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The Substantial Rights Standard: Navigating the Funded Research Exclusion in US R&D Tax Law (IRC § 41)

I. Executive Summary: The Crucial Role of Substantial Rights

The concept of Substantial Rights (SR) is a foundational element in determining the eligibility of research expenditures for the federal research and development (R&D) tax credit, codified under Internal Revenue Code (IRC) § 41. SR dictates which party—the entity performing the research (the contractor/taxpayer) or the entity paying for it (the customer/client)—is deemed the true economic investor in the research for tax purposes. When a taxpayer performs research on behalf of another person, the expenditure for that research is excluded from the taxpayer’s Qualified Research Expenditures (QREs) if the research is considered “funded”.1 The retention of Substantial Rights is the first half of a critical dual regulatory test for funded research. Specifically, SR requires that the performing taxpayer maintain the proprietary, unrestricted right to utilize the resulting research outcomes—including patents, technical data, and know-how—in their own trade or business without needing subsequent client approval or having to pay royalties for that usage.2 By demanding that the taxpayer retain this enduring right, the standard ensures that the tax incentive is directed toward entities that not only carry out the innovative activity but also retain the valuable Intellectual Property (IP) for future commercial exploitation, thereby aligning the tax benefit with the intended economic goal of promoting domestic innovation.4

The importance of the Substantial Rights standard is paramount because it acts as a gatekeeper to the research credit, preventing a common compliance trap where neither the performer nor the payer can claim the benefit. Treasury Regulations require that research meet a dual test: the performing taxpayer must both (1) retain Substantial Rights in the research results and (2) bear financial risk for the successful outcome (i.e., payment must be contingent on success).5 If the performing taxpayer fails the SR test because the client retains all intellectual property rights, the research is excluded from the performer’s QREs, irrespective of whether the performer took on financial risk.1 Most critically, if the contractor retains no Substantial Rights and the client’s payment is contingent on success (e.g., a fixed-price contract where the client buys the final, proprietary result), the regulations deem the research funded, resulting in neither the performing contractor nor the paying client being eligible to claim the credit.6 This “neither party claims” exclusion underscores the necessity for taxpayers to meticulously structure contracts to ensure the financial risk and the proprietary benefit reside in the same eligible claiming entity.

II. Statutory and Regulatory Foundation of the Funded Research Exclusion

A. Internal Revenue Code § 41: Qualified Research Expenses (QREs)

IRC § 41 establishes the framework for the R&D tax credit, defining Qualified Research Expenses (QREs) as the sum of in-house research expenses and contract research expenses paid or incurred by the taxpayer in carrying on any trade or business.7 In-house research expenses comprise three categories: wages paid for qualified services, amounts paid for supplies used in the research, and, under specific regulations, amounts paid for the right to use computers in the conduct of qualified research.7 A unique exclusion relating to computer usage stipulates that amounts paid for the right to use computers do not qualify to the extent the taxpayer receives or accrues amounts from another person for the right to use substantially identical personal property.7 This narrow test concerning identical property rights for computer usage is separate from, but occasionally confused with, the broader Substantial Rights test applied to the results of the research itself under the funded research exclusion.

B. The Funded Research Exclusion: IRC § 41(d)(4)(H) and Treasury Regulation § 1.41-4A(d)

The ultimate eligibility of research activities hinges on satisfying the four-part statutory test for qualified research and, critically, avoiding the explicit exclusion for research that is funded by another person or governmental entity, as stipulated in IRC § 41(d)(4)(H) and detailed in Treasury Regulation § 1.41-4A(d).5 The regulations provide a definitive framework for addressing contract research, which is categorized based on whether the performing taxpayer retains rights to the research outcomes.1

Regulation § 1.41-2(a)(3) addresses “Research performed for others” by defining two outcomes based on the retention of proprietary rights:

1. Taxpayer Not Entitled to Results: If the performing taxpayer conducts research on behalf of another person but retains no substantial rights in the results, that research shall not be taken into account by the taxpayer for purposes of Section 41.1 This failure on the rights prong immediately excludes the expenditures for the performer.
2. Taxpayer Entitled to Results: If the taxpayer performs research for others but retains substantial rights in the research, the taxpayer may take otherwise qualified expenses into account for the credit to the extent provided in Regulation § 1.41-4A(d)(3).1 This permissive language dictates that the analysis must then proceed to the financial risk standard.

The regulatory structure demands that auditors assess IP retention (Substantial Rights) entirely separately from financial exposure (Contingent Payment).5 The failure to retain Substantial Rights immediately disqualifies the performer from claiming the credit, regardless of the financial terms of the contract. Thus, the Substantial Rights analysis serves as a fundamental gatekeeper requirement; if it is not met, the financial risk standard becomes irrelevant for the performer’s claim.

C. Treatment of Partially Funded Research

The regulations recognize that research may be partially funded, and they provide specific rules for allocation. If a taxpayer performing qualified research retains Substantial Rights under the agreement, the research is deemed funded only “to the extent of the payments (and fair market value of any property) to which the taxpayer becomes entitled by performing the research”.6 This triggers a mandatory pro rata allocation requirement (Treasury Regulation § 1.41-4A(d)(3)(ii)), which dictates that the funding must be allocated across the qualified research expenditures.6 This allocation is particularly critical in complex cost-share or cost-overrun situations. For instance, if the taxpayer voluntarily continues research at their own expense after a contractual obligation has concluded, those self-funded expenditures may qualify, provided the taxpayer retains the necessary rights.9 Taxpayers frequently overlook these precise pro rata allocation rules, which are essential when determining the non-funded portion of expenses. Furthermore, if, at the time the tax return is filed, it is impossible to determine the precise extent to which research may be funded, the taxpayer must initially treat the research as completely funded; an amended return is then required when the funding amount is finally determined.6

III. Definitional Analysis: Meaning and Characteristics of Substantial Rights

A. Establishing the Standard: The Right to Proprietary Use

Substantial Rights require that the performing entity, in carrying out its trade or business, retain the ability to use the research results—the IP or technical work product—freely, without having to pay additional fees or seek approval from the contracting client for the privilege.2 This right focuses on proprietary use: the ability to internalize the resulting knowledge and apply it commercially. If the agreement requires the taxpayer to pay for the right to utilize the outcomes of the research, or if the client imposes overly restrictive requirements on the future exploitation of the IP, Substantial Rights are not retained.6 The retained right must allow the taxpayer to incorporate the resulting know-how, design, or developed processes into future commercial products, internal systems, or ongoing research projects, such as Independent Research and Development (IRAD).9 The economic rationale behind this requirement is that the credit is intended to reward an investment that yields an enduring, commercially valuable asset that benefits the claiming entity’s future operations or competitiveness.3

B. Nuance in Interpretation: Why “Substantial” is Not “Exclusive”

The interpretation of “Substantial Rights” was significantly shaped by the judiciary, particularly the seminal case of Lockheed Martin Corp. v. United States (Fed. Cir. 2000).3 This case provided essential clarification, rejecting the narrow argument that Substantial Rights required the taxpayer to retain the exclusive right to exclude others from using the IP.4 The court confirmed that the mere right to use the research results, even if shared non-exclusively with the client (such as the U.S. government), constitutes a substantial right.3 This precedent affirmed that a contractor is not required to retain all rights to satisfy the substantial rights standard; the retention of the ability to exploit the IP within its own business is sufficient.5

This judicial interpretation prevents a breakdown in the credit mechanism for industries, such as government contracting, where IP sharing is standard. However, taxpayers must still ensure the retained rights are genuinely usable. Contractual clauses that grant the client the “ultimate power” over the IP, such as requiring the transfer of title or imposing onerous prior approval mechanisms on the contractor’s use of the data, can still negate the retention of Substantial Rights.4 The retained proprietary use must therefore be legally and practically viable for the contractor.

IV. The Importance of Substantial Rights: Determining Eligibility via the Dual Test

A. The Interplay of Substantial Rights and Financial Risk (The Contingency Standard)

The Substantial Rights standard operates in tandem with the Risk Standard, which defines whether payment for the research is “contingent on the success of the research”.5 For the performing contractor to claim the research credit, both prongs of the Dual Test must be met: the contractor must retain Substantial Rights AND assume the financial risk, meaning the payment is contingent upon successful outcome.6

Contract types often serve as proxies for financial risk determination. Contracts classified as cost-plus, cost reimbursable, time and materials (T&M), or hourly arrangements generally fail the risk standard because the performing party is typically guaranteed payment for costs incurred, regardless of technical success or failure.11 Conversely, a fixed-price contract generally forces the performer to incur additional, non-reimbursed costs if the project exceeds budget or fails, thereby demonstrating the requisite financial risk.11 Crucially, even when the financial risk is satisfied via a fixed-price arrangement, the contract must simultaneously ensure the retention of Substantial Rights.

B. Application Matrix: Who is Entitled to Claim the Credit?

The following matrix synthesizes the outcomes of the Dual Test, illustrating how the presence or absence of Substantial Rights impacts eligibility for both the performing taxpayer (Contractor) and the entity funding the research (Client).

Dual Test Matrix for R&D Tax Credit Eligibility (IRC § 41)

C. The Disqualified Risk Trap: Scenario 3 Analysis

Scenario 3 reveals a critical regulatory nuance: the “neither party claims” rule. If the performing contractor undertakes a project on a fixed-price basis (thereby bearing financial risk), but the contract stipulates that the client will own all resulting Intellectual Property and technical data, the contractor fails the Substantial Rights standard.1 Since the contractor failed the SR test, the expenditure is excluded from their QREs. Simultaneously, the client (the paying party) also cannot claim the credit because their payment was contingent upon the successful delivery of the product or result. Regulations view payments contingent on success as amounts paid for the product of the research, not for the uncertain research process itself, meaning the client did not bear the financial risk required to claim the QREs.5

The regulatory consequence is the intentional closure of this gap: because the risk and the retained entrepreneurial value were decoupled, the research expenditures are excluded for everyone.6 This exclusion reinforces the policy objective of IRC § 41, which is to incentivize the party that commits financial capital to uncertain outcomes and retains the resulting reusable proprietary value. If a contractor assumes risk but relinquishes all rights, they are viewed as a service provider with a performance warranty, not an innovator investing in future technology.

V. Practical Application and Contractual Case Study (Example)

A. Detailed Analysis of Contract Types

The nature of the contract is often the starting point for IRS examiners. Contracts categorized as cost-plus, cost-reimbursable, or time and materials are typically scrutinized heavily because they tend to fail the financial risk standard, as the client guarantees payment regardless of success.11 The burden then shifts to the taxpayer to demonstrate they retained Substantial Rights and bore risk beyond the standard reimbursement, such as absorbing significant cost overruns or conducting independent research (IRAD) at their own expense after the contract concludes.9 Conversely, fixed-price contracts are essential to satisfy the risk requirement, yet they must be coupled with meticulous IP clauses that explicitly grant the performing contractor the necessary Substantial Rights.6

B. Example: Substantial Rights in Defense Contracting (Lockheed Martin Model)

Consider a scenario involving Contractor A, a technology firm that enters into a fixed-price contract with a government agency to develop a specialized communication software protocol. The fixed price structure exposes Contractor A to financial risk because any cost overruns must be absorbed internally.

The Intellectual Property clauses stipulate that the government receives full title to the final software deliverable, along with a perpetual, non-exclusive, royalty-free license to all underlying technical data and know-how generated during the development. Contractor A, however, explicitly retains the right to use all technical specifications, algorithms, and processes developed during the contract for its own internal business purposes, including integration into its future commercial software products and subsequent bidding on non-governmental contracts.

Analysis using the Dual Test:

1. Financial Risk (Contingency): Met. The fixed-price structure means payment is contingent on the successful delivery of the functioning protocol, and Contractor A assumes liability for cost overruns, satisfying the financial risk standard.6
2. Substantial Rights: Met. Drawing on the judicial precedent established in Lockheed Martin, even though the government retains ownership and the right to use the data, Contractor A retains an unrestricted, royalty-free right to use the underlying know-how in its own business.3 This retained proprietary use right, often referred to as a “shop right” or retained data right, is sufficient to qualify as a Substantial Right because Contractor A does not have to pay the government to utilize the developed IP.6

Conclusion: Since the fixed-price arrangement satisfies the risk standard, and the retention of proprietary use rights satisfies the Substantial Rights standard, the research expenses incurred by Contractor A are deemed non-funded and are eligible for the R&D Tax Credit.

VI. Tax Planning and Compliance Considerations

A. Documentation Requirements for Substantial Rights Claims

Compliance with the funded research exclusion necessitates rigorous documentation, centering primarily on the contractual agreement.12 During an IRS examination, examiners are instructed by Audit Techniques Guides (ATGs) to review the complete contract, including statements of work and all IP clauses, to rigorously determine both the nature of payment (risk) and the retention of IP (rights).6 The documentation must explicitly demonstrate that the performing taxpayer holds the proprietary right to utilize the research results within its business without restriction.2 Furthermore, beyond the contractual text, the taxpayer should maintain internal records demonstrating the actual exercise of those retained Substantial Rights—for instance, showing how technical data developed under the contract was subsequently integrated into the company’s independent R&D (IRAD) pipeline or utilized to enhance other commercial product lines.9

B. Interaction with IRC § 174 Capitalization Rules

Qualified research expenses claimed under IRC § 41 must first qualify as research and experimental (R&E) expenditures under IRC § 174, which governs the treatment of R&E costs.13 While recent legislation, such as the One Big Beautiful Bill Act (OBBBA), has reinstated immediate expensing for domestic R&E expenditures under Section 174A, the core requirement that the research must not be funded remains critical for the Section 41 credit.15 If the research is deemed funded because Substantial Rights were not retained, the performing taxpayer cannot include those costs in its QRE base, regardless of the treatment under Section 174A. The statutory linkage also requires that taxpayers claiming the R&D credit reduce their § 174A deduction (or increase their § 174 amortization) by the amount of the credit claimed, unless an election is made to reduce the credit.13 This provision emphasizes that the expenses claimed must be incurred by the taxpayer for the direct purpose of benefiting their own trade or business, a requirement inherently satisfied by the retention of Substantial Rights.

C. Increased Scrutiny and the Need for Specificity

The evolving landscape of R&D tax compliance, characterized by changes to Section 174 and increased IRS scrutiny on documentation (as highlighted by case law such as Harper), mandates a higher level of detail and specificity in tax credit claims.12 The explicit reliance on the contract to establish both Substantial Rights and Financial Risk makes ambiguous or boilerplate contractual language a significant audit vulnerability. The research credit is designed to reward the investment in the uncertain process leading to the retention of valuable IP. If a contract fails to clearly grant the contractor unrestricted proprietary use of the research results, the fundamental connection between the expenditure and the taxpayer’s future business value is jeopardized, leading to the disqualification of the QREs.

VII. Recommendations: Next Steps for Clarifying and Explaining Substantial Rights

The application of the Substantial Rights standard remains a persistent area of dispute and uncertainty, particularly given the evolution of modern IP licensing and shared risk arrangements.5 To fully clarify and standardize the use of Substantial Rights in R&D tax credit claims, the following next steps are recommended for both policymakers and practitioners.

A. Advocating for Comprehensive Treasury Guidance on IP Retention

The primary step required for clarifying Substantial Rights is the issuance of new, comprehensive Treasury regulations or formalized guidance that specifically addresses modern contractual environments. The current regulations predate many common arrangements, such as extensive data rights licensing, software development agreements involving shared IP, and complex government acquisition models. New guidance should formalize the judicial interpretation established in Lockheed Martin, explicitly affirming that the non-exclusive, perpetual right to use the results in the taxpayer’s trade or business is sufficient, thereby eliminating the persistent government argument that the right to exclude others is required.3 Clear safe harbors are necessary to define what constitutes acceptable retained Substantial Rights when IP ownership is shared or licensed, thus standardizing compliance and reducing the propensity for litigation. Furthermore, regulators should clarify the distinction between the general Substantial Rights test for funded research and the “substantially identical personal property” exclusion specific to computer usage QREs to prevent interpretive confusion.7

B. Leveraging the Private Letter Ruling (PLR) Process

For taxpayers entering into novel or highly complex contracting arrangements where the status of Substantial Rights is ambiguous, proactively utilizing the Private Letter Ruling (PLR) process is an essential planning measure.16 A PLR provides a binding, written determination from the IRS regarding the tax consequences of a specific proposed transaction, ensuring that the taxpayer’s retention of Substantial Rights is acknowledged before the return is filed.17 While PLRs are not binding precedent for other taxpayers, the consistent requests and resulting determinations often inform future IRS published guidance, indirectly contributing to the general clarification and consensus on acceptable SR arrangements.16

C. Establishing Contractual Drafting Best Practices

Tax practitioners must engage in direct collaboration with legal and contracting teams during the negotiation phase to proactively secure Substantial Rights. Contractual language must be precise and unequivocal regarding the performing contractor’s retained rights. Best practices require contracts to explicitly state that the performing contractor retains a non-exclusive, irrevocable, paid-up, worldwide license to use the developed IP and technical data for its own purposes, specifically including internal development, testing, and subsequent commercial sales to third parties, without requiring subsequent client approval or demanding future royalty payments back to the client.6 Ambiguous clauses that grant the client ultimate control over the exploitation of the IP or require the contractor to pay a license fee to utilize the technology are detrimental and must be avoided.

D. Monitoring Legal and Legislative Changes

Given the history of complexity and recent legal challenges surrounding the funded research exclusion, continuous monitoring of judicial decisions (like the post-Lockheed Martin cases) is critical for adapting compliance strategies.5 Furthermore, tracking ongoing legislative efforts and technical corrections regarding IRC § 41, § 174, and § 174A is necessary to understand how shifts in the R&E amortization/expensing landscape might affect the calculation and eligibility standards for the underlying QRE base.15 Only through vigilant monitoring and proactive contract structuring can taxpayers navigate the complexities of the Substantial Rights standard.

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