A&E and Custom Manufacturing IRC Section 41 Playbook: Surviving IRS Funded-Research Audits & Form 6765 Section G

01The four-part test, applied to design work

Under IRC § 41(d), a business component qualifies only if the activities meet all four tests. A&E work can meet them, but the evidence looks different from a lab notebook.

1. Section 174 test. The costs must be research or experimental expenditures under § 174, meaning they aim to eliminate uncertainty about the capability, method or appropriate design of a product or process.
2. Technological in nature. The work relies on principles of engineering, physical sciences or computer science. Structural, MEP, geotechnical and machine design work normally passes.
3. Elimination of uncertainty. At the outset, the firm did not know how to achieve the result, or which design was appropriate. Routine application of code tables to a standard building usually fails here.
4. Process of experimentation. Substantially all of the activities, measured as 80% or more, involve evaluating alternatives through modeling, simulation, iteration or testing.

Courts have looked hard at the fourth test. In Little Sandy Coal, the Seventh Circuit in 2023 required the taxpayer to show what share of its activities were experimental, not just that some were. In Meyer, Borgman & Johnson, a structural engineering firm's claim failed in the Tax Court, affirmed by the Eighth Circuit in 2024, largely because its records did not show a process of experimentation. Final sealed drawings show the answer; the credit depends on documenting the alternatives rejected on the way to it.

The shrinking-back rule helps: if a whole project does not qualify, the test applies to the next most significant subset, such as a novel connection system or a custom mechanical design within the building.

02Funded research: why contract terms decide the credit

IRC § 41(d)(4)(H) excludes research funded by another person. Under Treasury Regulation § 1.41-4A(d), research performed for a client is funded unless the firm both bears the financial risk of failure and retains substantial rights in the results. Both prongs are read from the contract.

• Financial risk. If the firm is paid regardless of whether the design succeeds, it does not bear the risk. Courts in Fairchild Industries and later Geosyntec Consultants (Eleventh Circuit, 2017) focused on whether payment was contingent on success. Time-and-materials and cost-plus contracts are the most exposed.
• Substantial rights. If the client takes all rights and the firm cannot use the results without paying, the firm lacks substantial rights. Retaining the right to reuse methods, details and know-how commonly satisfies this prong even where the client owns the drawings.
• Fixed-price and rework clauses help. In Populous Holdings, the Tax Court in 2019 declined to treat an architecture firm's work as funded at summary judgment, pointing to contract terms that could require the firm to correct deficient work at its own cost.

Custom machine builders face the same analysis. A machine sold at a fixed price with acceptance testing at the customer's plant usually leaves the builder at risk; a design-only engagement billed hourly usually does not. Read the payment, acceptance and IP clauses of each contract, not the summary in the project system.

03Form 6765 Section G and refund claim documentation

The revised Form 6765 adds Section G, which asks for information by business component: what it is, the type, the information sought to be discovered, and the wages, supplies and contract research costs tied to it. The IRS phased Section G in, making it optional for early tax years and exempting certain small taxpayers. Check the current instructions for the year you are filing.

Refund claims already carry a similar burden. IRS Chief Counsel guidance issued in 2021 requires a refund claim to identify each business component, the research activities performed, the individuals who performed them, and the information each sought to discover, along with total qualified expenses. Missing items can make a claim invalid before anyone reviews its merits.

04Cost model: a 60-person structural and MEP firm

Figures follow the house formula: total QRE = qualified wages + supplies + 65% of US contractor research spend, with foreign contractors excluded.

• Qualified W-2 wages: $1,800,000. Prototype and testing supplies: $40,000. US subconsultant research spend: $300,000 x 0.65 = $195,000.
• Total QRE: $1,800,000 + $40,000 + $195,000 = $2,035,000.
• Federal net credit at about 7.9%: $160,765.
• State credit, modeled at an illustrative 3% effective rate: $61,050. Combined credit $221,815.

The funded-research haircut. Suppose a contract review finds 40% of those wages were on time-and-materials contracts that would likely be treated as funded. Removing $720,000 of wages gives QRE of $1,315,000 and a federal credit of $103,885, a drop of $56,880. Claiming it anyway invites an audit adjustment plus penalties and interest; finding it before filing protects the rest of the claim.

Fee comparison. A 25% contingency fee on $221,815 is $55,454. A fixed-fee study at $8,500 plus 12 business components at $1,200 is $8,500 + $14,400 = $22,900, saving $32,554 in the first year. Model your own figures in the R&D credit and Section 174 calculator, and compare fee models in the contingency vs fixed-fee comparison.

05Section 174A, offshore drafting and the timing of deductions

The credit is only half of the tax picture. Under Section 174A, domestic research and experimental expenditures can again be deducted in the year paid, for tax years beginning after 2024. Foreign research spend remains capitalized and amortized over 15 years, which with the mid-year convention allows only about 3.33% in year one.

That matters for A&E firms using offshore drafting or modeling bureaus on qualifying projects. On $200,000 of offshore spend that is research under § 174, the year-one deduction is about $6,660 instead of $200,000. At a 21% corporate rate, that is a year-one cash-tax difference of about $40,600, the house benchmark of roughly 20.3% of foreign R&E spend. Foreign contractor spend also earns no Section 41 credit.

Two coordination rules to raise with your tax adviser: the § 280C reduction, which requires either reducing the deduction by the credit or electing a reduced credit, and any transition elections available for prior-year unamortized domestic costs. These change year to year; confirm current treatment before filing.

Firms with staff in several countries should also check each jurisdiction's own incentive; see the UK R&D relief guide and the Canada SR&ED guide.

06Phased checklist for a defensible A&E claim

During the year

• Code timesheets to project and phase so wages can be tied to business components.
• Save model versions and design alternatives, not just final calculations.
• Use contract templates with rework-at-own-cost and retained know-how clauses where commercially possible.

Before the study

• Pull every contract on candidate projects and classify funded-research risk.
• Shortlist business components where real uncertainty existed at the outset.

During the study

• Technical narratives written or reviewed by the engineers who did the work.
• Section G data prepared per business component, even if optional for your year.
• Separate domestic and foreign spend for Section 174A treatment.

After filing

• Keep the study, contracts and source records for the statute of limitations period.
• Feed lessons into next year's timesheet and contract templates.

07Run the numbers: iRC Section 41 R&D tax credit, Section 174A and contingency fee audit calculator

The same benchmarks as this sheet, with your inputs. Share link and printable brief open the full calculator page.