Navigating the Funded Research Exclusion: Comprehensive Guidance for the Illinois R&D Tax Credit

I. Executive Summary: The Exclusion Defined and Contextualized

A. Mandatory Opening Definition

Exclusion: Government-Funded Research means that any expenses incurred for Research and Development (R&D) activities paid for or reimbursed by a government entity or other third party are ineligible for the Illinois R&D tax credit.

The purpose of this exclusion is to ensure that the credit only incentivizes private capital investment where the taxpayer bears the financial risk and retains ownership of the research outcomes.

B. Contextual Analysis of Illinois Conformity

The Illinois Research & Development (R&D) Tax Credit is a critical incentive for state innovation, offering a 6.5% non-refundable credit on Qualified Research Expenses (QREs) that exceed a statutory base amount.1 This credit is authorized under the Illinois Income Tax Act (IITA), specifically 35 ILCS 5/201(k), and is administered by the Illinois Department of Revenue (IDOR).1 It has been extended for stability through tax years ending on or before December 31, 2031, providing a reliable incentive for long-term planning in sectors like manufacturing, technology, and pharmaceuticals.1

Crucially, the Illinois statute aligns its definition of “Qualified Research” and QREs closely with the criteria outlined in federal Internal Revenue Code (IRC) Section 41.1 This conformity means that Illinois does not maintain a separate, independent body of regulations defining what constitutes funded research. Consequently, all federal exclusions contained within IRC § 41, including the highly nuanced rules surrounding funded research, are automatically adopted and applied for the purpose of calculating the state credit.1

The specific statutory exclusion derives from IRC § 41(d)(4)(H), which removes eligibility for “any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)”.5 IDOR explicitly incorporates this restriction into its instructions, noting that research funded by another person or a government entity cannot be claimed for the credit.3 Therefore, the primary compliance risk for Illinois taxpayers involves adhering to the complex Treasury Regulations and decades of federal judicial precedent (such as the Fairchild and Lockheed decisions) that govern the application of the federal funded research exclusion.7 IDOR audits necessarily defer to these federal standards when determining initial expense eligibility before assessing the state-specific calculation.

This reliance on federal standards places a significant burden on businesses engaged in government contracts to maintain robust documentation. Given that the Illinois credit is non-refundable and allows for a carryforward period of up to five years 1, IDOR auditors must often review underlying contract documentation and cost accounting records spanning eight or more years—covering the credit year, the five carryforward years, and the three years necessary to establish the base period.1 This requires a detailed, contemporaneous accounting of contract terms and expenses to substantiate the financial risks borne by the taxpayer.9

II. The Illinois R&D Credit Framework and Incremental Calculation

A. Statutory Authority and Permanence

The Illinois R&D credit, codified under 35 ILCS 5/201(k), is an essential tool for state economic development.1 It is designed to encourage an increase in research activities within the state’s borders.1 The credit is non-refundable, meaning it serves exclusively to offset a taxpayer’s Illinois income tax liability; it cannot generate a cash refund, nor can it be used to offset other types of state tax, such as payroll tax.1

For businesses that cannot utilize the full credit amount in the current tax year, Illinois permits an unused credit carryforward of up to five years.1 Additionally, unitary groups filing a combined return are required to compute the credit based on the group’s combined QREs, following Illinois combined reporting rules and Schedule 1299 instructions.1

B. Qualifying Research Expenses (QREs)

The determination of QREs for the Illinois credit largely mirrors the federal definition under IRC § 41.1 However, a key distinction is the requirement that all activities must be Illinois-sourced.1 QREs include the following categories of expenses, provided they are incurred for research performed within the state:

1. Wages: Salaries paid to employees for performing, directly supervising, or directly supporting qualified research.1
2. Supplies: The cost of materials and prototypes consumed or used in the research process, such as testing components.1
3. Contract Research: Payments made to third-party contractors for qualified research services.1 (Only 65% of contract research expenses generally qualify under federal rules, which Illinois follows 12).
4. Computer Rentals: Costs associated with leased computers or cloud services used directly in the conduct of research.1

To qualify, these activities must also satisfy the four-part federal test for Qualified Research Activities (QRAs), which includes demonstrating that the intent was to eliminate “technical uncertainty” regarding the capability, method, or appropriate design of a business component, process, or software improvement.1 Furthermore, the research must not fall into any specifically disqualified categories, such as research conducted after commercial production begins, adaptation of existing products for a particular customer, or research in the social sciences.3

C. The Incremental Calculation Methodology

Illinois utilizes the traditional incremental research credit formula. The credit is not based on total QREs but only on those expenses that exceed a historical baseline, reinforcing the credit’s purpose of incentivizing increased research investment.1

The methodology requires two main calculations:

1. Computing the Base Amount: The “Base Period” is defined as the three taxable years immediately preceding the current tax year for which the determination is being made.1 The base amount is calculated as the average of the Illinois QREs incurred during this three-year period.1 If the taxpayer incurred no QREs during a base period year, the QREs for that year are counted as zero.13 This is the only calculation methodology available in Illinois, as the state does not offer alternative federal methods like the Alternative Simplified Credit (ASC).1
2. Determining the Credit: The “qualifying expenses for increasing research activities in Illinois” are the difference between the current year’s total Illinois QREs and the calculated three-year average base amount.3 The credit itself is 6.5% of these excess (or incremental) QREs.1

The incremental calculation method dramatically highlights the need for consistent application of the funded research exclusion, both in the current year and in the base period. Excluding funded research QREs from the current period directly reduces the pool eligible for the 6.5% credit. Conversely, if a taxpayer improperly included funded research QREs in a prior base year, removing those funded QREs retrospectively during a compliance review would lower the average base amount, consequently increasing the current year’s eligible incremental QREs and maximizing the credit. Due diligence regarding the funded research exclusion is thus essential, impacting not only the current credit calculation but also the historical calculation of the baseline against which future credits are measured.

III. Statutory Mandate: The Exclusion for Funded Research

A. The Federal Statutory Foundation (IRC § 41(d)(4)(H))

The directive to exclude funded research is a mandatory limitation inherent to the definition of qualified research under federal law. IRC § 41(d)(4)(H) unequivocally states that qualified research does not include “Any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)”.5

The fundamental purpose of this exclusion is incentive alignment. The R&D tax credit is designed to reward businesses that commit private capital and accept the financial risk associated with uncertain technical outcomes. If a governmental entity—whether federal, state, or local—or any other third party has already paid for or reimbursed the expense, the private incentive provided by the tax credit is deemed unnecessary because the financial risk has been transferred away from the taxpayer.14

B. Direct IDOR Conformity and Guidance

The Illinois Department of Revenue (IDOR) formalizes its adoption of this federal exclusion in its instructional guidance. Specifically, the Schedule 1299-I instructions, which detail how to calculate the Illinois QREs, explicitly state that research is ineligible if it is:

“research funded by another person (or government entity)”.3

This conformity is comprehensive, extending the exclusion beyond federal grants and contracts to encompass any funding received from any source—government or private—that falls under the definition of “funded research” established in Treasury Regulations.5

C. Exclusion vs. Disqualification

It is important to differentiate the funded research exclusion from general research disqualifications. The exclusion is not a categorical disqualification of the entire research project (e.g., research in the social sciences, which is non-qualified by definition 3). Instead, it is a necessary reduction applied to otherwise qualified research expenses.

The statute uses the critical language “to the extent funded”.5 This phrase allows for the possibility of partial qualification. If a project is only partially reimbursed or funded by an external party, the taxpayer must meticulously reduce their QREs only by the amount corresponding to the funded portion. Any expenses that exceed the funded amount, for which the taxpayer bore the financial risk (such as cost overruns), may still be claimed for the credit, provided the research itself meets all other QRA criteria.14 Consequently, taxpayers must maintain clear cost separation between funded and self-funded work to ensure that only eligible expenses are included in the credit calculation pool.

While the statute treats grants and contracts equally under the exclusion, the mechanism of funding often dictates the compliance effort. Government grants usually involve straightforward funding that may result in 100% exclusion due to clear IP transfer and upfront payment. Contracts, however, require rigorous legal analysis against the “risk and rights” tests, often leading to the identification of partially eligible expenses. This structural difference means that government contractors must dedicate significantly more resources to contract review and sophisticated cost allocation than recipients of simple grants.

IV. Deconstructing the Exclusion: The Substantive Legal Test (Risk and Substantial Rights)

Because Illinois relies on federal IRC § 41 standards, the determination of whether research under a contract is “funded” requires a meticulous, two-pronged analysis based on Treasury Regulations and controlling judicial precedent. The research expense is excluded if the taxpayer performing the research fails either test.

A. The Regulatory Foundation

The determination rests upon two inseparable criteria related to the contractual terms between the research performer (the taxpayer) and the funder (the governmental entity or third party). The taxpayer must demonstrate that they both bear the financial risk of failure and retain substantial rights to the research results.7

B. Prong 1: The Financial Risk Standard (The Fairchild Test)

The financial risk standard focuses on whether the taxpayer is guaranteed payment regardless of the research outcome. This test determines if the taxpayer must absorb the cost of failed experiments.14

1. Contingency Analysis: Research is considered not funded if the taxpayer’s right to payment is contingent upon achieving specific, successful results or milestones related to the technical uncertainty inherent in the project.7 If payment is guaranteed, the research is deemed funded and excluded from QREs.
2. Fixed-Price Contracts: Generally, research performed under a fixed-price contract suggests the taxpayer bears the economic risk. If the research fails or costs exceed the fixed price, the taxpayer absorbs the loss. However, auditors will scrutinize the contract language. If the payment is fixed simply for “services rendered” or “labor hours” rather than contingent on a technical result, the research may still be deemed funded, even under a fixed price.8
3. Cost-Plus Contracts: Payments made under cost-plus contracts, where the funder reimburses costs plus a set fee or profit, usually signify that the funder bears the financial risk. Therefore, QREs associated with cost-plus contracts are typically excluded entirely from the R&D credit calculation.14
4. Case Law: The foundational case for this standard, Fairchild Industries, Inc., established that if the contractual payment is contingent on the success of the research, the costs incurred are not treated as being funded by the payer.7

C. Prong 2: The Substantial Rights Standard (The Lockheed Martin Test)

The second prong requires the taxpayer to retain “substantial rights” to the research results.9 This test ensures that the research contributes to the taxpayer’s future business advantage, justifying the tax incentive.

1. IP Ownership: Substantial rights mean the taxpayer must have the right to use the research results, including any developed intellectual property (IP), in their own trade or business, even if the government or funder also receives rights.14
2. Exclusive Rights: If the contract dictates that the government retains exclusive, perpetual, and irrevocable ownership of all IP or technical data generated—leaving the taxpayer with no viable commercial rights—the research is considered funded and excluded.
3. Government Contracting: For federal government contractors, the data rights clauses within the Federal Acquisition Regulations (FAR) are critical. Tax professionals must carefully review these clauses to determine the nature of the retained license (e.g., whether the taxpayer retains “Limited Rights Data” or commercial exploitation rights).16
4. Case Law: The Lockheed Martin Corporation case confirmed that the substantial-rights standard is a mandatory element. If a taxpayer surrenders all proprietary rights to the research results, they cannot claim the related expenses for the R&D credit.7

Failing either the financial risk test or the substantial rights test results in the research being characterized as funded. While these tests are distinct, they often correlate: a contract that guarantees payment (no risk) often also requires the transfer of exclusive IP (no rights). Tax strategy requires identifying instances where costs associated with a contract might meet one prong but not the other, leading to a complex partial allocation requirement.

Table 4: Funded Research Eligibility Matrix: The Risk and Rights Test

Furthermore, companies that engage in government contracting often perform internal R&D—developing standardized software, internal processes, or proprietary tools—that is not directly billed to a specific contract but improves efficiency for future government projects. These internal expenses, if they meet the four-part QRA test and are not reimbursed, are self-funded and potentially eligible for the Illinois credit. Detailed cost separation is essential to accurately capture these “spillover” QREs and protect them from exclusion during an audit.

V. Illinois Department of Revenue (IDOR) Compliance and Documentation

Compliance with the funded research exclusion requires strict methodological discipline, ensuring that only non-funded, Illinois-sourced QREs flow into the incremental calculation mechanism.

A. IDOR Forms and Worksheets

Taxpayers claiming the Illinois R&D credit utilize specific forms based on their entity type. Corporations and fiduciaries must file Schedule 1299-D, using Credit Code 5340 to report the calculated credit amount.17 The underlying calculation is performed using the instructions and worksheets provided in Schedule 1299-I (or the entity-specific Schedule 1299 instructions).3

The worksheet within Schedule 1299-I is the critical juncture for applying the exclusion. This document requires the taxpayer to input their Illinois QREs—including wages, supplies, and contract research expenses.3 Taxpayers must ensure that the dollar amounts entered on these lines already exclude any expenditures determined to be funded research based on the “risk and rights” analysis.3 The accuracy of the Schedule 1299-I entries directly dictates the final credit amount reported on Schedule 1299-D.

B. Allocation Requirements

For projects involving mixed funding—where a portion of the QREs is covered by a grant or contract, and the remainder is self-funded—accurate allocation is mandatory.14

1. Methodology: Allocation must be based on verifiable, credible accounting methods. Common approaches include detailed time tracking for employee labor costs, consumption logs for supplies tied to non-funded milestones, and segregated invoices for non-reimbursable R&D activity. This methodology must be consistent and defensible under IDOR review.
2. Base Period Consistency: The necessity of applying the exclusion consistently extends to the calculation of the three-year base period.1 If a taxpayer performed funded research in Year 2 that was improperly claimed as a QRE, those funded QREs must be removed from Year 2’s total when computing the average base amount for the current credit year. Failure to do so artificially inflates the base, reducing the current year’s credit benefit.

This structural component of the incremental credit model creates a high risk of inconsistency. A new taxpayer claiming the credit must conduct a rigorous, comprehensive four-year review (three base years plus the current year) focused specifically on funding sources to ensure the base amount is calculated accurately. The administrative complexity of auditing historical contracts is thus unavoidable when seeking to maximize the Illinois R&D credit.

For unitary groups filing a combined return in Illinois, the complexity increases. While the credit calculation occurs on the combined return, the funded research exclusion must be applied individually to each unitary member’s QREs. If one member of the group receives substantial federal funding while another performs purely self-funded work, the funded QREs must be isolated and removed from the total consolidated QRE pool before the incremental base calculation is initiated.1

C. IDOR Audit Readiness and Record Retention

IDOR audits, particularly those involving R&D credits, focus heavily on substantiation and compliance with federal standards.

1. Retention Period: Given the statutory 5-year carryforward period 1, prudent record retention exceeds the standard three-year statute of limitations. Taxpayers must maintain detailed R&D documentation—including project narratives, time tracking, allocation studies, and, critically, source contracts that prove the “risk and rights” analysis—for at least five years beyond the year the credit was used, which often extends the retention requirement to 8 years or more.1
2. Focus Areas: During a review, auditors will prioritize examining contract language to verify retained rights and financial risk, as well as scrutinizing financial ledgers to confirm cost separation and verify that expenses were not reimbursed.9
3. Private Letter Rulings (PLRs): For highly ambiguous or specialized contracts where the funding structure is unclear, a taxpayer may request a Private Letter Ruling (PLR) from IDOR.18 Although a PLR is binding only on the specific taxpayer and for the facts presented 18, it offers a definitive path to confirm IDOR’s position on whether a specific contractual arrangement meets the funded research exclusion criteria.

VI. Practical Example: Quantifying the Exclusion in the Incremental Model

This case study illustrates the necessary steps to apply the funded research exclusion within the Illinois incremental R&D credit calculation.

A. Scenario Setup

Company: IL-Tech Innovations, an Illinois-based engineering firm (a corporation filing Form IL-1120 and Schedule 1299-D).

Context: IL-Tech conducts internal, self-funded R&D for new product lines. It also holds a large government contract (DoD) structured as a cost-plus arrangement where the DoD retained exclusive rights to all generated IP. Due to the complete transfer of risk and rights, the DoD contract expenses are characterized as fully funded and excluded. All QREs listed are assumed to be Illinois-sourced.

B. Step-by-Step Illinois R&D Credit Calculation

The calculation adheres strictly to the IDOR requirements for determining the 6.5% incremental credit.1

Step 1: Determine Base Period QREs

The base period QREs are the sum of QREs for Years 1, 2, and 3, after the funded research exclusion has been applied to each year:

• Year 1 QREs: $600,000
• Year 2 QREs: $750,000
• Year 3 QREs: $800,000
• Total Base Period QREs: $\$600,000 + \$750,000 + \$800,000 = \$2,150,000$

Step 2: Calculate the 3-Year Average Base Amount

The base amount is the average of the qualifying expenditures in the three preceding tax years.1

• Average Base QREs: $\$2,150,000 / 3 = \$716,667$

Step 3: Calculate Excess QREs for Current Year (Year 4)

The current year QREs used are $\$1,000,000$ (the total incurred research less the $\$500,000$ funded exclusion).

• Excess QREs: Current Year QREs – Average Base QREs
• Excess QREs: $\$1,000,000 – \$716,667 = \$283,333$

Step 4: Calculate the Illinois R&D Tax Credit

The credit rate is 6.5% of the excess QREs.1

• Illinois Credit Earned: $\$283,333 \times 0.065 = \$18,417$

Table 5: Illinois QRE Calculation Summary with Funded Research Exclusion

If IL-Tech Innovations had failed to exclude the $\$100,000$ in funded research from Base Year 3, the average base would have been calculated as $(\$2,250,000 / 3) = \$750,000$. This inflated base would have lowered the current-year excess QREs to $\$250,000$, yielding a credit of only $\$16,250$. This numerical difference underscores that the consistent and accurate application of the funded research exclusion throughout the base period is paramount to achieving the maximum allowed credit in the current tax year. Taxpayers must look historically to optimize future benefits by ensuring the comparative baseline is as low as legally permitted.

VII. Conclusion and Strategic Implications

The Illinois R&D Tax Credit, enacted under 35 ILCS 5/201(k) and extended through 2031, represents a robust, long-term state incentive for innovation.1 Successful utilization of this 6.5% non-refundable credit hinges on a sophisticated understanding of the “Exclusion: Government-Funded Research,” which aligns fully with federal tax law (IRC § 41(d)(4)(H)). For businesses, especially government contractors and service firms, the greatest area of compliance risk is the precise application of the dual-pronged “risk and substantial rights” test.

A. Key Compliance Summary

The analysis confirms the following non-negotiable compliance requirements for the Illinois R&D credit:

1. Federal Reliance: IDOR audits will prioritize verification that the taxpayer has correctly applied the financial risk and substantial rights standards derived from federal regulations and case law (e.g., Fairchild and Lockheed). State eligibility is entirely dependent upon federal compliance.7
2. Incremental Consistency: The exclusion must be applied systematically and uniformly across both the current credit year and all three years used to establish the incremental base amount.1 Errors in applying the exclusion in prior years directly and negatively affect the current year’s credit amount.
3. Mandatory Documentation: Due to the 5-year credit carryforward period, taxpayers must retain detailed, auditable records—including contracts, IP agreements, and rigorous cost allocation schedules—for an extended period to justify the exclusion decisions made in the current period and throughout the entire base period.1

B. Recommendations for R&D Tax Strategy

To mitigate audit risk and maximize the Illinois R&D credit benefit, companies should implement the following strategic measures:

1. Prioritize Contractual Clarity on Risk and Rights: During contract negotiation, legal and finance teams must collaborate to ensure contractual language maximizes the retained financial risk (e.g., conditioning payment on technical success rather than guaranteed service hours) and secures substantial, retained rights to the research results, such as a perpetual, non-exclusive license for internal commercial use.14
2. Institute Dedicated R&D Cost Separation: A robust internal accounting system must be maintained to segregate QREs into three categories: fully qualified (self-funded), partially qualified (requiring allocation), and non-qualified (fully funded). This system must clearly link employee time tracking and material consumption to non-funded projects or phases that bear taxpayer risk. This separation is crucial for accurately completing the Schedule 1299-I worksheet.3
3. Conduct Periodic Base Period Reviews: Taxpayers new to claiming the Illinois credit must conduct a rigorous historical review of all QREs spanning the three base years to identify and remove any previously included funded research. This proactive cleaning of the base period QREs is a crucial mechanism for maximizing future incremental credits by lowering the comparative baseline.

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