Time & Materials Contracts: The "Financial Risk" Factor
In the context of US R&D Tax Credits, the type of contract—specifically Time and Materials (T&M)—dictates who bears the financial risk of the research. Understanding this distinction is critical for determining eligibility under IRS regulations.
The Core Rule
To claim the R&D credit, a taxpayer must bear the financial risk of failure. In a typical T&M contract, the contractor is paid for hours worked regardless of the project's success. Therefore, the contractor bears no risk, and the paying client is usually the one eligible for the credit.
Why It Matters
IRS auditors scrutinize contracts to identify "Funded Research." If you are reimbursed for your expenses (as in T&M), your research is considered "funded," and your QREs (Qualified Research Expenses) may be disallowed.
Contract Risk Simulator
Adjust the contract parameters below to visualize how "Financial Risk" shifts between parties, determining who can likely claim the R&D Credit.
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Real World Example
Legal Context & Next Steps
A deeper dive into IRS regulations and how to substantiate your claim.
Meaning & Importance of T&M Contracts
The Meaning of Risk: In the realm of R&D tax credit law, specifically under IRC Section 41, the distinction between Time and Materials (T&M) contracts and Fixed-Price contracts is pivotal because it defines who bears the economic risk of the research. A T&M contract generally obligates the client to pay the contractor for hours worked and expenses incurred, regardless of whether the research project is successful or yields a deliverable. Because the contractor is guaranteed payment, the IRS views the contractor as taking no financial risk; they are simply providing a service. Consequently, the research is deemed "funded" by the client. The client, conversely, is the party paying out money with no guarantee of a usable result, thus bearing the financial risk and typically retaining the right to claim the R&D credit.
Importance in Compliance: Properly identifying contract types is crucial for audit defense. The "Funded Research" exclusion (Section 41(d)(4)(H)) explicitly disqualifies qualified research expenses (QREs) to the extent they are funded by any grant, contract, or otherwise by another person or governmental entity. If a contractor attempts to claim R&D credits for work performed under a standard T&M agreement, they face a high probability of disallowance during an IRS audit. Conversely, companies hiring contractors on a T&M basis must ensure they capture these expenses, as they likely hold the eligibility. Misclassifying these contracts can lead to significant lost opportunities for the client or penalties for the contractor.
Next Steps: Clarifying Your Position
Review "Payment Terms" Clauses
Scan contracts for phrases like "payable upon receipt," "billed monthly," or "hourly rate." These indicate T&M. Contrast with "payable upon acceptance" or "milestone completion," which imply Fixed Price.
Check for Warranty / Acceptance Clauses
Does the contract require the work to meet specific specs before payment is final? If the contractor must re-do work at their own expense (warranty), risk may shift back to them even in T&M scenarios.
Evaluate "Substantial Rights"
Risk is only half the battle. You must also retain "substantial rights" to the research results. If a T&M contract assigns all IP ownership to the client, the contractor fails the "Rights" test as well.
Time and Materials Contracts: Risk Allocation and Compliance within the Context of the U.S. R&D Tax Credit
I. Executive Summary: The Strategic Importance and Legal Context of T&M Contracts for Contract Research Expenses
Time and Materials (T&M) contracts are fundamentally defined by compensating a service provider based on the actual hours expended (time) at predetermined rates, plus the reimbursement of specific supply and material costs (materials).1 This contractual structure is essential in research and development (R&D) settings because it allows for immediate project commencement and provides the flexibility necessary when the precise scope, method, or design is technologically uncertain or “entirely unknown” at the outset.1 By enabling the client to pay for goods and labor upfront, the T&M model removes the necessity for the “extensive bidding and scoping” typical of fixed-price contracts, thereby aligning its inherent flexibility with the experimental nature mandated by the Internal Revenue Code (IRC) Section 41’s four-part test for qualified research.1 The primary economic consequence of this structure is the transfer of execution risk: the contractor is guaranteed payment for the effort regardless of technical success, while the financial risk of research failure is deliberately assumed by the client.2
The importance of the T&M contract lies squarely in its relationship to the “funded research” exclusion under U.S. tax law. For a client (taxpayer) to claim Contract Research Expenses (CREs) related to outsourced R&D, IRC §41 mandates that the research must not be “funded by any grant, contract, or otherwise by another person”.4 A T&M contract is crucial because it generally positions the client as the party bearing the necessary economic risk of research failure, provided the agreement stipulates that payment is non-contingent on the successful outcome of the research.5 Conversely, a straight T&M contract is typically excluded from eligibility for the R&D credit for the performer (the contractor) precisely because the performer is secure in being paid for the work and materials, thus bearing negligible financial risk.4 This structure is essential for compliance, as it restricts the tax credit to only one party, preventing both the taxpayer and the contractor from claiming the R&D credit for the same research activity.7 Therefore, the specific legal language within the T&M agreement determines which party satisfies the IRS’s crucial “risk and rights tests”.5
II. Regulatory Framework: R&D Tax Credit Fundamentals and Contract Research Expenses (CREs)
A. Statutory Foundation: IRC Section 41 and the Four-Part Test
Eligibility for the federal research and development tax credit is governed by Internal Revenue Code Section 41, requiring that activities satisfy a four-part test to be deemed “qualified research”.3 First, the research must have a permitted purpose, relating to the development or improvement of a business component’s function, quality, reliability, or performance.3 Second, the activity must be technological in nature, relying on principles of physical or biological sciences, engineering, or computer science.4 Third, there must have been technological uncertainty at the project’s outset regarding the capability, method, or appropriate design of the business component.3 Finally, the developmental process must be experimental in nature, involving a systematic process of trial and error, modeling, or testing to resolve technical uncertainties.4
The decision to utilize a T&M structure for external development often provides strong evidence that the underlying activity inherently satisfies the requirement of “Technological Uncertainty.” The fact that the scope and cost cannot be predetermined through a fixed-price model indicates that the capability or method of developing the component is not yet resolved, necessitating the flexible, effort-based payment structure of a T&M agreement.1 This connection reinforces the validity of utilizing T&M for activities that are truly experimental and lack a clear, definable scope, thereby linking the contract type directly to the core statutory requirements of the credit.
B. Definition and Scope of Qualified Research Expenses (QREs)
Qualified Research Expenses (QREs) are the costs central to calculating the R&D tax credit, offering a dollar-for-dollar reduction in tax liability for costs that meet specific IRS requirements.3 QREs generally fall into three categories: certain domestic employee wages, the cost of qualified supplies, and Contract Research Expenses (CREs).3 Qualified supplies must be tangible raw materials used in the R&D process that are not capitalized or depreciated, such as materials used for the fabrication and testing of prototypes.9
When utilizing T&M contracts, particular caution must be exercised regarding expenses passed through from the contractor. While the contractor bills for all time and materials, only the portion of the cost attributable to qualified research performed within the United States can be included as a QRE.3 Expenditures for supplies or labor that are indirectly related to R&D, such as general and administrative (G&A) overhead or non-research-related project management costs, do not qualify for the credit and must be strictly identified and excluded from the claimed QREs.3
C. Mechanics of Contract Research Expenses (CREs): The 65% Rule
Contract Research Expenses represent a specific category of QREs defined under IRC Section 41(b)(3)(B).10 The statutory definition stipulates that the term CRE means 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for the performance of qualified research.11
This 65% inclusion rule often leads to a misunderstanding: the 35% reduction is not intended to cover non-qualified expenses. Rather, the 65% statutory haircut is applied only after the taxpayer has successfully identified and subtracted all non-qualifying costs—such as G&A, travel, or purely administrative effort—from the total amount billed by the contractor.3 The underlying requirement, therefore, is for the taxpayer to fully substantiate 100% of the cost as being attributable to qualified research activities before the 65% calculation is performed. This administrative necessity imposes an extremely high documentation burden on the taxpayer claiming the CRE, as the basis for the 65% calculation must be impeccably accurate.12
III. Contractual Models and Inherent Risk Allocation
A. Defining Time and Materials (T&M) Contracts: Flexibility and Risk Transfer
A Straight Time and Materials contract is a commercial arrangement where the contractor is paid a predetermined hourly or daily rate for labor, plus the actual cost of materials. This model provides the contractor with substantial security and predictable margins because payment is guaranteed for actual effort and costs incurred, regardless of the research outcome.2 This payment predictability, tied to effort rather than technical success, is the defining factor that distinguishes T&M from Fixed Price contracts in the context of R&D tax credit eligibility.
For the client, the T&M model provides greater transparency regarding expenditures and allows for a quicker start to development when scope is undefined.1 Most critically, the client, by agreeing to pay for labor and materials irrespective of success, shoulders the financial risk of research failure.4 This assumption of economic risk by the client is the necessary condition for claiming the CRE under IRS regulations.
B. Comparison Matrix: Fixed Price vs. T&M vs. Cost-Plus
The choice of contract type fundamentally dictates which party is eligible to claim the R&D tax credit. When scope is clear and definable, a fixed fee contract is typically used, placing the risk of cost overruns and technical failure on the contractor.2 When the contractor bears this risk, they may be eligible to claim the R&D credit. Conversely, when the scope is uncertain, T&M is preferred, transferring the risk of expenditure failure to the client, thereby generally qualifying the client to claim the CRE.4 Hybrid structures, such as T&M Not-to-Exceed (NTE), introduce complexity and often fail the funded research test for both parties.
The relationship between contract structure, risk allocation, and R&D credit eligibility is summarized below:
Contract Type Comparison and R&D Risk Allocation
| Contract Type | Scope Clarity | Risk Burden for Performing Contractor | Eligibility for R&D Credit (Performer) | Eligibility for R&D Credit (Client/Taxpayer CRE) |
| Fixed Price (Lump Sum) | High | High (Bears cost overruns/failure costs) | Generally Eligible (Bears Risk) | Generally Ineligible (Client did not bear risk) |
| Straight Time & Materials (T&M) | Low/Uncertain | Low (Paid for effort regardless of success) | Generally Ineligible (Research Funded) 4 | Generally Eligible (Client bears risk of failure) |
| T&M Not-to-Exceed (NTE) | Medium | Variable (Bears risk above the cap) | Highly Scrutinized; Often Ineligible 4 | Highly Scrutinized; Risk of Fails Both Tests |
IV. Legal Analysis: The Funded Research Exclusion and T&M
A. The Mandate of IRC §41(d)(4)(H): Research Must Not Be Funded
The foundational barrier to claiming the R&D credit for outsourced work is the exclusion provided in IRC Section 41(d)(4)(H), which states that qualified research excludes any research to the extent it is “funded by any grant, contract, or otherwise by another person”.4 This exclusion is interpreted through Treasury Regulation Section 1.41-4A(d), which establishes two critical tests: the financial risk test and the substantial rights test.
B. Prong 1: The Financial Risk Test
For a taxpayer to claim the R&D credit, whether directly or as a CRE, they must bear the economic risk of the research work performed.9 Research is deemed “funded”—and thus ineligible for the credit—if the taxpayer receives payment that is not contingent on the success of the research.4 This regulatory language creates a sharp dichotomy regarding T&M contracts.
For the client (the party claiming the CRE), T&M contracts are generally the most favorable vehicle to satisfy the risk test. Because the client is obligated to pay the contractor for all time and materials, even if the research yields no usable or successful result, the client clearly bears the financial risk of failure.4
In contrast, Cost-plus, cost reimbursable, hourly, and Straight T&M contracts are specifically listed as contract types that generally preclude the performer (contractor) from claiming the credit.4 The reason a Straight T&M contract disqualifies the contractor is the exact reason it typically qualifies the client, provided the client documents the expense properly and retains intellectual property rights. The credit is legally intended to be claimed only by the party that ultimately suffers the economic loss if the R&D effort fails.7
C. Prong 2: Substantial Rights Test (IP Ownership and Retention)
The second prong of the funded research test concerns intellectual property (IP) ownership. Research is considered funded if the taxpayer performing the research for another entity retains “no substantial rights” in the research results.4
For the client claiming the CRE, the contract must explicitly stipulate that the client retains exclusive rights to exploit the results, including ownership of the resulting formulas, processes, or inventions. If the contract stipulates that another person holds exclusive rights to exploit the results, the research is deemed funded, and the CRE cannot be claimed.4 While retaining exclusive rights is safest, shared rights may also be allowable, provided the client retains rights that are deemed substantial enough to satisfy the test.7 Contract language regarding IP must be carefully drafted to ensure the client is the recognized owner of the research outcomes.
V. Case Law Precedent: Scrutiny of T&M and Hybrid Contracts
A. Detailed Review of Geosyntec Consultants, Inc. v. United States
Case law provides critical boundaries on the applicability of the R&D tax credit to contract research, particularly concerning the limits of risk assumption under hybrid contract structures. The case of Geosyntec Consultants, Inc. v. United States is highly relevant, as it analyzes how cost containment mechanisms within contracts affect the funded research determination.4
The court ruled that research expenses incurred under “capped contracts” or “Cost plus guaranteed max” fall within the funded research exclusion, thereby making them ineligible for the research credit.4 This decision was based on the finding that the contractor performing the work did not bear sufficient financial risk under these capped structures.
This precedent has significant implications for T&M Not-to-Exceed (NTE) contracts. T&M NTE contracts are inherently risky for the client seeking to claim a CRE because they introduce ambiguity regarding who truly bears the risk of failure.6 If the contract requires the contractor to correct deficient work at its own cost, or stipulates that the contractor will not be reimbursed for expenses incurred above the ceiling 6, the financial risk is partially shifted back to the contractor. The moment a T&M contract introduces performance-based risk or a cost containment cap that shifts financial burden back to the contractor, the client’s ability to claim the CRE is jeopardized. This creates a legal gray area where both parties might be deemed ineligible: the client fails to bear 100% of the risk required for a CRE claim, and the contractor still fails to bear sufficient financial risk as determined by the Geosyntec precedent.4 Consequently, for clarity and maximized compliance, Straight T&M contracts are legally safer for supporting the client’s CRE claim than complex, hybrid structures.
B. Documentation Deficiencies Highlighted by Precedent
Beyond the contractual structure, the sufficiency of documentation is paramount. The case of Moore v. Commissioner underscored that even when R&D activities are legitimate, the credit can be disallowed if documentation is insufficient to distinguish qualified research time from non-qualifying activities.13 The primary weakness identified in that case was the lack of clear time tracking.13
Since the T&M model relies entirely on accurate, verifiable time tracking for billing, this precedent imposes a mandatory compliance requirement: the taxpayer must contractually obligate the contractor to implement rigorous, detailed, contemporaneous record-keeping.12 The documentation must be precise enough to substantiate that the expenditures claimed are eligible for the credit, providing usable detail.9 Failure to enforce documentation standards on the contractor will inevitably lead to the failure of the CRE claim during an audit, regardless of the contractual allocation of risk.
VI. Practical Application: Contract Drafting and Hypothetical Example
A. Contract Drafting Requirements for Maximizing CREs
To ensure the client can successfully claim CREs under a T&M arrangement, specific contractual elements must be addressed:
- Timing: The contract must be entered into prior to the performance of the qualified research.5
- Risk of Payment: The agreement must explicitly state that the client is required to bear the expense, even if the research is unsuccessful, guaranteeing payment for time and materials regardless of outcome.5
- IP Rights: The contract must provide that the research is performed on behalf of the client (taxpayer), ensuring the client has substantial rights to the results.4
B. Example Case Study: Utilizing a T&M Contract for Qualified Research
A clear example demonstrates how a T&M structure supports a CRE claim:
Scenario Description:
- Taxpayer (Client): Bio-Tech Innovators, Inc. (BTI). BTI is developing a novel chemical separation technique for a pharmaceutical process, which qualifies as R&D because of technological uncertainty regarding the appropriate method.4
- Contractor: Alpha Labs. BTI outsources the required experimental engineering work to Alpha Labs under a Straight Time and Materials Contract.
- Contract Terms: Alpha Labs is paid $200 per hour for qualified engineering time and is reimbursed for all specific, required supplies, paid monthly. Critically, the contract stipulates that BTI must pay these amounts regardless of whether the separation technique is successfully optimized. BTI retains exclusive IP rights to all resulting formulae.
- Data Incurred (Qualified expenses performed in the U.S. only):
- Qualified Engineering Labor (U.S.): 600 hours @ $200/hr = $120,000.
- Qualified Supply Costs (Chemical Reagents/Prototypes): $10,000.
- Non-Qualified G&A/Administrative Time (Excluded): $5,000 (Properly segregated by Alpha Labs’ detailed invoicing).
Resulting Calculation:
- Total amount paid for qualified research: $120,000 (Labor) + $10,000 (Supplies) = $130,000.
- CREs Eligible for the R&D Credit (65% inclusion): $\$130,000 \times 0.65 = \textbf{\$84,500}$.
Analysis: BTI successfully substantiates the CRE claim of $84,500 because the Straight T&M structure unequivocally demonstrates that BTI bore the financial risk of the $130,000 expenditure being fruitless and retained substantial rights to the research output, thereby satisfying both prongs of the funded research test required by Treasury Regulation Section 1.41-4A(d).4 Alpha Labs, the contractor, is appropriately precluded from claiming the credit for the same effort.
VII. Audit Preparedness: Documentation and Contemporaneous Record-Keeping
A. General Requirements and Audit Focus
Strong documentation is not merely helpful; it is essential for claiming the R&D tax credit and avoiding costly audit adjustments.13 The IRS requires taxpayers to “retain records in a sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit”.9 For T&M contracts, this compliance burden is heightened because the documentation must link “every dollar of your QREs to specific research activities”.12
This requirement means that documentation must effectively “tell the story” of the research process, demonstrating the initial technological uncertainty, the systematic experimentation undertaken, and the alternatives considered.12
B. Specific Requirements for T&M Contract Invoices and Records
The critical documentation for T&M CREs extends far beyond summarized invoices. The taxpayer must obtain and retain detailed records that substantiate the activities and costs of the contractor.9 These records must allow the IRS to audit the hours claimed against the underlying research activities.
Specifically, invoices and supporting documents (such as Statements of Work, purchase orders, or master service agreements) must delineate the contractor’s labor hours and material costs, specifically coding them to the activities that satisfy the four-part test, such as “Experimentation: Testing Prototype 3.1”.5 The internal accounting systems of the contractor must, by necessity, be aligned with the client’s R&D tax compliance needs. Failure to contractually enforce the provision of auditable, raw data—such as employee time tracking logs and payroll registers—will likely lead to a disallowance of the CRE, echoing the documentation failures observed in cases like Moore v. Commissioner.9
The following requirements represent the minimum standard for defensible T&M CRE claims:
Essential Documentation Requirements for T&M Contract Research Expenses (CREs)
| Documentation Element | Required Detail | Risk Mitigation Focus |
| Master Services Agreement (MSA) / SOW | Clear delineation of IP rights; Explicit non-contingent payment terms; Indemnification clauses | Satisfying the “Risk” and “Rights” tests; preventing contractor from claiming the credit.4 |
| Time Tracking Data/Logs | Contemporaneous records linking contractor hours directly to qualified activities (e.g., testing, prototyping) | Substantiating the link between cost and research function; avoiding non-qualifying G&A inclusion.9 |
| Itemized T&M Invoices | Breakdown of labor rates, hours worked per task, specific materials consumed (supplies) | Verification of the exact amount paid/incurred; justifying the application of the 65% rule and the exclusion of non-qualifying costs.5 |
VIII. Strategic Recommendations and Next Steps for Enhanced Clarity
The utilization of Time and Materials contracts is a vital component in a taxpayer’s strategy for claiming the R&D tax credit, provided the arrangements are structured and documented to place the financial risk squarely on the client. To strengthen compliance and maximize the benefit derived from CREs, a comprehensive strategy integrating legal and financial controls is necessary.
A. Conduct a Comprehensive Contractual Risk Audit
The first actionable step is to immediately review all existing and proposed contract research agreements, paying particular attention to hybrid formats like T&M Not-to-Exceed (NTE) or Cost Plus Fixed Fee (CPFF).6 These contracts must be rigorously evaluated against the financial risk exclusion precedent established by the Geosyntec ruling.4 For any new R&D engagement, contracts should be classified based on their risk profile: Straight T&M is the preferred structure for maximizing the client’s CRE claim, while hybrid contracts that attempt to shift performance risk back to the contractor must be modified or eliminated to maintain a clear position regarding risk bearing.
B. Mandatory Implementation of Research-Specific Contract Language
To proactively mitigate audit risk, standardized legal templates for contract research (including Statements of Work and Master Service Agreements) must be developed. These templates should explicitly incorporate boilerplate clauses affirming the client’s financial risk bearing and exclusive ownership of intellectual property results.5 This standardization negates any potential ambiguity that could allow the contractor to claim the “funded research” exception or dilute the client’s rights to the research outcomes.4
C. Establishing Standardized, Contemporaneous Documentation Protocols
A mandatory internal compliance protocol should be implemented that requires all external contractors to utilize time tracking systems capable of coding labor hours directly to specific qualified research activities.13 This protocol must ensure the client receives auditable raw time data—not merely summarized invoices—to substantiate the T&M expenditures. Ensuring documentation is created in real-time, as the research is conducted, is the single most effective defense against IRS scrutiny and substantiates the link between cost and qualified activity.12
D. Next Steps: Quantifying the Financial Impact of CREs
To further clarify and explain the use and importance of T&M contracts for tax planning, the focus must shift to demonstrating the quantifiable financial return generated by the resulting Contract Research Expenses. The meticulous documentation derived from T&M contracts serves as the foundational input for complex tax modeling.
- Modeling the Regular Research Credit (RRC): The full value of the calculated T&M CREs (e.g., the $84,500 from the example) must be factored into the Regular Research Credit (RRC) calculation.15 This involves determining the fixed-base percentage (which generally starts at 3% for startups and is capped at 16%).15 This percentage is multiplied by the average annual gross receipts from the previous four years to calculate the base amount.16 The final R&D tax credit is then calculated as 20% of the difference between current year QREs and the calculated base amount (or 50% of current QREs, whichever is greater).16
- Modeling the Alternative Simplified Credit (ASC): The T&M CRE data should also be modeled using the Alternative Simplified Credit (ASC) method. The ASC method offers a more straightforward approach, calculating the credit as 14% of the amount by which the current year’s QREs exceed 50% of the average QREs for the three preceding tax years.15
By illustrating both complex calculation paths, the analysis will emphatically underscore that the rigorous compliance and meticulous T&M documentation protocols are the necessary inputs for achieving the highest possible R&D tax benefit, regardless of the chosen calculation methodology. This provides corporate tax counsel with the definitive financial justification for imposing strict compliance requirements on third-party contractors.
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What is the R&D Tax Credit?
The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
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