The Definition and Application of Qualified Services in the Idaho R&D Tax Credit

1. Executive Summary: The Core Definition of Idaho Qualified Services

1.1. Simple Meaning and Statutory Context

Qualified Services (QS) refers to the wages paid to employees who perform, supervise, or directly support qualified research activities as defined by Internal Revenue Code (IRC) Section 41. For the Idaho R&D Tax Credit, these services must be strictly performed within the State of Idaho, forming the “Wages for qualified services performed in Idaho” component of Qualified Research Expenses (QREs).1

Idaho Code section 63-3029B defines QS in conjunction with the state’s credit for increasing research activities (the Idaho research credit). Wages for qualified services constitute one of the four principal categories of QREs that can be utilized when calculating the state tax benefit.3 The calculation is carried out using Form 67.2 The legal structure mandates that for a wage expenditure to be recognized, it must satisfy two distinct compliance requirements simultaneously: first, the activity must meet the definitional standards of qualified services found in the federal IRC Section 41, and second, the physical performance of those services must be geographically sourced to Idaho.2 This dual compliance obligation creates a high threshold for inclusion, particularly for multi-state or remote-work employers.

1.2. The Nuance of Personnel Costs and Federal Alignment

Wages for qualified services typically represent the single largest component of a taxpayer’s total QREs. Idaho’s adherence to the federal framework simplifies the definitional complexity of what research activities qualify, while establishing a unique and strict geographical constraint on where those activities must occur. The Idaho research credit, authorized under Idaho Code section 63-3029G, uses “qualified research expenses” as defined in IRC section 41.4 Consequently, the definitions of basic research payments, qualified research expenses, and qualified research are the same as those used for the federal credit, with the critical exception that only amounts related to research conducted in Idaho qualify for the state credit.2

This federal alignment necessitates a complete understanding of the IRC framework, including the rigorous four-part test for qualified research and the specific tiers of service that qualify employee wages. The Idaho State Tax Commission (STC) emphasizes that research must be conducted in Idaho.2 Therefore, companies must manage a dual compliance burden: ensuring the research activity is technologically sound and experimental (federal standard), while meticulously proving the associated wages were incurred for work physically executed within state lines (Idaho standard).3 A failure in proving either the definitional standard or the state sourcing mandate will result in the disallowance of the associated wage QREs.

2. The Idaho R&D Tax Credit Landscape and Federal Alignment

2.1. Legislative Foundation and Credit Calculation Overview

The Idaho R&D tax credit is a significant financial incentive designed to stimulate technological advancement and encourage investment in research and development within the state.6 Enacted under Idaho Code §63-3029G, the credit is nonrefundable and can be carried forward for up to 14 tax years, providing a long-term benefit for businesses engaged in innovative activities.5

The core credit calculation is standardized and involves the traditional base method, which is calculated as 5% of the excess of qualified research expenses (QREs) for research conducted in Idaho over a base amount.8 This base amount is determined by multiplying the taxpayer’s fixed-base percentage by the average annual gross receipts from the four preceding tax years.6 A specific feature of Idaho’s tax law is the explicit exclusion of the Alternative Simplified Credit (ASC) calculation method, which is available federally. Taxpayers must rely solely on the traditional method, which requires a highly detailed tracking of historical QREs and gross receipts, particularly those gross receipts attributable to Idaho using multistate corporation apportionment rules.2

2.2. The Foundational Requirement: The Four-Part Test

For any service to be classified as a Qualified Service, it must support activities that meet the criteria of “qualified research.” Idaho adopts the IRC Section 41 standard for this definition, requiring the research project or activity to satisfy four cumulative criteria 2:

1. The Section 174 Test (Permissibility): The research expenditure must be eligible to be treated as an expense under IRC Section 174.2
2. The Technological Information Test: The activities must be undertaken for the purpose of discovering information that is technological in nature.2
3. The Business Component Test: The application of the research must be useful in the development of a new or improved business component of the taxpayer—meaning a new or improved product, process, service, or software.6
4. The Process of Experimentation Test: Substantially all the activities must constitute elements of a process of experimentation designed to eliminate technical uncertainty.2

If the research activity fails any of these four tests, the related wages paid to employees who performed, supervised, or supported that activity cannot be considered Qualified Services, regardless of the employee’s role or time allocation. Furthermore, Idaho explicitly aligns with federal exclusions, stating that qualified research involves only technological activities and does not include research in economics, business management, behavioral sciences, arts, or humanities.2 It is critical for tax planning that the services claimed do not represent activities that would occur regardless of whether the taxpayer was engaged in qualified research, such as routine quality control or general production costs, as these costs are excluded from the definition of qualified services.10

3. Defining Qualified Services: The Three Tiers of Engagement (IRC §41/ID Conformity)

The statutory definition of “qualified services” established in IRC Section 41(b)(2)(B), to which Idaho conforms, categorizes eligible employee labor into three distinct tiers of engagement. These tiers dictate which employee tasks are creditable and which must be excluded.

3.1. Tier 1: Engaging in Qualified Research

The first tier encompasses employees directly engaging in the actual conduct of qualified research.11 These are the individuals who are hands-on in the experimentation process, applying scientific and engineering principles to resolve technical uncertainties. This includes the primary inventors, engineers, scientists, and software developers who are responsible for designing experiments, conducting trials, building prototypes, or executing code changes.12 For a health-tech company, this might involve engineers creating and refining algorithms for personalized medication management or enhancing the user interface of patient engagement platforms to improve usability.13 These wages are included as Qualified Services because they represent the direct creation of the new technical information required by the four-part test.

3.2. Tier 2: Direct Supervision of Qualified Research

The second tier includes services consisting of engaging in the direct supervision of research activities that constitute qualified research.11 This role typically covers immediate, first-line managers or supervisors who oversee the Tier 1 researchers. The crucial distinction is that the supervision must be “direct.” This generally means managers who are involved in the immediate technical oversight of the project, such as attending technical and design review meetings, brainstorming, and technical problem-solving sessions.15

Higher-level management, such as Vice Presidents or high-level Directors, are typically excluded unless they are directly involved in the technical details and immediate supervision of the actual research.14 Supervision related solely to administrative functions—such as budgeting, scheduling, or personnel management unrelated to technical execution—does not meet the standard of direct supervision required for wage inclusion.

3.3. Tier 3: Direct Support of Qualified Research

The final tier covers services that directly support the people engaging in the actual conduct of qualified research or the direct supervision of that conduct.11 These employees provide auxiliary, non-creative services essential for the research process to function. Examples of qualified direct support services include a machinist fabricating a part for an experimental prototype, an employee organizing test results derived from laboratory trials, or a specialized technician maintaining the complex equipment used exclusively for R&D.12

However, the distinction between direct support and general administrative functions is strictly enforced. Services that only indirectly benefit research activities are explicitly disallowed. For instance, the wages paid to an employee for general and administrative services, or fees paid to an outside accountant hired to keep general books and records pertaining to the research project, do not qualify as QS or Contract Research Expense (CRE), respectively.15 Even if general and administrative personnel are physically part of the research department, their wages for non-research activities remain excluded from QREs.

4. Quantification Mechanics: The Critical 80% Rule and Sourcing Constraints

4.1. The “Substantially All” (80%) Threshold

A major leverage point in maximizing the Qualified Services component relates to the “substantially all” rule, often referred to as the 80% rule, mandated by IRC Section 41(b)(2)(B).11 If an employee performs Qualified Services (meaning Tiers 1 or 2 activities) for 80% or more of their total service time for the taxpayer during the tax year, then 100% of that individual’s wages are treated as QREs.11

This rule is vital because it permits the inclusion of up to 20% of an R&D employee’s non-qualified time—such as incidental administrative tasks, general meetings, or low-level operational support—without requiring complex time allocation systems for that fraction of the work.

When calculating this percentage, the denominator is the employee’s “performance of services.” Non-service hours, such as vacation time, sick leave, and holiday pay, are excluded from the total service time.17 This exclusion has the effect of increasing the likelihood that the remaining service time meets or exceeds the 80% threshold. Taxpayers must closely monitor and document employee time allocation to manage the sharp “cliff effect” associated with this threshold: an employee logging 79% QS time only qualifies for 79% of their wages, while an employee logging 80% QS time qualifies for 100%. This small difference in time allocation results in a substantial boost in included QREs, reinforcing the need for precise and robust time tracking systems.

The application of the 80% rule, derived from federal law, is synthesized below:

Table Title: Application of the Idaho 80% Threshold Rule (Federal Conformity)

4.2. The Idaho Sourcing Imperative: “Performed in Idaho”

The most significant state-level constraint imposed by the Idaho State Tax Commission (STC) is the requirement that the qualified services must be physically “performed in Idaho”.1 This geographical mandate is non-negotiable and differentiates the state credit calculation from the federal credit. The STC has issued audit decisions that emphasize this strict sourcing requirement. In one decision, the Tax Commission modified the claimed QREs by explicitly excluding wages paid to employees who resided in and worked from states other than Idaho, even though the employees were engaged in qualified research activities for the Idaho entity.3

The prevalence of remote and hybrid work models poses a considerable compliance challenge. If an Idaho-based company employs R&D personnel who work remotely full-time outside of Idaho, their wages—even if 100% qualified under the federal 80% rule—must be zeroed out for the state credit calculation. When R&D personnel divide their time between Idaho and other states, the wages must be carefully apportioned based on the percentage of time the services were physically rendered within Idaho. To successfully claim the credit, companies must therefore implement sophisticated payroll and time tracking mechanisms capable of recording and verifying the geographical allocation of work time for all R&D employees.

5. Idaho State Tax Commission Mandates: Audit Risk and Documentation

5.1. STC Audit Focus Areas

The Idaho State Tax Commission (STC) utilizes internal software to identify tax returns that may contain incorrect or unusual amounts, often leading to an audit.18 When reviewing claims for the Idaho research credit, the STC focuses intensely on two primary areas: validating that the underlying activities meet the four-part test, and verifying the accurate quantification and state sourcing of the QREs, particularly wages for Qualified Services.

STC audit precedent strongly demonstrates that the failure to provide adequate support results in disallowance. Decisions indicate that petitioners who failed to provide comprehensive documentation, such as “journal entries of the project numbers… to verify details of QREs recognized in Petitioner’s accounting system,” had their credit claims rejected.10 Furthermore, the STC has shown willingness to examine the base amount calculation, including adjustments to gross receipts and fixed-base percentages.3 Taxpayers should be aware that while the statute of limitations is generally three years, auditors may request a “statute waiver” to allow more time to complete a complex examination.18 Given that the credit has a 14-year carryforward period, all supporting documentation must be robustly maintained throughout that entire period.5

5.2. Essential Record-Keeping for Qualified Services

Successful defense of the Idaho R&D tax credit requires comprehensive and, ideally, contemporaneous documentation that addresses the specific requirements of the STC. The necessary records must establish three pillars of eligibility:

1. Technical Narrative and Substance: Documentation must clearly demonstrate how the project meets the four-part test, specifically addressing the technical uncertainty that was eliminated through the process of experimentation.6
2. Time Allocation and Quantification: Taxpayers must maintain detailed time logs or reliable allocation methodologies that link specific employee hours to qualified R&D activities (Tiers 1, 2, or 3) and differentiate them from non-qualified activities (G&A). These records are essential to justify the percentage inclusion, especially when utilizing the 80% threshold.17
3. Geographic Sourcing Evidence: Proof must be maintained showing that the services claimed were physically “performed in Idaho.” This may include VPN logs, facility access records, travel expense reports, and specific payroll allocation documentation.3

The STC’s focus on the integration of QREs into the accounting system means that reliance solely on retrospective, high-level narratives is insufficient. Best practice dictates that companies embed R&D tracking directly into their financial and payroll systems, utilizing cost centers or project codes that correlate directly with the three tiers of Qualified Services and respect the strict Idaho sourcing mandate.

6. Contract Research Services (Non-Employee QS)

6.1. CRE Definition and the 65% Rule

Qualified Research Expenses (QREs) include payments made to third parties who are not employees of the taxpayer for the performance of qualified research or qualified services. These expenditures are known as Contract Research Expenses (CREs). For both federal and Idaho credit calculations, only 65% of the amount paid or incurred for CRE is eligible for inclusion in QREs.8

The qualifying standard for CRE is parallel to that of employee wages. The outsourced services must satisfy the definition of Qualified Services. If the contractor performs services that would not qualify if performed by an employee—such as routine accounting, general legal services, or administrative functions—then no portion of the expense can be claimed as a CRE.16 The agreement under which the research is performed must be entered into prior to the research, provide that research be performed on behalf of the taxpayer, and require the taxpayer to bear the expense even if the research is unsuccessful.20

6.2. Sourcing of Contract Research

Idaho’s requirement that research must be “conducted in Idaho” applies broadly across all QRE categories, including CRE.2 While the 65% inclusion rate is straightforward, taxpayers must exercise caution regarding the location of the contracted activity. Unlike employee wages, where the individual’s physical location is the primary measure, the sourcing of CRE often relates to the location where the output of the research activity occurred or where the results were used.

If an Idaho company contracts with an out-of-state laboratory or vendor, the taxpayer must be able to demonstrate that the contracted work product directly contributed to a specific research project that was primarily located, managed, or conducted within Idaho, or that the contracted service itself was performed while the contractor was physically present in the state. If the research activity entirely occurs outside of Idaho’s jurisdiction, the expenditure, even at 65%, is not includible in the Idaho QRE base.

7. Practical Example: Apportioning Qualified Services Wages

To illustrate the complex compliance necessary for the Idaho R&D credit, the following scenario details how a company must integrate the federal 80% rule with Idaho’s geographic sourcing requirement to calculate includible wages.

7.1. Hypothetical Scenario Setup: Silicon Valley North Robotics (SVNR)

Silicon Valley North Robotics (SVNR) is an R&D intensive firm based in Meridian, Idaho, focused on developing an improved industrial automation process. This process reduces material waste in manufacturing, which constitutes a qualifying activity under the four-part test. The analysis below examines four high-value employees for the tax year to determine their Qualified Services wages for the Idaho credit.

7.2. Employee Roles and Apportionment Analysis

The following table demonstrates the precise mechanics of calculating Idaho Qualified Services Wages, showing that the 80% determination must first be made (IRC §41), followed by the application of the Idaho geographical sourcing percentage.

Table Title: Example: Calculation of Idaho Qualified Services Wages (SVNR)

Detailed Analysis of Results:

1. Employee A (Lead Research Scientist): This scientist’s time exceeds the 80% threshold (88%), triggering the federal “substantially all” rule, resulting in 100% of their wages being included for federal QREs. Since 100% of the services were physically performed in Idaho, the full annual wage of $150,000 is included in Idaho QREs.
2. Employee B (Data Analyst Technician): The technician performs qualified services (direct support, Tier 3) but falls short of the 80% threshold (75%). Therefore, only the actual time spent on QS qualifies for inclusion. Since the services were performed entirely in Idaho, the calculation is applied directly: $\$90,000 \times 75\% = \$67,500$.
3. Employee C (Remote Software Engineer): The engineer easily meets the federal 80% rule (92%), qualifying for 100% federal wage inclusion. However, because the individual performed all services remotely outside of Idaho (in Spokane, WA), Idaho’s strict sourcing mandate overrides the federal inclusion. $100\% \text{ qualified wages} \times 0\% \text{ Idaho source} = \$0$. This exemplifies the critical audit risk posed by remote work when claiming the Idaho R&D credit.3
4. Employee D (Hybrid Prototype Engineer): This engineer meets the 80% threshold (80%), resulting in 100% federal wage inclusion. Because the engineer splits work time between the Meridian office and a fabrication facility in Utah, the wages must be apportioned. The fully qualified wage amount is multiplied by the documented percentage of time spent performing services in Idaho: $\$110,000 \times 60\% = \$66,000$. This requires SVNR to have precise, contemporaneous logs verifying the engineer’s physical location for both R&D and non-R&D time.

8. Conclusion and Strategic Recommendations

8.1. The Synthesis of Federal Rigor and State Sourcing

The Idaho Research and Development tax credit, offering a valuable 5% credit on incremental QREs, is a significant tool for promoting innovation.7 However, leveraging this incentive effectively requires navigating a legal landscape that integrates the strict technical definitions of IRC Section 41 with the state’s uncompromising geographic sourcing rules. The calculation of Qualified Services is complex, demanding technical validation of the underlying research, detailed accounting of employee time allocation (including application of the 80% rule), and absolute verification that the services were physically performed within Idaho.2 The STC’s precedent demonstrates that auditors are equipped to challenge QREs based on insufficient project-level accounting documentation and non-Idaho work locations.3

8.2. Strategic Compliance Checklist for QREs and QS

To mitigate audit exposure and maximize the credit benefit, taxpayers claiming the Idaho R&D credit should implement the following strategic compliance measures focused on Qualified Services:

1. Geographic Vigilance and Sourcing Documentation: Establish robust internal controls and tracking systems to monitor the physical work location of all R&D personnel. Wages must be allocated precisely based on the documented time physically “performed in Idaho.” This proactive measure is essential for defending against challenges rooted in the strict STC precedent regarding out-of-state wages.3
2. Optimization of the 80% Threshold: Manage the time allocation for high-wage R&D employees strategically to ensure their percentage of time spent on Qualified Services (Tiers 1 and 2) meets or exceeds the 80% federal threshold. Achieving this minimum ensures 100% inclusion of that employee’s wages, substantially increasing the creditable QRE base.
3. Contemporaneous and Integrated Record-Keeping: Move beyond relying on retrospective studies. Implement systems that track time and payroll expenditures contemporaneously, linking these costs directly to specific, qualifying R&D cost centers and project numbers within the financial accounting system. This detailed, auditable trail, which includes journal entries and project descriptions, provides the necessary defense against STC inquiries.10
4. Accurate Form 67 Filing: Ensure that the final calculation reported on Idaho Form 67 reflects the precise Idaho-sourced QREs using the traditional base calculation method. Taxpayers must remember that Idaho specifically disallows the use of the federal Alternative Simplified Credit (ASC), necessitating careful adherence to the required base period calculation.2

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