The Funded Research Exclusion and the Nebraska Research and Development Tax Credit: A Comprehensive Regulatory and Statutory Analysis

The funded research exclusion prevents businesses from claiming tax credits for innovation activities where the financial risk or intellectual property rights belong to a third-party payer. Under Nebraska law, this ensures state incentives only subsidize research that a taxpayer independently funds and retains the right to exploit commercially.

The Nebraska Advantage Research and Development Act, governed by Neb. Rev. Stat. §§ 77-5801 to 77-5807, operates through a direct link to the federal Internal Revenue Code (IRC) Section 41. This statutory alignment means that the state credit inherits the federal definition of “qualified research,” including the critical exclusions outlined in IRC § 41(d)(4). Among these, the funded research exclusion serves as a primary gatekeeper, ensuring that tax benefits are not “double-dipped” when research is already being subsidized by government grants, corporate contracts, or other third-party arrangements. For the Nebraska Department of Revenue (DOR), the analysis of whether research is funded hinges on two complex legal standards: the allocation of financial risk and the retention of substantial rights. As the state moves toward the 2033 sunset of the current R&D incentive framework, understanding the intersection of federal jurisprudence and local administrative mandates—such as the mandatory E-Verify system—remains paramount for businesses seeking to maximize their refundable credits while maintaining audit readiness..1

The Statutory Foundation of Nebraska’s R&D Incentives

The Nebraska research and development tax credit was established to stimulate investment and employment in Nebraska by rewarding business firms that incur research and experimental expenditures within the state.1 This credit is available for tax years beginning on or after January 1, 2006, and is notable for its high degree of flexibility, allowing businesses to use the credit as a refundable income tax credit or to obtain a refund of sales and use taxes paid.1

Integration with the Internal Revenue Code

The Nebraska statute does not operate in a vacuum; rather, it “leverages off” federal definitions and calculations. Specifically, Neb. Rev. Stat. § 77-5803 provides that the credit amount is equal to 15 percent of the federal tax credit allowed under Section 41 of the Internal Revenue Code of 1986, as amended.6

By pegging the state credit to the federal credit “allowed,” Nebraska incorporates the entire body of federal law regarding what constitutes qualified research. If an activity is excluded at the federal level due to being “funded,” it is automatically disqualified from the Nebraska credit pool.3

The Evolution of the Nebraska Advantage Act

While the original R&D credit was born under the Nebraska Advantage Research and Development Act, it has remained a persistent feature of the state’s economic policy even as newer programs like the ImagiNE Nebraska Act have been introduced to handle broader investment and employment goals.8 The R&D credit is unique because, unlike many other incentives, it does not require a prior application or an agreement with the Department of Economic Development before the credit is earned.1 Instead, a business firm simply performs the research, ensures compliance with E-Verify, and claims the credit on its Nebraska tax return using Form 3800N and Worksheet RD.1

Defining the Funded Research Exclusion

The funded research exclusion is codified at IRC § 41(d)(4)(H), which 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)”.2 This definition is deceptively simple, but its application involves a deep dive into the contractual and economic realities of the research relationship.

The Scope of “Funded” Research

The term “funded” encompasses any payment made to a taxpayer for the performance of research activities. This includes:

• Federal or state government grants (e.g., SBIR or STTR grants).8
• Contracts for the development of a specific product or process where the client pays for the research hours.
• Intercompany transfers in some contexts where research is performed on behalf of a related entity that bears the ultimate cost.11

The exclusion applies “to the extent” the research is funded. This means that if a project costs $500,000 but a third party only provides $200,000 in funding, the remaining $300,000 may still qualify for the credit, provided the taxpayer meets the other requirements of the four-part test.12

The Four-Part Test Nexus

To understand the exclusion, one must first look at what it excludes. Under IRC § 41(d)(1), qualified research must meet four criteria:

1. Section 174 Test: The expenditures must be deductible as research and experimental costs under IRC § 174.13
2. Technological in Nature Test: The research must fundamentally rely on principles of physical science, biological science, engineering, or computer science.7
3. Permitted Purpose Test: The research must be intended to develop a new or improved business component, such as a product, process, software, or formula.7
4. Process of Experimentation Test: Substantially all of the activities must involve a process of experimentation to resolve technological uncertainty.15

The funded research exclusion acts as a final filter. Even if a project meets all four of these tests, if it is “funded” by someone else, it cannot be claimed by the person performing the work.14

The Two-Pronged Analytical Framework: Risk and Rights

Federal Treasury Regulation § 1.41-4A(d) provides the operational definition used by both the IRS and the Nebraska Department of Revenue to determine if research is funded. This regulation establishes two primary hurdles: the financial risk standard and the substantial rights standard.18

The Financial Risk Standard

Research is considered funded if the taxpayer’s right to payment is not contingent upon the success of the research.18 If a company is paid regardless of whether the research project fails or succeeds, it has not borne the economic risk of the innovation.

Contingency of Payment

To satisfy the risk standard, the taxpayer must demonstrate that their payment is “at risk.” This typically means that if the research does not yield the desired result, the taxpayer is not entitled to payment or must refund previous payments.16

• Fixed-Price Contracts: These are often viewed as carrying more risk for the researcher, but they are not automatically “unfunded.” If the fixed price is paid regardless of the technical outcome, the research remains funded.19
• Time and Materials Contracts: These are almost always considered funded research, as the researcher is paid for the hours worked, not for the success of the invention.19
• Success-Based Milestones: Contracts that tie payments to the successful resolution of a technological uncertainty are the strongest evidence of a lack of funding.19

Judicial Interpretations of Risk

The landmark case Fairchild Industries, Inc. v. United States clarified that the focus must be on who bears the cost if the project fails.18 The court rejected the IRS’s argument that progress payments made during a project constituted funding, provided those payments were subject to clawback or were contingent on final acceptance of a successful product.18 Conversely, in Geosyntec Consultants, the court found that even “capped” contracts were funded because the payment for the work performed up to the cap was not strictly contingent on the success of the research results.19

The Substantial Rights Standard

Even if a researcher bears the financial risk, the research is still considered funded if the taxpayer retains “no substantial rights” in the research results.18 If a contract requires the researcher to transfer all intellectual property, patents, and usage rights to the client, the researcher is essentially “selling” their research services, and the client (the payer) is the one deemed to be performing the research for tax purposes.

Retention of Usage Rights

“Substantial rights” do not require the researcher to have exclusive rights. If the researcher retains a non-exclusive, royalty-free right to use the research results in their own trade or business, they generally satisfy this standard.18

• Lockheed Martin v. United States: This case established that the right to use research results in other projects for other customers constituted a substantial right, even if the government (the funder) also held extensive rights to the same information.18
• Incidental Benefits: The IRS often argues that “know-how” or the general experience gained from a project is an incidental benefit, not a substantial right. The Dynetics case confirmed this view, stating that simply becoming more skilled at a craft does not constitute a retained right in the specific research performed.19

Nebraska Department of Revenue Guidance and Local Application

The Nebraska Department of Revenue (DOR) provides administrative guidance through various channels, including official FAQs, Revenue Rulings, and tax form instructions. While the DOR does not frequently issue rulings solely on the “funded” aspect of the credit, its alignment with federal law makes its general guidance essential for local interpretation.

Revenue Ruling 29-10-2: Enhanced Credits on Campus

One of the most specific pieces of Nebraska guidance is Revenue Ruling 29-10-2, which clarifies the “enhanced” 35% credit.4 This ruling is critical because it defines what constitutes a “college or university” and what it means for research to be conducted “on campus.”

The ruling explains that if a business makes expenditures in research and experimental activities on the campus of a Nebraska college or university, it may claim 35% of the federal credit instead of the standard 15%.4 However, the ruling implicitly requires that these expenditures meet the federal definition of “qualified research.” If a university provides a grant to a business to conduct research in a university lab, that research is likely “funded” by the university (a governmental or third-party entity) and would be excluded from both the federal and state credits.2

Form 3800N and Worksheet RD Compliance

The Nebraska DOR requires the completion of Form 3800N and Worksheet RD to claim the credit.1

• Form 3800N: Acts as the summary for all incentive credits, including the R&D Act credit (Line 18).21
• Worksheet RD: This is where the mathematical interaction with the federal credit occurs. Line 2 of Worksheet RD requires the taxpayer to “Enter total amount of federal research credit allowed for this tax year”.10

The use of the word “allowed” is a vital legal distinction. It signifies that the amount entered must be the final federal credit after all federal exclusions—including the funded research exclusion—have been applied.10 If a taxpayer includes funded expenses on their federal Form 6765, they are effectively claiming an unallowed credit on their Nebraska return, making them vulnerable to state audits.

E-Verify: The Nebraska-Specific Compliance Pillar

A major divergence from federal law is Nebraska’s E-Verify mandate. Since October 1, 2009, all business firms claiming the R&D tax credit must electronically verify the work eligibility status of all employees hired in Nebraska during the tax year for which the credit is claimed.1

The Nebraska DOR takes this requirement seriously. Failure to timely E-Verify even a single employee who is part of the R&D team (or even employees not in the R&D team but hired in Nebraska that year) can lead to the complete disqualification of the R&D credit for that year.1 In an audit, the DOR will often cross-reference E-Verify logs with the payroll records used to calculate the credit.3

Analyzing Statistical Trends in Nebraska R&D Credits

Data provided in the 2024 and 2025 Nebraska Tax Incentives Annual Reports, as well as audits by the National Conference of State Legislatures (NCSL), provide a window into how these credits are utilized across the state’s economy.9

Sectoral Distribution of Credits

The Nebraska R&D credit is heavily utilized by the high-tech, agricultural, and manufacturing sectors. For research activity between 2006 and 2020, 460 companies were awarded over $72.3 million in credits.23

This data suggests that while high-tech and renewable energy are significant, a vast majority of the credits (roughly 74%) flow to more traditional Nebraska sectors like agriculture and manufacturing.23 For these businesses, contract research is common. An equipment manufacturer might hire a university team to test new hydraulics. If the manufacturer pays the university for this service, the manufacturer may be able to claim the credit (as “contract research expenses”), but the university cannot, because the university’s work is “funded” by the manufacturer.2

Fiscal Impact and Utilization Rates

Nebraska companies have used over $67.7 million of the awarded credits, representing a 93.7% utilization rate.23 This high rate is likely due to the credit’s refundability. Small businesses and startups, which may not yet have an income tax liability, can receive the credit as a cash refund of sales and use taxes paid, which provides immediate liquidity to reinvest in further research.3

However, this high utilization has led to costs exceeding the legislature’s initial estimates. For example, in 2020, over $10 million in credits were used, doubling the annual $5 million estimate.23 This fiscal pressure makes it more likely that the Department of Revenue will strictly enforce exclusions like the funded research provision to protect the state’s general fund.24

Impact of the Tax Cuts and Jobs Act (TCJA) and IRC Section 174

Perhaps the most significant change in the R&D landscape in recent years is the federal mandate to capitalize research expenditures. Effective for tax years beginning after December 31, 2021, IRC § 174 was amended by the TCJA to eliminate the immediate expensing of research and experimental (R&E) costs.25

Capitalization and Amortization Requirements

Taxpayers must now capitalize their § 174 costs and amortize them over five years for domestic research and fifteen years for foreign research.17 This change creates a unique interaction with the Nebraska credit:

• Conformity: Nebraska follows IRC § 174, meaning Nebraska businesses must also capitalize these costs for state income tax purposes.25
• Nexus with the Credit: To claim the § 41 credit, the expenses must first qualify as § 174 expenditures. If a cost is excluded from § 174 (for example, because it is “funded” and the taxpayer has no risk), it cannot be part of the credit calculation.13

The “One Big Beautiful Bill Act” (OBBBA) introduced at the federal level has sought to reinstate full expensing for domestic research starting in 2025, but the overall landscape remains complex and varies by tax year.26

Example: Navigating Funded Research in a Nebraska Business Scenario

To provide a practical application of these rules, let us examine a hypothetical Nebraska-based software company, “Cornhusker Tech Solutions (CTS).”

The Setting

CTS is a startup in Omaha specializing in precision agriculture software. In 2024, CTS hired three new employees (all E-Verified) and engaged in three distinct projects.

Project 1: The Federal SBIR Grant

CTS received a $150,000 Small Business Innovation Research (SBIR) grant from the federal government to develop a drought-prediction algorithm.

• Analysis: This research is funded by a governmental entity.2 CTS cannot include any of the wages or supplies used for this project in its R&D credit calculation.
• Impact: If CTS spends $150,000 and is reimbursed $150,000, the net qualified research expense (QRE) is zero.

Project 2: Contract with “Mega-Farm Corp”

CTS entered into a contract with a large agricultural firm to develop a custom harvest-optimization tool.

• Contract Terms: CTS is paid a flat fee of $100,000. The contract states that CTS will only be paid if the software reduces harvest time by at least 10%. However, the contract also specifies that “Mega-Farm Corp” shall own all copyrights and patents to the software, with CTS retaining no rights to reuse the code for other clients.
• Analysis: While CTS bears the financial risk (payment is contingent on success), they fail the substantial rights standard because they cannot reuse the research results.18
• Impact: This research is considered funded by the client. CTS cannot claim the credit.

Project 3: Internal “v2.0” Development

CTS spends $200,000 of its own venture capital to develop the next version of its flagship product, which it sells to several hundred farmers.

• Analysis: This project is self-funded, meets the four-part test, and the employees were E-Verified.
• Impact: These expenses qualify for the credit. CTS would calculate its federal credit based on these $200,000 in QREs and then claim 15% of that federal amount on its Nebraska return.3

Audit Guidelines and Recordkeeping for Nebraska Taxpayers

The Nebraska Department of Revenue performs audits to ensure compliance with the Advantage Research and Development Act. Audit guidelines suggest that businesses should retain their records for at least four years, aligning with federal § 41 standards.3

Documentation to Substantiate “Unfunded” Status

To survive an audit focused on the funded research exclusion, a business must be able to present:

1. Fully Executed Contracts: Auditors will look for “Inspection and Acceptance” clauses that prove payment was contingent on technical success.18
2. Intellectual Property Provisions: Contracts must clearly state that the researcher retains the right to use the results of the research without paying a fee to the client.18
3. Project Accounting: Evidence that the costs claimed were actually incurred for the specific “unfunded” project and not for a funded one.16
4. E-Verify Logs: Proof that the work eligibility of every Nebraska hire was verified. The DOR will often ask for the E-Verify “Case Details” page for employees hired during the credit year.1

Refund Recapture and Interest

If the DOR determines that a credit was improperly claimed—either because the research was funded or because E-Verify mandates were missed—the state can recapture the refund. Under Neb. Rev. Stat. § 77-5804(5), interest is generally not allowed on taxes refunded under the Act, but the state may charge interest and penalties on the recapture of an improper refund.5

Strategic Implications for Nebraska Business Owners

For professional services firms, engineering companies, and technology developers, the funded research exclusion is more than a technicality—it is a central pillar of tax planning.

Negotiating Contracts for Credit Eligibility

Business owners should work with legal counsel to structure contracts that preserve R&D credit eligibility. If a company wishes to claim the credit for a client project, the contract should ideally:

• Make payments contingent on the successful resolution of a technical uncertainty.
• Explicitly grant the researcher a non-exclusive, perpetual license to use the results, modifications, and “know-how” generated during the project.19

Coordinating with Federal and State Filings

Because the Nebraska credit is derived from the federal credit, any adjustment made by the IRS will typically trigger an obligation to file an amended Nebraska return. Conversely, if a Nebraska auditor identifies a funded research issue, they may report that finding to the IRS, potentially leading to a federal audit.12

Conclusion: Innovation with Compliance

The Nebraska Advantage Research and Development Act offers a powerful incentive for businesses to push the boundaries of technology within the state. However, the refundable nature of the credit—which essentially puts state cash directly into the hands of innovators—comes with a high standard of accountability. The funded research exclusion ensures that these cash incentives are reserved for companies that truly “invest” in their own futures, bearing the financial weight of failure and holding the rights to their successes.

By aligning state law with the rigorous standards of IRC § 41 and § 174, Nebraska has created a system that is both predictable and strictly regulated. For the Nebraska business community, the path to a successful R&D claim involves more than just innovative engineering; it requires a disciplined approach to contract management, a commitment to local employment mandates like E-Verify, and a deep understanding of the risk and rights tests that define the boundary between service work and qualified research. As the program continues toward its 2033 sunset, maintaining this balance will remain the hallmark of successful tax strategy for Nebraska’s most innovative firms..1

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