The Constraint of Reimbursement: Analyzing Cost-Plus Contracts, the Funded Research Exclusion, and Eligibility for the U.S. R&D Tax Credit (IRC §41)

I. Executive Summary: Definition and Paramount Importance of Cost-Plus Contracts in Tax Law

I.1. Defining the Cost-Plus Mechanism in Contracted R&D

The Cost-Plus Contract (CPC) is a fundamental contractual mechanism utilized extensively in research and development (R&D) projects, particularly those characterized by high complexity, specialized expertise, and inherent scope uncertainty.1 Under a CPC structure, the performing party (the contractor) is reimbursed for all allowable direct expenses incurred, including labor, materials, and other associated costs, and receives an additional agreed-upon fee, which may be a fixed amount (Cost-Plus Fixed Fee, or CPFF) or a percentage of costs.1 This mechanism is essentially an open-book approach to project costs, ensuring that the contractor is compensated for actual expenditures.2 This contractual approach is critical in environments like R&D, where unforeseen challenges make accurate cost estimation difficult, thereby allowing critical research to proceed without being constrained by predetermined, fixed budgets.1 While commercially practical for mitigating the financial volatility of nascent R&D, the structure of guaranteed, full reimbursement fundamentally alters the required tax analysis under U.S. law, creating a direct conflict with the regulations governing the Research and Development Tax Credit (IRC §41) because the complete certainty of cost recovery negates the financial risk that the law requires a claimant to bear.

I.2. The Critical Constraint: CPCs as the Default Excluder under IRC §41

The primary significance of the CPC structure, within the context of R&D tax credit law, lies in its default classification as “funded research,” which directly triggers the exclusion provision of Internal Revenue Code Section 41(d)(4)(H).3 Treasury Regulation § 1.41-4A(d) specifies that research is considered funded—and therefore ineligible for the performing taxpayer—if the taxpayer is protected from financial risk or fails to retain substantial rights in the resulting intellectual property (IP).4 Because a standard Cost-Plus contract guarantees the contractor full recovery of expenses, plus a profit margin (such as a fixed fee), the financial risk associated with cost overruns or technical failure remains entirely with the customer, or the “funder”.5 Consequently, for a research service provider operating under a typical CPC, the research expenditures are deemed funded by the client and must be excluded from the performing party’s Qualified Research Expenses (QREs). This framework dictates that IRS auditors will primarily focus on the contractual compensation arrangement during an examination, treating CPCs, including Time-and-Materials (T&M) agreements, as initial evidence of non-qualifying activities due to the absence of contractor financial exposure.5

II. Foundational Contractual Mechanics and Statutory Context

II.1. Detailed Taxonomy of Cost-Plus Arrangements

The analysis of a Cost-Plus arrangement under IRC §41 requires a detailed taxonomy of the reimbursement structure to accurately determine where financial risk resides.

Cost-Plus and Time-and-Materials (T&M) Structures

Standard Cost-Plus and T&M contracts reimburse the performing contractor for nearly all costs incurred, including labor and materials. This structure is generally considered unfavorable for the contractor seeking the R&D tax credit because it transfers 100% of the cost risk to the client.5 The research expenses are fully reimbursed, meaning the activities are funded, thereby disqualifying them from being considered Contract Research Expenses (CREs) for the contractor.4

Cost-Plus Fixed Fee (CPFF)

The CPFF arrangement is characterized by the contractor being reimbursed for all allowable costs, with a predetermined, fixed fee added on top.2 This fixed fee does not fluctuate based on the actual costs of the project.2 While commercially attractive because it guarantees the contractor a known profit margin, this guaranteed profit reinforces the IRS’s position that the contractor is not bearing economic risk related to the research outcome or cost volatility.5 Investopedia notes that CPFF contracts are often utilized when initial cost estimates are difficult, confirming their relevance in R&D, but the guaranteed profit element is a strong indicator for IRS examiners that the performing entity bears no financial risk, making disqualification highly probable for the performer.

Capped Cost-Plus (CPGMP)

A key differentiation exists in the Capped Cost-Plus contract, sometimes referred to as Cost-Plus Guaranteed Maximum Price (CPGMP). In this structure, the contractor is paid for labor and other expenses, plus a mark-up, but only up to an agreed-upon maximum price.6 If the actual project costs exceed this cap, the contractor is required to absorb the excess.6 This contractual element is strategically significant, as it creates a point where financial risk shifts back to the performer. As demonstrated in relevant case law, this cap provides the only potential pathway for recovering the R&D credit under a Cost-Plus methodology, specifically for the expenses incurred above the guaranteed maximum.4

II.2. Overview of IRC §41: Qualified Research Expenses and Contract Research

The R&D tax credit is intended to incentivize taxpayers who incur Qualified Research Expenses (QREs) during the course of their trade or business.8 QREs are statutorily defined to include in-house research expenses (such as wages and supplies) and Contract Research Expenses (CREs).8 CREs, which relate to research performed by a third party for the taxpayer, are limited to 65 percent of the amount paid or incurred.8

The framework of the funding rules exists specifically to ensure that the R&D credit incentivizes the party that is financially investing in the research and bearing the risk of failure.9 The exclusion is consistent with broader tax policy, including rules governing the capitalization of research expenditures under Section 174.9 When a research service provider is compensated on a cost-plus basis, the presumption arises that they do not bear financial risk, and thus the party funding the research—the client—is the one generally entitled to the credit (or, more commonly, neither party is eligible for the specific expense if the research is not qualified for the client).9 The limitation on CREs to 65 percent highlights the potential impact of the funded research exclusion; if an expense is deemed funded, it is entirely excluded from an already restricted pool of eligible contract expenses.

III. The IRC §41(d)(4)(H) Funded Research Exclusion: The Two-Pronged Test

The core legal mechanism that disqualifies expenses under a Cost-Plus Contract is the funded research exclusion set forth in IRC §41(d)(4)(H), implemented through Treasury Regulation § 1.41-4A(d).

III.1. The Controlling Legal Framework (Treas. Reg. § 1.41-4A(d))

The statute explicitly excludes “any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)”.4 In determining the extent to which research is funded, all agreements between the taxpayer performing the research and other persons must be considered, not only the primary research contracts.3

Furthermore, regulatory provisions establish a strict administrative bias toward exclusion. Treasury Regulation § 1.41-4A(d)(5) mandates that if, at the time the taxpayer files a return, it is impossible to determine the extent to which particular research may be funded, the taxpayer must treat the research as completely funded for that return.3 This requirement forces the taxpayer to amend the return later when the funding amount is finally determined. This provision establishes a significant regulatory obstacle, placing an extremely high burden of contemporaneous and certain documentation on the taxpayer to prove non-funding status at the time of filing.

III.2. Prong I: The Financial Risk Test (The Primary CPC Constraint)

The Financial Risk Test is the primary constraint imposed by the funded research rules on Cost-Plus contracts. Under this prong, research is considered funded if the taxpayer receives payment that is not contingent on the success of the research.4 To legitimately bear financial risk, the contractor must be required to either guarantee success and potentially return funds upon failure, or incur additional costs beyond the amount the client is paying.4

Cost-Plus contracts inherently fail this test. Since they guarantee the reimbursement of costs, they are structurally designed to insulate the performing contractor from the financial downside of technical failure or cost overruns.5 When a contractor operates under a CPFF arrangement, the guaranteed fixed fee ensures a profit regardless of the outcome, failing the critical test of bearing economic risk. Overcoming this exclusion strategically requires the introduction of enforceable contractual elements—such as performance metrics, non-payment terms for defined failure points, or warranty terms—that subject the contractor’s compensation, or at least the recoupment of costs, to a material degree of financial risk.7 Without such terms, the contractor’s expenditures are simply offset by guaranteed reimbursement, resulting in zero unfunded QREs.

III.3. Prong II: The Substantial Rights Test

Even if a research performer manages to pass the Financial Risk Test, they must still satisfy the Substantial Rights Test. This prong requires that the taxpayer performing the research retain substantial rights in the research results, property, or intellectual property (IP) created by the research.3

In the context of outsourced R&D, commercial arrangements structured as Cost-Plus often explicitly stipulate that the customer (the funder) holds exclusive rights to exploit the research results or the resulting know-how.4 If the performing contractor retains no “unfettered right” to use the resulting product in its trade or business, or to otherwise exploit the results through sale, lease, or license, the research is deemed funded.9 The results need not be patentable; however, common arrangements permitting a research provider to utilize resulting know-how are generally insufficient if domestic and foreign law protects the results.9 The commercial desire of a client to demand both full cost transparency (Cost-Plus) and exclusive IP ownership creates a pervasive commercial situation that typically fails both the risk and rights prongs of the funded research exclusion, resulting in the definitive ineligibility of the performing contractor for the R&D credit.

IV. Judicial Precedent: The Cost-Plus Contract as a Disqualifying Example

The legal standing regarding the ineligibility of standard Cost-Plus arrangements for the R&D tax credit has been firmly established through judicial precedent.

IV.1. Analysis of Geosyntec Consultants, Inc. v. United States

The case of Geosyntec Consultants, Inc. v. United States provides the defining legal example that confirms the inherently disqualifying nature of standard Cost-Plus arrangements. Geosyntec, an engineering consulting firm, sought R&D tax credit refunds for work performed under various contract types, including Fixed-Price, Capped Cost-Plus, and standard Cost-Plus agreements.6

The most salient point of the case is Geosyntec’s crucial concession to the government regarding the standard Cost-Plus contracts. The firm agreed that standard Cost-Plus contracts do not qualify for the Section 41 credit because the client, or funder, assumes the entire economic risk for all time and material costs incurred.6 This concession was based on the understanding that the full reimbursement characteristic transfers the burden of research risk away from the contractor. Consequently, the litigation focused entirely on the Capped Cost-Plus agreements, requiring the court to analyze the threshold at which financial risk shifted to the contractor (i.e., when costs exceeded the specified maximum cap).6 This judicial confirmation demonstrates that the industry and the judiciary view full cost reimbursement, as defined by a standard CPC, as inherently failing the Financial Risk Test.

IV.2. Broader Implications of Case Law

Beyond Geosyntec, various court cases involving government contractors operating under cost-reimbursement schemes, such as those analyzed in Fairchild Industries, Inc. v. United States, consistently reinforce that the assumption of genuine financial risk is the cornerstone of eligibility.5 The performing taxpayer must be exposed to the possibility of economic loss beyond merely failing to collect a guaranteed profit, which sharply contrasts with the intent and structure of typical CPFF contracts.2 If a contract is structured such that the contractor bears no financial uncertainty and can expect full payment of costs regardless of success, the expenses are considered funded, and the performing entity is disqualified from claiming the associated QREs.4

V. Strategic Contract Modification and Mitigation of Risk

For contractors whose business requires a degree of cost recovery flexibility but who also wish to claim the R&D tax credit, outright avoidance of the CPC structure is ideal, but strategic modifications are often necessary to carve out eligible expenses.

V.1. Transitioning to Favorable Structures

The most favorable structure for R&D tax credit eligibility is the Firm-Fixed-Price (FFP) contract, where the contractor assumes the maximum economic risk for cost overruns.5 If FFP is impractical, utilizing Success-Based Fees (SBF)—where a substantial portion of the fee is contingent upon the technical success or measurable performance of the research—reintroduces the necessary element of financial risk required by Regulation § 1.41-4A(d).4

V.2. Analyzing Hybrid Structures and Carve-Outs

Maximizing CPGMP Eligibility

When a Capped Cost-Plus contract (CPGMP) is utilized, the taxpayer’s only pathway to eligibility lies in expenses incurred above the cap.6 Only these excess costs are considered unfunded QREs because they represent absorbed financial risk that was not reimbursed by the client. This approach necessitates a robust, detailed cost accounting system capable of delineating the specific cost center subject to the cap and meticulously tracking costs that exceed that threshold. The financial system must record these expenses as true, non-reimbursable business losses rather than simply offsetting them against a guaranteed margin.

Internal R&D (IR&D) Carve-Outs

Research conducted internally by the contractor—specifically, pre-award work, foundational scientific research, or feasibility studies necessary to define the client’s scope—is typically self-funded.4 These costs may qualify as in-house research expenses. To substantiate this, the IR&D must be rigorously documented through internal project authorization requests (AFEs), time tracking data, and meeting minutes to prove that the costs were incurred and funded internally prior to, or outside of, the definitive client funding contract.11 This ensures that the expenses satisfy the requirement of being “paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer”.8

VI. Documentation Requirements and IRS Audit Focus

To substantiate R&D credit claims, particularly those related to contract research, the IRS requires meticulously documented proof that the expenses are not funded.7 This is essential for navigating potential IRS examinations (audits) regarding IRC §41 claims.13

VI.1. Substantiating Research Funding Status

Auditors demand detailed documentation that goes beyond general ledger entries. This includes compensation arrangements (e.g., fixed-price, cost-plus with a cap, etc.), specific payment terms, nonpayment terms, IP terms, and warranty terms.7 These documents must clearly define the risk allocation mechanism, especially regarding contractual stipulations for non-payment or return of funds upon failure.4

Furthermore, taxpayers claiming Contract Research Expenses (CREs) must satisfy the three-part test for third-party research: (1) the agreement must be entered into prior to the performance of the qualified research; (2) it must provide that the research be performed on behalf of the taxpayer; and (3) the taxpayer must become entitled to the resulting research property or results.3 Failure to meet the “entitlement” prong, common in CPCs where the client retains exclusive IP rights, often definitively seals the exclusion of the expenses for the performing contractor. The documentation must support the allocation between eligible and ineligible costs, utilizing instruments such as invoices, purchase orders, general ledgers, and work orders.11

VI.2. Essential Contract Documentation Checklist for Contract Research Expenses

The IRS specifically scrutinizes the contractual instruments that define cost recovery and risk transfer.7 The following table summarizes essential documentation required to address the funded research exclusion, especially in the context of Cost-Plus contracts.

Documentation Checklist for Contract Research Expenses (CREs)

VII. Recommendations: Next Steps for Clarification and Full Utilization

To fully clarify the application of the R&D tax credit to Cost-Plus arrangements and ensure the maximum allowable use of the credit, specialized, proactive steps focused on contract design and tax positioning are required.

VII.1. Immediate Audit Risk Assessment and Contract Portfolio Review

• Step 1: Contract Portfolio Triage: A mandatory, comprehensive review of all current and historical R&D service agreements should be conducted to segment them based on compensation type (CPFF, T&M, CPGMP). The immediate priority must be the detailed analysis of hybrid Capped Cost-Plus contracts to accurately determine in which tax years the contractually defined cap was exceeded, thereby mathematically creating unfunded Qualified Research Expenses (QREs).6
• Step 2: Cost System Verification: The internal general ledger and cost accounting system must be verified and, if necessary, upgraded to cleanly delineate reimbursed (funded) costs from internally absorbed (unfunded) costs. This capability is absolutely essential for claiming expenses incurred above a cap and for separating eligible, self-funded Internal R&D (IR&D) costs from subsequent client-funded activities defined by the Cost-Plus agreement.4

VII.2. Establishing a Formal Protocol for Contract Negotiation and Drafting

• Step 3: Mandate Financial Risk Clauses: The legal and contracting departments must implement a formal policy requiring R&D contracts to incorporate specific financial risk-bearing clauses as a prerequisite for potentially qualifying the research for the credit. This involves actively structuring compensation to include substantial success-based fees (SBF) or setting explicit contractual caps (CPGMP) designed to introduce material cost risk that the contractor must absorb upon failure.
• Step 4: Substantial Rights Retention Policy: Standardize the Master Service Agreement template to legally retain non-exclusive, perpetual, royalty-free rights for the performing contractor to utilize the resulting IP, know-how, or research product in its general trade or business.4 This proactive policy addresses the “substantial rights” prong of the funded research test, providing a defense against disqualification even if the financial arrangement approaches full reimbursement.

VII.3. Engaging Tax Counsel for Definitive Legal Opinions on Ambiguous Contracts

• Step 5: Obtain Legal Opinions for Hybrid Structures: Given the inherent complexity and high audit scrutiny applied to hybrid arrangements like Capped Cost-Plus contracts, specialized tax counsel should be engaged to issue a definitive legal opinion. This opinion should analyze the precise allocation of risk under the cap, quantify the resulting eligibility of expenses incurred above the maximum price, and document the rationale for the R&D claim, providing robust documentation and defense against future IRS challenges.

Step 6: Regulatory Advocacy for De Minimis Exceptions: Consideration should be given to proactive engagement in advocacy efforts urging the Treasury Department and the IRS to issue clarifying regulations. These regulations should aim to define a “de minimis” level of contractual risk or specify standard warranty clauses that, if included, would not automatically trigger the funded research exclusion. Such flexibility is necessary to align the tax credit requirements with the commercially standard contractual risks inherent in typical contract research arrangements.9

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/