The Substantially All Mandate: Navigating the Process of Experimentation for the Idaho R&D Tax Credit

The Substantially All (SA) rule is a quantitative and qualitative threshold requiring that 80% or more of a taxpayer’s research activities for a specific business component must involve elements of a rigorous process of experimentation. For Idaho taxpayers claiming the state’s Research and Development (R&D) tax credit, compliance with this 80% rule is the definitive gateway to qualified research expenditure eligibility.

This mandate, derived from Internal Revenue Code (IRC) Section 41 and enforced rigorously by the Idaho State Tax Commission (ISTC), demands meticulous documentation proving adherence to the scientific method, rejecting generalized activity descriptions or arbitrary cost estimates that fail to substantiate the high percentage of qualifying experimental work.1 Understanding the dual application of the 80% rule—at the project level and the employee wage level—is critical for maximizing the credit while minimizing audit risk in Idaho.

2.0 Legal Framework: Idaho’s Adoption of Federal R&D Standards

The foundation for the Idaho R&D tax credit rests on a direct adoption of federal definitions, creating a mandatory link between state compliance and IRC standards.

2.1 Idaho Code § 63-3029G: Linking State and Federal Requirements

Idaho Code section 63-3029G allows for a nonrefundable credit designed to incentivize increased research activities conducted physically within the state.1 For the purpose of the Idaho research credit, the definition of “qualified research expenses” (QREs) is precisely the same as that defined in Internal Revenue Code (IRC) section 41, with the critical caveat that the research activities must be performed in Idaho.1

The state credit is calculated as 5% of a company’s qualified research expenditures that exceed a predetermined base amount, which is determined by multiplying the fixed base percentage by the average annual gross receipts from the preceding four years.2 While this offers a valuable incentive, the state’s administrative guidance demonstrates that eligibility hinges entirely on satisfying the rigorous federal qualitative requirements as interpreted locally by the ISTC.

2.2 The Four-Part Test: Prerequisite for Qualified Research Expenses (QREs)

To ensure that research activities conducted in Idaho qualify under IRC Section 41, taxpayers must satisfy the stringent four-part test. Failure to meet any one of these criteria will disqualify the activity. The “Substantially All” rule is intrinsically tied to the fourth test, the Process of Experimentation.3

1. Permitted Purpose: The research must be undertaken to create or improve the functionality, performance, reliability, or quality of a product, process, software, or technique intended for sale, lease, license, or use in the taxpayer’s trade or business (the “business component”).3
2. Elimination of Uncertainty: The activity must be intended to discover information that resolves or eliminates technical uncertainty regarding the appropriate design, capability, or methodology of developing or improving the business component.3
3. Technological in Nature: The research activities must fundamentally rely on the principles of the physical sciences, such as engineering, chemistry, biology, physics, or computer science.3
4. Process of Experimentation (POE): The research must involve a systematic process of experimenting with alternatives to resolve the identified technological uncertainties.3 This is the test to which the Substantially All mandate applies.

3.0 Defining “Substantially All”: The Quantitative 80% Threshold

The concept of “substantially all” is explicitly quantified in federal regulations, establishing the 80% minimum standard. This standard applies to two separate areas of R&D credit calculation: the qualification of the research project itself (the business component activities) and the qualification of employee wages.

3.1 Statutory Basis: Treasury Regulation § 1.41-4(a)(6)

The core definition of the Substantially All rule is found in Treasury Regulation § 1.41-4(a)(6). This regulation specifies that the requirement is met only if 80 percent or more of the taxpayer’s research activities dedicated to the development or improvement of a business component constitute elements of a process of experimentation.5 This measurement of 80% or more must be calculated “on a cost or other consistently applied reasonable basis”.5

3.2 Application 1: Business Component Activities (The Gateway Test)

The most critical application of the 80% rule occurs at the project level, concerning the activities performed on the business component. This is often referred to as the gateway test.

For a project to qualify, at least 80% of the total time or cost incurred during the research phase must be directly attributable to activities that meet the standards of a Process of Experimentation (POE).3 If the project activities meet this 80% threshold, then 100% of the research expenses associated with that business component are eligible as QREs, assuming the expenses meet the other IRC § 41 requirements (e.g., they are wages, supplies, or computer rentals).3

However, if fewer than 80% of the component activities qualify as POE, the entire component could be disqualified.3 This necessitates a complex decision regarding the application of the Shrink-Back Rule, which allows the taxpayer to redefine the business component down to a smaller, qualifying subset of improvements.

3.3 Application 2: Qualified Employee Wages (The Administrative Simplification)

The 80% rule also provides an administrative simplification for calculating qualified wages. If an employee spends 80% or more of their working hours performing qualified R&D services (i.e., activities meeting the four-part test), then 100% of that employee’s associated wages may be treated as qualified research expenses (QREs).3

For employees who spend less than 80% of their time on qualified R&D, only the specific portion of wages corresponding to the documented qualified hours may be claimed. For instance, if 65% of the employee’s time is qualified, only 65% of their wages may be claimed.3 Accurate time tracking, using payroll records and timesheets, is thus essential for leveraging this rule.3

It is vital to recognize the hierarchy between these two applications. The Business Component Activity test functions as the absolute gateway to eligibility. An organization might successfully document that an engineer spent 85% of their time on a project, qualifying 100% of their wages under the wage rule.3 However, if an audit later determines that the project itself only involved 75% POE and 25% routine development, the project fails the component-level Substantially All test, and the engineer’s wages related to that component would be disallowed entirely, unless a successful shrink-back defense is mounted.8 This demonstrates that passing the project-level test is paramount, as it validates the eligibility of the QRE pool derived from qualifying employee wages.

Table 1 summarizes the dual application of the Substantially All requirement.

Table 1: Dual Application of the Substantially All (80%) Rule

4.0 The Qualitative Mandate: Process of Experimentation (POE)

Idaho’s enforcement strategy focuses heavily on the qualitative nature of the activities to ensure the 80% threshold is met by genuine experimentation, not routine engineering or production.

4.1 POE and the Scientific Method Requirement

The Idaho State Tax Commission has adopted a strict stance, explicitly mandating that a “true process of experimentation” must adhere to the scientific method.10 Merely conducting trials or producing prototypes is insufficient.

Based on case law cited in ISTC dockets, specifically Union Carbide Corp. & Subs. v. Commissioner, the research project must involve a methodical, systematic plan.10 This methodology requires four critical elements: (1) formulating and testing a hypothesis, (2) collecting and analyzing the resulting data, (3) refining or adjusting the initial hypothesis based on the analysis, and (4) retesting the refined hypothesis.10 This structured, cyclical approach must be clearly documented to satisfy the ISTC’s requirements.

4.2 Investigative Nature vs. Routine Tasks

A recurring issue in Idaho audits is the failure to distinguish between activities that are “investigative in nature” and those that represent the application of known solutions or standard manufacturing procedures.10

Activities must be investigative, meaning the taxpayer must “closely examine the uncertainty at issue and systematically inquire about potential solutions to resolve it”.10 The ISTC often finds that processes such as “fitment and testing,” or the use of pilot models and real-world feedback (such as from a patient or surgeon), often represent standard production or diagnostic procedures rather than true scientific inquiry.11 Similarly, applying “common solutions to common problems that all manufacturers would encounter in a production process to meet a particular customer’s requirements and needs” fails the POE test because the uncertainty is not technological but operational or commercial.10

4.3 Strategic Compliance: Utilizing the Shrink-Back Rule

When the entire business component fails the 80% Substantially All test, the taxpayer may look to the “shrink-back rule” to save the claim.9 This rule allows the taxpayer to narrow the scope of the claim to the smallest, most significant subset of the product or process that does satisfy the four-part test.9

However, the ISTC has demonstrated a significant barrier to entry for utilizing the shrink-back rule: inadequate documentation of cost allocation and activity segregation. If the taxpayer cannot provide sufficient details demonstrating how the costs were allocated to specific experimental items, or if they claim the entire manufacturing process as R&D, they fail the burden of proof.10 When this happens, the ISTC will conclude that the necessary isolation of unique, experimental elements (the subset) from routine activities (the whole) was not performed, leading to the disallowance of the entire claim.10 This administrative hurdle emphasizes that the ability to shrink back is wholly reliant on proactive, granular documentation.

5.0 Idaho State Tax Commission (ISTC) Guidance: Audit Focus and Case Law

The ISTC’s administrative dockets provide tangible evidence of their scrutiny, emphasizing that inadequate documentation and failure to prove scientific rigor are the most common points of failure for Idaho taxpayers.

5.1 Documentation Failure as the Primary Disqualifier

Idaho’s tax authorities have made it explicitly clear that meeting the R&D credit requirement necessitates more than just assertion; it requires proof that substantially all activities were research that constituted elements of a process of experimentation.1

The ISTC has issued definitive warnings that “Generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time performing experimentation are not enough”.1 Taxpayers must be able to prove, through documentation, that the research was performed in strict accordance with the requirements of IRC Section 41(d).1 If a business fails to provide the details required to show how costs were systematically allocated to each unique project or to verify the time spent specifically on the experimental elements, the ISTC will conclude the taxpayer has failed to meet their burden of proof.10

5.2 Case Study 1: Modular Building Manufacturer (ISTC Docket No. 1-854-194-688)

In one ISTC docket involving a modular building manufacturer, the petitioner claimed R&D credits by asserting that each module produced was a “prototype/first article”.10

The ISTC rigorously analyzed the claimed activities and determined that the work did not constitute a “true process of experimentation”.10 The commission found that the activities were focused on applying standard industry solutions to common production problems encountered in meeting specific customer requirements, rather than seeking to eliminate technological uncertainty through systematic inquiry. These activities were therefore deemed not to be investigative in nature.10

Crucially, the Bureau determined that the taxpayer claimed the entire process of making a modular building as R&D, rather than isolating the unique experimental elements. Because the taxpayer lacked documented details on how costs or time were allocated to specific, unique experimental items within the construction process, they failed the burden of proof. This lack of segregation prevented the consideration of the shrink-back rule, resulting in the disallowance of the entire claim.10 This outcome suggests that the ISTC operates under the presumption that activities within a taxpayer’s established business history are “normal functions” unless the experimental nature is rigorously proven and segregated from routine procedures.10

5.3 Case Study 2: Fixed Prosthetic Production (ISTC Docket No. 1-401-911-296)

A separate ISTC docket involved a petitioner claiming credits for improvements to Fixed Prosthetic Production Procedures (FPPPI).11 The petitioner argued that they used prototypes and relied on real-world feedback from patients and dentists to diagnose and refine their products.11

The ISTC concluded that the documentation did not demonstrate that the activities met the “substantially all” requirement because they lacked the elements of a process of experimentation in the scientific sense.11 The general process—receiving an order, creating a mockup, and providing it for feedback—was viewed as standard operational procedure, not a methodical plan involving hypothesis formation, data analysis, and iterative refinement.11

The analysis showed that relying on patient feedback alone, without systematic testing against alternatives to resolve a predefined technological uncertainty, did not qualify the activities as “investigative in nature”.11 By referencing specific federal case law, the ISTC is actively harmonizing its state audit standard with the stringent requirements seen in federal Tax Court challenges. This elevates the standard of proof for Idaho taxpayers, requiring them to benchmark their documentation against a high-scrutiny federal environment.

Table 2 provides a summary of the ISTC’s primary points of failure regarding the Process of Experimentation.

Table 2: Idaho State Tax Commission Interpretations of POE Failure

6.0 Documentation and Substantiation for the 80% Test

Achieving compliance with the Substantially All test requires the implementation of structured record-keeping designed to satisfy both the quantitative 80% measure and the qualitative proof of the Process of Experimentation (POE).

6.1 Best Practices for Time Tracking and Cost Allocation

To substantiate the 80% measurement, costs must be tracked accurately and consistently.

For Employee Wages, records such as payroll registers, timesheets, and detailed daily activity logs are essential to verify the specific hours spent performing qualified services within Idaho.3 These records are necessary to claim the 100% wage inclusion under the 80% rule.9

For Business Component Activities, taxpayers must ensure that all expenditures—including wages, supplies, and computer rental costs—are directly allocable to the specific research project.12 This detailed allocation provides the “consistently applied reasonable basis” required by regulations to measure whether 80% or more of the total activity cost was dedicated to POE.5 The segregation of costs must proactively differentiate experimental labor from routine administrative, production, or testing labor, thereby demonstrating the focus on investigative work.

6.2 Substantiating Process of Experimentation (POE)

Because the ISTC uses a stringent standard based on the scientific method, the documentation must provide chronological and technical evidence of the process of inquiry.

Documentation should include project narratives that go beyond mere descriptions of the final product, focusing instead on the methodical plan undertaken. This involves maintaining:

• Uncertainty and Hypothesis Logs: Formal documents or records identifying the specific technological uncertainty being addressed (e.g., capability, design, or methodology) and the testable hypothesis formulated to resolve that uncertainty.4
• Trial and Data Logs: Detailed records of the experimental trials performed, including the specific design alternatives evaluated, the data collected from each trial, and the performance metrics used.9
• Refinement Documentation: Evidence, such as engineering change orders, design review meeting minutes, or internal memos, that explicitly detail how the analysis of the trial data led to a refinement of the initial hypothesis or the development path.11

6.3 Compliance Strategy: Preparing for Shrink-Back

Given the ISTC’s strict interpretation of routine activities, it is strategically advisable for taxpayers to preemptively define and track costs for potential sub-business components that might qualify if the overall project fails the 80% test.

If a project’s overall costs include too many routine, non-experimental activities (falling below 80% POE), a well-documented claim should already be capable of identifying a smaller, qualifying element (e.g., a specific material formulation improvement or a unique control system developed within a larger machine assembly).9 This proactive segregation of costs and activities ensures that if the primary component fails the SA test, the taxpayer possesses the necessary records to immediately apply the shrink-back rule, preventing total disallowance.10

7.0 Practical Application Example: Applying Substantially All to a Business Component

This example illustrates how an Idaho company must track and classify activities to meet the 80% Substantially All threshold at the business component level, which is the most common point of audit failure.

7.1 Scenario Setup: Improved Manufacturing Process

Gem State Fabrication LLC, an Idaho-based manufacturing company, undertakes a project to develop a novel, automated welding technique for large structural joints used in specialty piping (the Business Component). The research aims to resolve uncertainty regarding material stress tolerance and improve structural reliability (Permitted Purpose and Elimination of Uncertainty).

The company tracks all expenses related to the development activities of this new technique. The total documented research activity cost (including qualified wages, supplies, and computer rental costs) for the development phase of the new technique is $100,000.

7.2 Activity Breakdown and Qualification Assessment

Gem State Fabrication uses a time-tracking system to classify all hours spent by engineers and technicians involved in the project, ensuring segregation between investigative and routine work.

7.3 Calculation Methodology and Substantially All Decision

1. Identify POE Activities: The qualified experimental activities are Phase B (Initial Trials) and Phase D (Refinement Trials).
   
   $$\text{POE Costs} = \$35,000 + \$45,000 = \$80,000$$
2. Calculate POE Percentage: The percentage of research activity constituting the process of experimentation is determined by dividing the POE Costs by the Total Project Cost.
   
   $$\text{POE Percentage} = \frac{\$80,000}{\$100,000} \times 100\% = 80\%$$
3. Apply Substantially All Test: The requirement under Treas. Reg. § 1.41-4(a)(6) is met only if the percentage is 80% or greater.5 Since the calculated percentage is exactly 80%, the requirement is Met.
4. Result: Since the business component passed the Substantially All test, 100% of the $100,000 in costs related to this business component—provided they are otherwise qualified expenses (wages, supplies, etc.)—are eligible as Qualified Research Expenses (QREs) for the Idaho R&D credit.

7.4 The Impact of Documentation Failure

Had Gem State Fabrication failed to meticulously track and segregate the costs related to routine activities (Phases A, C, and E), those costs may have been inadvertently lumped into the experimental phases.

For example, if the research project had only $65,000 dedicated to pure experimentation (65% POE), and the remaining $35,000 (35%) was assumed to be routine non-experimental activity, the project would fail the 80% SA threshold. In this scenario, the entire $100,000 business component cost would be subject to disallowance.8 The only remaining defense would be to attempt the shrink-back rule, which would necessitate retrospective documentation proving that a subset of activities that totaled $52,000 (80% of $65,000) was performed with sufficient scientific rigor, a defense that the ISTC views skeptically without upfront segregation.10

8.0 Conclusion and Key Recommendations for Idaho Taxpayers

The Idaho R&D tax credit, administered under Idaho Code § 63-3029G, relies entirely on the federal definition of qualified research found in IRC Section 41. However, enforcement by the Idaho State Tax Commission places a uniquely high emphasis on the documentation surrounding the “Substantially All” (80%) requirement for the Process of Experimentation (POE). The analysis of ISTC dockets shows a pattern of disallowance rooted in inadequate proof of adherence to the scientific method and failure to segregate experimental costs from routine business activities.

8.1 Critical Takeaways for Idaho Compliance

1. The POE is the Critical Test: The 80% rule functions primarily as a qualitative test, ensuring that R&D projects are fundamentally investigative and experimental, not dominated by routine development or standard manufacturing procedures. Passing the employee wage threshold does not compensate for a project’s failure to meet the 80% activity standard.
2. Scientific Rigor Must Be Evident: The ISTC’s requirement for activities to be “investigative in nature” and to adhere to the scientific method (hypothesis, test, analyze, refine, retest) is strictly enforced. Generalized descriptions of uncertainty, novelty, or standard fitment testing are insufficient and have been successfully challenged by the state.10
3. Proactive Cost Segregation is Essential: The primary mechanism used by the ISTC to deny claims is the failure to meet the burden of proof, specifically concerning the allocation of costs and time to unique experimental activities.1 This failure prevents the taxpayer from demonstrating the 80% threshold and precludes the use of the shrink-back rule to salvage the claim.

8.2 Strategic Recommendations for Risk Mitigation

To successfully substantiate R&D credit claims in Idaho, businesses must implement compliance protocols that address the specific scrutiny points raised in ISTC administrative guidance:

• Implement Formal POE Documentation: Adopt a formal R&D protocol that mandates documentation of the technical uncertainty, the specific hypothesis being tested, and the systematic analysis and retesting steps for every project. This documentation should be prepared by the technical staff concurrent with the research activities to demonstrate the scientific chronology.4
• Segregate Experimental Activities and Costs: Define the Business Component narrowly, focusing only on the experimental elements (e.g., the specific material improvement or algorithm development). Employ rigorous, time-sheet-based tracking systems to allocate employee hours and supply costs directly to these discrete experimental activities, ensuring clear separation from routine production steps, general project management, and final documentation.12
• Establish a Shrink-Back Defense Strategy: Before filing, taxpayers should conduct a self-assessment of the 80% SA test for the entire business component. If the threshold is not met, the underlying documentation must already exist to define a viable sub-component and isolate the QREs associated with that smaller, qualifying element, thereby proactively preparing a defense against inevitable audit scrutiny.9

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