Does Your Aerospace Company Qualify for R&D Tax Credits?

Aerospace companies, from commercial aviation manufacturers to satellite developers and defense suppliers, routinely conduct research and development that may qualify for significant federal R&D tax credits under IRC §41. But there is one major catch unique to this industry: if your research is funded by a government contract, it may not qualify. Understanding that distinction is the key to unlocking what can be a substantial credit for your business.

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What Is the R&D Tax Credit and Why Should Aerospace Companies Care?

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The federal Research and Development (R&D) tax credit, codified under IRC §41, is a dollar-for-dollar reduction in your tax liability for qualifying research activities performed in the United States. It is not a deduction, it is a direct credit, making it one of the most valuable incentives available to innovative businesses.

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Aerospace is a major R&D-performing industry in the country. Engineers are constantly developing new propulsion systems, designing lighter and stronger materials, improving avionics, and solving problems that have never been solved before. Much of this work involves exactly the kind of technical uncertainty and systematic experimentation that Congress designed this credit to reward.

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Yet many aerospace companies either do not claim the credit at all or significantly undercount their qualifying activities. That is money left on the table.

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What Qualifies? The Four-Part Test

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To qualify for the R&D credit, research activities must meet all four parts of the IRS's qualification test under IRC §41(d)(1). Here is what that means in plain terms:

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1. Permitted Purpose: The research must be aimed at developing or improving a business component — a product, process, software, technique, formula, or invention. In aerospace, this covers a wide range of work, from designing a new airframe component to developing improved flight control software.

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2. Technological in Nature: The research must rely on principles of hard science (engineering, physics, chemistry, computer science, or biology). Many aerospace engineering activities rely on engineering, physics, computer science, or other hard sciences, which can help satisfy the technological-in-nature prong.

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3. Technical Uncertainty: The taxpayer must face genuine uncertainty about whether the development can be achieved or how it can be achieved. If your engineers are trying to figure out whether a design will work, whether a material will withstand the required stresses, or which approach will produce the best performance, that uncertainty is real and it counts.

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4. Process of Experimentation: There must be a systematic process to evaluate alternatives — testing, modeling, prototyping, simulation, or iteration. Aerospace engineering is often experimental: designs are tested, modified, retested, and refined. This step is usually straightforward to satisfy if the work is genuine engineering.

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What Activities in Aerospace Typically Qualify?

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Aerospace companies engage in a wide range of activities that can qualify as qualified research expenses (QREs) under IRC §41(b), provided they meet the four-part test. Common examples include:

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• Developing new or improved propulsion systems, including engine testing and combustion analysis

• Designing and testing new airframe structures, materials, or aerodynamic configurations

• Developing advanced avionics, flight control systems, or navigation technology

• Prototyping and testing new satellite components or communication systems

• Engineering new manufacturing processes to produce aerospace components more efficiently or to new tolerances

• Developing software for simulation, flight management, or embedded systems

• Testing new composite materials or coatings for thermal or structural performance

• Independent research and development (IRAD) performed without a specific government contract

• Bid and proposal (B&P) engineering work involving genuine technical problem-solving

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Importantly, the IRS published a dedicated Aerospace Industry Audit Techniques Guide because aerospace is a unique industry with specialized contracts, documentation, terminology, and audit issues. It is important to note, that the Aerospace Audit Technique Guide is not controlling legal authority, but simply the IRS’s position on the research credit for this industry. The IRS acknowledges that aerospace work involves design, development, manufacturing, and delivery of products that are often tailor-made to meet unique requirements, which is exactly the kind of work this credit is designed to encourage.

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The Critical Catch: The Government-Funded Research Exclusion

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Here is where aerospace diverges from a lot of other industries, and where the analysis gets complicated.

Under IRC §41(d)(4)(H), research funded by another person or governmental entity does not qualify for the R&D credit. The exact statutory language is clear:

"Any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)."

For an industry where much of the research is performed under Department of Defense contracts, NASA contracts, or other government agreements, this exclusion is the central challenge in any R&D credit analysis.

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The exclusion does not automatically disqualify all government contract work. The analysis is fact-specific and depends on two questions for every contract:

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Question 1: Who Bears the Financial Risk?

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Under Treasury Regulation §1.41-4A(d)(1), research is "funded" if the payments to the contractor are not contingent upon the success of the research. In other words: if you get paid regardless of whether the research succeeds, the IRS treats it as funded research.

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This is where contract type matters enormously:

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• Firm-Fixed-Price (FFP) Contracts: Generally favorable for the R&D credit. Generally, the Federal Acquisition Regulations, (“FAR”) has favorable clauses for fixed-price contracts related to inspection and acceptance of the work product.  These clauses put the risk of research success on the contractor and not the government. This risk-bearing generally satisfies the financial risk requirement.

• Cost-Plus (CPFF, CPAF, CPIF) Contracts: Generally unfavorable. The government reimburses the contractor's actual costs regardless of whether the research succeeds. Because the contractor does not bear the economic risk of failure, this usually fails the financial risk test for the reimbursed portion.

• Time-and-Materials (T&M) Contracts: Generally unfavorable. Like cost-plus, the contractor is paid for time and expenses regardless of outcome, which typically fails the risk test.

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Question 2: Does the Contractor Retain Substantial Rights?

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Even if financial risk is present, the contractor must also retain "substantial rights" in the research results. Under Treasury Regulation 1.41-4A(d)(3)(i), a contractor does not retain substantial rights if it must pay for the right to use the results of its own research.

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In the government contracting world, this comes down to the intellectual property (IP) clauses in each contract — particularly the FARs or the Defense Federal Acquisition Regulations (DFARS) data rights provisions for defense contracts. The key DFARS clauses are:

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• DFARS 252.227-7013 (Technical Data): Governs rights to technical data. If the government acquires only "limited rights" or "government purpose rights," the contractor generally retains substantial rights.

• DFARS 252.227-7014 (Computer Software): Governs software rights similarly. "Restricted rights" or "government purpose rights" typically preserve the contractor's substantial rights. "Unlimited rights" may not.

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Court decisions including Lockheed Martin Corp. v. United States have established that a contractor has substantial rights to research if it retains the right to use the research without paying for that right — and that contractors need not have exclusive rights to satisfy this standard.  Additionally, in Lockheed the court held that the contractor maintained substantial rights in the technology even though the government was granted unlimited rights.

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Importantly: if a contractor fails the substantial rights test and the client's payments are contingent on success, neither the contractor nor the paying party can claim the credit for those expenses. This is why contract-by-contract analysis matters so much.

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The Cleanest Path: IRAD and B&P Expenses

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For many aerospace and defense contractors, the clearest path to R&D credits is through Independent Research and Development (IRAD) and Bid and Proposal (B&P) costs.

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IRAD (Independent Research and Development): This is technical work performed at the contractor's own expense and initiative — not tied to any specific government contract. Because the contractor funds the research itself, the funded research exclusion does not apply. The contractor bears the full financial risk and retains full rights to the technology. IRAD is often the foundation of an aerospace R&D credit claim.

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B&P (Bid and Proposal) Engineering Work: When preparing proposals for government contracts, engineers often conduct genuine technical analysis, design iterations, and problem-solving. That work can qualify as R&D if it involves real technical uncertainty and experimentation. Administrative proposal activities — cost estimating, compliance paperwork — do not qualify.

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An important clarification: IRAD costs are often allowable under FAR 31.205-18 as indirect costs recoverable through overhead rates. That FAR treatment does not make them "funded" for purposes of IRC §41. The two analyses are separate.

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Documentation

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Documentation can seem overwhelming. Contemporaneous records are best, but an experienced R&D tax consultant is capable of helping you compile what records and documentation you have into a defensible claim.

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What Expenses Count as Qualified Research Expenses (QREs)?

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Under IRC §41(b), the following categories of expenses can be counted if they relate to qualifying research activities:

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• Employee Wages: Wages paid to employees for time spent directly performing, directly supervising, or directly supporting qualified research. This includes engineers, scientists, software developers, and technicians. First-line supervisors of qualifying work count; higher-level management generally does not unless they personally perform qualifying work.

• Supplies: Tangible property consumed or used in the research. Materials used in prototypes, components used in testing, consumables in experimental processes. Capital equipment and property subject to depreciation do not count as supplies.

• Contract Research Expenses: 65% of amounts paid to third parties (non-employees) to perform qualified research on the company's behalf, provided the company bears the financial risk and retains rights to the results. Additionally, 75% for qualified research consortia and 100% for certain energy research payments to eligible small businesses, universities, or federal laboratories.

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For aerospace companies, wages to engineering teams conducting IRAD, prototype materials, testing supplies, and contract engineers performing qualifying work on fixed-price engagements are typically the primary sources of QREs.

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The Bottom Line for Aerospace Companies

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Aerospace is one of the industries most likely to have significant, legitimate R&D tax credit opportunities, and also one of the most complex to analyze correctly. The funded research exclusion under IRC §41(d)(4)(H) means that a contract-by-contract review of your government work is essential, not optional.

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The good news: many aerospace companies have both IRAD and contract work that qualifies, and the credits can be substantial. But getting it right requires expertise in both the tax law and the specific mechanics of government contracting, such as the FAR/DFARS clauses, data rights provisions, contract type analysis, and cost accounting.