Strategic Compliance: Navigating the “Contractual Employee” Definition for the Arkansas R&D Tax Credit

I. Executive Summary: The Arkansas R&D Payroll Distinction

A Contractual Employee under Arkansas law is defined as an individual who is an employee of a separate business (such as a Professional Employer Organization or staffing firm) but is under the direct supervision of the qualified taxpayer receiving R&D incentives.1 The inclusion of their taxable wages as a Qualified Research Expenditure (QRE) is critical for maximizing the 20% or 33% state tax credit.2

This report provides a granular analysis of how this specific statutory definition, anchored in the Arkansas Consolidated Incentive Act of 2003 (Ark. Code Ann. § 15-4-2701 et seq.), governs the eligibility of outsourced labor costs for the Arkansas R&D tax credit. We detail the necessary compliance guidance from the Arkansas Department of Finance and Administration (DFA) and the Arkansas Economic Development Commission (AEDC), focusing on the crucial differentiation between a “Contractual Employee” (W-2 payroll arrangement) and a non-qualifying 1099 independent contractor. By understanding the stringent statutory language, businesses can properly structure their external labor relationships to ensure all applicable R&D wage expenses are included in their credit calculation.

II. Deconstructing the “Contractual Employee” Statutory Definition

The term “Contractual Employee” represents a critical statutory accommodation within Arkansas tax law, recognizing the complexity of modern co-employment and staffing arrangements. For a business seeking to claim the Research and Development tax credit, the accurate classification of these workers is non-negotiable, as the eligibility of the associated wages hinges entirely on meeting this specific state-level definition.

A. The Legal Foundation in Arkansas Incentive Law

The eligibility of outsourced payroll costs for Arkansas tax incentives is strictly dictated by the Arkansas Consolidated Incentive Act of 2003, which establishes criteria that are distinct from standard federal or state common law definitions of employment.

1. Statutory Source and Intent: Arkansas Code § 15-4-2703

The definitive legal standard for the classification of a Contractual Employee is codified in Arkansas Code § 15-4-2703(4). This section dictates a two-part test that must be satisfied for an individual’s compensation to be included in the taxpayer’s qualified payroll calculation:

• Employment by Another Business: The individual must legally be an employee of a business other than the one receiving the incentives.1 This typically points to relationships with Professional Employer Organizations (PEOs) or third-party staffing agencies, which serve as the “employer of record.”
• Direct Supervision Requirement: Crucially, the individual must be under the direct supervision of the qualified business receiving the incentives.1 This clause ensures that the taxpayer maintains operational control over the specific R&D duties being performed, maintaining the nexus between the taxpayer’s qualified research activities and the associated labor costs.

The intent of incorporating this definition into the Arkansas R&D QRE rules, specifically in Ark. Code § 15-4-2708, is to ensure that businesses utilizing PEOs or leased employees are not penalized simply because the entity issuing the Form W-2 is not the entity claiming the credit.3 This provides a necessary mechanism for businesses to use common modern employment arrangements while remaining compliant with tax incentive programs. Qualified wages for R&D purposes are explicitly defined as taxable wages paid to a full-time permanent employee or a Contractual Employee for performing qualified services.2

B. Contractual Employee (W-2) vs. Independent Contractor (1099)

A significant compliance hurdle in R&D tax credit claims is the failure to differentiate between the qualified Contractual Employee (W-2 relationship) and the standard independent contractor (1099 relationship). Under Arkansas law, the distinction is absolute and based on underlying tax obligations and control.

1. The Federal Tax Classification Baseline

Federal tax law draws a clear boundary between W-2 employees and 1099 independent contractors. W-2 employees, including those hired through a PEO who meet the Contractual Employee criteria, are subject to mandatory tax withholding, and the employer pays employment taxes (Social Security and Medicare).4 They typically use company resources and have little control over how their work is conducted.4 Conversely, 1099 independent contractors are self-employed, responsible for paying their own self-employment taxes (the full Social Security and Medicare burden), and exercise greater professional autonomy.5 They receive a Form 1099-NEC to report nonemployee compensation, provided they were paid $600 or more during the calendar year.4

2. Why 1099 Independent Contractors Are Excluded from R&D QRE Wages

The strict definition of “Contractual Employee” effectively bars traditional 1099 independent contractors from having their compensation included as qualified R&D wages. This exclusion is rooted in two statutory deficiencies inherent in the 1099 relationship:

• Failure to Constitute “Taxable Wages”: Arkansas QRE rules specifically require “taxable wages paid”.3 Payments to 1099 independent contractors are classified as nonemployee compensation, not wages, and therefore do not meet the base requirement for labor QRE inclusion.
• Failure of the “Direct Supervision” Test: Independent contractors are defined by their autonomy and control over the means and methods of their work.4 If a business were to exert “direct supervision” over a 1099 contractor, the Internal Revenue Service (IRS) and the Arkansas Department of Finance and Administration (DFA) would likely deem the worker misclassified, exposing the business to potential penalties for unpaid employment taxes.4 This inherent conflict between control and classification ensures that true 1099 arrangements cannot satisfy the Contractual Employee definition.1

The reliance on the narrow statutory definition confirms that Arkansas maintains a significantly narrower scope for R&D labor QREs than the federal government’s allowance for 65% of contract research expenses (CREs). This deliberate constraint reinforces the fact that for R&D labor costs to qualify in Arkansas, the underlying relationship must be an explicit payroll relationship (W-2).

Table 1: Comparison of Worker Classifications and R&D Eligibility

III. The Arkansas R&D Tax Credit Landscape

The value of including Contractual Employee wages in the QRE calculation is magnified by the various rates and rules governing Arkansas’s R&D tax credit programs. These programs are designed to incentivize different types of research based on business maturity and strategic focus within the state.

A. Overview of Arkansas R&D Tax Credit Programs

Arkansas provides state income tax credits against qualified research expenditures, administered largely by the AEDC and the Arkansas Science and Technology Authority (ASTA).6 All programs require that the underlying research activity meet the same three federal qualification tests (technological in nature, useful in a business component, and utilizing a process of experimentation).8

1. In-House Research and Development (Mature Firms)

This program targets mature companies performing ongoing R&D within the state.9 The credit offered is 20% of qualified research expenditures.9 Crucially, this is an incremental calculation, meaning the credit is based only on QREs that exceed a baseline expenditure established in the preceding year.8 Businesses must already be participating in the Federal R&D program before applying for this state incentive.9

2. In-House Research by a Targeted Business

Targeted businesses—typically younger, technology-based firms—may be offered a higher credit rate. This income tax credit is equal to 33% of the qualified research expenditures incurred each year for a period of up to five years.8 Because this rate applies to total QREs incurred during the year, rather than just the incremental increase, it is often more financially beneficial for startups or firms undertaking high-cost, short-term R&D projects.

3. Research in an Area of Strategic Value

This program also offers a 33% income tax credit for research conducted in fields identified as having long-term economic or commercial value to the state, as determined by the ASTA.8 However, this specific credit program imposes a maximum claim limit of $50,000 per tax year.8

The tax credits available under these programs may be used to offset up to 100% of a company’s annual income tax liability, and any unused credits can be carried forward for nine years.8

Table 2: Summary of Arkansas R&D Tax Credit Programs

B. Defining Eligible QREs: Where Contractual Employees Fit

The structure of Arkansas QREs dictates that Contractual Employee wages are often the most significant eligible expenditure for in-house R&D claims, as the state definition is significantly narrower than the federal standard.

1. Narrow Scope: Focus on Wages and Limited Benefits

For the In-House and Targeted Business R&D credits, QREs are generally confined to labor costs. Qualified research expenditures include in-house expenses for taxable wages paid and the usual fringe benefits specific to research activities.3 The critical constraint here is that common federal QRE categories, such as supplies, equipment, and buildings, generally do not qualify for the 20% In-House R&D credit.9

Because the QRE base is severely constrained, excluding capital expenditures and supplies, the taxpayer’s ability to maximize the inclusion of labor—whether direct employees or Contractual Employees—is essential for achieving a substantial credit claim. This structure necessitates a high degree of precision in allocating employee time and costs to qualified research activities.

2. Qualified Services and the Research Test

For the wages of a Contractual Employee to be counted, the individual must be performing “qualified services.” This includes activities that are:

• Engaging directly in qualified research.
• Directly supervising qualified research.
• Directly supporting qualified research.2

Furthermore, the underlying research activity itself must meet all elements of the statutory test, which involves discovering information that is technological in nature, intended to be useful in a new or improved business component, and involves a process of experimentation relating to function, performance, or quality.8 This rigorous standard applies regardless of whether the labor is performed by a full-time employee or a Contractual Employee.

IV. Application of Contractual Employee Costs to QREs

The mechanics of counting Contractual Employee costs involve stringent documentation requirements focused on separating eligible wages from administrative fees and proving ongoing control over the leased personnel.

A. Eligibility and Calculation of Contractual Employee Wages

For a Contractual Employee’s costs to be included in the QRE calculation, the taxpayer must isolate the direct compensation components and discard all third-party administrative overhead.

1. Inclusion of Taxable Wages and Usual Fringe Benefits

Only the remuneration paid to the individual that constitutes “taxable wages” and “usual fringe benefits” is eligible for inclusion as a QRE.2 This includes salary, hourly compensation, payroll taxes (Social Security and Medicare employer contributions), and standard benefits paid for the employee. Any amounts paid to the PEO or staffing agency that represent administrative fees, markups, or profits are not considered compensation paid to the employee and must be systematically removed from the QRE base during the calculation phase. Failing to strip out these non-wage costs will result in an overstated and disallowed claim.

2. The Burden of Proving “Direct Supervision”

The most significant compliance challenge related to Contractual Employees is satisfying the “direct supervision” test.1 Since the PEO or staffing agency is the technical employer of record, the taxpayer must meticulously maintain documentation proving they retain functional control over the research activities.

This proof requires detailed internal records, such as:

• Organizational charts that place the Contractual Employee under the R&D management hierarchy of the taxpayer.
• Detailed time allocation records (e.g., daily time sheets or labor journals) signed by the taxpayer’s R&D manager, demonstrating the percentage of time spent on qualified R&D tasks.
• Project assignment documents, scope-of-work agreements, and performance evaluation records initiated and executed by the taxpayer.

If a DFA audit determines that the control rests primarily with the PEO or that the leased employee exercised high autonomy typical of a 1099 contractor, the QRE will be disallowed, confirming that the statutory mandate for direct control cannot be bypassed, even when utilizing a formal PEO arrangement.

B. Comparison to Contract Research Expenses (CREs)

Contractual Employee wages must be strictly differentiated from Contract Research Expenses (CREs), as they relate to entirely different credit mechanisms and eligible payees in Arkansas.

1. Arkansas’s Specific Rule for Institutional Contracts

In Arkansas, the term “Contract Research” is narrowly defined to include only contractual agreements, which must be approved in writing by the director, with a state college, an Arkansas state university, or another approved Arkansas-based research organization.3

Payments made under these institutional agreements may qualify the taxpayer for the 33% University-Based Research and Development credit.7

2. Non-Fungibility of Contract Costs

It is crucial to recognize that the ability to claim CREs is limited only to payments made to approved institutions. Payments made to a private, non-institutional 1099 consultant cannot be categorized as an eligible QRE wage (due to the lack of taxable wages) or as an eligible CRE (due to the lack of institutional affiliation and written approval).

This strict separation emphasizes that the Arkansas R&D incentive structure is not flexible regarding outsourced research labor. A taxpayer cannot convert general consulting fees into a qualified expenditure. The use of the “Contractual Employee” designation is the sole avenue for incorporating outsourced private sector labor costs into the in-house QRE calculation, and this designation strictly requires a documented W-2 relationship and direct supervision.

V. State Revenue Office (DFA/AEDC) Guidance and Compliance

Compliance with the Arkansas R&D tax credit programs requires navigating the administrative requirements set forth by the AEDC and the Department of Finance and Administration (DFA). The discretionary nature of the credit demands a proactive and sequential application process.

A. Administrative and Discretionary Approval Process

The ability to claim the Arkansas R&D credit is contingent upon approval and certification by state agencies before the expenditure period concludes.

1. The Role of the AEDC Executive Director and ASTA

The In-House Research and Development credit and the Targeted Business credit are discretionary, offered “at the discretion of the AEDC Executive Director”.8 This discretionary power requires a formal application process to the AEDC/ASTA before the credit can be claimed.

The application for the income tax credit, especially for Targeted Businesses, must include a detailed project plan. This plan must identify the intent of the project, planned expenditures (including labor costs for Contractual Employees), the start and end dates, and an estimate of total project costs.8 The application and project plan form the basis for the Commission’s decision to approve tax credit treatment.9 The financial incentive agreement, once signed, typically grants a term of five years, starting on the first day of the business’s tax year in which the agreement is formalized.9

This pre-approval step, where the use and scale of Contractual Employees must be forecasted and approved, is a significant departure from the federal process and underscores the necessity of strategic planning when utilizing leased labor for R&D in Arkansas.

B. Reporting and Filing Requirements

The DFA, specifically the Tax Credits/Special Refunds section, manages the ultimate filing and reporting of the credit.10 Taxpayers must ensure they use the most current forms available on the DFA website.10

1. Obtaining and Using the Certificate of Tax Credit

Upon approval by the ASTA, the business will receive a Certificate of Tax Credit.11 This Certificate is the primary required documentation that must be attached to the Arkansas state income tax return to effectuate the claim. Arkansas does not utilize a state-specific equivalent of the federal Form 6765; the Certificate of Tax Credit serves as the official evidence of eligibility.11

2. Utilization of Form AR1100BIC

Corporate taxpayers claiming an income tax credit on their AR1100CT Corporation Income Tax Return must complete the AR1100BIC (Business Incentive Credit) form.12 If the taxpayer is part of an Arkansas Consolidated Group, each eligible member must complete a separate AR1100BIC form.12

The AR1100BIC form requires the taxpayer to identify the specific credit type being claimed. For R&D credits, this typically involves selecting:

• Credit Type 0023: In-House Research Income Tax Credit.
• Credit Type 0024: In-House Research by Targeted Business Income Tax Credit.12

General information on Business Incentive and Tax Credit Programs is maintained on the DFA website, and specific questions can be directed to the Tax Credits/Special Refunds Section at (501) 682.7106.12

C. Classification Risk and Audit Preparedness

While the DFA provides general instructions for 1099 processing to ensure accurate reporting of nonemployee compensation 13, this general guidance does not override the specific R&D statute. The risk of misclassification is twofold: federal penalties for employment tax deficiencies 4 and state disallowance of QREs.

To mitigate this risk, businesses must establish clear documentation demonstrating the legitimacy of the Contractual Employee classification:

• Formal Agreements: The written agreement with the PEO must clearly define the taxpayer’s right to direct and supervise the R&D labor, ensuring the relationship is structured as a co-employment arrangement.
• W-2 Reconciliation: Thoroughly reconcile PEO or staffing invoices with underlying payroll data to ensure that only W-2 taxable wages and documented usual fringe benefits are claimed as QREs. Any line items related to agency administrative fees or other costs not constituting employee compensation must be excluded.
• Internal Oversight Logs: Maintain contemporaneous records showing the supervision and direction provided by the qualified business’s personnel to the Contractual Employee, directly substantiating the statutory “direct supervision” requirement.1

VI. Practical Example: R&D Cost Inclusion

To demonstrate the imperative of correct worker classification, this example contrasts the inclusion of Contractual Employee wages (W-2) versus the exclusion of independent contractor payments (1099) for a business claiming the R&D credit.

A. Scenario Setup: Targeted Business Utilizing Contractual Engineers

Company: TechInnovate, an eligible, technology-based firm seeking the 33% In-House Research by a Targeted Business credit. TechInnovate’s R&D project involves developing proprietary manufacturing software (a qualified activity involving technological discovery and experimentation).14

Personnel: TechInnovate requires three specialized software engineers for a 12-month period to integrate new algorithms.

1. Staffing Model A (Qualified): TechInnovate contracts with a PEO, Workforce Solutions, for the three engineers. Workforce Solutions handles the W-2 payroll, benefits, and tax remittance. TechInnovate’s VP of Engineering manages the engineers daily, assigns specific coding tasks, and approves all R&D time allocation. These engineers are classified as Contractual Employees.1
2. Staffing Model B (Non-Qualified): TechInnovate hires a separate, self-employed database architect to consult on system security during the project. The architect works independently, determines their own schedule, and submits monthly invoices for nonemployee compensation. This individual is a 1099 independent contractor.

B. Calculation of Qualified Research Expenditures

Total annual expenditures associated with the R&D personnel:

QRE Calculation for Credit Claim:

1. Qualified Wages Inclusion: Only the $310,000 (taxable wages and usual fringe benefits) of the Contractual Employees qualify. The PEO markup and the 1099 payments are excluded.
2. Total QRE Claimed: $310,000
3. Credit Calculation (Targeted Business Rate): $310,000 $\times$ 33% = $102,300 Tax Credit

C. Contrast and Implication

Had TechInnovate failed to secure the PEO arrangement (Model A) and instead utilized 1099 contractors for all the engineering roles, the entire $430,000 in R&D labor costs would be disqualified from the QRE wage calculation. This scenario clearly demonstrates that the explicit inclusion of the Contractual Employee definition is an essential allowance that facilitates capital recovery for businesses utilizing leased labor, preventing the automatic rejection of W-2 payroll costs managed by third parties.

VII. Conclusion and Strategic Recommendations

The Arkansas R&D Tax Credit Program, while a powerful incentive for innovation, is highly specific and relies upon rigid statutory definitions regarding qualified labor. The legal mechanism of the “Contractual Employee” provides a critical pathway for co-employment arrangements (e.g., PEO or staffing firms) to qualify for the 20% or 33% state tax credit, provided the taxpayer satisfies the dual requirements of W-2 status and direct supervision.

The most critical takeaway for practitioners and corporate leaders is that the Arkansas R&D tax credit framework fundamentally excludes traditional 1099 independent contractor payments from the qualified wage base. This design prevents the inclusion of general consulting fees and mandates that nearly all qualified in-house labor, whether direct or outsourced, must pass through a formal payroll structure. Furthermore, the limited nature of Arkansas QREs, focusing heavily on labor and excluding most supplies and equipment, makes the precise, compliant capture of every eligible labor dollar—including that of Contractual Employees—an economic necessity for maximizing the incentive benefit.

Strategic Recommendations for Maximizing Arkansas R&D Tax Credit

1. Formalize PEO Relationships: Companies planning to use outsourced technical personnel for R&D should mandate the use of Professional Employer Organizations or staffing firms that maintain W-2 employment relationships, thereby satisfying the requirement for “taxable wages” for the Contractual Employee.
2. Establish Clear Supervisory Control: Documentation must confirm that the qualified business, not the third-party employer, maintains direct supervision over the day-to-day R&D activities. This includes creating and preserving internal performance reviews, R&D time logs, and organizational reporting charts that clearly place the Contractual Employees under the authority of the taxpayer’s R&D management.
3. Ensure Pre-Approval of Arrangements: Due to the discretionary nature of the credits, businesses must detail the planned use of Contractual Employees and the corresponding projected wages within the R&D project plan submitted to the AEDC/ASTA for approval. This proactive step secures the eligibility of the expenditures before they are incurred.
4. Rigorous Cost Segregation: When calculating QREs, meticulously isolate the Contractual Employee’s actual W-2 taxable wages and usual fringe benefits from any administrative fees, markups, or costs charged by the PEO, as only the former components are eligible for the credit.

Adhere to Filing Procedures: Claim the approved credit by attaching the ASTA-issued Certificate of Tax Credit to the Arkansas income tax return (AR1100CT) and correctly completing the relevant section on Form AR1100BIC (e.g., Credit Type 0024).

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