The Funded Research Exclusion within the Mississippi Research and Development Tax Credit Framework
The funded research exclusion is a statutory provision that prevents a taxpayer from claiming tax credits for research activities financed by a third party through grants, contracts, or subsidies. In Mississippi, this rule ensures that state tax incentives only benefit entities that bear the actual financial risk of failure and retain substantial intellectual property rights over their innovations.1
Comprehensive Analysis of the Funded Research Doctrine
The funded research exclusion represents one of the most complex and litigated areas of modern tax law, particularly as it pertains to the intersection of federal and state incentives. While the term is frequently cited in the context of the Internal Revenue Code (IRC) Section 41, its application within Mississippi requires a nuanced understanding of how the state has carved out its own unique incentive landscape. Unlike states that simply mirror federal guidelines, Mississippi has developed targeted programs such as the Strengthening Mississippi Academic Research Through Business (SMART) Act and the Research and Development Skills Tax Credit, each of which addresses the concept of “funding” with varying degrees of specificity.2
The underlying policy objective of the funded research exclusion is to prevent “double-dipping.” This occurs when a company receives a direct payment for a research project from a client or a government grant and then attempts to claim a tax credit on the same set of expenditures. By excluding funded research, the law ensures that the tax credit acts as a true incentive for private investment and risk-taking, rather than a secondary subsidy for services already paid for by a third party.1
To determine whether research is “funded,” tax authorities—including the Mississippi Department of Revenue (MDOR) and the Internal Revenue Service (IRS)—apply a two-pronged test derived from Treasury Regulation Section 1.41-4A(d). These two prongs are the “Risk Standard” and the “Substantial Rights Standard.” A taxpayer must satisfy both standards to prove that the research is unfunded and therefore eligible for tax benefits.1
The Risk Standard and Financial Contingency
The Risk Standard evaluates which party bears the financial loss if the research project fails to achieve its intended technical outcome. Research is considered “funded” if the taxpayer is entitled to payment regardless of the success or failure of the research. Conversely, research is “unfunded” if the taxpayer’s right to payment is contingent upon the success of the research.6
The legal inquiry centers on the terms of the contract governing the research. In the case of Fairchild Industries, Inc. v. United States, the Federal Circuit established that the sole inquiry in evaluating financial risk is who bears the research costs upon failure, not the likelihood of a project’s success. This means that even if a project is highly likely to succeed, if the contract states that the researcher will not be paid unless it does succeed, the researcher bears the risk.6
| Contract Type | General Risk Profile | Likelihood of Being Deemed “Funded” |
| Firm-Fixed-Price (FFP) | High risk for the contractor; payment is set regardless of cost overruns. | Low; typically viewed as unfunded research if success is required for payment.9 |
| Cost-Plus-Fixed-Fee (CPFF) | Low risk for the contractor; all costs are reimbursed plus a fee. | High; usually deemed funded because the client bears the cost of failure.9 |
| Time and Materials (T&M) | Contractor is paid for hours worked and materials used. | High; generally considered funded research.1 |
| Capped Contracts | Fixed maximum price but costs are reimbursed up to that cap. | Mixed; often deemed funded if payment is not contingent on specific research success.1 |
Recent case law, such as Meyer, Borgman & Johnson, Inc. v. Commissioner, highlights that even fixed-price contracts can be deemed “funded” if they lack explicit language linking payment to the success of the research itself, rather than just the delivery of a serviceable product.8
The Substantial Rights Standard and Intellectual Property
The Substantial Rights Standard focuses on whether the taxpayer retains the right to use the results of the research in its own trade or business. If a taxpayer performs research but is required to transfer all rights to the results to a third party, the research is considered “funded” by that third party.1
Taxpayers do not need exclusive rights to satisfy this standard. If the researcher retains a non-exclusive, royalty-free right to use the research results, they are generally considered to have “substantial rights.” However, if the researcher must pay a fee or royalty to the client to use the very technology they developed, they have not retained substantial rights.6
| Right Category | Interpretation under the Substantial Rights Standard |
| Exclusive Rights | Always satisfies the standard; the taxpayer owns the innovation.6 |
| Shared/Non-Exclusive Rights | Generally satisfies the standard; the taxpayer can use the results in their business.1 |
| Right to Use for a Fee | Does not satisfy the standard; the taxpayer lacks true ownership.1 |
| Incidental Benefits (e.g., Knowledge) | Does not satisfy the standard; “know-how” gained is not a substantial right.1 |
Mississippi’s Statutory Framework for Research Incentives
Mississippi’s approach to research incentives is distinct. While many states offer a credit that conforms directly to IRC Section 41, Mississippi does not offer a standalone spending-based R&D tax credit.4 Instead, the state utilizes a combination of employment-based credits, academic rebates, and immediate expensing rules. The funded research exclusion applies differently across these various mechanisms.5
The SMART Business Act and Academic Collaboration
The Strengthening Mississippi Academic Research Through Business (SMART) Act is the primary vehicle through which Mississippi incentivizes R&D spending. It offers a 25% rebate for qualified research costs incurred when a company partners with a Mississippi Institution of Higher Learning (IHL).5
The SMART Act provides the most explicit state-level definition of the funded research exclusion. Under Mississippi Code Section 37-148-3(c), “qualified research” is defined as a systematic investigative process for discovering information, but it specifically excludes “research expenses that are already being funded by any grant, contract or otherwise by another person or governmental entity”.2
The administrative rules for the SMART Act, found in Title 8, Part 13 of the Mississippi Administrative Code, further clarify that the rebate is only available for costs paid by an “investor” (the business) to a “college or research corporation” under a “research agreement”.3 If the investor is using federal grant money (such as SBIR funds) to pay the university, that portion of the expenditure is excluded from the state rebate calculation because it is already “funded” by the federal government.2
The Research and Development Skills Tax Credit
The Research and Development Skills Tax Credit is an employment-based incentive. It provides a $1,000 annual income tax credit for each full-time employee hired for a position requiring R&D skills.18
| Requirement | Description |
| Eligible Position | Must be engaged in R&D activities.18 |
| Education | Minimum of a bachelor’s degree in a scientific/technical field.5 |
| Experience | Professional level compensation and employment in area of expertise.5 |
| Benefit | $1,000 per employee per year for five years.13 |
| Cap | Limited to 50% of state income tax liability.5 |
While the Skills Credit is focused on headcount, the “funded research” principle still applies. If an engineering firm hires 50 engineers but their entire salary is reimbursed by a federal defense contract where the firm retains no rights to the IP, the MDOR may conclude that the firm is not “carrying on” research and development within the meaning of the state’s trade or business requirements.12
Immediate Expensing: H.B. 1733 and Section 174 Decoupling
A significant shift occurred in April 2023 with the passage of House Bill 1733. Historically, Mississippi conformed to federal rules for the deduction of research and experimental (R&E) expenditures under IRC Section 174. When the federal Tax Cuts and Jobs Act (TCJA) began requiring businesses to amortize these costs over five years starting in 2022, Mississippi chose to “decouple” from this requirement.11
Under H.B. 1733, Mississippi allows businesses to elect to fully deduct R&E expenditures in the year they are incurred. This provides a significant cash-flow advantage for Mississippi-based companies compared to those in states that strictly follow the federal amortization schedule.11 However, the definition of what constitutes an R&E expenditure remains tied to the concept of technical uncertainty. If the research is “funded” by a third party, the researcher generally cannot treat those expenditures as their own deductible R&E costs; instead, they are treated as the cost of goods sold or a service expense, while the funding party (the client) is the one entitled to the Section 174 treatment.10
Local State Revenue Office Guidance and Administrative Procedures
The Mississippi Department of Revenue (MDOR) provides specific guidance on how to claim these incentives and how they audit for the funded research exclusion. The “2025 Mississippi Tax Incentive Booklet” and Title 35 of the Mississippi Administrative Code serve as the primary sources of authority.21
Administrative Requirements for the Skills Tax Credit
The MDOR requires a proactive application process for the Research and Development Skills Tax Credit. Businesses cannot simply claim the credit on their tax return; they must first be authorized by the department.5
The taxpayer must submit a letter to the MDOR containing:
- The job title and detailed purpose of the position.21
- The specific education and experience requirements.12
- The weekly hours and professional salary level.12
- The hire date of the employee.21
Once approved, the business receives a letter of authorization. This letter, along with a computation schedule, must be attached to the state income tax return. The credit code for this incentive is 07.21 The MDOR uses this process to verify that the positions are truly “innovative” and not merely routine technical support for funded contracts.21
Audit Standards and Documentation
In the event of an audit, the MDOR may request contemporaneous records to prove that the research was not funded. This is particularly relevant for the SMART Business Act rebate.4 Required documentation often includes:
- Project descriptions and project accounting records.11
- Full copies of research agreements and any amendments.1
- Time tracking for employees assigned to specific projects.4
- Proof of payment to the university (for SMART Act claims).12
- An analysis of the contract terms regarding “Inspection and Acceptance” to determine if payment was contingent on success.1
How the Law Applies: Mechanics of the Exclusion
The application of the funded research exclusion involves a technical analysis of the taxpayer’s business model. In Mississippi, this often manifests in the “contract research” relationship.7
Contract Research Dynamics
When a Mississippi company hires an outside contractor to perform research, only 65% of the costs paid to that contractor are generally eligible for the federal R&D credit.7 At the state level, if that contractor is a Mississippi university, the company can receive a 25% rebate on the full amount under the SMART Act.2
However, the “funded” status must be determined for both parties:
- The Funding Party (The Client): They can claim the credit/rebate if they bear the financial risk and have the rights to the results.1
- The Performing Party (The Researcher): They are generally excluded from claiming the credit/rebate because their work is “funded” by the client.1
If the researcher (the performing party) wants to claim the credit, they must prove that the contract was “at risk.” This means that if the research failed, the researcher would not have been paid. If they can prove this, and they also retained rights to the IP, then the researcher claims the credit and the client is excluded.1
University Partnerships and the SMART Act
A unique aspect of Mississippi law is the Strengthening Mississippi Academic Research Through Business (SMART) Act. This act is designed to encourage businesses to use the state’s university infrastructure.14
| Program Factor | SMART Act Provision |
| Ineligible Research | Any research conducted outside the state of Mississippi.2 |
| Timing Requirement | Research conducted before IHL certification is not qualified.12 |
| Funding Exclusion | Research funded by third-party grants or contracts is excluded.2 |
| Eligible Entities | Corporations, LLCs, Partnerships subject to MS income tax.14 |
Under Section 37-148-3, the term “Qualified research” specifically excludes “research expenses that are already being funded by any grant, contract or otherwise by another person or governmental entity”.2 This means if a company gets a federal SBIR grant to work with the University of Southern Mississippi, the company cannot get the 25% state rebate on the portion of the university’s invoice paid for by that grant.2
Comprehensive Example: The “Delta Biotech” Scenario
To illustrate the interplay of these rules, consider “Delta Biotech,” a fictional startup based in Jackson, Mississippi.
The Situation
In 2024, Delta Biotech engages in three distinct research activities:
- Activity A: Delta receives a $200,000 federal SBIR grant to develop a new soil-testing sensor. They hire the Mississippi State University (MSU) research lab to help. The grant covers $50,000 of MSU’s fees.
- Activity B: Delta enters into a contract with a large agricultural company to develop a specific pesticide formula. The contract is a “Fixed-Price” agreement of $100,000, but the client only pays if the formula achieves a 95% efficacy rate in field trials. Delta Biotech retains the right to use the underlying chemical “chassis” for other products.
- Activity C: Delta hires a lead chemist (PhD) at a salary of $120,000 to manage all internal projects.
The Tax Analysis
Activity A (Funded Research):
- The $50,000 MSU fee paid by the SBIR grant is “funded research” under MS Code § 37-148-3(c).2
- Delta Biotech cannot claim the 25% SMART Act rebate on that $50,000.
- If Delta Biotech paid MSU an additional $20,000 of its own funds, it could claim a 25% rebate ($5,000) on that portion.5
Activity B (Risk and Rights):
- Risk: Because payment depends on the “95% efficacy rate” (success), Delta Biotech bears the financial risk. This is unfunded research under the Risk Standard.1
- Rights: Delta Biotech retained rights to the chemical chassis. This satisfies the Substantial Rights Standard.1
- Outcome: Delta Biotech can include the costs of Activity B in its calculation for state and federal R&D benefits.
Activity C (Skills Credit):
- Delta Biotech applies to the MDOR for the Research and Development Skills Tax Credit for the lead chemist.12
- Since the chemist has a PhD (exceeds bachelor’s requirement) and is working on both Activity A and B, and is compensated at a professional level, the MDOR approves the credit.5
- Delta Biotech receives a $1,000 credit per year for five years.13
Statistical Insights and Economic Context
Mississippi’s incentives are designed to be targeted rather than broad. This is reflected in the statutory caps and the specific sectors targeted for growth.29
| Metric | Value |
| SMART Act Total Annual Rebate Fund | $5,000,000 14 |
| SMART Act Maximum Rebate per Investor | $1,000,000 5 |
| R&D Skills Credit per Employee | $1,000 18 |
| Carryforward Period (Skills Credit) | 5 years 4 |
| Carryforward Period (Federal R&D) | 20 years 4 |
| MS General Fund Collections (FY21 Actual) | $6.74 Billion 30 |
| Business-Funded Academic R&D (Trend) | Growing, influenced by state collaboration credits 31 |
Mississippi ranks as an “Active R&D Tax Credit State,” but its lack of a general spending-based credit puts it in a unique category alongside Alabama and Tennessee, which also lack broad state-level R&D credits.4 However, Mississippi’s SMART Act rebate (25%) is significantly higher than the typical 5–15% credits offered in other states, making university collaboration a highly attractive strategy for Mississippi firms.31
Comparisons with Other Jurisdictions
To understand the severity and application of the funded research exclusion, it is helpful to look at how Mississippi’s neighbors and peers handle similar issues.
| State | R&D Credit Type | Collaboration Incentive | Funded Research Stance |
| Mississippi | Skills-Based ($1k/job) | 25% Rebate (SMART Act) | Strictly excludes funded research in SMART Act.2 |
| Arkansas | Spending-Based (20-33%) | 33% University credit | Follows federal § 41 funded exclusions.33 |
| Florida | Spending-Based (10%) | No specific university rebate | Follows federal § 41 funded exclusions.34 |
| Alabama | No broad credit | No specific university rebate | Generally no state-level R&D incentives.4 |
| Louisiana | Spending-Based | Part of general R&D credit | Strong focus on funded research risk standards (e.g., Grigsby case).1 |
In Mississippi, the reliance on the SMART Act makes the funded research exclusion more of a “binary” obstacle than in other states. In a state with a broad credit, funded research might only reduce a portion of the claim. In Mississippi, if the research agreement is deemed “funded” by an outside grant, the entire 25% rebate for that project is typically lost.2
Deep Regulatory Insights: Mississippi Administrative Code Title 35
The Mississippi Administrative Code provides the “how-to” for businesses navigating these exclusions. Title 35, Part VI, Subpart 2, Chapter 11 governs the R&D Skills Tax Credit, while Subpart 1, Chapter 4 provides broader definitions for “business enterprises”.21
One critical insight from the Administrative Code is the treatment of pass-through entities. For S-corporations, Partnerships, and LLCs, the credit earned at the entity level is passed through to the individual owners. However, the funded research exclusion remains at the entity level. If the LLC is performing funded research, the individual partners cannot claim the credit on their personal returns even if they personally bore some of the costs.20
Furthermore, the “Minimum Annual Increase” requirement for job credits (10 to 20 jobs depending on the Tier) does not apply to the R&D Skills Credit. There is “no minimum number of positions” that must be created for a business to qualify for the $1,000 credit, making it accessible to even the smallest startups—provided their research is unfunded and they have the proper scientific credentials.13
The Future of Mississippi R&D: H.B. 1953 and Beyond
Legislative activity in 2024 (H.B. 1953) suggests a continued commitment to targeted credits. The state is increasingly focusing on specific industries, such as hospitals and healthcare, while maintaining the aggregate caps on credit allocations to ensure fiscal stability.36
The trend in Mississippi is toward “Universal Tax Credits” like the Mississippi Flexible Tax Incentive (MFLEX). MFLEX streamlines the application process for multiple credits (income, sales, franchise) into one universal calculation.19 As MFLEX becomes more prevalent, the traditional funded research exclusion will likely be integrated into the “Performance Agreement” that companies sign with the Mississippi Development Authority (MDA). These agreements often require the company to maintain a certain level of “own-source” research spending to remain eligible for the incentive.19
Practical Recommendations for Mississippi Businesses
To navigate the funded research exclusion successfully, Mississippi businesses should consider the following steps:
- Contractual Audit: Review all current and pending research contracts. Ensure they are structured as “Fixed-Price” and include “Inspection and Acceptance” clauses that make payment contingent on meeting technical specifications.1
- IP Rights Retention: Explicitly state in contracts that the business retains a right to use all research results and derivatives in its own trade or business.1
- Separate Funding Accounts: When using federal grants (like SBIR) alongside state rebates (SMART Act), maintain separate accounting sub-ledgers. This allows for the easy identification of “unfunded” portions of the university’s research fees.2
- Early Certification: Do not wait for tax time to document R&D positions. Apply to the MDOR as soon as an eligible researcher is hired to ensure the position is certified as “innovative” before any “funded” contract work begins.5
- Utilize H.B. 1733: Take advantage of the state-level immediate deduction for R&E expenditures, even if the federal government requires amortization. This provides immediate cash flow that can be reinvested into “unfunded” research projects.11
Conclusion
The funded research exclusion is not merely a technicality; it is a fundamental boundary that defines the eligibility for Mississippi’s most lucrative innovation incentives. By distinguishing between research conducted as a service and research conducted as a strategic investment, the exclusion protects the state’s fiscal resources while rewarding the companies that take the greatest risks. Whether a business is partnering with a university under the SMART Act or hiring skilled engineers for the R&D Skills Credit, a thorough understanding of the “Risk” and “Substantial Rights” standards is essential for maximizing tax benefits and ensuring compliance with Mississippi’s evolving regulatory framework.1
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The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
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