Expert Analysis: The Research Funded by a Government Entity Exclusion and the Colorado EZ R&D Tax Credit

Research Funded by a Government Entity (Exclusion) bars expenses from the Colorado Enterprise Zone Research and Development (EZ R&D) tax credit if the work is paid for or reimbursed by a governmental body (federal, state, or local).1 Compliance requires interpreting this absolute exclusionary statement using the stringent, two-pronged federal standard under Internal Revenue Code (IRC) Section 41, which disqualifies research where the taxpayer fails to retain substantial rights to the results and/or fails to bear financial risk of research failure.2

I. Statutory and Administrative Framework of the Colorado EZ R&D Credit

The Colorado EZ R&D Tax Credit is integral to the state’s Enterprise Zone (EZ) Program, which was legislatively created to encourage economic development in specific distressed areas, characterized by criteria such as high unemployment or low per capita income.1 The EZ Program comprises 16 designated zones across the state, with administrative oversight shared between local enterprise zone administrators and the state’s Office of Economic Development & International Trade (OEDIT).3 Businesses seeking to claim the EZ R&D credit must first obtain pre-certification from OEDIT, underscoring the necessity of navigating the state’s administrative structure.4

Credit Mechanics and Qualification Criteria

The financial incentive structure of the credit is specifically targeted at increasing research investment within these zones. The credit rate is 3% of the amount by which the taxpayer’s current year Qualified Research Expenditures (QREs) incurred in the enterprise zone surpass the average QREs from the preceding two tax years in the same zone.5 A business must be located within an Enterprise Zone and generally must maintain its presence in that same zone for three years to claim the credit, with relocation necessitating a restart of this three-year prerequisite.1

The credit is nonrefundable but highly valuable due to its carryforward period. Taxpayers are restricted to claiming no more than 25% of the total generated credit in the initial tax year.5 The remaining credit balance may be carried forward indefinitely until it is fully utilized.1 This extended usage period means a single year of generating the credit can impact tax returns for many years, which necessitates absolute precision in the initial QRE calculation.

The research itself must meet technical criteria, requiring it to be technological in nature, designed for the development of new or improved products or components, and involving systematic experimentation.1 Eligible expenses include in-house costs (wages, supplies) and contract research expenses, provided the contract research is performed within an Enterprise Zone.1

The Non-Qualified Expense: Research Funded by Any Government Entity

Among the list of non-qualified expenditures—which includes costs for land, depreciable equipment, and management surveys—the most consequential is the explicit exclusion of “research funded by any government entity”.1

The decision to allow an indefinite carryforward for this credit, coupled with the annual 25% usage limit, means that a calculation error concerning the funded research exclusion in the initial year can structurally impact and potentially invalidate credit claims for numerous subsequent tax years.5 An adjustment made by an auditor to the original QRE calculation base, resulting from the improper inclusion of government-funded research, would require recalculating the credit balance and usage for every year thereafter. This significant administrative burden and high penalty exposure mandate that taxpayers treat the initial determination of funded research with the utmost rigor and caution, as if the analysis were subject to an immediate federal audit.

II. Definitional Analysis of the Government-Funded Exclusion

In the absence of detailed, codified regulations from the Colorado Department of Revenue (CDOR), the determination of whether research is “funded by a government entity” relies upon the established federal framework under IRC § 41 and its accompanying Treasury Regulations. This approach is necessary because the fundamental concept of QREs is derived from the federal definition, and the purpose of the exclusion is to ensure the credit only benefits the party who actually bears the economic cost of the research.8

The federal analysis requires the performing taxpayer to satisfy two simultaneous requirements concerning the research expenses to include them as Qualified Research Expenditures. Failure on either of the following two prongs results in the exclusion of the associated expenses.

1. Prong 1: Retention of Substantial Rights to Research Results

For the research to qualify, the taxpayer must retain “substantial rights” to exploit the intellectual property (IP) or results generated from the research.2 If the terms of the government contract or grant require the taxpayer to transfer exclusive ownership of the deliverables or IP to the governmental entity, the work is considered funded and non-qualified.8

Substantial rights typically mean the taxpayer retains the necessary commercial rights to use the results in their own trade or business. While government entities often reserve a non-exclusive, royalty-free license for internal governmental use, the retention of exclusive commercial licensing and exploitation rights by the taxpayer is usually essential to satisfy this test. If the government retains all exclusive rights, the research expenses are fully disqualified from the Colorado EZ R&D credit.

2. Prong 2: Bearing Financial Risk (The “At-Risk” Standard)

The taxpayer must demonstrate that they bore the economic risk associated with the technical success or failure of the research.2 The underlying principle is that the expense should be treated as incurred by the taxpayer only if it is not paid for or reimbursed by the government entity, irrespective of the project’s outcome.8

This prong is commonly failed in standard government procurement arrangements. For example, under Cost-Reimbursable Contracts (e.g., CPFF), the government guarantees reimbursement of all allowable costs. Because the contractor is paid regardless of whether the research yields a successful outcome, the taxpayer bears no financial risk, and the QREs are considered fully “funded” and thus excluded.9

Conversely, in Fixed-Price Contracts or in certain Success-Based Grants where payment or the retention of funds is contingent on achieving measurable experimental milestones, the performing taxpayer assumes the risk of cost overruns or technical failure. In these instances, the portion of expenses that the taxpayer is potentially liable for may qualify, provided the substantial rights prong is also met.8

III. Colorado Department of Revenue Guidance and Compliance Protocol

CDOR Guidance and the Reliance on Federal Authority

The primary source of comprehensive eligibility requirements for the EZ R&D credit is the Enterprise Zone Income Tax Credit Guide published by OEDIT.1 Beyond the guide’s explicit exclusion of government-funded research, no publicly available, universally binding regulatory guidance (such as CDOR regulations or General Information Letters) has been issued by the CDOR detailing how Colorado interprets the substantial rights and financial risk prongs.10

CDOR provides administrative processes, such as allowing taxpayers to request non-binding General Information Letters or binding Private Letter Rulings (PLRs) for specific transactions.10 However, this individualized guidance does not establish general regulatory standards. Consequently, taxpayers must proceed by treating the Colorado funded research exclusion as a direct incorporation of the federal IRC § 41 requirements.

Distinction Between Contracts and Grants

The analysis of funding depends entirely on the terms of the instrument, not its label. A contract typically reflects a procurement relationship where the government purchases goods or services (contractor), while a grant reflects financial assistance to the recipient (subrecipient) to carry out a program for a public purpose.11

Table 2: Classification of Government Funding Types and R&D Credit Eligibility

Filing Requirements and Documentation

To claim the Enterprise Zone R&D credit, taxpayers must electronically file using Form DR 1366 (Certified Economic Development Credit Schedule), attaching copies of the pre-certification forms from the OEDIT system.13 The need for meticulous documentation is critical. For any research project involving government funding, the taxpayer must maintain the full text of the contract or grant, along with internal cost accounting records that explicitly separate the government-funded costs from the taxpayer’s “at-risk” expenditures.8

IV. Case Study Example: Analyzing Funded Research Eligibility for EZ QREs

To illustrate the necessary analysis, consider Quantum Dynamics, Inc. (QDI), a certified EZ business with a base period average QRE of $\$800,000$. In 2025, QDI incurs $\$2,500,000$ in EZ QREs across three projects.

Project Sigma: Cost-Plus Defense Contract (Total Disqualification)

• QREs Incurred: $\$1,500,000$.
• Funding: U.S. Department of Defense via a Cost-Plus Incentive Fee (CPIF) contract.
• Terms: The contract guarantees reimbursement for all $\$1,500,000$ in allowable costs, and the DoD retains all exclusive, worldwide intellectual property rights.
• Analysis: QDI fails both the financial risk test (payment is guaranteed regardless of outcome 9) and the substantial rights test (exclusive IP transfer).
• Qualified QREs Included: $\$0$.

Project Tau: State Research Grant (Partial Qualification)

• QREs Incurred: $\$600,000$.
• Funding: Colorado state transportation department via a research grant.
• Terms: The grant provides $\$400,000$. A clause mandates QDI must repay $\$200,000$ (50% of the grant) if a specific energy density benchmark is not achieved. QDI retains exclusive rights to license the resulting technology commercially, granting the state only a non-transferable right for governmental use. QDI incurred an additional $\$200,000$ in self-funded cost overruns.
• Analysis:

• Substantial Rights: QDI retains substantial commercial rights. Passes.
• Financial Risk: The guaranteed portion of the grant $(\$200,000)$ is funded/excluded. The portion of the grant subject to repayment contingency $(\$200,000)$ is deemed at risk and qualifies.8 The self-funded overrun $(\$200,000)$ also qualifies.
• Qualified QREs: $\$200,000$ (at-risk grant) $+\$200,000$ (self-funded overrun) = $\$400,000$.

Project Upsilon: Internal Optimization Software (Fully Qualified)

• QREs Incurred: $\$400,000$.
• Funding: Internal corporate funds.
• Analysis: No government funding; QDI bears all risk and retains all IP.
• Qualified QREs Included: $\$400,000$.

Final Credit Quantification

• Total Claimable EZ QREs (2025): $\$0$ (Sigma) $+\$400,000$ (Tau) $+\$400,000$ (Upsilon) = $\$800,000$.
• Incremental QREs: $\text{Max}(\$800,000 \text{ Claimable QREs} – \$800,000 \text{ Base QREs}) = \$0$.
• Total Generated Credit: $\$0 \times 3\% = **\$0$.**

This quantification demonstrates that the disqualification of the $\$1.5$ million cost-plus contract expenses fundamentally eliminated the ability to claim an incremental credit. The power of guaranteed reimbursement to disqualify QREs is significant, often overriding the general eligibility of research activities.

V. Conclusions and Recommendations

The Colorado EZ R&D tax credit features a definitive, though broadly stated, exclusion for government-funded research. Compliance success rests entirely upon the taxpayer’s ability to rigorously apply the two-pronged federal test—financial risk and substantial rights—derived from IRC § 41, due to the lack of specific, binding CDOR interpretive guidance.

Recommendations for Compliance

1. Prioritize Contract Review: Before entering into any government contract or accepting any grant, tax counsel must evaluate the terms. Contracts that stipulate guaranteed payment (Cost-Plus) or mandate the transfer of exclusive IP rights should be assumed to render all associated QREs ineligible for the Colorado EZ R&D credit.
2. Ensure Economic Risk is Borne: When negotiating funding, taxpayers should favor structures that maintain their financial risk, such as fixed-price contracts or success-contingent grants, and always ensure the retention of substantial commercial rights to the generated IP.
3. Mandate Cost Segregation: Internal accounting must be capable of segregating government-funded QREs by project and, within projects, clearly isolating “at-risk” costs from guaranteed-reimbursement costs. This documented separation is the primary line of defense against audit adjustments regarding the funded exclusion.

Base Defense on Federal Precedent: Should the EZ R&D credit claim be audited by the CDOR, the defense strategy must rely on detailed legal memoranda that systematically map the contractual language to federal Treasury Regulations § 1.41-4(d) and related case law, establishing why the taxpayer satisfies both the substantial rights and at-risk requirements for the qualified expenditures claimed.

R&D Tax Credit Preparation Services

Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states.

If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725.
Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.

R&D Tax Credit Audit Advisory Services

creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.

Our Fees

Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/about-us/research-tax-credit-consulting/our-fees/