Analysis and Application of Contract Research Expenses in the Context of the Delaware R&D Tax Credit (Del. Code Ann. tit. 30, § 2070)

I. Executive Summary: The Definition and Context of Contract Research Expenses in Delaware

Contract Research Expenses (CRE) represent costs incurred by a taxpayer for qualified research performed by external parties, generally calculated as 65% of the total amount paid to non-employees. For the Delaware Research and Development (R&D) tax credit, these expenses must align with federal Internal Revenue Code (IRC) standards but are strictly limited to qualified research activities physically conducted within the State of Delaware.

1.1 Simple Definition of Contract Research Expenses (CRE)

Under the structure established by the Internal Revenue Code (IRC) Section 41, which Delaware incorporates, CRE is defined as 65 percent of any amount paid or incurred by the taxpayer to any person, other than an employee, for the execution of qualified research.1 For the purpose of the state credit, this amount is recognized only insofar as the contracted research activities are demonstrably performed within Delaware’s geographical boundaries.

1.2 Statutory Framework and High-Value Proposition of the Delaware Credit

The Delaware R&D Tax Credit is a significant incentive for innovation, established under Del. Code Ann. tit. 30, §§ 2070-2075 and administered by the Delaware Division of Revenue.3 Unlike many state R&D credits, a key distinguishing feature of the Delaware program is its fully refundable nature.3 This means that if the credit exceeds the taxpayer’s liability for corporate income tax, the unused portion is paid out as a direct cash refund to the taxpayer.3

This mechanism of refundability represents a potent state economic strategy, effectively converting a potential tax reduction into a direct governmental subsidy. This structure is particularly vital for startups and growth-stage companies—especially those in capital-intensive sectors such as biotechnology, finance, and manufacturing—that may generate substantial R&D expenditures (including large CRE claims) but may not yet be profitable enough to utilize a non-refundable credit.3 Coupled with enhanced rates provided to small businesses, this fully refundable structure positions the Delaware credit as an explicit cash-flow incentive designed to attract and retain high-growth technology and research enterprises, encouraging them to establish their principal research operations within the state.

1.3 The Foundational Nexus: Federal Definitions and State Limitations

The foundation of the Delaware R&D credit is inextricably linked to the federal IRC framework. The State of Delaware utilizes the federal R&D tax credit guidelines established under IRC § 41 to determine whether the underlying activities qualify as research and how the expenses, including CRE, are defined.3 This reliance on federal definitions simplifies the initial qualification process for taxpayers already claiming the federal credit.

However, a crucial distinction exists between the federal and state credits regarding the scope of application. While the federal Qualified Research Expenses (QREs) generally encompass research activities conducted nationwide, Delaware strictly restricts the benefit only to QREs, including CRE, that are Delaware-apportioned or demonstrably Delaware-sourced.3 This geographic limitation means that while an activity may qualify under IRC § 41, only the portion of that activity physically performed within Delaware’s borders can be included in the calculation of the Delaware credit. This localization requirement is central to accurately calculating the allowable Delaware QREs (DQREs).

II. The Statutory Foundation of Contract Research Expenses (CRE)

The definition and treatment of Contract Research Expenses (CRE) in Delaware begin, and are largely governed by, the definitions provided in 26 U.S. Code § 41(b)(3) of the Internal Revenue Code.

2.1 Detailed Adoption of IRC § 41(b)(3): The 65% Rule

Delaware adopts the foundational federal rule that CRE means only 65 percent of the total amount paid or incurred by the taxpayer to an unrelated third party for qualified research.1 This 65% rule—often colloquially termed the “haircut”—reflects the legislative assumption that the remaining 35% of the payment covers overhead, profit, or non-qualified costs of the contractor.

The significance of this adoption by Delaware is that this reduction must be applied before any further state-specific apportionment calculations are performed. Taxpayers must meticulously track these costs, categorize them correctly, and apply the mandatory reduction before integrating them into the overall Delaware Qualified Research Expenses (DQREs) calculation. The state law requires that all QREs must meet the definitions and substantiation requirements of IRC § 41(b).3

2.1.1 Qualified Recipient Requirements and Exclusions

To qualify as CRE, the expenditure must be paid to any person other than an employee of the taxpayer.1 This distinction is critical for compliance. If the contracted individual or entity is later determined by the Internal Revenue Service (IRS) or the Delaware Division of Revenue (DOR) to be a common law employee, the 65% payment classification as CRE is invalid. Such a reclassification introduces audit risk on the claimed CRE.

However, if reclassified as an employee, the expense might transition into a 100% wage QRE, provided the research duties and nexus are fully confirmed and documented. Taxpayers must therefore implement rigorous documentation protocols, ensuring that contracts with third-party researchers explicitly define their independent status and limit the taxpayer’s control over the methods and means of performance, thereby mitigating the risk associated with contractor misclassification.

2.1.2 Treatment of Related Party Transactions

While the provided research materials do not detail the specific statutory language regarding related party transactions under Delaware law, the state explicitly requires the use of federal definitions and methodology.5 Federal law, particularly IRC § 41(d)(4)(F), typically restricts or modifies the treatment of contract research payments made between related parties (entities controlled by, or controlling, the taxpayer).

Therefore, standard federal related-party exclusion rules apply in Delaware, generally barring payments to related entities from qualifying as CRE unless the credit itself is passed through from the performing entity to the entity claiming the credit, subject to complex aggregation rules. Taxpayers engaging in intercompany CRE arrangements must confirm compliance with the complex federal framework governing controlled groups and related businesses to ensure the expenses are properly includible.

2.1.3 Timing and Prepaid Contract Research Amounts

The timing of when CRE is recognized as incurred is governed by the federal rules, which Delaware adopts. Specifically, IRC § 41(b)(3)(B) dictates that if any contract research expenses are prepaid during a taxable year, those amounts attributable to research that will be performed in a subsequent year must be taken into account only in the taxable year the research is actually performed.1

This timing rule is crucial for accurate financial reporting and credit calculation. It effectively prevents taxpayers from artificially accelerating QREs simply by prepaying large research contracts at the end of a fiscal year. The expense must be matched strictly with the performance of the qualified activity, ensuring the credit accurately reflects the R&D effort undertaken during the claim year.

III. Delaware Division of Revenue Guidance: Apportionment and Compliance

The core challenge in claiming CRE in Delaware is satisfying the geographical limitation imposed by the Division of Revenue. Delaware mandates that the R&D activity be conducted within the state to qualify.

3.1 Legislative Mandate: Delaware-Sourced Contract Research

Delaware law requires that QREs, including all categories such as wages, supplies, and CRE, must be apportioned to the state based exclusively on activities performed within its borders.3 This is the most significant differentiating factor from the federal credit.

3.1.1 The Crucial Geographic Limitation for CRE

For contract research, the federal inclusion rate (65%) is applied first to the total payment. The resulting expense amount must then be multiplied by the percentage of that contract research physically performed within Delaware.

To illustrate, if a taxpayer pays a contractor $100,000 for research, the federal qualified amount is $65,000. If that contractor performs 70% of the research work in Delaware and 30% in New Jersey, the resulting Delaware QRE (DQRE) from that contract is $\$65,000 \times 70\%$, or $\$45,500$.

This state-specific apportionment rule creates a substantial operational and documentation burden that exceeds standard federal compliance requirements. Taxpayers cannot simply rely on the contractor’s billing address or the location of the taxpayer’s headquarters. They must secure detailed, verifiable records from the third-party contractor documenting the percentage of research time, effort, or expense expended inside Delaware versus outside. Typical acceptable documentation includes itemized invoices, detailed time logs, project reporting, and location tracking data signed off by both the contractor and the taxpayer. Failure to secure and maintain this highly granular documentation will likely result in the partial or total disqualification of the non-apportioned CRE during a DOR review.

3.2 Credit Eligibility and Enhanced Rates for Small Businesses

The Delaware R&D tax credit is widely available, open to C-Corporations, S-Corporations, Partnerships, and LLCs.3 For flow-through entities such as S-Corps and Partnerships, the credit is calculated at the entity level and then passed through to the owners via Schedule K-1, who then claim the credit on Delaware Income Tax Credit Schedule Form 700.3

The state provides significantly enhanced credit rates for businesses classified as “small.” A small business is defined as any taxpayer with average annual gross receipts of $20 million or less.6 The enhanced benefits are designed to provide a more aggressive subsidy to businesses during their critical high-growth phases.

The credit rates differ substantially based on both business size and the calculation method selected, as detailed in the Delaware statute (Del. Code Ann. tit. 30, § 2070).3

Table 1: Delaware R&D Credit Rates and Eligibility Parameters

IV. Computational Analysis: Methods for Calculating the Delaware R&D Tax Credit

Delaware taxpayers have an annual option to elect one of two distinct methodologies for calculating the R&D credit, which involves integrating the calculated DQREs (including the properly apportioned CRE) into the base calculation.

4.1 Annual and Independent Election Requirement

The choice between Method A (Traditional/Incremental) and Method B (Alternative Simplified Credit or ASC) is an annual election documented on Delaware Form 2070AC.8 A critical element of Delaware’s compliance structure is that this state election is entirely independent of the method used to compute the federal R&D tax credit.8

This independence grants companies significant strategic flexibility in their tax planning. A sophisticated tax strategy requires modeling both options for the Delaware claim, irrespective of the federal outcome. For example, a company experiencing exceptionally high growth in its DQREs (driven by new local facilities or increased Delaware-sourced CRE) may find that Method A generates a larger credit by maximizing the “excess” over the historical base amount, even if Method B (ASC) was optimal for the consolidated federal return. This flexibility allows businesses to strategically optimize their state credit claim based on the unique trajectory of their in-state research spending.

4.2 Method A: The Traditional/Incremental Method

Method A calculates the credit based on the excess of current-year DQREs over the Delaware Base Amount.4 The calculation requires historical data spanning the preceding four tax years.

4.2.1 Calculation of the Delaware Base Amount

The Delaware Base Amount (DBA) establishes the baseline of historical R&D spending that the taxpayer must exceed to generate a credit. The calculation follows specific steps, mirroring the complex federal definitions:

1. Delaware Fixed-Base Percentage (DFBP): The DFBP is determined by dividing the taxpayer’s total Delaware QREs for the four preceding years by the total Delaware gross receipts for the same four preceding years.3
2. Average Annual Gross Receipts: Calculate the average annual Delaware gross receipts for the four preceding years.8
3. Preliminary Base Amount: Multiply the DFBP by the Average Annual Delaware Gross Receipts.3
4. Minimum Base Floor: A crucial constraint ensures that the Base Amount is never excessively small. The final DBA is floored at the greater of the calculated preliminary base amount or 50% of the current year’s DQREs.3

This structure favors companies with sustained, but steadily increasing, R&D investment. For companies with historically low or zero QREs in Delaware, but who have dramatically ramped up their current-year CRE spending, the application of the mandatory 50% minimum base can severely limit the credit under Method A. In such scenarios, if the current year DQRE is double the base, the resulting excess QRE is only 50% of current spending. This limitation often makes Method B (ASC) a more attractive option for periods characterized by sudden, massive investment, particularly where CRE constitutes a large portion of the QREs.

4.3 Method B: Alternative Simplified Credit (ASC) Method

Method B simplifies the credit calculation by tying it directly to the federal ASC calculation under IRC § 41(c)(5). This method is preferred by businesses with fluctuating QREs or limited historical data.3

4.3.1 Apportionment of Federal ASC to Delaware

Under Method B, the credit is equal to 50% of Delaware’s apportioned share of the taxpayer’s federal R&D tax credit calculated using the ASC method.3 For a small business, the rate is 100%.6

The calculation requires taking the total federal ASC calculated on Federal Form 6765 and apportioning it to Delaware based on the ratio of research activity performed in the state 8:

$$\text{Delaware’s Apportioned Share} = \text{Federal ASC} \times \left( \frac{\text{Delaware QREs (DQRE)}}{\text{Total National QREs}} \right)$$

This apportionment ratio is critically influenced by how much qualified research activity is physically located in Delaware. Every dollar of Delaware-sourced CRE (after the 65% reduction) that is documented and included in the DQRE figure disproportionately improves this apportionment ratio, thereby increasing the amount of the overall federal credit claimed by Delaware. Taxpayers strategically focused on maximizing the Delaware credit under Method B recognize that localized CRE spending has a powerful leveraged impact on the final outcome.

V. Administrative Compliance and Fiscal Constraints

Compliance with the Delaware Division of Revenue (DOR) requirements involves strict adherence to filing procedures, including deadlines and required forms. Furthermore, the state imposes an annual fiscal constraint that taxpayers must acknowledge when forecasting the expected realized value of their credit.

5.1 Required Forms and Application Process (Division of Revenue Guidance)

To claim the Delaware R&D tax credit, taxpayers must submit an annual application using Delaware Form 2070AC.3 This application is mandatory, regardless of whether the business is claiming the credit under Method A or Method B.

The application, along with the required attachments, must be filed on or before September 15th following the end of the taxable year during which the qualified R&D expenses were incurred.6

A non-negotiable compliance requirement is the need for Federal Form 6765 (Credit for Increasing Research Activities) to be attached to Form 2070AC.8 For corporate applicants filing a consolidated corporate income tax return, a proforma Form 6765 specific to the corporate applicant must be attached.8 This requirement confirms to the DOR that the underlying qualified activities, including the calculated CRE, have been substantiated federally, providing a verified foundation for the state’s QRE base.

5.2 The $5 Million Annual Credit Cap and Proration Mechanism

Despite the credit’s statutory refundability, its total aggregate utilization is capped annually, a critical fiscal consideration for any claimant. The Delaware General Assembly limits the total amount of R&D tax credits applied for by all taxpayers in any fiscal year to $5,000,000.8

If the aggregate amount of eligible research and development tax credits applied for by all applicants exceeds this $5 million cap, a proration mechanism is triggered. In this event, the credit received by each applicant is calculated by multiplying $\$5,000,000$ by a fraction. The numerator of this fraction is the eligible credit applied for by the specific applicant, and the denominator is the total of all eligible research and development tax credits applied for by all applicants.8

This mechanism introduces significant fiscal risk and uncertainty regarding the final realized value of the refundable credit. A taxpayer’s expected cash refund is not guaranteed but is dependent upon the total cumulative demand from all other Delaware R&D claimants that year. This uncertainty necessitates advising tax directors and financial officers to model their cash flow with this proration risk in mind, particularly for large corporations or in years where high demand for the credit is anticipated.

VI. Comprehensive Case Study: Calculation of the Delaware R&D Credit Including CRE

The following numerical example, based on a hypothetical small business, illustrates the detailed integration and apportionment of Contract Research Expenses (CRE) and compares the outcomes of Method A and Method B.

6.1 Scenario Setup: TechCo Innovations (Small Business)

TechCo Innovations, a Delaware-based R&D firm, qualifies as a small business because its average annual gross receipts are below the $20 million threshold.6

Current Year (CY) R&D Data:

• CY Wages (100% Delaware-sourced): $500,000
• CY Supplies (80% Delaware-sourced): $150,000
• CY Contract Research (Paid to 3rd Party): $300,000 (90% of activity performed in Delaware)
• Total National QREs (CY): $1,200,000
• Federal ASC Calculated: $100,000
• Delaware Base Amount (DBA) Calculated from historical records (before minimum floor): $400,000

6.1.1 Step-by-Step Determination of Delaware Qualified Research Expenses (DQRE)

The calculation requires applying the federal inclusion rules and then the Delaware apportionment rules.

1. Contract Research Expense (CRE) Calculation:

• IRC § 41 Inclusion: $\$300,000 \times 65\% = \$195,000$
• Delaware Apportionment: $\$195,000 \times 90\% = **\$175,500**$

1. In-House Wages: $\$500,000 \times 100\% = \$500,000$
2. Supplies: $\$150,000 \times 80\% = \$120,000$

Table 2: Calculation of Total Delaware Qualified Research Expenses (DQRE)

The total Delaware Qualified Research Expenses (DQRE) for TechCo Innovations is $795,500.

6.2 Numerical Calculation using Method A (20% Small Business Rate)

Method A utilizes the enhanced 20% rate applicable to small businesses.3

1. Delaware Base Amount (DBA) Calculation:

• Initial DBA calculated from historical data: $400,000
• Minimum Base Check (50% of DQRE): $0.50 \times \$795,500 = \$397,750$
• Final Base Amount: $\$400,000$ (The greater of the calculated base or the minimum base).8

1. Excess QREs:

• DQRE $(\$795,500) – \text{DBA } (\$400,000) = \$395,500$

1. Credit Calculation (20% Rate):

• $\$395,500 \times 20\% = **\$79,100**$

6.3 Numerical Calculation using Method B (100% Apportioned ASC)

Method B utilizes the enhanced 100% rate applicable to the Delaware portion of the federal ASC for small businesses.6

1. Apportionment Ratio Calculation:

• DQRE $(\$795,500) / \text{Total National QREs } (\$1,200,000) = 66.29\%$

1. Apportioned Federal ASC:

• Federal ASC $(\$100,000) \times 66.29\% = \$66,290$

1. Credit Calculation (100% Rate):

• $\$66,290 \times 100\% = **\$66,290**$

6.4 Strategic Conclusion of Case Study

In this specific scenario, Method A yields a credit of $79,100, while Method B yields $66,290. TechCo Innovations should therefore elect Method A on Form 2070AC. This outcome demonstrates that for a small business experiencing high growth in Delaware QREs—even with the complexity of accurately apportioned CRE factored in—the Traditional/Incremental method can sometimes outperform the Alternative Simplified Credit method, despite the latter’s enhanced 100% small business rate. The key determining factor here is the company’s relatively high level of current-year DQREs compared to its historical base.

VII. Summary of DOR Compliance Requirements and Final Considerations

The successful utilization of the Delaware R&D tax credit, particularly concerning Contract Research Expenses, depends fundamentally on compliance rigor and a robust understanding of the state’s fiscal limitations.

7.1 Critical Documentation and Substantiation

The foundation of any defensible R&D credit claim rests on meticulous documentation. For CRE, the key to compliance is substantiating not just that the underlying research meets the federal four-part test (which is required by Delaware law), but that the payments are properly categorized (subject to the 65% reduction) and, most critically, that the taxpayer maintains contemporaneous documentation from the independent contractor detailing the physical location of the research activity.

Taxpayers must move beyond simple invoices and ensure that external contracts specify tracking requirements, requiring contractors to provide time allocations or effort distributions that explicitly tie the expenditure to activities performed within Delaware. Without robust location-based evidence, the Division of Revenue is likely to disallow the Delaware apportionment of the CRE.

7.2 Managing the Annual Proration Risk

While the refundability of the Delaware R&D credit offers invaluable immediate cash flow, the state’s $\$5,000,000$ aggregate annual cap introduces an unavoidable element of risk. The proration mechanism means that the expected cash value of the credit is not absolute but is contingent upon the total claims made by all taxpayers in that fiscal year.8

For businesses, especially capital-strapped startups relying on this credit for working capital, accurate forecasting of the expected realized credit (i.e., the credit value post-proration) is paramount for sound capital budgeting and financial planning. Taxpayers must remain aware that high collective demand for the credit could diminish the actual cash benefit received.

7.3 Policy Implications and Economic Incentive

Delaware’s decision to limit QREs, including CRE, strictly to activities performed within the state is a deliberate policy choice designed to maximize local economic return. By geographically restricting the CRE benefit, the state creates an explicit incentive for Delaware companies to contract research services from other Delaware-based entities, such as local R&D specialty firms, universities, or local scientific contractors.

This structure encourages the formation of local research networks and ensures that the state’s tax incentive dollars remain within Delaware, supporting local employment and fostering the growth of the in-state R&D service industry. This policy functions as a powerful fiscal multiplier, maximizing the local economic impact derived from the R&D tax credit program.

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