Analysis of Average Qualifying Expenditures (AQE) in the Context of the Illinois Research and Development Tax Credit

I. Executive Summary: The Average Qualifying Expenditures (AQE) Rule

The Average Qualifying Expenditures (AQE) functions as the historical benchmark for calculating the Illinois Research and Development (R&D) Tax Credit under 35 ILCS 5/201(k). This base amount is derived by averaging the Illinois-sourced Qualified Research Expenditures (QREs) incurred during the three immediately preceding tax years.1

The Illinois R&D Tax Credit is fundamentally an incremental credit, awarded at a rate of 6.5% on current QREs only to the extent they surpass this calculated three-year AQE base.3

A more detailed analysis reveals that the AQE mechanism is designed to reward companies that consistently increase their investment in qualified research activities within Illinois. Specifically, the amount of qualifying expenditures eligible for the credit is calculated as the current year’s QREs minus the sum of the average expenses for the three taxable years immediately preceding the year for which the determination is being made.5 This structure ensures that taxpayers are incentivized to maintain or expand their research footprint in the state, rather than simply receiving a benefit for baseline operational costs.

II. Foundational Statutory and Regulatory Framework

The Illinois R&D tax credit framework is governed primarily by 35 ILCS 5/201(k) and implemented through administrative rules detailed in the Illinois Administrative Code, specifically 86 Ill. Admin. Code 100.2160. This regulatory structure defines the parameters of both eligible expenditures and the crucial base calculation.

2.1 Legislative Intent and the Incremental Design

The design of the Illinois R&D tax credit mirrors the incremental approach found in the Federal Alternative Simplified Method (ASM).2 The primary objective is to drive economic activity by rewarding new investment rather than sustaining existing research budgets.7 The credit rate is fixed at 6.5% of the excess QREs, establishing a clear incentive threshold.1

The choice of the three-year AQE average as the base amount, as opposed to complex alternatives like the Federal Fixed-Base Percentage (FBP), creates a system that is transparent and easier for taxpayers to administer.3 This streamlined calculation method allows businesses in Illinois, particularly small and mid-sized firms, to efficiently assess and utilize the R&D Tax Credit, reducing the complexity often associated with federal R&D tax provisions. The predictability provided by the fixed three-year lookback aids long-term strategic planning for businesses considering R&D investment locations.

2.2 Defining Qualified Research Expenditures (QREs) in Illinois

To be included in the AQE calculation for the base period, or in the current year’s eligible expenses, the expenditures must meet the definition of Qualified Research Expenditures (QREs). Illinois largely aligns with the federal definitions found in Internal Revenue Code (IRC) Section 41(d) and 41(e).4

Illinois QREs encompass 2:

1. Wages: Compensation disbursed to employees actively involved in conducting qualified research and development activities within the state.
2. Supplies: Costs of tangible property used or consumed in the research process.
3. Contract Research: Payments made to subcontractors who contribute to the execution of qualified activities (typically 65% of the contractual payment).

Crucially, these expenditures must be solely related to activities performed within Illinois. The precise tracking and documentation of these costs over the base period are essential for establishing a defensible AQE.

III. Dissection of the Base Period: Calculation Mechanics of AQE

The AQE serves as the mathematical baseline against which current efforts are measured. An accurate determination of the AQE is the single most important factor in calculating the final credit amount.

3.1 Sourcing Requirement: Illinois-Only QREs

The determination of QREs for the base period requires strict geographic sourcing. Only research expenses directly tied to activities physically performed in Illinois are includable in the base.3 For companies operating across multiple states, this necessitates allocating costs—particularly labor—based on the time and effort spent by researchers within Illinois borders during the prior three tax years.

This stringent Illinois-only requirement mandates that taxpayers maintain comprehensive historical records capable of supporting the physical location of research activity for each base year. Exclusion of non-Illinois expenses or receipts is fundamental to the computation.3 For unitary groups, QREs must be computed on a combined return basis, following the prescribed allocation rules outlined in the state’s combined reporting regulations and Schedule 1299 instructions.3

3.2 Calculation Mechanics of the Average

The AQE calculation is an arithmetic average of the QREs incurred during the base period. The base period consists of the three taxable years immediately preceding the year for which the credit is determined.3

The formula for calculating the AQE is:

$$\text{AQE} = \frac{\text{QRE}_{\text{P-3}} + \text{QRE}_{\text{P-2}} + \text{QRE}_{\text{P-1}}}{3}$$

Where $\text{P-1}$, $\text{P-2}$, and $\text{P-3}$ denote the first, second, and third preceding tax years, respectively.3 Historical QRE data should be derived from prior Illinois tax returns (e.g., Form IL-1120).3

IV. IDOR Administrative Guidance: Special Rules for AQE Determination

The Illinois Department of Revenue (IDOR) applies specific administrative rules, primarily articulated in the Illinois Administrative Code, Title 86, Section 100.2160, to ensure fair computation of the AQE, especially when dealing with partial operations or incomplete historical data.9

4.1 Special Rule 1: Partial Taxable Years and Annualization

A critical administrative requirement addresses taxpayers who were “doing business” in Illinois for only a fraction of a base period year. In such cases, the reported QREs for that partial year must be adjusted, or annualized, to accurately reflect a full year’s level of research activity.9

The administrative guidance specifies that the actual qualifying expenditures incurred during that partial year must be multiplied by 365 and then divided by the number of days the taxpayer was doing business in the state during that portion of the taxable year.9

The annualization formula is mandated as:

$$\text{Annualized QREs} = \text{Actual QREs} \times \frac{365}{\text{Number of days in the portion of the taxable year during which the taxpayer was doing business in this State}}$$

This annualization requirement prevents artificial inflation of the incremental credit amount. If a company rapidly scaled R&D activities late in a base period year, using only the actual, unannualized expenditures for a short period would significantly depress the AQE. By normalizing the expenditures to a full 365-day basis, the state ensures that the historical base level truly represents a comparable annual measure of R&D effort, validating that the current year’s credit reflects genuinely increased investment, not merely a statistical anomaly resulting from a short historical period.

4.2 Special Rule 2: Inclusion of Non-Credit Years

A frequent point of confusion is whether QREs from years in which the taxpayer did not claim the credit must be included in the AQE calculation. The administrative code explicitly clarifies this.9

Regardless of whether the taxpayer qualified for or claimed the credit in a base period year, those qualifying expenditures must still be determined and included in the AQE computation.9 This applies even if the credit was unavailable during certain historical periods. This mandate places a heavy burden on compliance and record-keeping, as it requires reconstructing Illinois-sourced QREs for historical periods where tax planning efforts may not have focused on documenting state R&D expenses. The absence of documentation may force taxpayers to either default to zero QREs (which benefits the taxpayer if the historical expenditures were high) or attempt estimation, both of which carry audit risk.

4.3 The New Business Rule

For taxpayers that have not been in existence, or have not incurred QREs in Illinois, for the full three-year base period, the approach is straightforward. The base period QREs for any year in which the taxpayer did not exist or incurred zero QREs are treated as zero.3

This treatment provides a substantial advantage to start-up companies. If a business is calculating the credit in its first tax year, the AQE base amount is effectively zero. This allows the company to claim the credit—6.5%—on all current-year QREs, maximizing the immediate financial incentive for establishing R&D operations in Illinois.3

V. IDOR Compliance and Reporting (Schedule 1299 Series)

The AQE calculation is fundamental to the required reporting forms used to claim the credit with the Illinois Department of Revenue (IDOR).

5.1 Required Filing Schedules

Taxpayers must report the credit on specific Illinois income tax schedules depending on their legal structure 10:

• C-Corporations and Fiduciaries utilize Schedule 1299-D, Income Tax Credits.
• Pass-Through Entities (Partnerships and S Corporations) use Schedule 1299-A, Tax Subtractions and Credits.

These schedules must be attached to the relevant Illinois tax return (e.g., Form IL-1120 for corporations).10

5.2 Integration with Schedule 1299-I (Worksheet)

The core mechanism for reporting the calculation is located on Schedule 1299-D, referencing the underlying calculations performed on Schedule 1299-I (Income Tax Credits Information and Worksheets).11

On the Research and Development Worksheet in Schedule 1299-I, the computed three-year Average Qualifying Expenditures (AQE) is entered on Line 1, Column A, labeled “Base period avg. expenses”.11 The current year’s QREs are entered on Line 1, Column B (“This year’s expenses”). The subtraction performed on Line 2 (Column B minus Column A) explicitly quantifies the incremental investment (Excess QREs).11 This structure confirms that the AQE is the legal threshold that must be surpassed to generate any tax credit.

5.3 Audit Preparedness and Record Retention

Due to the nature of the AQE, which relies entirely on historical data, rigorous record-keeping is non-negotiable for audit defense.10 The base calculation requires records for the three preceding tax years. Furthermore, Illinois allows unused credits to be carried forward for five tax years.2

This combination means that an audit of a current-year R&D credit claim or a carried-forward credit may require documentation dating back eight years or more. Taxpayers must be prepared to substantiate the Illinois sourcing of QREs for all base period years, validating the input figures used to determine the AQE, a requirement articulated in the IDOR audit guidance.14

VI. Practical Application: Detailed Numerical Example

This example demonstrates the calculation of the Average Qualifying Expenditures (AQE) and the final credit amount, incorporating the mandatory annualization rule for a partial tax year.

6.1 Scenario Setup

A taxpayer, Innovate Corp., is calculating its Illinois R&D tax credit for the Current Tax Year (CY) 2024.

6.2 Step-by-Step Calculation of the Adjusted Base Amount (AQE)

1. Adjust QREs for P-3 (2021) using Annualization: Since Innovate Corp. was only doing business in Illinois for 120 days in 2021, the QREs for that year must be annualized.9
   $$\text{Adjusted QRE}_{2021} = \$400,000 \times \frac{365}{120} \approx \$1,216,667$$
2. Sum the Adjusted Base Period QREs: The annualized P-3 QREs are combined with the full-year QREs of P-1 and P-2.
   
   $$\text{Total Base QREs} = QRE_{2023} + QRE_{2022} + QRE_{2021, \text{ Adjusted}}$$
   $$\text{Total Base QREs} = \$950,000 + \$750,000 + \$1,216,667 = \$2,916,667$$
3. Calculate the Average Qualifying Expenditures (AQE): The total is divided by three, representing the three years in the base period.
   
   $$\text{AQE} = \$2,916,667 / 3 \approx \$972,222$$

6.3 Final Credit Determination for CY 2024

1. Calculate Excess QREs: The AQE is subtracted from the current year’s QREs.
   
   $$\text{Excess QREs} = \text{Current QREs} – \text{AQE}$$
   $$\text{Excess QREs} = \$1,500,000 – \$972,222 = \$527,778$$
2. Calculate Illinois R&D Credit: The credit rate of 6.5% is applied to the excess amount.2
   $$\text{Credit} = \$527,778 \times 6.5\% = \$34,306$$

This example demonstrates how the administrative rule regarding partial years forces the base amount to reflect a normalized level of historical spending ($972,222), preventing the taxpayer from gaining an unwarranted benefit by using the lower actual P-3 QREs ($400,000) in the base average.

VII. Strategic Compliance and Conclusion

The operation of the Average Qualifying Expenditures (AQE) provision in Illinois demands strategic tax planning, as it links current credit realization directly to future credit availability.

7.1 Strategic Planning and the Rolling Base

The AQE operates as a rolling three-year average, a structural element that requires businesses to assess the long-term consequences of current R&D spending. Substantial increases in QREs in the current year, while yielding a high credit immediately, will inevitably raise the calculated AQE for the next three subsequent years. This results in a higher hurdle for generating “excess QREs” in the immediate future.

Taxpayers with highly fluctuating R&D budgets—such as those undertaking massive, multi-year projects followed by periods of minimal maintenance—must strategically time their investments. Achieving incremental growth becomes significantly harder during the years immediately following a peak spending period. Effective tax planning must model the impact of large current expenditures on the succeeding three years’ AQE, perhaps suggesting the smoothing of QRE recognition where legally permissible, or accepting that the credit will be cyclical rather than continuous.

7.2 Unitary Group Obligations

Unitary business groups operating in Illinois must compute the credit on their combined return. This means the AQE calculation requires the aggregation of Illinois-sourced QREs across all component members of the group for the entire three-year base period.3 This aggregation requires consistent methodologies for QRE identification and allocation across all related entities, demanding robust internal controls to ensure data synchronization and prevent errors in the combined base determination.

7.3 Conclusion: The Centrality of AQE to Compliance

In summary, the Average Qualifying Expenditures (AQE) is the cornerstone of the Illinois R&D tax credit system. Its purpose is singular: to ensure the credit is limited strictly to incremental research investment over a normalized historical baseline. Compliance is not merely dependent on accurately identifying current-year QREs, but on the ability to retroactively establish and defend the Illinois sourcing and amount of QREs for the three preceding tax years. The mandatory annualization rule for partial years and the inclusion requirement for non-credit years are the key administrative tools IDOR utilizes to enforce comparability, making meticulous record-keeping and proactive adherence to 86 Ill. Admin. Code 100.2160 essential for mitigating audit risk and realizing the benefit of this incentive.

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