The Substantial Rights Rule: What You Need to Know to Protect Your R&D Credit

The Substantial Rights Rule: A Growing Risk Area for R&D Credits

If your company conducts contract research, understanding the “substantial rights” rule is now essential.

Over the past several years, the IRS has applied an aggressive interpretation of this rule to deny R&D tax credits, especially in situations where a third party (such as a customer, government agency, or partner) funds the research.

In this post, we will explain:

• What the substantial rights rule is
• Why the IRS is focusing on it
• How recent case law affects your position
• What tax teams can do to protect their credits

What Is the Substantial Rights Rule?

In simple terms, the IRS argues that to claim the R&D credit on contract research:

• The taxpayer must retain substantial rights in the research results.
• If the taxpayer performs work for hire or if a customer fully controls and owns the results, the credit is disallowed.

Here is the problem:

• The statute (Section 41) does not explicitly require substantial rights.
• Treasury Regulations and IRS guidance have inserted this requirement, but many tax practitioners argue it is invalid.

Why Is the IRS Focusing on This Now?

Recent court cases and IRS litigation trends show that substantial rights and funded research are key IRS attack areas.

In cases like U.S. v. Grigsby, the IRS successfully argued that research performed under a fixed-price contract was “funded” even though the taxpayer bore financial risk. Courts are now taking a strict view of whether taxpayers retain real rights in the IP or research outputs.

Meanwhile, the IRS continues to apply the substantial rights rule even though there are strong arguments that:

• The 1986 Tax Reform Act rendered it obsolete.
• Case law such as Lockheed Martin Corp. v. United States shows that a company can qualify for the credit even when developing inventions for sale or license, not solely for its own use.

In practice, many IRS exam teams aggressively apply this rule to deny credits, especially in large-dollar claims.

What the Law Actually Says

Let us unpack this.

The statute (Section 41) defines qualified research by activity, not by the ownership of results.

The regulations (Treas. Reg. §1.41-4A(d)(2)) create funded research exceptions, but the substantial rights test is not explicitly present in the statute itself.

The Tax Reform Act of 1986 introduced the concept of “business components,” including inventions to be sold or licensed. This language undermines the idea that only research for the taxpayer’s internal use can qualify.

Case law supports this view:

• In Lockheed Martin, the Federal Circuit upheld credits even where the taxpayer developed tangible property to deliver to a customer, as long as it retained rights to use the results for other purposes.
• The IRS cites Dynetics Inc. v. Commissioner, but this case is fact-specific and does not negate the broader principle.

What This Means in Practice

Even though the substantial rights rule may be flawed, the IRS is enforcing it. Appeals may uphold IRS positions unless taxpayers fight them successfully.

Contract language matters enormously. The IRS will scrutinize:

• Who owns the research outputs
• Whether the taxpayer has a right to use the results independently
• Whether payments are fixed-price or cost-plus
• Whether “work made for hire” clauses are present

If your contracts do not support your position, defending your credit will be difficult.

How Tax Teams Can Protect the Credit

Here are four steps to mitigate risk and strengthen your position:

1. Review Contracts Proactively

Work with legal and business teams to review customer and government contracts that involve R&D activities. Pay close attention to:

• IP ownership clauses
• Licensing rights
• Use rights after project completion

2. Structure Rights Retention Thoughtfully

When negotiating contracts, aim to retain:

• The right to use the research results in your own business.
• The right to license or commercialize the results independently.

Even if your customer gains a license or ownership of specific deliverables, you should retain broader usage rights whenever possible.

3. Document Substantial Rights in Your Study

During your credit study, document the rights your company retains. Clearly explain how your rights align with the ability to use or commercialize the research outcomes.

This is especially critical if a contract’s language is ambiguous or if IRS scrutiny is expected.

For practical guidance on how to align documentation with evolving IRS expectations, see Optimizing Your R&D Tax Credit Process Using Today’s Technology.

4. Train SMEs and Legal Teams

Your SMEs and legal teams need to understand why contract language matters for the R&D credit. MASSIE’s How to Train SMEs for R&D Tax Documentation offers helpful insights for building cross-functional awareness.

Bottom Line

The substantial rights rule is one of the IRS’s sharpest tools in challenging R&D credits today. Even though its legal foundation is questionable, taxpayers need to be prepared.

With proactive contract structuring, clear documentation, and alignment across legal and tax teams, you can protect your credit and reduce risk.

If your team would like to review key contracts or strengthen your credit defense in this area, we are here to help. Contact us for a consultation.

Jason Massie, CPA, Esq.

As the Founder and President of MASSIE R&D Tax Credits, Jason is responsible for the quality, consistency, and integrity of our services. His strategic vision and leadership drive innovation within the company, encouraging collaboration and ne...