Navigating the Exclusion: Government-Funded Research and the Indiana R&D Tax Credit

I. Executive Summary: The Nexus of Innovation and Funding Eligibility

The Exclusion: Government-Funded Research prevents a taxpayer from claiming the Indiana Research Expense Credit (REC) on Qualified Research Expenses (QREs) to the extent those expenses are subsidized by a governmental entity (federal, state, or local). Eligibility requires the taxpayer to demonstrate both that they bear the financial risk of research failure and that they retain substantial intellectual property rights in the research results.

The Indiana Research Expense Credit (REC), codified under IC 6-3.1-4, is fundamentally linked to the federal R&D tax credit provisions found in Section 41 of the Internal Revenue Code (IRC).1 Specifically, IC 6-3.1-4 explicitly adopts the federal definition of “Qualified research expense” as defined in IRC § 41(b).1 This critical statutory linkage dictates that the federal exclusion criteria for funded research, outlined in IRC § 41(d)(4)(H) and further detailed in Treasury Regulation § 1.41-4A(d), apply directly to the Indiana state credit.4 Consequently, an Indiana taxpayer seeking to claim the REC must successfully navigate a stringent, two-pronged federal standard concerning financial risk and proprietary rights before any expenses may be considered eligible for the state incentive.

To claim the credit, the taxpayer must demonstrate that the Qualified Research Expenses were incurred under conditions where they satisfy two mandatory criteria: the Financial Risk Test (requiring that payment be contingent on success or that the taxpayer bear additional costs) and the Substantial Rights Test (requiring the taxpayer to retain unrestricted rights to use and exploit the research results).4 This direct adoption of federal standards means that decades of federal case law and IRS Audit Technique Guides (ATGs) are highly relevant in defending an Indiana REC claim, amplifying the compliance risk if federal standards are not met.5

II. Statutory Foundation: The Indiana Research Expense Credit (REC)

Defining Scope and Intent

The Indiana REC is designed to provide an incentive for increasing qualifying research activities performed exclusively within the state.7 The core legislative intent mandates that expenses must be “incurred for research conducted in Indiana” to be considered “Indiana qualified research expense”.1

Indiana Qualified Research Expenses (QREs) are defined as the sum of amounts incurred during the taxable year that fall into three categories: wages paid to employees for conducting, supervising, or supporting qualified research; costs of supplies consumed in research; and 65% of contract research expenses, provided these activities are executed within Indiana.2 For multi-state filers, this jurisdictional restriction is as critical as the funded research exclusion. Even if a project passes the federal Risk and Rights tests, if the research execution—the place where services are performed or supplies are consumed—occurs outside Indiana borders, the associated QREs are ineligible for the state credit.3 Therefore, robust geographical labor tracking is required alongside contract analysis.

Calculation Methodology

The Indiana REC is a nonrefundable credit calculated based on the incremental increase of QREs over a determined base amount.9

The standard calculation uses a tiered approach:

1. Base Calculation: The base amount, defined by IRC § 41(c), is modified to consider only Indiana qualified research expenses and Indiana gross receipts when calculating the fixed base percentage and average annual gross receipts.1
2. Credit Tiers: The potential value of the credit is equal to the excess of current Indiana QREs over the base amount, multiplied by tiered percentages 7:

• 15% on the first $\$1$ million of excess QREs.
• 10% on any excess QREs exceeding $\$1$ million.2

Taxpayers may alternatively elect the Alternative Simplified Credit (ASC) method. Under the ASC, the base amount is calculated as 50% of the average Indiana QREs incurred during the three immediately preceding tax years. The credit is then 10% of the excess QREs above this base. If the taxpayer had no Indiana QREs in any one of the three prior years, the credit is calculated as 5% of the current year’s Indiana QREs.9 Unused credits may be carried forward for 10 years.9

III. The Federal Mandate: Exclusion of Funded Research (IRC § 41(d)(4)(H))

The statutory basis for exclusion is clear: qualified research expenses do not include research “to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)”.4 This exclusion covers funding received from federal, state, and local government sources, as well as private third parties.11

The underlying policy rationale is to prevent the government from effectively subsidizing the same research twice: once through direct payment (via a contract or grant) and a second time through a reduction in tax liability (via the tax credit).

A common misunderstanding involves the scope of the contracts reviewed. Determining the extent of funding necessitates examining all agreements entered into between the taxpayer performing the research and other persons, not just those formally designated as “research contracts”.5 This includes, but is not limited to, grants, joint development agreements, and commercial agreements that contain embedded R&D components.

IV. Detailed Analysis of the Two Pillars of Exclusion

For any research activity to qualify for the Indiana REC, it must satisfy both the Financial Risk Test and the Substantial Rights Test. Failure in either area results in the exclusion of the corresponding QREs.4

A. Pillar A: The Financial Risk Test (Treas. Reg. § 1.41-4A(d)(1))

Research is deemed funded if the taxpayer does not bear the financial risk of failure.6 This determination centers on whether the taxpayer receives payment that is contingent upon the success or result of the research.12

If a taxpayer receives payment regardless of the research outcome or if the contract guarantees full reimbursement of costs, the taxpayer is considered to have borne no financial risk, and the research is excluded.6 The taxpayer bears the financial risk if the contract specifies a success-based fee, requires the taxpayer to return funds upon failure, or stipulates that the taxpayer must incur additional costs beyond what the client is paying to ensure the delivery of the result.6

An analysis of common contract types illuminates this distinction, which is critical for government contractors 13:

• Favorable Contract Types (Risk is Borne by Taxpayer): Firm-Fixed-Price (FFP) Contracts are generally favorable because the contractor agrees to a fixed payment regardless of the actual costs incurred. If the R&D costs exceed the FFP, the contractor absorbs the loss, demonstrating financial risk.13
• Unfavorable Contract Types (Risk is Shifted Away): Contracts such as Cost-Plus, Time-and-Materials (T&M), Hourly, Cost-Plus-Fixed-Fee (CPFF), and Cost Plus Guaranteed Maximum typically result in the exclusion of the associated QREs. In these structures, time and expenses are often reimbursed, regardless of technical success, shifting the economic risk away from the researcher.6

It is important to note that internal R&D (IR&D) efforts—such as pre-award work or bid and proposal activities—that are self-funded and not directly reimbursed by a contract may still qualify for the credit, provided they meet the four-part definition of qualified research.6

B. Pillar B: The Substantial Rights Test (Treas. Reg. § 1.41-4A(d)(2))

The taxpayer performing the research must retain “substantial rights” in the research results. If the funding agreement dictates that the funding entity (the government or a third party) holds exclusive rights to the intellectual property (IP), the taxpayer does not retain substantial rights, and the research is excluded.4

The concept of substantial rights means the taxpayer must be able to use or exploit the research results commercially without having to make an additional payment to or receive approval from the funding party.5 If the contract requires the taxpayer to purchase or pay for a license to use the results of their own research, the taxpayer is deemed not to have retained substantial rights.5 Case law confirms that this determination hinges on the right to exploit the IP commercially.

A major compliance issue arises from the interconnection between the R&D credit (IRC § 41) and the capitalization rules for Specified Research or Experimental Expenditures (SREs) under IRC Section 174. If a taxpayer retains substantial rights in the research (passing Pillar B for the R&D credit), the associated expenditures must generally be capitalized and amortized under Section 174, as mandated by the Tax Cuts and Jobs Act (TCJA).14 Conversely, if the research is fully funded, and the taxpayer retains no rights, the costs are usually treated as contract costs, often immediately expensed against contract revenue. When a taxpayer claims the Indiana REC, they implicitly affirm they passed the Substantial Rights Test, meaning they should simultaneously be capitalizing the expenses under IRC 174. An inconsistency in treating the same cost—expensing it for financial reporting while claiming the R&D credit—can signal a failure in both federal and state compliance.

V. Indiana Department of Revenue (IDOR) Guidance and Compliance

The Indiana Department of Revenue (IDOR) explicitly incorporates the federal funded research exclusion framework into its guidance materials for the REC.2 While IDOR confirms that the core definitional and exclusionary principles of IRC § 41 apply, the state has enacted a critical, state-specific compliance mandate that increases scrutiny on the funded research exclusion.

The Mandatory Disclosure Requirement (HEA 1001)

The Indiana General Assembly introduced HEA 1001, Section 121, effective January 1, 2019, which added specific reporting requirements regarding the federal R&D credit.7

This mandate requires that any taxpayer claiming the Indiana REC must report to the IDOR whether they have determined a credit for those Indiana QREs under the federal IRC § 41 (either the regular or alternative credit). Crucially, if a taxpayer claims the Indiana credit but does not claim the federal credit for those same QREs, the taxpayer must disclose to the IDOR the reasons for not claiming the federal credit.7

This disclosure mechanism acts as an important anti-abuse check. Since Indiana adopts the federal exclusion standards, any defensible reason for claiming the state credit but not the federal credit must relate to non-funding issues (e.g., location of the research, which might qualify for the state credit but not be captured in the overall national federal calculation). If the underlying reason for the federal exclusion was “funded research,” the same research activity should be excluded from the Indiana claim. This rule places the burden of proof directly on the taxpayer to justify any discrepancy between their state and federal research credit calculations, ensuring tight alignment with the federal funded research exclusion framework.

Documentation Standards

IDOR emphasizes that rigorous documentation is necessary to support a claim, especially when dealing with cost allocation in complex projects. Prior administrative review findings have shown that claims were denied due to the taxpayer’s failure to adequately document employee activities and wages attributable to specific research projects and the lack of a “contemporary system of project accounting” to quantify eligible research expenses.16 This failure undermines the ability to accurately segment QREs, which is essential for distinguishing funded activities from unfunded, self-financed work.

VI. Advanced Compliance: Allocation of Partially Funded Projects

For research projects that receive only partial funding, the Treasury Regulations provide specific rules for allocating the research expenses between the funded (excluded) and unfunded (eligible) portions. The default rule is highly restrictive, placing significant pressure on taxpayers to qualify for the proportional allocation exception.17

The Default Allocation Rule

Under Treasury Regulation § 1.41-4A(d)(3)(i), if a research project is partially funded, the general rule dictates that 100% of the funding amount must be applied exclusively to reduce the otherwise Qualified Research Expenses (QREs) first.17 This approach maximizes the exclusion of QREs before the funding is applied to non-QRE expenses (e.g., overhead or administrative costs).

Furthermore, if the amount of funding is impossible to determine at the time the taxpayer files the return, Treasury Regulation § 1.41-4A(d)(5) mandates that the taxpayer must treat the entire research project as completely funded (100% excluded) for the purpose of the initial filing. Once the funding amount is finally determined, the taxpayer is required to amend the return to reflect the proper allocation.17

The Pro Rata Allocation Exception (The 65% Test)

Taxpayers can achieve a much more favorable result by allocating the funding proportionally across all project expenditures (QREs and non-QREs). To utilize this Pro Rata Allocation Exception, the taxpayer must establish to the satisfaction of the IDOR (or the Service, federally) that all three of the following conditions are met 5:

1. The total amount of research expenses (QREs plus non-QREs) must exceed the total funding received.
2. The amount of otherwise qualified research expenses (QREs) must exceed 65% of the total funding received.
3. The taxpayer must be able to establish and substantiate the total amount of all research expenses incurred.

Meeting the 65% requirement (Condition 2) is a critical technical hurdle. This threshold serves as an incentive for contractors to rigorously classify their internal costs. By ensuring the maximal amount of internal labor and supplies related to the project are correctly categorized as “direct supervision” or “direct support” QREs 18, the taxpayer increases the ratio of QREs to total research cost, thus improving the likelihood of exceeding the 65% funding threshold. If the requirements are met, the funding is allocated proportionately based on the ratio of funding to total expenses, typically resulting in a lower exclusion amount and a higher eligible Indiana REC base.

VII. Practical Case Study: Calculating Eligible Indiana QREs and REC

To illustrate the complexity of the funded research exclusion and the application of the Pro Rata Allocation Rule, consider the case of Innovate Dynamics, Inc. (IDI), an Indiana manufacturer.

IDI’s total QREs incurred in Indiana for the current year, before considering the funding exclusion, were $2,400,000. IDI uses the Alternative Simplified Credit (ASC) method. Their average Indiana QREs for the three preceding tax years was $1,800,000.

Step 1: Applying the Risk/Rights Tests

• Project A (Internal R&D): Since the project is entirely self-funded (zero funding) and IDI retains all exclusive rights, it passes both the Financial Risk and Substantial Rights Tests. Eligible QREs: $800,000.
• Project B (DoD Contract): This project is a Cost-Plus-Fixed-Fee (CPFF) arrangement, meaning expenses are reimbursed, and the DoD retains exclusive IP rights. It fails the Financial Risk Test (no risk borne by IDI) and fails the Substantial Rights Test (no rights retained).6 Excluded QREs: $1,100,000.

Step 2: Allocation Analysis for Partially Funded Project (Project C)

Project C involves a hybrid structure: IDI received a $\$400,000$ grant but incurred $\$600,000$ in total expenses, including $\$500,000$ in otherwise QREs. IDI retained substantial rights to the underlying technology, passing the Rights Test. Since the funding is less than the total cost, IDI attempts to use the Pro Rata exception.

1. Requirement 1 (Total Cost > Funding): $\$600,000 > \$400,000$. (Passed)
2. Requirement 2 (Otherwise QREs > 65% of Funding):

• 65% of Funding: $\$400,000 \times 0.65 = \$260,000$.
• Otherwise QREs: $\$500,000$. Since $\$500,000 > \$260,000$. (Passed)

1. Apply Pro Rata Allocation (Treas. Reg. § 1.41-4A(d)(3)(ii)):

• Exclusion Ratio: $\frac{\text{Funding}}{\text{Total Cost}} = \frac{\$400,000}{\$600,000} \approx 66.67\%$.
• Excluded QREs: $\$500,000 \times 66.67\% = \$333,333$.
• Eligible QREs (Project C): $\$500,000 – \$333,333 = \$166,667$.

Step 3: Final Indiana REC Calculation (ASC Method)

Total Eligible Indiana QREs: $\$966,667$.

Calculating the Credit using the ASC Method 10:

1. Base Amount: $50\% \times \text{Prior 3-Year Average} = 0.50 \times \$1,800,000 = \$900,000$.
2. Excess QREs: $\text{Current Eligible QREs} – \text{Base Amount} = \$966,667 – \$900,000 = \$66,667$.
3. Indiana REC: $10\% \times \text{Excess QREs} = 0.10 \times \$66,667 = \mathbf{\$6,667}$.

VIII. Conclusion: Strategic Implications for Indiana Businesses

The analysis confirms that the exclusion of government-funded research poses the single greatest compliance challenge for Indiana taxpayers claiming the Research Expense Credit (REC). Success hinges entirely on the congruence between state law (IC 6-3.1-4) and the robust, complex standards established under federal tax law (IRC § 41 and associated Treasury Regulations).

Federal Consistency is Paramount

The Indiana REC is a derivative of the federal credit. The IDOR’s mandatory disclosure rule (HEA 1001) forces taxpayers to reconcile any disparity between QREs claimed federally versus those claimed in Indiana.7 If a taxpayer excludes QREs from their federal calculation due to funding issues, those same QREs must be excluded from the Indiana calculation. Taxpayers must rely on federal precedents—including court cases and IRS Audit Technique Guides—to defend their state-level funded research exclusions, as the underlying legal framework is identical.

Contract Management as Tax Compliance

Taxpayers must integrate tax planning directly into their contract negotiation phase. The determination of eligibility is established at the moment the agreement is executed. To maximize REC eligibility, operational and legal teams should prioritize Firm-Fixed-Price (FFP) contracts, which demonstrate financial risk, and must advocate for contract language that explicitly retains substantial rights—at minimum, a non-exclusive, royalty-free license—to exploit the resulting IP commercially.5

Audit Defense Readiness

The ability to sustain an Indiana REC claim relies on establishing a reliable system of contemporaneous documentation. This system must accurately track labor and supply costs to specifically segment QREs by location (Indiana) and by funding source. For hybrid contracts, documentation must rigorously support the application of the Pro Rata Allocation Exception (Treas. Reg. § 1.41-4A(d)(3)(ii)) by demonstrating that otherwise qualified expenses exceed 65% of the funding amount. Failure to maintain adequate project accounting documentation remains a key reason for claim denial.16

While navigating the exclusion is complex, the Indiana credit offers a valuable financial incentive, providing up to 15% on the first $\$1$ million of incremental QREs, alongside a significant 100% sales and use tax exemption for qualified R&D equipment.2 Diligent management of the funded research exclusion is therefore mandatory for maximizing the state’s tax advantages for innovation.

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