Navigating Innovation: The IRC $\S 174$ Test and Strategic Compliance for the Idaho R&D Tax Credit

I. Executive Summary: The Strategic Value and Compliance Risks of Idaho R&D Incentives

The Internal Revenue Code (IRC) Section 174 Test establishes the foundational eligibility for research expenses, defining the scope of activities that qualify for the federal R&D tax credit and, by extension, the Idaho R&D tax credit.

The test requires activities to be aimed at discovering information to eliminate technical uncertainties concerning the capability, method, or design of a business component, using a systematic process of experimentation.

A. Simple Meaning of the IRC $\S 174$ Test (Required 2-Line Summary)

The IRC $\S 174$ Test serves as the gateway criterion, defining eligible costs as expenditures incurred for research and development activities in the experimental or laboratory sense, essential for qualifying expenses for the Idaho R&D tax credit.1

B. Key Findings and Actionable Recommendations

Compliance with the Idaho R&D Tax Credit (Idaho Code $\S 63-3029G$) requires strict adherence to federal definitions while navigating unique state-level complexities related to sourcing, conformity, and high audit standards imposed by the Idaho State Tax Commission (ISTC).

Risk Mitigation: The Idaho State Tax Commission (ISTC) imposes a rigorous documentation standard for the $\S 174$ Test, demanding evidence of a systematic, scientific process of experimentation and definitive proof of technical uncertainty at the outset of the project.2 This heightened scrutiny necessitates documentation that goes beyond standard engineering records.

Strategic Opportunity: Idaho offers a statutory decoupling mechanism allowing an irrevocable Start-Up Company election regardless of federal status, potentially optimizing the base amount calculation for newer R&D operations.3 This provides flexibility not available under federal law, but requires careful long-term modeling due to its permanent nature.

Income Tax Complexity: Taxpayers must manage the federal shift to mandatory $\S 174$ amortization (post-2021), which requires complex state modifications on the Idaho corporate income tax return due to Idaho’s conformity timeline and legislative attempts to decouple.1 This creates a dichotomy where the activity qualifies for the credit, but the associated expense deduction requires separate state accounting.

II. The Federal Foundation: IRC $\S 174$ as the Essential Gateway for Qualified Research

The Idaho R&D credit is inextricably linked to the federal framework established by IRC $\S 41$ (the credit calculation) and IRC $\S 174$ (the definition of qualified research expenditure, or QRE). Section 174 expenditures are those related to research and development activities, generally qualifying in the experimental or laboratory sense.1

A. Historical Context and Scope of IRC $\S 174$ Expenditures

Defining Research and Experimental (R&E) Expenditures: IRC $\S 174$ defines the range of costs that qualify as Research and Experimental (R&E) expenditures, providing the foundational definition of eligible costs for the IRC $\S 41$ R&D credit.1 These costs must be directly connected to the taxpayer’s trade or business.7 Examples of eligible costs include wages paid to employees directly involved in R&D activities, supervisors, and support staff; the cost of supplies and raw materials used in design, fabrication, or testing; and contract research costs paid to third parties, provided the business assumes the economic risk of the research outcome.7

Specific Inclusions: A crucial inclusion for many modern firms, particularly those in the Gem State’s growing technology sector, is that any amount paid or incurred in connection with the development of software shall be treated as a research or experimental expenditure for $\S 174$ purposes.9 Technology and software companies must diligently track these expenses, noting that, in theory, all expenses incurred in connection with software development must now be subject to the amortization rules for deduction purposes.8

Explicit Exclusions: Expenditures that fail the $\S 174$ test are ineligible for the Idaho R&D credit. These exclusions are critical to compliance, including costs related to market research, advertising, and sales promotions.8 Also excluded are costs incurred after commercial production of a product has begun, routine quality-control testing, and research funded by another party where the taxpayer does not retain substantial rights to the research.8 Furthermore, $\S 174$ expenditures explicitly exclude costs incurred for the purpose of ascertaining the existence, location, extent, or quality of any mineral deposit, including oil and gas exploration.9

A key alignment between federal and Idaho law concerns geographical limitations: the federal $\S 174$ definition explicitly excludes research conducted outside of the United States.8 This provision naturally complements Idaho’s statute, which only allows a credit for qualified research expenses (QREs) that are specifically sourced for research conducted in Idaho.10 This reinforces the necessity for meticulous geographic allocation of all R&E labor and supply costs to satisfy both the federal gateway requirements and the Idaho state sourcing restrictions.

B. The Four-Part Test: Detailed Analysis of the Section 174 Test Components

To qualify for the Idaho R&D tax credit, the underlying activities must satisfy the federal four-part test for Qualified Research Activities (QRA).10 This test ensures that the activities are truly innovative and systematic.

1. Permitted Purpose Test (Business Component)

The fundamental requirement of the Permitted Purpose Test is that the R&D activity must be intended to develop or improve the functionality, performance, reliability, or quality of a new or existing business component.7 A business component is broadly defined as any product, process, computer software, technique, formula, or invention that is either held for sale, lease, license, or used in the taxpayer’s trade or business.1

This test serves to ensure the research is focused on commercial advancement or internal operational enhancement, providing a tangible benefit to the taxpayer’s business activities.13 Research that is purely theoretical or unrelated to a component of the taxpayer’s business will fail this test.

2. Technological in Nature Test

For an activity to qualify, the process of experimentation used to discover information must fundamentally rely on principles derived from the physical or biological sciences, engineering, or computer science.1 This is often summarized as the activity needing to be “brainy enough”.13

It is important to understand that the focus is on the process of discovery, not the novelty of the eventual outcome. The taxpayer may, in fact, employ existing technologies and rely on established scientific principles to satisfy this requirement.1 However, the research must be dedicated to resolving issues using these established scientific disciplines. Activities related to areas such as economics, business management, behavioral sciences, or the arts are explicitly excluded from the definition of qualified research.4

3. Elimination of Uncertainty Test

This test is arguably one of the most heavily scrutinized components by the ISTC, requiring that the R&D activities seek to discover information that would eliminate technical uncertainties regarding the appropriate design of the component, its capability, or the method of its development.2

The Idaho State Tax Commission (ISTC) guidance defines uncertainty as existing if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.2 To establish that expenditures are truly experimental, the taxpayer must demonstrate two critical points: (1) that they did not already possess the information necessary to address the capability, method, or design (i.e., uncertainty exists), and (2) that their activities were specifically undertaken to eliminate those documented uncertainties.2

A crucial point established in federal jurisprudence, and recognized by the ISTC, is that uncertainty may exist even if the taxpayer knows that it is technically possible to achieve a goal.1 The uncertainty hinges on the taxpayer being unsure of the specific method or appropriate design required to reach that goal.1 This specific technical requirement means that taxpayers must document why standard industry practices, existing internal knowledge, or commercially available solutions were insufficient to provide a clear pathway to the desired improvement. The failure to prove this initial uncertainty is a common administrative finding against taxpayers in Idaho.2

4. Process of Experimentation Test

The final critical component requires that substantially all (defined as 80% or more) of the research activities constitute elements of a systematic process of experimentation.4 This ensures that the R&D expenditure involves a systematic approach, often involving modeling, simulation, or a disciplined trial-and-error methodology, leading toward technical success or failure.13

This process must be more than routine testing or quality control; it must demonstrate a methodical plan for testing hypotheses, analyzing data, and retesting those hypotheses.2 This systematic requirement ensures that the research conducted is part of a process of experimentation in the scientific sense, rather than just standard design or fabrication work.2

III. The Idaho R&D Tax Credit: Statutory Framework and Calculation

The Idaho R&D Tax Credit, codified under Idaho Code $\S 63-3029G$, is designed to incentivize businesses to invest in qualified research activities specifically conducted within the state.10 While it aligns closely with the federal IRC $\S 41$ credit, it includes specific modifications and geographical restrictions.

A. Idaho Code § 63-3029G: State Adoption and Modification

Credit Type and Applicability: Idaho provides a nonrefundable credit against taxes imposed by Idaho Code $\S \S 63-3024, 63-3025$, and $63-3025A$ for increasing research activities in Idaho.3 This nonrefundable nature means the credit can only offset the taxpayer’s existing Idaho income tax liability.

Credit Calculation Rate: The state credit allowed is the sum of two components: 5% of the excess of qualified research expenses for research conducted in Idaho over the base amount, and 5% of basic research payments allowable under IRC $\S 41(\mathrm{e})$ for basic research conducted in Idaho.3 This structure mirrors the federal incremental credit calculation methodology.

Geographical Restriction: A mandatory restriction, critical for compliance, is that the credit applies only to QREs for research conducted in Idaho (Idaho-sourced QREs).10 This necessitates meticulous internal accounting to isolate R&D labor, supplies, and contract expenses incurred within the state’s borders.

B. Calculation of Idaho Qualified Research Expenses (QREs)

The specific definition of QREs for Idaho purposes aligns with the federal definitions under IRC $\S 41$ but must be geographically limited to Idaho.4 Taxpayers utilize Idaho Form 67 to calculate the credit.4

• Wages for Qualified Services: This includes wages for employees who were directly involved in the R&D activities, along with those individuals who directly supervised or directly supported that work, provided those services were performed in Idaho.4
• Cost of Supplies: This covers the costs of supplies and raw materials consumed or used up during the R&D process, provided they were used in Idaho and were not capitalized or depreciated.4
• Rental or Lease Costs of Computers: The credit includes costs incurred for the rental or lease of computers specifically used for qualified research activities within Idaho.4
• Contract Research Expenses: This includes the applicable percentage (typically 65%) of amounts paid for qualified research performed by a third party in Idaho, assuming the business claiming the credit bore the economic risk of the research, regardless of the outcome.4

C. Base Amount Determination and the Irrevocable Start-Up Election

The calculation of the base amount is essential as the Idaho credit is only provided for incremental QREs (QREs over the base amount).3 The base amount calculation typically involves historical QREs and Idaho Gross Receipts over a defined base period, where Idaho gross receipts are defined as only those attributable to sources within the state.3

The Irrevocable Start-Up Election: Idaho statute provides a significant decoupling point from federal rules regarding the base amount calculation. Specifically, Idaho Code $\S 63-3029G$ allows a taxpayer to elect to be treated as a start-up company for Idaho credit purposes, regardless of whether the taxpayer meets the strict federal requirements of IRC $\S 41(\mathrm{c})(3)(\mathrm{B})(\mathrm{i})(\mathrm{I})$ or (II).3

This decoupling allows many established companies or those that otherwise failed the federal start-up criteria to benefit from a lower, simpler base calculation. If this election is made, the taxpayer uses a simplified method based on a fixed-base percentage of 3% for the first five tax years after 1993 that the taxpayer had qualified research expenses for research conducted in Idaho.4

The strategic implication of this state provision is profound: a lower base amount generally translates to a higher immediate credit yield. However, the statute explicitly states that an election to be treated as a start-up company for Idaho tax credit purposes is irrevocable.3 Therefore, businesses must conduct thorough modeling to ensure the benefits derived from the lower initial fixed base outweigh the potential benefit of a potentially lower calculated base amount in future years based on standard historical QREs and gross receipts.

D. Credit Ordering, Limitation, and Unitary Group Sharing

Credit Limitation: The Idaho research credit is nonrefundable, meaning it is limited to the extent of the taxpayer’s Idaho income tax liability for the taxable year.4 The taxpayer must use the credit up to this allowable limitation before any carryovers or sharing can occur.4

Unitary Sharing: Idaho permits a corporation included as a member of a unitary group to share the Idaho research credit it earns but does not use with other members of the unitary group.14 This requires careful documentation. The corporation earning the credit must first claim the credit to the extent allowable against its own Idaho income tax. Only after satisfying its own limitation can the unused portion be shared, requiring a schedule that clearly identifies the shared credit and the computation of any resulting credit carryovers.4

IV. Idaho State Tax Commission (ISTC) Guidance on $\S 174$ Compliance and Audit Defense

The Idaho State Tax Commission’s (ISTC) enforcement and administrative decisions provide critical insight into the stringent documentation required to successfully claim the Idaho R&D credit. Administrative guidance, such as that found in protest dockets, indicates that the ISTC holds taxpayers to a high evidentiary standard, particularly concerning the Process of Experimentation and Elimination of Uncertainty tests.2

A. ISTC Administrative Focus Area 1: Proving “Elimination of Uncertainty”

The ISTC demands concrete evidence of technical uncertainty that existed prior to the research.2 The administrative ruling in one protest docket found that the petitioner failed to meet its burden of proof by not establishing the specific uncertainty that the research activity was intended to eliminate.2

High Evidentiary Standard: The taxpayer must demonstrate that the information available at the project’s inception did not establish the capability or method for the intended product improvement or design.2 The mere presence of a technical challenge or complexity is insufficient. The ISTC has observed that, in certain denied cases, the capability or method appeared to be within the information already available to the petitioner and technically feasible without the need for specific experimental research.2

To mitigate this administrative risk, taxpayers must ensure their initial project documentation—such as project plans, internal memos, or preliminary design reviews—explicitly define the technical roadblocks, confirming that the path forward was unknown, thereby proving that the activities undertaken were indeed meant to eliminate those technical unknowns.2 This establishes a clear cause-and-effect relationship between the documented uncertainty and the subsequent QREs.

B. ISTC Administrative Focus Area 2: Documenting the “Process of Experimentation”

The Process of Experimentation Test requires that substantially all activities constitute elements of a process of experimentation for a qualified purpose.2 The ISTC rigorously examines documentation to ensure this is a systematic, scientific endeavor, not merely standard product development.

Mandate for Scientific Method: The ISTC mandates that taxpayers show, through contemporaneous records, a methodical plan setting forth a series of trials to test a hypothesis, analyze the resulting data, and then retest the hypothesis.2 This requirement emphasizes the need for a structure resembling a scientific research journal or laboratory notebook.

Documentation Deficiencies: The Tax Commission has repeatedly denied the credit when taxpayers fail to provide evidence establishing how they formulated or tested hypotheses, engaged in systematic trial and error, or evaluated alternatives during the tax years in question.2 It is not enough to show that a product was eventually built; the records must prove that the research was a structured inquiry into the unknown. Furthermore, the ISTC notes that even if uncertainty existed, it must be eliminated via a process of experimentation, distinguishing this from uncertainty that might be resolved by simpler means, such as an engineering calculation or literature review.2

C. Specific Exclusions and Risks Cited by the ISTC

Beyond the four-part test, the ISTC enforces specific exclusions under IRC $\S 41$.

Adaptation Exclusion: The ISTC confirms that research is excluded from “qualified research” if it is merely an adaptation of an existing business component to a particular customer’s need.2 This is critical for businesses that customize proprietary solutions for clients; they must clearly delineate the generalizable, technological improvements from the client-specific adjustments.

Knowledge Requirement: The knowledge gained from the research activities must exceed that which was known in the relevant field.2 Taxpayers must ensure that their project summaries articulate the new technical information discovered, demonstrating that the research activities contributed unique knowledge that was not readily available or known within the industry.

V. Federal-State Decoupling: The IRC $\S 174$ Amortization Complication

The Tax Cuts and Jobs Act (TCJA) significantly altered the cost recovery treatment of $\S 174$ expenditures, forcing a complex accounting reconciliation between federal and state tax returns in Idaho.

A. The Federal Mandatory Amortization Rule

Prior to the TCJA, taxpayers generally had the option to immediately expense R&D costs. However, for tax years beginning on and after January 1, 2022, the TCJA mandated that domestic $\S 174$ R&D expenditures (R&E) must be capitalized and amortized over a five-year period.1 This shift eliminated the immediate deduction benefit for federal purposes, leading to a deferral of cost recovery and a corresponding increase in near-term taxable income for many businesses.

B. Idaho’s Conformity Status and Corporate Tax Base Impact

Idaho’s tax system relies on conformity to the federal Internal Revenue Code (IRC) as of a specific date, which is typically updated annually (e.g., as of January 1, 2024, for 2024 tax filings).6 If the current conformity date incorporates the post-TCJA changes to $\S 174$, then Idaho technically adopts the amortization rule as a starting point for calculating state taxable income.1

However, the policy implications of this conformity are widely debated at the state level. Analysis by organizations focusing on fiscal policy has strongly recommended that Idaho legislators decouple from the federal R&E cost recovery amortization requirement.5 This recommendation stems from the concern that conforming to the federal rule would result in significant state revenue loss (estimated at $96 million in one analysis) by allowing corporations to spread the deduction of investments made anywhere in the country over five years, rather than prioritizing Idaho businesses.5

This tension between technical conformity and legislative policy goals requires Idaho taxpayers to perform complex corporate income tax base adjustments. Since the calculation of Idaho corporate taxable income begins with Federal Taxable Income, which reflects the mandatory 5-year amortization 1, if Idaho chooses not to conform to the amortization rule, the taxpayer must execute specific state modifications. This would typically involve adding back the federally amortized portion already deducted and subtracting the full cost of the R&E expenditure (if Idaho law allows immediate expensing) to arrive at the correct Idaho taxable income.

It is critical to distinguish between the two separate tax implications: the activity meeting the $\S 174$ Test is the qualifier for the Idaho R&D credit (a benefit calculated on Form 67), but the mandatory federal capitalization rule dictates the timing of the R&E cost deduction (a separate calculation impacting the Idaho corporate income tax base).1 Both the credit and the deduction must be handled independently, with the amortization rule requiring careful monitoring of Idaho’s specific conformity legislation each year.

Table: Federal vs. Idaho Treatment of R&E Expenditures (Post-TCJA)

VI. Comprehensive Example: Applying the $\S 174$ Test to Idaho QREs

The following example illustrates how an Idaho company must apply the stringent $\S 174$ requirements and source expenses to claim the Idaho research credit.

A. Scenario Setup: Gem State Automation, Inc. (GSA)

Gem State Automation, Inc. (GSA) is an Idaho-based advanced manufacturing firm that develops high-precision industrial machinery. GSA undertakes a project to create proprietary, AI-driven calibration software for advanced Computer Numerical Control (CNC) milling machines. The goal is to drastically reduce material waste associated with thermal deformation when machining variable geometry components. GSA is an established company, not treated as a federal start-up.

Project Goal (Permitted Purpose): The intent is to improve the process reliability and quality of the CNC milling operation by developing a new, predictive, adaptive software algorithm capable of adjusting tool paths in real-time based on calculated thermal stress parameters.7 This clearly targets an improvement to a business process component.

Technical Uncertainty: Uncertainty exists because no commercial off-the-shelf software or existing internal engineering knowledge provides the complex mathematical modeling required to accurately predict material stress deformation under specific combinations of tool pressures and variable feed rates inherent to GSA’s specialized alloy.1 This ambiguity regarding the appropriate methodology for real-time predictive control establishes the technical uncertainty.

B. Step-by-Step Compliance and Documentation

1. Technological in Nature: The research relies on computer science (developing the AI neural network architecture) and principles of engineering and physical sciences (stress analysis and thermodynamics modeling).1 The initial project charter confirmed that the activity fundamentally relied on these scientific principles, explicitly excluding elements related to business management or marketing.
2. Elimination of Uncertainty: GSA’s contemporaneous project documentation defined the uncertainty by citing the failure of three existing linear modeling techniques to achieve the required 98% accuracy threshold necessary for high-value component milling. This documentation established that the specific method to achieve the desired predictive control was unknown at the outset, thus fulfilling the requirement that the activity was intended to discover information to eliminate that uncertainty.2
3. Process of Experimentation (Crucial Step): To eliminate the uncertainty, GSA implemented a systematic process of experimentation. This involved testing three distinct AI neural network architectures (Hypotheses A, B, and C) through defined phases:

• Phase I (Modeling): Engineers ran 100 simulations for each architecture, systematically varying input parameters. Logs confirmed that Hypothesis A and Hypothesis B failed to converge on an acceptable solution within tolerance limits.
• Phase II (Physical Trial and Error): The refined Architectures B and C were subjected to physical testing on prototype CNC machines located in GSA’s Boise facility. Daily testing logs documented 20 trials per day over four weeks, detailing the systematic adjustment of control algorithms (trial and error) and the quantitative analysis of material waste reduction versus computational load.
• Required ISTC Documentation: To satisfy the ISTC’s rigorous standard, GSA maintained detailed time sheets tracking the labor of the Idaho-based software engineers and technicians.4 Testing logs captured raw data outputs, and analysis reports confirmed the failure of initial hypotheses and the selection of the most effective architecture (Hypothesis C), demonstrating the methodical and systematic nature of the experimentation process.2

C. Calculating Idaho Qualified Research Expenses (QREs) and Credit (2024 Tax Year)

GSA incurred the following expenses, all for research performed exclusively in Idaho:

Table: Idaho Qualified Research Expenses (QREs)

Incremental Credit Calculation: GSA must now determine its base amount using its historical Idaho gross receipts and the fixed-base percentage.

Table: Idaho R&D Incremental Credit Calculation

GSA earns a nonrefundable credit of $3,900, which can be used to offset GSA’s Idaho income tax liability, subject to credit ordering and limitation rules.4

VII. Conclusion and Strategic Compliance Recommendations

The Idaho R&D Tax Credit offers a valuable incentive for innovation within the state, but successful claims hinge entirely on a deep understanding and rigorous application of the federal IRC $\S 174$ Test as interpreted by the Idaho State Tax Commission. The complexity of the claim lies less in the calculation mechanics and more in the evidentiary burden required to prove that the activities satisfy the technological prerequisites.

A. Strategic Importance of Contemporaneous Documentation

The primary operational challenge for taxpayers claiming the Idaho R&D credit is meeting the ISTC’s high standard for documentation, particularly regarding the scientific nature of the research.2 The $\S 174$ Test requires not just an expense, but a corresponding activity rooted in the scientific method. Failure to document the systematic process of experimentation—specifically, the formulation of hypotheses, the analysis of data, and the evaluation of alternatives—is the most common deficiency observed in administrative protests, directly undermining compliance with the $\S 174$ requirements.2

B. Checklist for Maximizing the Idaho R&D Credit

1. Define and Document Uncertainty: Implement a process to create formal, dated project documentation (e.g., project charters, feasibility studies) that explicitly defines the technical uncertainties regarding capability, method, or design before the research commences. This is the crucial evidence required to demonstrate that existing knowledge was insufficient.2
2. Maintain Scientific Logs: Adopt strict internal policies to ensure that research activities generate records reflecting a systematic process of experimentation. This includes detailed testing logs, quantitative data analysis showing failures and refinements, and documentation of all evaluated alternatives to satisfy the ISTC’s mandate for a methodical plan.2
3. Optimize the Base Calculation: For taxpayers newly qualifying or undergoing expansion, a thorough analysis of the irrevocable Start-Up Election provided under Idaho Code $\S 63-3029G$ is essential. Modeling the long-term impact of locking into the 3% fixed-base percentage can maximize the incremental credit during the initial five years.3
4. Reconcile Cost Recovery: Due to the federal mandatory $\S 174$ amortization rule post-2021, corporate taxpayers must collaborate with tax professionals to accurately calculate and apply the necessary state income tax modifications. This is required to reconcile the federal amortization deduction with Idaho’s specific IRC conformity position, ensuring that R&E expenditures are treated optimally for both credit calculation and deduction purposes on the Idaho income tax return.1
5. Source QREs Geographically: Establish rigorous time-tracking, payroll, and expense allocation methodologies to precisely segregate Idaho-sourced QREs from R&E activity conducted outside the state. This strict segregation ensures compliance with the geographical requirement of the state credit and prevents common sourcing audit adjustments.10

R&D Tax Credit Preparation Services

Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states.

If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725.
Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.

R&D Tax Credit Audit Advisory Services

creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.

Our Fees

Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/about-us/research-tax-credit-consulting/our-fees/