If your company performs research under a government contract, the IRS may argue you are not entitled to the R&D tax credit because someone else “funded” your work. That argument sounds reasonable on the surface. In practice, it has cost contractors millions of dollars in credits they legitimately earned.
The 1995 landmark case Fairchild Industries, Inc. v. United States changed everything.
In July 1982, Fairchild Industries an aerospace company signed a fixed-price incentive contract with the U.S. Air Force to design and build the T-46A, a next-generation training aircraft for new pilots.
The project was massive. Fairchild reported $109.4 million in qualified research expenses (QREs) on its 1982–1985 federal tax returns related to the T-46A contract. The IRS disallowed approximately $19.6 million as unrelated to the program. So far, standard audit procedure.
Then the IRS went further.
The Air Force had funded 55.8% of Fairchild’s research costs through progress of payments under the contract. Using that ratio, the IRS disallowed $50 million of the remaining QREs on the grounds that the research was “funded” by the government. The result: approximately $5.8 million in R&D tax credits denied.
Fairchild appealed. The Court of Federal Claims initially sided with the IRS, ruling that Fairchild’s receipt of progress payments meant the government not Fairchild was incurring the research costs. Fairchild appealed again, this time to the U.S. Court of Appeals for the Federal Circuit.
Under Section 41 of the Internal Revenue Code, research expenses that are “funded” by another party do not qualify for the R&D tax credit. The logic is straightforward if you are not the one at financial risk; you should not receive the credit designed to reward that risk.
The IRS argued that Fairchild’s receipt of progress payments meant the government was effectively bankrolling the research, regardless of the contract’s outcome.
Fairchild’s argument was sharper: payment was not guaranteed. If the T-46A failed to meet the Air Force’s strict acceptance requirements, Fairchild would not only lose final payment; it would be required to repay all progress payments already received.
During the contract development phase, the Air Force had repeatedly reduced those progress payments, and Fairchild had incurred unrecovered costs exceeding $95 million.
That is not a company spending someone else’s money. That is a company betting its own.
The Fairchild ruling established foundational principles that still govern R&D credit claims under government and commercial contracts. Here is what each principle means in practice:
Fairchild Principle | What It Means | Action for Your Business |
Financial risk is the deciding factor | If payment depends on delivering a successful result and failure means real loss, your research is likely not “funded” | Review every contract: are you on the hook if the work fails? |
Progress payments do not automatically disqualify a claim | Receiving advance payments does not end your eligibility. Structure and conditions matter more than the payment itself | Do not assume advance payments mean you cannot claim the credit |
Contract language is evidence | Courts look at actual contract terms: acceptance requirements, repayment obligations, risk allocation | Keep all contracts. They are your primary documentation in a dispute |
Substantial rights matter | Retaining IP rights in the research, even non-exclusively, was a critical factor in Fairchild’s eligibility | Ensure your contracts preserve your rights to the research you perform |
For government contractors, defense firms, aerospace companies, and any business performing R&D under contract, the “funded research” question is one of the most misunderstood and most abused areas of tax law. A poorly structured claim or a misread contract can result in the IRS denying credits you legitimately earned.
TaxDrone.AI was developed by National Tax Group (NTG), combining decades of tax expertise with AI-powered precision. NTG’s team understands the funded research analysis inside out the two-prong test established in Fairchild, the subsequent refinements from Lockheed Martin, Geosyntec, and other cases, and the contract-by-contract documentation strategy that protects credits from IRS challenge.
TaxDrone.AI doesn’t just identify qualifying research. It builds audit-ready documentation that reflects the actual financial risk your company bore the standard Fairchild established 30 years ago, and the IRS still applies today.
Run your contracts through TaxDrone.AI today to identify your qualifying activities in minutes reinforces the speed and automation of the platform. See TaxDrone.AI in Action.
