Analysis of the Funded Research Exclusion (FRE) in the Context of the Indiana Research Expense Credit (REC)

I. Executive Summary: The Exclusion of Funded Research

The Funded Research Exclusion (FRE) dictates that research expenses are ineligible for the tax credit to the extent the research is financed by another party (via contract, grant, or other means) where the taxpayer does not bear economic risk or retain substantial rights to the research results. This exclusion, codified under Internal Revenue Code (IRC) Section 41(d)(4)(H), is strictly applied by the State of Indiana, requiring detailed contractual evidence to substantiate eligibility for the state incentive.1

The fundamental policy rationale underpinning the FRE is to prevent taxpayers from claiming a credit for research expenditures when the financial burden of innovation or the resulting intellectual property (IP) is already assumed by a funding client or governmental entity.3 The credit is intended solely to incentivize self-funded innovation and risk-taking by the claiming taxpayer. For Indiana taxpayers claiming the Research Expense Credit (REC), established under Indiana Code (IC) 6-3.1-4, compliance requires demonstrating that they satisfy both the Economic Risk Test and the Substantial Rights Test, as defined federally.4 The Indiana Department of Revenue (DOR) audit process critically examines all agreements related to the research. Recent judicial interpretations, specifically concerning Indiana contractors, confirm that establishing economic risk often relies on the sophisticated analysis of how contractual terms interact with mandatory state commercial law, such as the Indiana Uniform Commercial Code (UCC).1

II. The Indiana R&D Tax Credit (REC) Statutory and Regulatory Framework

A. State Law Adoption and Federal Conformity (IC 6-3.1-4)

The Indiana REC is a significant state tax incentive formalized under IC 6-3.1-4, targeted specifically at encouraging in-state investments in research and development.4 Taxpayers who incur qualified research expenses (QREs) in Indiana may receive a credit against their state income tax liability.4

The statutory definition of QRE for Indiana purposes directly incorporates the federal definition from the Internal Revenue Code (IRC). Specifically, Indiana qualified research expense is defined by reference to Section 41(b) of the IRC.4 The state allows for tiered credit rates: 15% on the first $1 million of QREs exceeding the base amount, and 10% on amounts above $1 million.6 An alternative simplified credit (ASC) of 10% of current QREs exceeding 50% of the three-year average is also available.6 The credit is nonrefundable but carries forward for up to 10 years.6

Fixed Conformity Date Analysis

A critical component of Indiana’s statutory framework is its fixed-date conformity. Indiana adopts IRC Section 41 as in effect on January 1, 2001.7 This fixed-date conformity governs the definition of QREs and the application of exclusions, including the FRE. This static alignment requires taxpayers to apply the federal regulations, particularly Treasury Regulation § 1.41-4, as they existed at that time for definitional purposes.4

B. Federal Basis for Exclusion (IRC §41(d)(4))

The foundational definition of “qualified research” under IRC §41(d)(1) requires that the activity satisfy three fundamental tests: the Expenses under IRC §174 Test, the Discovering Technological Information Test, and the Process of Experimentation Test.4

Beyond these positive requirements, IRC §41(d)(4) provides a list of activities that are explicitly not considered qualified research.4 These exclusions include, but are not limited to: research conducted after commercial production begins, activities related to adaptation or duplication of existing components, surveys and studies, foreign research, and research in the social sciences.9

The specific provision targeted by this report is the Funded Research Exclusion (FRE), found under IRC §41(d)(4)(H). This clause stipulates that research is non-qualified “to the extent funded by any grant, contract, or otherwise by another person or governmental entity”.1 This exclusion is often the single greatest cause of federal and state R&D credit disallowances in audit.

C. The Duality of Fixed Conformity and Dynamic Judicial Review

The application of the Indiana REC presents a complexity stemming from the dual nature of its governing laws. While the state statute fixes the definition of QREs and exclusions to the IRC as of January 1, 2001, the practical execution and defense of the FRE—specifically the assessment of economic risk—is governed by dynamic state contract law and evolving judicial interpretation, which necessarily post-date 2001.

The taxpayer is required to ensure that the research activities themselves meet the 2001 definitions, such as the requirement that “substantially all” (80% or more) of the research constitutes elements of a process of experimentation.4 However, when auditing a contract, the DOR must determine the allocation of financial risk. As demonstrated by recent judicial opinions, such as the 2025 Tax Court decision in System Technologies, Inc. v. Commissioner 1, the court relies on contemporary Indiana contract law (specifically the UCC) to interpret risk allocation for activities undertaken in 2016. Therefore, Indiana taxpayers must navigate a challenging hybrid compliance environment: adhering to static federal definitions for the research activity itself, while using the most current legal jurisprudence concerning state contract law to structure and defend their contracts against the FRE. This hybrid approach demands rigorous legal review of contractual documents during the planning phase.

III. Definitive Analysis of the Funded Research Exclusion (FRE) Two-Pronged Test

The determination of whether research performed under contract is funded is based on a rigorous two-pronged analysis derived from Treasury Regulation § 1.41-4A(d). Both prongs must be satisfied for the performing taxpayer to claim the associated research expenses. If either condition fails, the expenses are excluded entirely, or to the extent funded.

A. Prong 1: Economic Risk (Contingency of Payment)

The first prong assesses who bears the financial risk of technical failure. Research is deemed not funded to the extent that the payment to the taxpayer is contingent upon the successful completion of the research, meaning the payment is made for the result or product, not merely for the effort.1

The Contingent Payment Standard

If the funding party (the client or granter) is obligated to pay the taxpayer regardless of whether the research yields a desired result or a functional product, the research is deemed funded.3 To satisfy this test, the taxpayer must be able to demonstrate that, in the event of technical failure, they are obligated to return funds already paid or are not entitled to receive future payments. The DOR and federal auditors rigorously scrutinize payment schedules, holdbacks, and warranty clauses to determine if a fixed fee arrangement compensates for the performance of services rather than the achievement of an uncertain technological objective.3

B. Prong 2: Substantial Rights to Research Results

The second prong evaluates intellectual property ownership and control. Research is deemed not funded if the performing taxpayer maintains substantial rights to the results of the research.3

Defining Substantial Rights

Substantial rights typically imply that the taxpayer retains the right to exploit the intellectual property—which includes any new product, process, technique, or formula developed—for their own trade or business purposes.11 This includes the retained right to manufacture the product, license the process, or sell the derived knowledge to other parties. If the contract grants the funding party exclusive rights, proprietary ownership, or places severe limitations on the taxpayer’s ability to utilize the derived knowledge (e.g., perpetual confidentiality clauses or sweeping competitive restrictions), the research often fails this prong, regardless of the financial arrangement.3

C. The Comprehensive Documentation Burden

Due to the binary nature of the FRE exclusion—where failing either test can lead to the disallowance of all related expenses—comprehensive compliance requires contemporaneous documentation addressing both the financial risk and the IP rights prongs for every contract research project. Focusing solely on negotiating favorable payment terms (passing Prong 1) while conceding all proprietary rights (failing Prong 2) will still lead to the entire qualified research expense being excluded. Tax planning must therefore mandate a coordinated review of both the financial risk and the IP assignment provisions across all contract documentation.3

Table Title: Summary of the Funded Research Exclusion (FRE) Two-Pronged Test and Audit Standard

IV. Indiana Department of Revenue (DOR) Guidance and Audit Procedures

The Indiana DOR administers the REC and provides specific guidance regarding the documentation required to overcome the FRE, particularly in an audit setting.

A. DOR Directive on Contract Review and Audit Scope

DOR guidance explicitly instructs auditors to conduct a broad review of documentation. Auditors are mandated to consider “All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons” to determine the full extent to which the research is funded.2 This comprehensive scope means that side letters, modifications, and general terms and conditions documents are as crucial as the primary statement of work. Auditors are directed to request a complete copy of all such documents to determine the extent of the funding exclusion.2

B. Contract Research Expenses (CRE) and the 65% Limitation

If research is determined to be unfunded, the IRC imposes a further limitation on the qualified research expense claimed. IRC Section 41(b)(3)(B) states that the term “contract research expenses” means only 65 percent of any amount paid or incurred by the taxpayer to any non-employee person for qualified research.12

The Indiana DOR information addresses the calculation, noting that the “otherwise qualified research expenses… exceed 65 percent of the funding”.2 This phrasing can be interpreted as confusing and requires clarification regarding the correct order of operations.

The correct application is sequential: the 65% limitation is a calculation haircut applied after the FRE determination. If a contract is deemed fully funded (0% unfunded), 0% of the expenses qualify for the credit. If a contract is determined to be fully unfunded (100% QRE), only 65% of that QRE is eligible for the credit base. Where a contract is only partially funded, the DOR’s instruction requires a precise allocation methodology: the funded portion must be entirely excluded, and only 65% of the remaining unfunded QRE constitutes the eligible credit base.2 Taxpayers must ensure their internal expense allocation documents clearly separate expenses attributable to the funded portion (excluded) from the unfunded portion (subject to the 65% limit).

C. In-State Requirement and Jurisdictional Audits

A fundamental requirement of the Indiana REC is the geographical limitation: the credit applies only to expenses incurred for research conducted in Indiana.4 The DOR rigorously scrutinizes the nexus of the research activity to the state. Audit findings have resulted in credit disallowance where taxpayers failed to substantiate that the qualified research activities occurred within Indiana borders.13

To meet the documentation standard, taxpayers must maintain records that clearly establish the Indiana nexus, including: the specific places in Indiana where services are performed, the Indiana location of the personnel performing the services, and the Indiana location where qualified research supplies are consumed.4

D. Disclosure Requirement for Federal/State Divergence

Indiana law includes a specific mandate regarding the consistency of federal and state claims. IC 6-3.1-4-8 requires a taxpayer who claims the state REC but does not claim the corresponding federal R&D credit to disclose the reasons for this divergence to the DOR.5

This disclosure is particularly relevant to the FRE. If a taxpayer structurally determines that certain contract research is too risky to claim federally (e.g., because of a complex IRC interpretation or fear of audit), but claims it as unfunded for Indiana purposes (perhaps relying on a strict interpretation of the 2001 conformity date), this statutory disclosure mechanism triggers heightened scrutiny by the DOR. A substantial difference in the QRE claimed on federal Form 6765 versus Indiana Form IT-20REC will inevitably necessitate a detailed, defensible explanation regarding why the research is qualified only at the state level.15

V. The Role of Indiana Contract Law: Judicial Interpretation and the System Technologies Precedent

The determination of economic risk within the FRE framework is not purely a federal tax question; it is fundamentally linked to state contract and commercial law. For contracts governed by Indiana law, the principles of the Indiana UCC can become the dispositive factor in overcoming a FRE challenge.1

A. Detailed Case Study: System Technologies, Inc. v. Commissioner

The case of System Technologies, Inc. v. Commissioner (issued in 2025 concerning 2016 tax years) provides critical guidance for Indiana contractors.1 System Technologies, an Indianapolis-based engineering firm specializing in automotive coating designs, claimed credits for developing finishing systems under contracts specifying Indiana law.1 The Internal Revenue Service (IRS) disallowed the credits, arguing the research was “funded” because the contracts contained limited warranty provisions (repair or replacement only), which the Commissioner argued demonstrated a lack of financial risk for the company if the research failed.1

The Critical Finding Regarding Indiana UCC

The U.S. Tax Court disagreed with the Commissioner by focusing its analysis on a provision within Indiana’s enactment of the Uniform Commercial Code (UCC), specifically Ind. Code § 26-1-2-711(1).1 This state law provision establishes that if a seller fails to deliver a promised product (a “good” under the UCC), the buyer is entitled to remedies, including, at a minimum, “recovering so much of the price as has been paid”.1

The court concluded that this state law remedy—the mandatory right to a refund for non-delivery—”fit directly within the Commissioner’s regulatory definition of what is not funded research”.1 This ruling established that payment was legally contingent on the success of the research culminating in the delivery of the product. The limited remedy specified in the contract (repair or replacement) was deemed insufficient in the event of a complete failure to deliver the promised product, and thus had to yield to the mandatory UCC refund provision.1

B. Mandatory Legal Backup and Contract Drafting

The reliance on the Indiana UCC in System Technologies provides a powerful, mandatory legal defense for establishing economic risk in contracts governed by state law, particularly where the contract involves the development and sale of a tangible business component (a “good”). The principle is that even if a taxpayer’s contract contains restrictive clauses intended to limit liability, the mandatory right to a refund for non-performance under state commercial law places the contract revenue at risk, satisfying the Economic Risk Test.1

However, the protection afforded by the UCC is confined to contracts for the sale of “goods.” Taxpayers engaged in research purely involving consulting services, feasibility studies, or non-tangible IP development (which often fall outside the UCC’s scope) cannot rely on this mandatory state law backup. For these service contracts, the taxpayer must explicitly draft robust risk allocation language into the agreement, confirming that payment is directly contingent upon the successful technological outcome and providing for refunds or non-payment in case of failure.

VI. Practical Example and Documentation Requirements

To illustrate the strict application of the FRE in Indiana, a comparison of contract structures is necessary, followed by a summary of mandatory documentation requirements.

A. Scenario: Contract Structure and Risk Assessment

Consider an Indiana manufacturer contracted to develop a novel, high-strength alloy (a product that qualifies as a “good” under the UCC).

Contract Structure 1 (Fails FRE):

The client pays $100,000 upfront for 100 hours of research effort, regardless of whether the alloy meets the specified tensile strength tests. The contract explicitly assigns all proprietary formulas and derived knowledge exclusively to the client upon completion.

• Analysis: This structure fails the Economic Risk Test because the payment is for effort (labor hours) and is non-refundable, regardless of technical failure. It also fails the Substantial Rights Test because the client retains all proprietary formulas, preventing the taxpayer from exploiting the knowledge for future business.3 Result: 100% Funded (Ineligible QRE).

Contract Structure 2 (Passes FRE via UCC):

The client agrees to pay $100,000 upon delivery of the alloy product, contingent on it passing specific, defined tensile strength tests. The contractual warranty limits the client’s remedy to repair or replacement if the delivered alloy fails the test. The taxpayer retains a non-exclusive, royalty-free license to use the underlying manufacturing process developed during the research.

• Analysis: This structure passes the Substantial Rights Test because the retained non-exclusive process license allows the taxpayer to use the knowledge for their own purposes.10 It also passes the Economic Risk Test. Although the contract limits the warranty to repair/replacement, the Tax Court’s ruling in System Technologies confirms that, under Indiana Code § 26-1-2-711(1), the payment is still contingent on success. If the taxpayer cannot deliver a conforming alloy, the client has a statutory right to a full refund of any amounts paid, placing the $100,000 at financial risk for the taxpayer.1 Result: Eligible QRE (subject to 65% limit on contract research expenses).

B. Comprehensive Documentation Checklist for Indiana REC

To successfully defend a claim for the Indiana REC, particularly concerning contract research, taxpayers must maintain detailed records that address both the in-state nexus and the FRE two-pronged test.4 The DOR requires attachment of the federal Form 6765 to the state Form IT-20REC.8

1. Financial Documentation:

• Detailed accounting ledgers substantiating the separation of funded research expenses (excluded) from unfunded qualified research expenses (eligible for credit calculation).
• Payroll records substantiating the wages paid to employees directly conducting or supervising research activities in Indiana.14
• Invoices and inventory records for supplies consumed in Indiana for qualified research.4

2. Legal and Contractual Documentation:

• Complete copies of all primary contracts, statements of work, change orders, and side agreements related to the research projects, as auditors review “All agreements”.2
• Legal memorandum prepared contemporaneously with the contract review, analyzing the FRE risk profile for each project under both the Economic Risk Test and the Substantial Rights Test, citing applicable Indiana contract law (especially for UCC contracts).1

3. Compliance Forms and Disclosure:

• Completed Indiana Form IT-20REC, which is comparable to the federal Form 6765.8
• Mandatory disclosure (as required by IC 6-3.1-4-8) explaining the reasons for any divergence if the state REC is claimed but the corresponding federal credit is not.5

VII. Conclusion and Strategic Recommendations

The Indiana Research Expense Credit offers a substantial incentive for innovation, but its realization is fundamentally dependent on strict adherence to the federal Funded Research Exclusion framework as adopted by IC 6-3.1-4. The nuances of the FRE, particularly the dynamic interplay between the fixed federal tax definition and the fluid assessment of economic risk under Indiana state contract law, create a high compliance bar for taxpayers engaging in contract research.

Strategic planning for Indiana taxpayers must emphasize a coordinated legal and technical review process during contract structuring to maximize credit eligibility and minimize audit exposure. Key recommendations include:

1. Prioritize Contingent Payment: Contractual arrangements must establish payment contingency on the delivery of the successful technological result, not merely effort or service provision. For contracts involving the sale of goods, taxpayers should understand that the mandatory provisions of the Indiana UCC (specifically the right to refund for non-delivery) establish this risk, providing a robust legal defense established by System Technologies, Inc. v. Commissioner.1
2. Mandate IP Retention: Taxpayers must secure and document the retention of substantial rights to the underlying intellectual property (process, technique, or formula). This often requires negotiating a non-exclusive license or retained ownership rights, even if the client receives proprietary rights to the final product.3
3. Ensure Strict In-State Nexus: All claims must be supported by documentation that verifies QREs were incurred for research conducted physically within Indiana, detailing the location of personnel and consumption of supplies.13
4. Adopt a Conservative Allocation Method: When dealing with partially funded projects, taxpayers must strictly adhere to the rule that the funded portion is excluded entirely, and only 65% of the remaining unfunded qualified expenses may enter the credit calculation base.2
5. Address Federal/State Divergence Proactively: Any decision to claim the Indiana REC without claiming the federal R&D credit must be accompanied by the statutory disclosure, necessitating a detailed, pre-prepared memorandum explaining the specific differences in interpretation or application that led to the divergence.5

By meticulously addressing both prongs of the FRE and ensuring consistency between contract structure and state commercial law, Indiana taxpayers can successfully substantiate their REC claims against potential disallowance by the DOR.

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