Expert Report: Navigating the Intersection of Defense Contracting and Indiana R&D Tax Incentives: A Strategic Guide

Executive Summary

A United States Department of Defense (DoD) contractor is an entity that performs work for the U.S. government under contract, often involving highly complex research and development. In the context of the Indiana Research Expense Credit (REC), the status of a DoD contractor is defined not by the relationship itself, but by the federal tax rules that exclude research expenses to the extent they are funded by the government.1

The economic vitality of Indiana is significantly intertwined with the defense and aerospace sectors, which receive billions in federal spending annually.3 For these entities, claiming the Indiana REC requires navigating the stringent federal exclusion under Internal Revenue Code (IRC) Section 41(d)(4)(H). This rule mandates that a contractor must bear the financial risk of the research failure or retain substantial rights in the resulting intellectual property to qualify their expenses.1 The Indiana Department of Revenue (DOR) strictly enforces these federal criteria, requiring robust, contemporaneous, project-level documentation.6 Recognizing the structural tax challenges faced by its largest defense manufacturers due to historical federal tax policy, Indiana created a specialized incentive: the Aerospace Advanced Manufacturer Credit (IC 6-3.1-4-2.5). This alternative method offers a stabilized base calculation and a maximum 10% credit, specifically targeted at high-wage, high-employment jet propulsion contractors, providing a significant strategic advantage over the standard tiered REC calculation.7

I. The United States Department of Defense Contractor Defined in Tax Context

A. A Concise Definition of a DoD Contractor for R&D Tax Purposes

A United States Department of Defense (DoD) contractor is a commercial entity engaged by the federal government, through grants or contracts, to supply goods or services, including research and development (R&D) activities.3

For the purpose of claiming the Indiana Research Expense Credit (REC), a DoD contractor’s expenses are subject to exclusion if the research activities are determined to be “funded” by the governmental entity, thereby transferring the financial risk or proprietary rights away from the contractor.1

B. Statutory Alignment: Indiana’s Reliance on Federal IRC §41

The Indiana Research Expense Credit is codified under Indiana Code (IC) 6-3.1-4. This statute is not self-contained but rather explicitly incorporates and modifies the foundational federal guidelines established by IRC Section 41, ensuring that eligibility for the state credit is contingent upon federal compliance.

1. Adoption of Federal QREs and the Funded Research Exclusion

Indiana law defines Qualified Research Expenses (QREs) by reference to IRC §41(b) as in effect on January 1, 2001.6 This statutory reference brings the entirety of the federal definition into the state code, including the requirements that research must satisfy the “Four-Part Test” (e.g., involving a process of experimentation and technological uncertainty) and, critically for DoD contractors, the exclusion for “funded research” under IRC §41(d)(4)(H).1 Consequently, any research that fails the federal funded research test—even if conducted in Indiana—is automatically disqualified for the state credit.

2. State Geographic Constraint and Qualifying Expense Categories

While federal eligibility is mandatory, Indiana imposes a unique and crucial geographic constraint. The state explicitly modifies the definition of QREs to include only expenses for qualified research activities that are conducted in Indiana.6

This state nexus requirement demands granular tracking of all research activities:

• The wages claimed must be for services performed in Indiana.8
• Supplies must be consumed in qualified research within the state.8
• Contract research expenses (65% of payments to unrelated third parties, 75% to qualified research consortia) must pertain to research conducted physically in Indiana.9

This structure establishes a dual qualification requirement: a DoD contractor must first demonstrate that an expense is not federally funded, and subsequently, must verify that the corresponding activity occurred geographically within the State of Indiana. This necessity for project-level tracking to confirm both federal eligibility and state location of research increases the complexity of compliance for multi-state contractors, particularly in the defense industry, which often operates across various installations and facilities.

C. Economic Context: The Role of A&D and DoD Spending in Indiana

The presence of strong defense and aerospace industries provides the fundamental economic rationale for Indiana’s tailored tax incentives. In Fiscal Year (FY) 2023, the state of Indiana received $6.4 billion in Federal Defense spending, with $4.7 billion specifically awarded in contracts.3 The Aerospace and Defense (A&D) sector supports 26,663 total jobs in Indiana, with high-value direct employment of 10,887 and an average wage of $103,876, contributing significantly to the state’s Gross Domestic Product (GDP).3

Recent strategic investments, such as the growth of the Naval Surface Warfare Center (NSWC) Crane Division and partnerships among major Indiana universities (Purdue, IU, Notre Dame) focused on defense technology, emphasize the state’s intent to become a national security and defense hub.10 The legislative response embodied in the specialized Aerospace Advanced Manufacturer Credit (IC 6-3.1-4-2.5) reflects the understanding that standard federal tax rules, often influenced by defense spending trends from decades past, created a systemic disincentive for large, high-technology defense manufacturers to continue their QRE investments within the state.7 The state’s action to create this specialized tax mechanism is a direct policy measure to protect and foster this critical, high-wage manufacturing base.

II. The Critical Challenge: The Federal Funded Research Exclusion

The most significant legal hurdle for a DoD contractor seeking the Indiana REC is overcoming the federal exclusion for funded research, which dictates whether the expense is even considered a QRE.

A. IRC §41(d)(4)(H): Research Funded by a Governmental Entity

IRC Section 41(d)(4)(H) stipulates that qualified research does not include research “to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)”.1 For a DoD contractor, the “governmental entity” is the Department of Defense, and the funding mechanism is typically the contract itself.

Taxpayers must retain extensive documentation regarding the scope of funding. All agreements, including contracts, modifications, letters of understanding, and similar documents, must be reviewed to determine the precise extent to which the research is considered funded.6 This process is so critical that specialized technical advisors are sometimes necessary for reviewing classified government contracts.11

B. The Regulatory Framework: Treasury Regulation §1.41-4A(d)

To determine if research is funded and thus excluded from QREs, the Treasury Regulations provide a two-part test, focusing on financial risk and intellectual property rights. For the research to qualify, the taxpayer must satisfy at least one of the following criteria: either the contractor must bear the financial risk of failure, or the contractor must retain substantial rights in the research results.1

C. Detailed Analysis of the Financial Risk Test

The Financial Risk Test evaluates whether the contractor’s payment is contingent upon the success of the research. If a contractor receives payment regardless of the research outcome, the research is considered funded.1

1. Exclusion of Cost-Plus and Cost-Reimbursable Contracts

Contract types that shift performance costs and risk primarily to the government are generally excluded from qualifying as R&D expenditures. Under cost-reimbursement contracts, the government agrees to pay the contractor for all allowable costs incurred, plus a fixed or incentive fee.12

Contract types commonly excluded from QREs because they transfer cost risk to the government include:

• Cost-plus 1
• Cost-reimbursable 1
• Time and materials (T&M) 1
• Hourly contracts 1
• Cost-plus-fixed-fee (CPFF) 1

In these arrangements, the government typically bears the greatest risk, as the contractor is usually obligated only to provide its best effort, and the fee is largely independent of technical success, failing the risk requirement.12

2. The Role of Firm-Fixed-Price Contracts in Mitigating Funding Risk

Firm-Fixed-Price (FFP) contracts are the preferred structure for DoD contractors seeking the R&D credit. Under an FFP arrangement, the contractor is fully responsible for performance costs and the resulting profit or loss, as they agree to deliver the outcome for a set price.12

A taxpayer successfully bears the financial risk if the contract stipulates that they are required to succeed, return funds upon failure, or incur additional costs beyond the client’s payment amount.1 Judicial precedent, such as the Geosyntec Consultants, Inc. v. United States case, supports the view that fixed-price and capped cost-plus arrangements may qualify for the credit because the contractor assumes the economic risk of research failure.14 Therefore, research conducted under FFP contracts for the DoD stands the best chance of satisfying the Financial Risk Test.

3. Qualifying Internal Research and Development (IR&D) Expenditures

Expenses related to Internal Research and Development (IR&D) activities are usually fully eligible for the R&D credit. Since IR&D work—often occurring in the pre-award or bid and proposal (B&P) phase—is self-funded, no governmental entity is providing payment at that time, and thus, the funded research exclusion does not apply.1 These self-funded activities represent a vital and generally clear path for DoD contractors to generate QREs, provided the work meets the fundamental Four-Part Test of IRC §41.

D. Detailed Analysis of the Substantial Rights Test

If a contractor fails the Financial Risk Test (e.g., operating under a cost-plus contract), the research expenditures may still qualify if the contractor retains substantial rights in the results of the research.11

1. The Substantial Rights Standard and DFARS Compliance

A taxpayer retains substantial rights if they are not required to pay for the right to use the results of the research for their own commercial or research purposes.11 Conversely, if the contract grants another person (the DoD) exclusive rights to exploit the research results, the taxpayer does not retain substantial rights, and the research is excluded.1

In DoD contracting, the retention of rights is governed by complex regulations, including the Defense Federal Acquisition Regulation Supplement (DFARS). Clauses like DFARS 252.227-7013 often require the contractor to grant the Government a royalty-free, worldwide, nonexclusive, irrevocable license to technical data.15 The determination of whether this reserved license allows the contractor to retain “substantial rights” requires careful interpretation, often depending on whether the research relates to the contractor’s background intellectual property (IP) versus IP specifically developed for the government under the contract.

2. Retention Confirmation and IP Strategy

To ensure compliance, contractors must demonstrate that their retained rights permit the independent use of the research results for commercialization or further R&D without restriction or additional payment to the government.11 This analysis often results in QREs being limited to expenses associated with the development of the contractor’s proprietary IP, which may be incorporated or adapted within the scope of the government contract but remains fully owned by the contractor. Research efforts leading to government-exclusive or government-owned data are almost always fully funded and excluded from the credit calculation.

III. Standard Indiana Research Expense Credit (REC) Mechanics and Application

The standard Indiana REC, applicable to most qualifying DoD contractors, offers a competitive, tiered incentive for increasing research activities within the state.6

A. Calculation of the Standard Indiana REC

The standard credit calculation follows an incremental model, rewarding increases in current QREs over a historic baseline, as governed by IC 6-3.1-4-2.

The methodology requires taxpayers to first determine the base amount, which is calculated by multiplying the taxpayer’s fixed-base percentage by the average Indiana gross receipts over the preceding four taxable years.9 To prevent the credit mechanism from becoming too restrictive, the state mandates a floor: the base amount cannot be less than 50% of the current year’s Indiana QREs.9

The credit is then applied to the resulting excess QREs using a tiered rate structure:

This structure is designed to heavily incentivize the initial $1 million in incremental research investment with a 15% rate, followed by a sustained 10% incentive for investments above that threshold.6 The credit can be carried forward for 10 years, though it is neither refundable nor transferable, except in the case of pass-through entities (S corporations and partnerships) which may pass the credit through to their owners.9

B. Additional Indiana Incentives: The Sales and Use Tax Exemption

In addition to the income tax credit, Indiana provides a significant capital investment incentive specifically for R&D activities. The state offers a 100 percent sales tax exemption for qualified research and development equipment and property.6 This exemption, found under IC 6-2.5-5-40, applies to property purchased for use exclusively and directly in qualified research in Indiana.6

For large DoD contractors and advanced manufacturers, this exemption often yields substantial and immediate financial benefits compared to the income tax credit, which is subject to limits based on tax liability and carries forward.6 The cost of high-technology testing apparatus, specialized manufacturing tools, and prototyping machinery used in defense R&D can be immense, making the exemption a crucial tool for immediate cash flow preservation and reducing the cost of new R&D infrastructure. Strategic financial planning for defense contractors must prioritize the full utilization of this sales tax exemption alongside the income tax credit.

IV. Indiana Department of Revenue (DOR) Guidance and Compliance for Government Contractors

The Indiana DOR has established clear protocols for reviewing the REC, which heavily rely on federal methodology and require rigorous documentation, particularly concerning the funded research exclusion.

A. Adoption of Federal Audit Standards

The Indiana DOR explicitly relies on federal guidance for auditing the research credit. The DOR follows the IRS Audit Techniques Guide (ATG) for research credits.6 This alignment minimizes regulatory divergence but demands that Indiana-based DoD contractors adhere to the same stringent documentation and technical standards as those required by the IRS.

Furthermore, if the IRS has already conducted an audit of a company’s research credit, the DOR will generally follow the federal determination (excluding settlements), provided the expenses in question were incurred within Indiana.6 However, if the IRS audit was limited in scope, excluding the Indiana operations, DOR auditors reserve the right to review the computations and documentation for those specific in-state activities in greater detail, potentially leading to adjustments.6

B. Key Reasons for Credit Adjustments by DOR

The DOR identifies several common reasons for adjustments to the Indiana research credit, many of which are directly linked to the unique issues facing government contractors 6:

1. Funded Research: Claiming research expenses that were, in fact, funded by a governmental entity or other person, thereby claiming the credit for the incorrect entity.6
2. Lack of Substantiation: Failure to maintain adequate contemporaneous documentation to validate the qualified activity, the related expense, or the computation of the credit.6 The DOR, like the IRS, finds that retroactive reconstruction of activities through employee interviews is generally insufficient without supporting records.6
3. Geographic Misallocation: Including expenses for qualified research or contract research performed outside of Indiana, violating the state’s nexus requirement.6
4. Incorrect Base Computation: Mistakes in calculating the fixed-base percentage or the associated gross receipts, which affects the incremental calculation.6

C. Documentation Requirements for Funded Research Compliance

The maintenance of detailed, audit-ready records is critical for DoD contractors. Taxpayers must retain records in a usable form and detail sufficient to substantiate all claimed QREs (wages, supplies, and contract research) at the project level, aligning with federal record-keeping requirements.6

Specifically regarding funded research, documentation must include 6:

• Complete copies of contracts, including all modifications, letter agreements, or memoranda of understanding for research performed for or on behalf of a third party.
• Documentation of any funding received via grant, contract, or otherwise from another person or governmental entity.
• Work papers detailing the exact computation of the research credit.

This mandatory documentary requirement means that compliance teams must gather evidence at the time the qualified research is performed. This evidence must not only validate the technical and financial aspects of the R&D activity but must also explicitly demonstrate which party retained the economic risk and proprietary rights, often through careful analysis of contract payment and IP clauses, to successfully counter the funded research exclusion.

V. The Advanced Tax Strategy: The Aerospace Advanced Manufacturer Credit (IC 6-3.1-4-2.5)

In a distinct legislative move, the Indiana General Assembly created an alternative credit mechanism specifically for highly specialized defense contractors, recognizing the financial impediments posed by the standard IRC §41 base calculation.

A. Legislative Intent and Statutory Findings

IC 6-3.1-4-2.5 was enacted following explicit findings by the General Assembly regarding the aerospace industry. The legislature concluded that the standard qualified research expense credit calculation was adversely affected by the Internal Revenue Code’s historical treatment of federal defense spending, which created a disincentive for R&D investment in Indiana.7 The statute was designed to promote vital state interests, including maintaining a strong aerospace manufacturing base that employs science and engineering graduates, and supporting critical military installations like NSWC Crane.7

B. The Four Statutory Hurdles for Eligibility (IC 6-3.1-4-2.5(b))

Due to its specific policy objective, this alternative credit is only available to taxpayers who satisfy a restrictive four-part eligibility test 7:

1. Industry Focus: The taxpayer must be primarily engaged in the production of civil and military jet propulsion systems.
2. Certification: The taxpayer must be certified by the Indiana Economic Development Corporation (IEDC) as an aerospace advanced manufacturer.
3. Contractor Status: The taxpayer must be a United States Department of Defense contractor.
4. Employment and Wage Thresholds: The taxpayer must maintain one or more manufacturing facilities in Indiana that employ at least 3,000 full-time employees in positions that pay an average wage greater than 400% of the state hourly minimum wage (or its equivalent).7

These high thresholds ensure the credit is only claimed by Indiana’s largest, highest-value defense employers.

C. Calculation of the Alternative Incremental Credit (AIC)

A qualifying taxpayer may elect to calculate the research expense tax credit under the AIC (IC 6-3.1-4-2.5) instead of the standard method.7 The election is made on the DOR-prescribed Schedule IT-20REC and applies to the taxable year of the election and all succeeding years unless revoked with the consent of the department.19

The AIC calculation offers stability by utilizing a simplified base amount calculation 9:

• The credit amount is determined by the IEDC, not to exceed 10%.7
• This percentage is multiplied by the excess of the current year’s qualified research expenses over 50% of the average of the previous three years’ qualified research expenses.9

This base calculation method provides financial predictability and maximization of excess QREs, regardless of fluctuations in gross receipts that complicate the standard fixed-base percentage calculation. By setting the base amount at a fixed, lower ratio (50% of the prior three-year average QREs), the credit ensures that a greater portion of the current year’s QREs exceeds the base, thereby increasing the tentative credit amount. This stabilization mechanism is a direct financial advantage tailored to the investment cycle of large-scale defense manufacturing.

VI. Case Study: Maximizing QREs for an Indiana DoD Contractor

This example illustrates the critical determination of qualified expenses and the comparative benefit of utilizing the specialized Alternative Incremental Credit (AIC) under IC 6-3.1-4-2.5.

A. Scenario Description: Titan Advanced Propulsion (TAP)

Titan Advanced Propulsion (TAP) is an established Indiana manufacturer primarily engaged in civil and military jet propulsion systems. TAP is certified by the IEDC, is a DoD contractor, and employs over 3,500 highly-compensated personnel in Indiana, meeting all criteria for the AIC.

B. Analysis of Qualifying and Non-Qualifying QREs

TAP’s $15 million in total R&D expenditures must first be screened for the funded research exclusion. The $5 million spent under cost-plus arrangements, where the government bears the performance risk, fails the Financial Risk Test. Assuming TAP also failed to retain substantial rights in the IP developed under those cost-plus contracts, those expenses are fully excluded as federally funded research.1 The remaining $10 million is assumed to consist of IR&D and work performed under Fixed-Price contracts where TAP bore the economic risk and retained substantial rights. Since all activities occurred in Indiana, the $10 million represents the final, eligible Indiana QRE amount.

C. Comparison of Credit Calculations

By qualifying under IC 6-3.1-4-2.5, TAP has the option to choose between the Standard REC (IC 6-3.1-4-2) and the Alternative Incremental Credit (AIC).

In this scenario, utilizing the AIC generates a tentative credit of $400,000, which is $50,000 greater than the $350,000 generated by the standard REC. This advantage is gained by the AIC’s legislative mechanism that uses a fixed, lower base (50% of the three-year average QREs) compared to the potentially higher or more volatile base amount generated by the standard method. This demonstration confirms that for large, qualified DoD contractors, the strategic election of the Alternative Incremental Credit provides a significant financial incentive due to its design, which maximizes the incremental research investment recognized by the state.

VII. Strategic Planning and Conclusion

A. Key Strategic Recommendations for DoD Contractors

For United States Department of Defense contractors operating in Indiana, maximizing research tax benefits requires a layered compliance and strategic approach that addresses both complex federal tax law and specialized state incentives:

1. Contract-Level Segregation of Expenses: It is imperative to structure contracts and track internal research activities to demonstrate eligibility under the federal funded research exclusion. DoD contractors should actively seek firm-fixed-price (FFP) contracts, which inherently transfer the economic risk to the contractor, and meticulously separate these eligible expenditures from non-qualifying cost-plus arrangements.1
2. Robust Contemporaneous Documentation: The Indiana DOR’s adherence to IRS audit standards means documentation must be comprehensive and generated concurrently with the research activity. This includes detailed time tracking for wages, records of supplies consumed, and the retention of all contracts and related funding documents to prove the location and non-funded status of the QREs.6
3. Mandatory Review of IC 6-3.1-4-2.5 Eligibility: Any defense contractor focused on aerospace or jet propulsion systems must annually evaluate whether they meet the restrictive criteria (3,000 employees, 400% minimum wage, and IEDC certification) for the Aerospace Advanced Manufacturer Credit. If these thresholds are met, the Alternative Incremental Credit offers a highly stable and often more advantageous base calculation for calculating the credit.7
4. Full Utilization of Sales Tax Exemption: Beyond the income tax credit, contractors should ensure they utilize the 100% sales and use tax exemption for all eligible R&D equipment purchases. This provides an immediate, dollar-for-dollar reduction in capital costs, serving as an important source of R&D cash flow management.6

B. Final Conclusion

The ability of a United States Department of Defense contractor to claim the Indiana Research Expense Credit is fundamentally controlled by the federal definition of “funded research.” Indiana’s application of IRC §41(d)(4)(H) ensures that only expenditures for research in which the contractor bears the financial risk or retains substantial rights can qualify for the state incentive.

The legislative decision to create the specialized Aerospace Advanced Manufacturer Credit (IC 6-3.1-4-2.5) is a sophisticated policy mechanism designed to preserve and encourage R&D investment within Indiana’s critical defense and aerospace manufacturing base. This alternative credit overcomes the volatility and disincentives inherent in the standard federal R&D base calculation method for massive enterprises, providing a stable, predictable tax benefit that maximizes the recognition of incremental research investments within the state. Consequently, strategic success for Indiana-based DoD contractors relies on strict compliance with federal risk/rights tests, coupled with an assessment of whether the contractor meets the high thresholds required to benefit from the state’s bespoke AIC structure.

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