Details qualified versus non-qualified research payments.
- Form 6765, Part II: Used to report contract research expenses under the Regular or ASC method.
Step 1: Definition of Contract Research
Contract Research occurs when a taxpayer pays another party to conduct qualified research activities on its behalf.
However, the taxpayer can claim only a portion of the cost unless specific ownership and risk conditions are met.
Key Conditions for Qualification:
- The taxpayer bears the financial risk of research failure.
- The taxpayer retains substantial rights to the research results.
- The research must meet the four-part test under IRC §41(d) (Permitted Purpose, Elimination of Uncertainty, Process of Experimentation, Technological Nature).
Step 2: The 65% Rule (Standard Contract Research)
Most outsourced R&D expenses qualify for 65% of the payment amount.
This applies when:
- The contractor performs research on behalf of the taxpayer.
- The taxpayer retains rights to the results.
- The taxpayer bears financial risk.
Example:
Company A pays a lab $200,000 for product testing under an R&D agreement.
It retains ownership of results and pays regardless of success.
Qualified Expense: 65% × $200,000 = $130,000 QRE
Claimable QRE = $130,000
Step 3: The 75% Rule (Research Funded by a University or Institution)
Under IRC §41(b)(3)(C), certain research conducted by qualified educational institutions, scientific research organizations, or nonprofit institutions may qualify at a 75% rate.
Example:
Company B sponsors a project at a state university for $100,000, and the agreement gives both parties shared rights to use the research results.
Qualified Expense: 75% × $100,000 = $75,000 QRE
Claimable QRE = $75,000
Step 4: The 100% Rule (In-House or Controlled Research)
Taxpayers can claim 100% of research costs only when the research is performed:
- Internally by the company’s own employees, or
- Through qualified small business consortiums under IRC §41(b)(3)(C)(ii),
- Or when the taxpayer owns all rights and assumes full risk of the project outcome.
Example:
Company C funds internal testing performed by its employees with wages of $300,000.
Since it bears full risk and owns results:
Qualified Expense: 100% × $300,000 = $300,000 QRE
Claimable QRE = $300,000
Step 5: Documentation Requirements
To substantiate contract research claims:
- Maintain executed contracts or work orders defining ownership and risk.
- Retain invoices, lab reports, and payment records.
- Ensure that intellectual property clauses in agreements align with IRS requirements.
- Distinguish between R&D services and non-qualified services (e.g., administration, training).
- Keep records for at least four years for potential IRS audit.
Step 6: Common Mistakes to Avoid
- Claiming 100% for contractor payments without ownership rights.
- Including foreign research not performed in the U.S.
- Misclassifying routine testing or reverse engineering as qualified research.
- Failing to apply the correct percentage (65% vs. 75%).
- Ignoring controlled group aggregation rules under IRC §41(f).
Conclusion
Understanding the Contract Research percentage rules under IRC §41(b)(3) helps taxpayers correctly allocate qualified expenses for R&D credit purposes.
Applying the 65%, 75%, or 100% rules properly ensures IRS compliance and maximizes credit potential — particularly for companies collaborating with external partners, universities, or internal teams.
Call to Action
For expert guidance in determining the correct Contract Research qualification rate and maximizing your R&D credit, contact Anshul Goyal, CPA EA FCA, a U.S.-licensed Certified Public Accountant, Enrolled Agent authorized to practice before the IRS, and cross-border tax expert representing American and Indian businesses in R&D and IRS compliance.
Disclaimer
This blog is for informational purposes only and does not constitute legal or tax advice. Consult a licensed CPA before making R&D credit claims.
Top 5 FAQs
- What percentage of contract research can I claim?
Typically 65%, unless it involves universities (75%) or in-house work (100%). - Can foreign research qualify?
No, only research conducted in the United States is eligible. - What determines ownership of results?
The written contract — ensure it specifies that the taxpayer retains substantial rights. - Are software development contractors covered?
Yes, if the activity meets the R&D four-part test and risk/ownership criteria. - How do I prove contract research expenses?
Maintain contracts, payment records, technical reports, and project documentation.
About Our CPA
Anshul Goyal, CPA EA FCA is a Certified Public Accountant licensed in the U.S., an Enrolled Agent admitted to practice before the IRS, and a cross-border tax specialist assisting American and Indian businesses in R&D credits, tax compliance, and IRS representation.