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Research and Development (R&D) Tax Credits for Government Contractors: A Guide

Article

April 24, 2026

Businesses engaged in R&D or software development activities have the potential to qualify for the R&D tax credit, a federal tax benefit designed to incentivize innovation and reward organizations for investing in R&D. This tax credit enables businesses to offset their income taxes and, in some cases, their payroll taxes, resulting in substantial tax savings. Some individual states also offer R&D tax benefits.

With increasing pressure to limit government spending, many government contractors are seeing their clients tighten budgets and reduce discretionary spending, leaving them to seek ways to improve cash flow without compromising operations. The R&D tax credit offers government contractors a strategic opportunity to lower tax liabilities, increase liquidity and reinvest in their businesses.

Can Government Contractors Qualify for the R&D Tax Credit?

Yes. However, in order to receive the R&D tax credit, government contractors must perform qualifying R&D or software development activities and must retain the rights and financial risks of the development. Qualifying R&D activities may encompass a wide range of efforts, including, but not limited to, the development of systems, products for government sale and government system development.

R&D Activity Qualifications

The federal R&D tax credit under Section 41 applies to activities that satisfy a four-part test. The activity must:

Be intended to develop or improve a product, process, software, technique, formula or invention
Rely on principles of the physical or biological sciences, engineering or computer science
Involve uncertainty as to capability, method or appropriate design at the outset
Be carried out through a process of experimentation, such as systematic evaluation of alternatives, modeling, simulation or prototyping and testing

Qualifying R&D Activities

For government contractors, qualifying activities commonly include:

The development and testing of new or improved weapon systems, vehicles, aircraft, sensors and communications equipment
The design and integration of mission-specific software and firmware; engineering analysis and prototyping
The development of new materials, components or manufacturing processes
Work performed under Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) awards, in each case subject to the funded-research and rights-and-risks analyses

Some more specific examples in the context of government contracting include:

Defense Contracting: A contractor is being paid by the government to design or develop aircraft, submarines, analytical platforms or assist with the design of integrated bridge systems on ships.
Medical Contracting: During the pandemic, a contractor was being paid by the government to develop COVID-19 vaccines.
Government System Development: A contractor is being paid to perform custom development on government systems, such as providing new functionality on existing systems, writing custom code to integrate disparate systems, and improving the scalability and performance of back-end systems.

But keep in mind, the critical aspects of contract R&D for government contractors revolve around the concepts of rights and risks.

Rights and Risks for Contract R&D Activities

The rights and risks associated with contract R&D activities are vital considerations for qualifying for the R&D tax credit. These concepts evaluate whether the taxpayer has the right to exploit the R&D and whether they retain the financial risks of the development.

When determining R&D tax credit eligibility, it is crucial for a company to consider contract requirements and clauses, including Federal Acquisition Regulation (FAR) clauses. These provisions can establish which party retains the rights and bears the financial risks of development. Understanding these clauses is essential, as specific clawback or warranty clauses may indicate whether a taxpayer is at risk for successfully performing the R&D project.

For taxpayers that hire third-party contractors or subcontractors to perform R&D, the same rights and risks analysis should be done to determine eligibility for the R&D tax credit.

How Contract Type Affects Financial Risk and Funded Research

The type of contract is particularly important to the financial-risk portion of the analysis.

Firm-fixed-price contracts generally keep the contractor at risk for cost overruns and technical failure, which supports R&D tax credit eligibility.

Cost-reimbursement contracts, including cost-plus-fixed-fee and cost-plus-incentive-fee arrangements common in DCAA-audited work, often shift the risk back to the government because the contractor is reimbursed for allowable costs whether or not the underlying research succeeds.

Under Treas. Reg. § 1.41-4A(d), research that is funded by another party is excluded from the R&D tax credit if the contractor is not at risk and does not retain substantial rights in the research.

Clawback provisions, payment milestones tied to technical success, warranty, and termination-for-convenience clauses, and the cost-principle treatment under FAR Part 31 should be reviewed on a contract-by-contract basis to determine whether the funded-research rule applies.

Risk Allocation in Grants vs. Contracts

The distinction between grants and contracts warrants similar attention, as each can carry different financial risk implications.

Recipients of federal grants, including many awards funded by NIH, NSF, and DOE or governed by 10 CFR Part 600, the NIH Grants Policy Statement and the NSF PAPPG, typically have limited exposure to economic risk because grant payments are generally drawn down to cover allowable costs regardless of research outcomes. Even where a grantee retains meaningful intellectual property and data rights, the absence of financial risk often causes grant-funded research to be treated as funded research for R&D credit purposes.

Contractors that receive both government grants and procurement contracts should segregate qualified research expenditures by award and retain the underlying award documents to support the eligibility analysis.

SBIR and STTR Awards: R&D Tax Credit Considerations by Phase

SBIR and STTR awards require separate analysis. SBIR and STTR programs typically leave intellectual property and data rights with the small business, which favors eligibility on the rights portion of the analysis.

The financial-risk portion, however, depends on the specific award. Phase I and Phase II SBIR awards are often structured as grants or cost-reimbursement instruments that may trigger the funded-research exclusion, while Phase III work is generally procurement-style and more likely to preserve eligibility.

Small businesses moving between SBIR phases should reassess R&D tax credit eligibility at each transition rather than assume consistent treatment across an award lifecycle.

R&D Capitalization Requirements Under Section 174

It is also important to note that the Tax Cuts and Jobs Act (TCJA) has introduced mandatory capitalization of research and experimental expenditures (SREs) under Section 174 costs for tax years beginning after December 31, 2021. This new requirement has implications for the tax treatment of your R&D expenses, both domestically and internationally, affecting the taxable income of government contractors engaged in R&D and software development activities.

Under Section 174 of the tax code, government contractors may be required to capitalize and amortize R&D-related costs, including software development expenditures. This provision entails the capitalization and amortization of all costs incidental to R&D and software development, such as:

Planning
Upgrades
Enhancements
Designing
Building
Writing Source Code
Testing Software

Activities that are not considered software development include training employees, tech support, data conversion, straightforward installation, production implementation, configuration and maintenance activities.

Guidance released by the IRS in September 2023 provides further insight into R&D capitalization requirements for research performed under contracts. To the extent contractors retain rights to the development or financial risks, the contractor is required to capitalize the research and experimentation costs.

This treatment continues to apply to foreign R&E expenditures across the board, and to domestic R&E at the state level for contractors operating in states that have not conformed to Section 174A, which we discuss in further detail below.

R&D Capitalization Rule Changes Under Section 174A

The R&D capitalization rules changed significantly with the enactment of the “One Big Beautiful Bill Act” (OBBBA) on July 4, 2025, which updated Section 174 and introduced new Section 174A.

For tax years beginning after December 31, 2024, Section 174A permits taxpayers to immediately deduct domestic research and experimental expenditures, or alternatively to elect to capitalize and amortize those costs over a period of not less than 60 months. Foreign R&E expenditures, by contrast, must continue to be capitalized and amortized over 15 years under Section 174.

OBBBA also allows eligible small business taxpayers (generally those meeting the Section 448(c) gross receipts test) to elect retroactive application of Section 174A to tax years beginning after December 31, 2021, and permits all taxpayers to accelerate the deduction of remaining unamortized domestic Section 174 costs from the 2022 through 2024 tax years over a one- or two-year period beginning in 2025.

Government Contractor R&D Tax Credit Opportunities

Government contractors can take advantage of R&D tax credits, depending on their eligibility, in the following ways.

Federal R&D Tax Credit: Tax Saving Opportunities

The federal R&D tax credit rewards businesses for developing new or improved products, processes or software, activities that many government contractors perform daily. By claiming the tax credit, government contractors can reduce their federal tax obligations, allocating more cash to business operations. Even small projects, like enhancing internal systems or developing prototypes for government clients, may qualify.

Payroll Tax Offset: Small Business Tax Credit for R&D

Qualified small businesses with less than $5 million in gross receipts and less than five years of reporting gross receipts can use the federal R&D tax credit to offset up to $500,000 in payroll taxes each year. This option allows early-stage contractors or businesses without significant income tax liability to benefit from the tax credit, turning innovation into cash flow even when profits are low.

State R&D Tax Credit Refunds: Cash Back in Your Pocket

Several states offer refundable R&D tax credits that can put cash directly back into a contractor’s business, regardless of income tax liability. In fact, more than 35 states offer their own R&D tax credit regimes, including Florida, Georgia, Massachusetts, Maryland, Texas and Virginia.

Why Contract Rights and Risks Matter at the State Level

In this environment, the rights and risks contract analysis has implications that extend beyond the federal R&D tax credit. Section 174, which continues to govern domestic R&E in non-conforming states and foreign R&E across the board, places the capitalization obligation on the party that retains the rights to, and financial risks of, the development.

A defensible contract analysis is therefore the foundation for determining who must capitalize at the state level, the size and duration of the resulting state-level book and tax difference. And because most state R&D tax credit regimes are based on the federal qualified research expenditure determination, contract analysis also directly affects the magnitude of the state credit benefit itself.

Contractors with operations in non-conforming states should plan to maintain dual federal and state computations for several years and should evaluate each state’s specific conformity position when modeling project cash flow.

State Conformity to Federal R&D and Section 174 Rules

State R&D tax credit regimes and state capitalization rules are both influenced by each state’s conformity to the federal code, and state conformity to Section 174A is not uniform.

States generally fall into three categories:

States with rolling federal conformity that automatically adopt new Internal Revenue Code (IRC) provisions
States with static or fixed-date conformity that require affirmative legislative action to adopt federal changes
States that have specifically decoupled from particular federal R&E rules

California, for example, operates under its own static conformity date (currently January 1, 2015) and its own pre-Tax Cuts & Jobs Act (TCJA) R&E framework, neither of which tracks Section 174A.

Texas, whose franchise tax is tied to the IRC as of January 1, 2007, likewise does not automatically follow the new federal treatment.

Pennsylvania and Wisconsin each have partial-decoupling provisions that preserve a capitalization-and-amortization regime at the state level.

Even Virginia, central to the Washington, DC metro contracting community, conforms to the IRC on a fixed-date basis and may not adopt OBBBA changes for a given tax year until its General Assembly acts.

Virginia and Maryland R&D Tax Credit Refundability Rules

Virginia’s refundable R&D tax credit historically allowed small businesses to receive cash refunds for qualifying research expenses, while Maryland offers refundable tax credits to both small and large businesses performing R&D activities.

Virginia’s credits, however, sunset for taxable years ending on or after January 1, 2025, under House Bill 1518 (2024), and House Bill 1969, which would have extended the program, failed in conference committee during the 2025 Regular Session of the Virginia General Assembly. Previously earned Major Research and Development Expenses Tax Credit carryforwards remain available within their statutory window, and reinstatement is expected to be considered in the 2026 Regular Session.

Maryland’s refundable credit continues to offer an immediate cash flow boost for qualifying taxpayers, which is especially valuable during periods of reduced client spending.

State R&D Tax Credit Planning for Government Contractors

It is essential to evaluate each state's credit regime based on the specific company's fact pattern and the states they operate in. Notably, government contractors based in the Washington, DC metro region, the epicenter for government contracting, should pay attention to R&D Tax Credit legislation in Virginia, particularly the 2026 Regular Session of the Virginia General Assembly, where reinstatement of the Commonwealth’s lapsed R&D Tax Credits is expected to be considered.

Contractors with a significant presence in the Northeast, including the many small federal contractors and SBIR and STTR recipients headquartered in Massachusetts and neighboring states, should similarly monitor the Massachusetts R&D tax credit (a permanent, Section 41-based credit that is generally non-refundable for C corporations) and the Commonwealth’s conformity position on Section 174A.

Recommendations for Government Contractors Involved in Research & Development 

If you are planning on using R&D tax credits for your organization, be sure to consider the following recommendations.

Get Tax Involved in Contract Negotiations 

Government contractors should involve tax professionals in contract negotiations because the terms of the contract can significantly impact their eligibility for the R&D tax credit and the capitalization and amortization of R&D costs under Sections 174 and 174A.

Tax professionals are well-versed in identifying the specific R&D activities that qualify for the tax credit and can see to it that the contract terms align with the requirements for claiming the credit. Additionally, they can help navigate the complex rules regarding the capitalization and amortization of Section 174 costs.

Set Up or Use Existing Project Accounting

While it is not a requirement for the R&D tax credit, government contractors are uniquely positioned to capture the necessary project accounting details due to their often-required detailed time tracking system. Businesses with clear and comprehensive documentation for all R&D activities are seen as favorable in establishing the nexus between qualifying research activities and qualifying research expenditures.

Along with implementing a robust time tracking system that provides a comprehensive record of the time and resources allocated to qualifying R&D activities, government contractors should also set up efficient tracking mechanisms and task names to better capture contemporaneous data for R&D credit calculation and Section 174 calculations. With these setups in place, government contractors can also reduce the need for frequent interruptions or additional reporting from the development team, allowing them to focus on their core responsibilities and maximizing the capture of R&D activities.

Your Guide Forward

The R&D tax credit can provide significant tax savings for government contractors engaged in R&D activities. However, navigating the complexities of federal and state tax laws can be complex. Additionally, a quantitative and qualitative aspect is necessary to ensure that the activities rise to the threshold of the four-part test, and this requires the knowledge and expertise of a multidisciplinary team of CPAs, lawyers and engineering/development teams to navigate successfully.

Cherry Bekaert’s Tax Credit & Incentives Advisory team not only has significant experience in R&D credits and Section 174 analysis but also in working within the government contracting industry. If you have any questions or concerns, our consultants are available to discuss your unique situation.

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