Expert Analysis Report: The Definition and Compliance Requirements for Employee Qualified Services under the Idaho Research and Development Tax Credit

An Employee performing Qualified Services is an individual whose Idaho-situs wages are attributable to research activities defined under Internal Revenue Code (IRC) Section 41. These services must involve either Direct Research, Direct Supervision, or Direct Support of qualified research experimentation, rigorously documented under the federal “Substantially All” rule, which Idaho strictly enforces.

The Idaho R&D Tax Credit is designed to incentivize technical innovation and capital investment within the state. Because the Idaho State Tax Commission (ISTC) relies heavily on federal tax code definitions and precedent, taxpayers must achieve a level of documentation rigor commensurate with a federal audit standard to successfully claim the employee wage component of the Qualified Research Expense (QRE). This report provides an exhaustive analysis of the definition, local guidance, compliance mandates, and practical application of qualified service wages in Idaho.

I. Statutory Foundation and Idaho’s Adoption of IRC Section 41

A. Legislative Authority: Idaho Code § 63-3029G and Credit Mechanics

The Idaho R&D Tax Credit is authorized primarily under Idaho Code § 63-3029G, which grants a credit against state income tax.1 The purpose of this legislation is to stimulate economic growth by rewarding companies for increasing their research activities within the state. The statutory calculation allows for a credit equal to five percent (5%) of the incremental Qualified Research Expenses (QREs) that exceed a calculated base amount.1

This calculation necessitates a complex historical review. The base amount is calculated by multiplying a fixed-base percentage by the average annual Idaho gross receipts for the four preceding taxable years.1 Critically, the base is subject to a minimum requirement, as it cannot be less than 50% of the current year’s QREs.1 For new businesses, Idaho offers an irrevocable start-up election on Form 67, allowing taxpayers to use the federal startup formula based on Idaho-sourced data, capped at a 16% fixed-base percentage.1

A significant feature of the Idaho credit is its duration. The credit is nonrefundable, meaning it can only offset income tax liability, but any unused credit may be carried forward for up to 14 tax years.1 The long carryforward period underscores the long-term utility of maximizing and defending current year QRE claims, as the benefit can be deferred significantly into future tax years.

B. Explicit Reliance on Federal Law: IRC § 41 Conformity

The foundational definition of qualified activities and expenses in Idaho is governed by the Internal Revenue Code (IRC). Idaho Admin. Code r. 35.01.01.720 explicitly mandates that the Idaho credit computation must utilize the same definitions for “qualified research expenses,” “qualified research,” “basic research payments,” and “basic research” as those established in IRC Section 41.1

This dynamic conformity imposes the stringent federal standards for qualified research upon Idaho taxpayers. To qualify, activities must satisfy the four-part test derived from federal law:

1. The expense must be eligible for treatment as a research and development expenditure under IRC § 174.
2. The goal must be to discover information that is technological in nature.
3. The results must be intended for use in the development or improvement of a business component.
4. Substantially all of the activities must constitute elements of a process of experimentation.1

The strict adherence to IRC § 41 definitions means that Idaho effectively incorporates the entire body of federal guidance, including IRS Audit Technique Guides and federal tax court rulings. Taxpayers should be aware that the ISTC recognizes federal judicial precedent regarding the process of experimentation. For instance, the ISTC cites the Union Carbide case to define the “Substantially All” requirement, confirming that 80% or more of the taxpayer’s research activities must constitute a process of experimentation.5 Consequently, failure to document activities sufficiently to pass a federal audit standard is highly likely to result in a deficiency assessment for the state credit, demonstrating a direct correlation between federal and state compliance rigor.6

C. Scope Limitation: The Requirement for Idaho-Sourced Activities (Situs)

While Idaho adopts federal definitions for what constitutes qualified research, it applies a crucial geographical limitation: only QREs related to research conducted in Idaho qualify for the state credit.1

This sourcing requirement extends to all QRE components: wages (salaries for qualified services), supplies (materials and prototypes), and 65% of contract research payments must all be demonstrably sourced to activities physically performed within the state.1

The geographical limitation presents a considerable compliance risk, particularly in modern operating environments involving highly mobile or remote workforces. For an R&D claim to be defensible, the taxpayer must be able to prove the physical location (situs) of the qualified service. For instance, if a software engineer whose services meet the criteria for QRE wages works remotely from outside Idaho, those wages cannot be included in the Idaho QRE calculation, even if the research project benefits an Idaho facility or is managed by an Idaho team. Therefore, detailed time-tracking must be coupled with meticulous records verifying the physical location of the research performance.

II. Qualified Research Expenses (QREs): Deconstructing the Employee Wage Component

A. The Employee Wage QRE

Wages paid for qualified services represent the most common and often largest category of QREs claimed by taxpayers engaged in R&D.1 These wages include all taxable compensation paid to an employee, provided that the employee is performing “qualified services.” The fundamental challenge in calculating QRE wages lies in accurately defining and substantiating these services according to the strict federal framework adopted by the ISTC.

B. The Three Categories of Employee Qualified Services (IRC § 41(b)(2)(B))

The Internal Revenue Code, and by extension Idaho, recognizes only three distinct categories of service that constitute “qualified services”.7 The inclusion of wages in the QRE calculation depends on the employee’s role fitting into one or more of these three defined functions, and the time spent on these functions must be meticulously tracked.2

1. Engaging in Qualified Research (Direct Research)

This category includes individuals who are directly and physically performing the core technical work of the research or experimentation. These are the hands-on personnel conducting the actual design, modeling, coding, testing, or chemical formulation work necessary to overcome technological uncertainty.1

Qualifying job roles typically include:

• Engineers (e.g., Mechanical, Electrical, Design, Software).9
• Computer programmers and Data Scientists responsible for developing external-use software or algorithms.9
• Process technicians directly involved in running experimental production batches.

2. Directly Supervising Qualified Research

Direct Supervision refers to the immediate, first-line management and technical oversight of the individuals performing the direct research. This function must be technical and proximate, involving expert direction and evaluation of the scientific or engineering methodology used in the experimentation process.7

Examples of qualifying personnel include:

• Project Engineers or Team Leads who actively define and monitor the technical parameters of the research.8
• Chief Technology Officers (CTOs) or Vice Presidents of R&D, but only to the extent their time is spent specifically supervising the technical research and development activities, not general corporate management.8

Executive compensation is often highly scrutinized. If an executive’s role is primarily strategic, financial, or administrative, their services are generally disqualified, as they lack the required functional and technical proximity to the experimentation.

3. Directly Supporting Qualified Research

Direct Support involves services that are integral and essential to the conduct of the qualified research, provided they are performed in physical and functional proximity to the location of the research activity.2 This category carries the highest audit risk because taxpayers frequently attempt to include non-technical or generalized administrative support roles.

To qualify, the service must be demonstrably required for the technical function of the R&D activity. Examples include:

• Specialized quality assurance (QA) personnel whose testing activities are integrated into the iterative experimentation process, rather than routine, post-production checks.9
• Technicians or logistics personnel who specifically maintain, calibrate, or prepare specialized research equipment or materials for immediate use in the lab.9
• Welders or machinists fabricating custom prototypes or specialized tooling required for testing the business component improvement.

General administrative services, such as general IT help desk support, payroll processing, security, or routine cleaning, are excluded. The critical requirement is the proximate necessity of the support to the experimentation process itself.

Table 1: Categories of Employee Qualified Services

III. ISTC Guidance: Application of the “Substantially All” Rule to Employee Wages

A. Defining “Substantially All”: The 80% Threshold

The cornerstone of claiming employee wages as QREs is the rigorous application of the “Substantially All” rule, which Idaho enforces by citing federal tax court precedent.5 “Substantially all” is uniformly defined in tax policy as eighty percent (80%) or more of an employee’s work time.5 This requirement applies to the measurement of whether the employee’s time on research activities, measured on a cost or other consistently applied reasonable basis (e.g., hours or days), constitutes a process of experimentation for a qualified purpose.5

This rule is pivotal because it dictates how much of an employee’s compensation can be claimed as a QRE.

B. The 100% Inclusion Rule vs. The Apportionment Rule

The 80% threshold establishes a clear demarcation for wage inclusion:

1. The 100% Inclusion Rule (80% or More)

If an employee spends 80% or more of their working hours on activities that qualify under one of the three service categories (Direct Research, Direct Supervision, or Direct Support) conducted in Idaho, then 100% of that employee’s wages attributable to their time in Idaho can be treated as a QRE.10 This rule significantly simplifies calculations and maximizes the benefit for highly specialized R&D personnel.

2. The Apportionment Rule (Less than 80%)

If the employee’s documented time on qualified services falls below the 80% threshold, the 100% inclusion rule is lost. In this scenario, only the precise, proportional amount of wages corresponding to the time spent on qualified activities may be claimed.10 The remainder of the employee’s compensation, often attributable to general administration, routine maintenance, or training, must be excluded from the QRE calculation.

The application of this rule creates a compliance precipice. If an employee consistently records 79% qualified services, the taxpayer cannot claim 100% of the wages. If the taxpayer intended to use the 100% inclusion rule but failed to meet the 80% threshold, they must possess adequate, contemporaneous records to substantiate the 79% portion. Without such records, the ISTC, following federal compliance standards, may reject the entire wage claim, as generalized descriptions and arbitrary estimates are deemed inadequate.6

C. ISTC Mandate for Substantiation and Documentation Rigor

The Idaho State Tax Commission places a high value on detailed substantiation, recognizing that the process of experimentation is inherently technical and requires clear proof.6 Compliance is not merely about listing job titles (though job titles like engineer or programmer often qualify 9); it is about documenting the specific tasks performed, the technological uncertainty addressed, and the experimental nature of the work.

The ISTC specifically cautions taxpayers that “Generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time performing experimentation are not enough” to satisfy the documentation burden.6 This instruction directly targets the practice of estimating R&D time retrospectively, emphasizing that only contemporaneous, consistent, and specific time-tracking will successfully support QRE wage claims.10

Required documentation elements to defend the allocation of employee time include:

• Detailed time sheets or electronic time logs that segregate hours or days spent on qualified R&D tasks versus non-R&D tasks.10
• Project authorization documents, work orders, and budgets that initiate the research project and define the technological goals.11
• Technical progress reports, meeting minutes, and lab verification data that tie specific employees to the documented experimentation process.11

IV. Compliance and Reporting Requirements for Idaho QREs

A. Sourcing and Situs of Employee Activities

As established, Idaho’s primary geographical requirement is that research must be conducted within the state.4 For employee wages, this means the compensation claimed must be tied to services physically performed within Idaho. This is a crucial step that occurs before applying the Substantially All rule.

For companies with operations across multiple states or those employing remote workers, robust internal controls are necessary to:

1. Verify the physical location where the employee performed the QRE activity.
2. Apportion the wages of qualified employees based on their time spent working inside Idaho versus outside the state.
3. Apply the 80% rule or the apportionment rule only to the wages sourced to Idaho activities.

Audit defensibility requires documentation—such as secure access logs, project location assignments, and contemporaneous personnel tracking—that conclusively links the claimed QRE hours to Idaho soil.

B. ISTC Form 67: Calculation and Claim

The calculation of the Idaho Research Credit, including the quantification of qualified employee wages, is finalized on Idaho Form 67, Credit for Idaho Research Activities.2

The rigorous definition and calculation of qualified service wages ultimately feed into Form 67 as a component of the Total Idaho QREs (Line 4).2 This total QRE amount is then used to calculate the incremental credit:

1. The base amount is calculated based on prior Idaho-sourced gross receipts.1
2. The difference between current QREs and the base amount yields the Excess QREs.
3. The taxpayer claims the credit equal to 5% of this excess.1

For qualifying corporations, the credit can also include a 5% allowance on basic research payments in excess of the qualified organization base period amount, provided the basic research was conducted in Idaho.1

C. Critical Documentation Checklist for ISTC Audits

To ensure the successful claiming of the R&D tax credit, particularly the wage component, Idaho taxpayers must prepare an audit-ready package that addresses both the federal definitions and the Idaho-specific sourcing rules. The ISTC expects more than generalized ledger entries; it requires proof of the process.6

Key elements for inclusion in the substantiation package are 11:

• Contemporaneous Time Logs: Detailed records (e.g., daily or weekly) tracking time spent by individual employees on specific, qualifying R&D tasks versus non-qualifying administrative or routine tasks.10
• Project Authorization and Management Records: Formal approvals, work orders, and budget documentation establishing the technical objective and scope of the research.11
• Technical Evidence: Progress reports, test results, field verification data, and technical specifications that detail the process of experimentation and the iterative nature of the development.11
• Financial Linkage: Payroll records and W-2s that clearly connect the claimed QRE wages back to the tracked time and specific employees.
• Sourcing Verification: Documentation (e.g., travel reports, internal project allocation summaries) that confirms the QRE activities were physically performed within Idaho.

V. Detailed Case Study: Applying the Employee Qualified Services Definition in Idaho

A. Scenario Setup: Gem State Tech Innovations (Boise, ID)

Gem State Tech Innovations, located in Boise, Idaho, manufactures precision components. The firm is undertaking a project to redesign and optimize its manufacturing process using proprietary software algorithms—an activity that qualifies under the federal four-part test. The company wishes to claim the QRE wages for two employees whose services are sourced entirely to Idaho.

B. Time Allocation and Compliance Analysis

Gem State Tech Innovations maintains detailed, contemporaneous time logs that document how the 2,080 standard hours were utilized:

1. Process Improvement Engineer (PIE)

The PIE is responsible for writing and testing the new software algorithms.

• Hours on Direct Research (Coding, testing, documentation of experimentation): 1,850 hours
• Hours on Routine Maintenance and Staff Training (Non-QRE): 230 hours
• QRE Percentage: $1,850 / 2,080 = 88.9%

2. R&D Project Manager (RPM)

The RPM spends time overseeing the technical staff and also handles non-technical budget and scheduling meetings for external stakeholders.

• Hours on Direct Supervision (Technical oversight of PIE team): 1,500 hours
• Hours on General Administration/Financial Reporting (Non-QRE): 580 hours
• QRE Percentage: $1,500 / 2,080 = 72.1%

C. Step-by-Step Calculation of Qualified Wage Expense (QRE)

1. PIE Calculation (Direct Research)

• Threshold Test: The PIE’s QRE allocation is 88.9%.
• Rule Application: Since 88.9% is greater than the 80% threshold, the 100% Inclusion Rule applies.10
• Qualifying Wages (QRE): $120,000 $\times$ 100% = $120,000.
• Documentation Requirement: The company must retain the contemporaneous time logs proving the 88.9% allocation to defend the 100% inclusion claim during an ISTC review.

2. RPM Calculation (Direct Supervision/Support)

• Threshold Test: The RPM’s QRE allocation is 72.1%.
• Rule Application: Since 72.1% is less than the 80% threshold, the 100% Inclusion Rule is failed. The company must use the Apportionment Rule.10
• Qualifying Wages (QRE): $160,000 $\times$ 72.1% = $115,360.
• Documentation Requirement: The company must possess time logs that precisely substantiate the 1,500 hours as legitimate Direct Supervision, ensuring that the services were technical and proximate to the experimentation. If these records are deemed “arbitrary estimates,” the ISTC could disallow the entire $115,360 claim.6

Table 2: Case Study Summary of Qualified Wage Expense

D. Conclusion of Case Study

Gem State Tech Innovations successfully calculates $235,360 in qualified employee wages to be included in its Total Idaho QREs on Form 67. This result demonstrates that rigorous, contemporaneous time tracking is essential not only to secure the maximum 100% benefit for employees who meet the 80% threshold, but also to provide the necessary precision for the proportional apportionment of wages for high-value employees who do not meet that threshold. The integrity of the entire claim relies on the quality of this underlying time data.

VI. Conclusion and Recommendations for Idaho Taxpayers

A. Synthesis of Nuanced Compliance Requirements

The definition of an employee performing Qualified Services in Idaho is deceptively simple in its reliance on IRC Section 41, yet exceptionally complex in its compliance requirements. The analysis confirms that Idaho has structurally linked state R&D credit utilization to federal standards of technical qualification, meaning the primary challenge for Idaho taxpayers is not definitional but evidential.

The successful claim of employee wage QREs hinges on three critical factors:

1. Technical Qualification: Services must align precisely with the Direct Research, Direct Supervision, or Direct Support categories.
2. The 80% Documentation Cliff: The difference between 79% and 80% QRE time determines whether 79% or 100% of Idaho wages are claimed, demanding extreme precision in time tracking.
3. Idaho Situs: The activities must be provably conducted within Idaho, a critical sourcing requirement that supersedes the federal definition of QREs.

B. Strategic Recommendations for Maximizing and Defending the Credit

Based on the ISTC’s stringent documentation requirements and the structure of the R&D credit, taxpayers operating in Idaho should adopt the following recommendations:

1. Implement Strict Contemporaneous Time Tracking Systems

To mitigate audit risk, the taxpayer must move beyond reliance on job titles or generalized payroll allocations. Taxpayers should institute project-specific time-tracking systems (e.g., electronic time sheets or project management software logs) that capture daily or weekly allocations for all claimed employees. These systems must differentiate qualified time (Direct Research, Supervision, or Support) from non-qualified time (e.g., routine administration, general training). This contemporaneous tracking is the only reliable way to defend the application of both the 100% inclusion rule and the apportionment rule.6

2. Segregate High-Risk and Low-Risk Payroll

Taxpayers should strategically analyze the QRE involvement of personnel. Employees who consistently hover between 70% and 80% QRE activity require the most intensive documentation under the apportionment rule. Personnel whose involvement is purely general or administrative (e.g., general HR, finance, security) should be definitively excluded from the QRE base to avoid introducing high-risk, non-proximate claims that could jeopardize the audit standing of otherwise qualifying expenditures.

3. Conduct Integrated State and Federal Compliance Reviews

Given Idaho’s full adoption of IRC § 41, businesses should conduct an integrated R&D study that satisfies both federal and Idaho requirements simultaneously. The study must explicitly include an Idaho-specific sourcing mechanism that verifies the physical situs of the QRE activities. By rigorously adhering to the comprehensive documentation standards derived from federal precedent, taxpayers ensure they are properly positioned to benefit from Idaho’s valuable 5% incremental credit and its 14-year carryforward period.1

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