Navigating Non-Conformity: The Mandate to Disclose Reasons for a State-Only Indiana R&D Tax Credit Claim

The Disclosure of Reasons for Not Claiming the Federal Credit is a mandatory compliance requirement in Indiana, compelling taxpayers claiming the state Research Expense Credit (REC) to explain why the corresponding federal R&D tax credit was not utilized in the same tax year. This disclosure provides the Indiana Department of Revenue (DOR) with essential audit defense documentation, justifying claims that result from the structural non-conformity between state and federal tax codes.

I. Foundational Context: The Dual R&D Tax Environment

The necessity for disclosure arises directly from the relationship between the federal Credit for Increasing Research Activities (IRC § 41) and the Indiana Research Expense Credit (REC), codified under Indiana Code (IC) 6-3.1-4. While the state credit leverages federal definitions, fundamental differences in calculation, scope, and effective dates lead to scenarios where a taxpayer may legitimately qualify at the state level but not the federal level.

A. The Federal Research and Development Tax Credit Framework

The federal R&D tax credit is a permanent incentive designed to encourage innovation and experimentation.1 Taxpayers claim this benefit using IRS Form 6765, titled “Credit for Increasing Research Activities”.3

Federal law requires taxpayers to determine their credit using one of two primary methods: the Regular Research Credit (RRC) under IRC § 41(a)(1) or the Alternative Simplified Credit (ASC) under IRC § 41(c)(4).4 The ASC method is often beneficial for companies lacking comprehensive historical records needed for the RRC base period calculation, as it relies on Qualified Research Expenses (QREs) from the preceding three years.4 Taxpayers should note that the federal credit may be claimed retroactively for three years and carried forward for 20 years.1 Generally, taxpayers not claiming the federal credit are not required to file Form 6765, unless they are partnerships or S corporations.3 However, this federal leniency is overridden by Indiana’s explicit state compliance requirements when the state credit is claimed.

B. The Indiana Research Expense Credit Structure

Indiana offers a compelling, nonrefundable Research Expense Credit (REC) that can be carried forward for up to 10 taxable years.6 The Indiana credit is based solely on qualified research conducted within the state.6

The Indiana REC calculation is incremental, providing a significant incentive structure:

• A credit of 15% is applied to the amount of Indiana QREs that exceeds the base period amount, up to the first $1 million of the increase.6
• A 10% credit is applied to any excess qualified research expense over the base period amount greater than $1 million.8

An alternative calculation method is also available for Indiana QREs incurred after December 31, 2009. This method awards 10% of the QREs that exceed 50% of the average QREs for the three preceding years. If the taxpayer did not have Indiana QREs in any of the three preceding years, the credit is 5% of the current year’s QREs.6

The robust nature of the Indiana credit, with rates up to 15%, presents a strong financial motivation for businesses to pursue the state credit even if the federal credit yields a zero or negligible benefit. This economic reality necessitates the DOR’s implementation of the mandatory disclosure to ensure the integrity of claims derived from complex tax planning or technical ineligibility at the federal level. The state explicitly requires the taxpayer to consider both the RRC and ASC federal methodologies before justifying a non-claim at the federal level, ensuring that taxpayers cannot simply argue ineligibility under only one calculation method.5

II. Statutory Analysis: Defining the Disclosure Mandate in IC 6-3.1-4-8

The requirement for disclosure was formalized by amendments to the Indiana Code, specifically P.L.108-2019, SEC.121, which added the crucial compliance language in IC 6-3.1-4-8.7 This mandate serves to connect the state’s audit function to the taxpayer’s federal tax position, regardless of whether a federal credit was formally claimed.

A. The Requirement to Report and Disclose

IC 6-3.1-4-8 imposes dual responsibilities on any taxpayer claiming the Indiana REC:

1. Reporting Federal Status (Subsection (a)): The taxpayer must report to the DOR whether they have both (1) determined and (2) claimed a credit for those Indiana QREs under either the RRC (IRC § 41(a)(1)) or the ASC (IRC § 41(c)(4)).5
2. Mandatory Disclosure of Reasons (Subsection (b)): If the taxpayer claims the Indiana REC but does not claim the corresponding federal credit, they are required to “disclose to the department any reasons for not claiming the credit for those Indiana qualified research expenses for federal purposes”.5 This disclosure must be made “in the manner specified by the department”.5

This statutory mandate places the burden of proof squarely on the taxpayer to justify any state-only filing. By requiring the taxpayer to provide a substantive explanation for the non-claim at the time of filing, the DOR gains a proactive mechanism to assess the veracity of the state claim and mitigate potential audit risks associated with non-conforming tax treatments.

B. Federal Audit Linkage and Modifications

A significant component of the Indiana statute is the provision governing federal changes. IC 6-3.1-4-8(c) states that a change to the federal credit determined under IRC § 41 shall be considered a modification for purposes of Indiana tax law.5

This provision establishes a clear legal connection between the federal audit process and Indiana compliance. If the IRS subsequently audits a taxpayer’s federal return and determines that a federal R&D credit should have been claimed, or if the federal QRE base is adjusted, the taxpayer has a statutory obligation to report this change as a modification to Indiana. This mechanism ensures that the state can appropriately capture the resultant changes to the state tax liability, reinforcing the DOR’s interest in the accuracy of the federal determination, even if the federal credit was initially reported as zero.

III. Technical and Strategic Drivers for State-Only Claims

The most compelling and defensible reasons for claiming the Indiana REC while foregoing the federal credit are rooted in the specific technical divergences between Indiana’s historical conformity date and recent federal law, coupled with strategic decisions related to the deduction of R&E expenditures.

A. Fixed Conformity Date and QRE Divergence

Indiana’s definition of Qualified Research Expense (QRE) is anchored to the Internal Revenue Code (IRC) Section 41(b) as in effect on January 1, 2001.8

Any regulatory or statutory changes to the definition of qualified research (IRC § 41(d)) enacted after this specific date are generally disregarded for Indiana REC purposes, but they are mandatory for federal claims. This fixed conformity date often creates a technical divergence in QRE eligibility:

• Internal Use Software (IUS) Example: One notable area of divergence is the treatment of Internal Use Software (IUS). After 2001, federal regulations significantly tightened the requirements for IUS, subjecting it to a “high-threshold test” requiring substantial economic significance and technical risk.9 Research expenses for administrative or general business function software that fail this rigorous current federal test may still satisfy the less restrictive IRC § 41 requirements as they existed on January 1, 2001.
• Disclosure Justification: For taxpayers with significant IUS research, the disclosure narrative can state that the federal claim was forgone because current federal law disqualified a material portion of their QREs, while Indiana law, relying on the 2001 definition, recognizes those expenses as qualified.

B. Non-Conformity with IRC § 174 Amortization

A major strategic factor driving state-only claims involves the federal treatment of Research and Experimentation (R&E) expenditures under IRC § 174.

Since tax years beginning after December 31, 2021, federal law generally requires taxpayers to capitalize and amortize domestic R&E expenditures over five years (and foreign R&E over 15 years).11 This deferral of deductions significantly reduces immediate cash flow benefits. In contrast, Indiana chose not to conform to this federal change.12 For Indiana state tax purposes, taxpayers are still allowed to immediately deduct R&D expenses in the year they are incurred.12

• Strategic Optimization: Taxpayers facing the new federal amortization requirements may calculate a modest federal R&D credit but recognize that claiming it necessitates the burdensome and cash-flow-negative IRC § 174 amortization requirement at the federal level. They may strategically elect to forgo the federal R&D credit entirely to prioritize the superior immediate deduction benefit available on their Indiana state return. The immediate deduction provides a greater overall tax saving or cash flow advantage than the incremental federal credit, especially when the federal credit is zeroed out by calculation constraints.
• Documentation Precedence: It is crucial for taxpayers to possess documentation that meets the 2001 IRC standard for QREs, not merely current federal best practices. Furthermore, a strong disclosure will articulate both the technical failures (like IUS exclusion) and the strategic tax optimization based on IRC § 174 amortization non-conformity.

C. Calculation Constraints and Strategic Forgoing

Other reasons for a determined federal credit of zero, which must be disclosed, relate to the calculation mechanics of IRC § 41:

• Base Period Erosion: Both the RRC and ASC methods rely on comparing current QREs to a historical base period.4 If a company had unusually high QREs in the base period, leading to a high fixed-base percentage or three-year average, the incremental federal credit calculation can easily result in a zero credit determination. In such cases, the taxpayer is technically ineligible federally but may still qualify for a substantial Indiana REC due to differences in state base period calculation rules.
• Federal Tax Liability Limits: If a company has large Net Operating Losses (NOLs) or other carryforwards that result in zero federal tax liability, claiming a non-refundable federal R&D credit may only add to the credit carryforward, offering no immediate benefit.13 If the same taxpayer has sufficient state tax liability, the immediate use of the Indiana REC offers a clear financial advantage, justifying the decision to forgo the federal credit for tax optimization purposes.

IV. DOR Compliance Guidance and Model Disclosure

Indiana law requires the disclosure to be made “in the manner specified by the department”.5 While the DOR has not created a specific form for the narrative, its filing instructions mandate the submission of specific attachments and a formal written statement.

A. Required Filing Protocol

To comply with IC 6-3.1-4-8(b), the taxpayer must complete and enclose the following documents with their annual Indiana income tax return (e.g., Form IT-20 for corporations):

1. Schedule IT-20REC: The completed Indiana schedule used to calculate the Research Expense Credit.14
2. Federal Form 6765 (Required Attachment): Taxpayers must attach a copy of the completed federal Form 6765, or Form 8820, to Schedule IT-20REC.14 This is mandatory even if the determined federal credit amount reported on the form is zero. The requirement to attach the completed Form 6765 provides the DOR with the underlying federal calculation data, including QREs and base period calculations, allowing administrators to verify the technical accuracy of the taxpayer’s disclosure regarding base erosion or calculation failure.
3. Formal Written Disclosure Statement: The formal narrative detailing the reasons for not claiming the federal credit must be included as an attachment to the state tax return.16 This statement must clearly identify the taxpayer by name, Federal Employer Identification Number (FEIN), and the relevant tax year.16 The submission must be sufficiently detailed to serve as a substantive audit defense document.

B. Example: Illustrating the Disclosure Requirement

Consider a mid-sized Indiana manufacturer, TechPro Inc., with $1.8 million in current-year Indiana QREs. $400,000 of these QREs relate to internal administrative process development software that qualifies under Indiana’s 2001 IRC standard but fails the current federal IUS test. Furthermore, due to high R&D activity three years ago, both the federal RRC and ASC calculations result in a determined credit of $0. TechPro Inc. also decides not to claim the federal credit because they seek to maximize the immediate deduction of the full $1.8 million in R&E expenses on the Indiana return, avoiding the five-year federal amortization requirement.

TechPro Inc. must submit the written statement articulating these three reasons, along with the completed, zeroed-out federal Form 6765 and Schedule IT-20REC, to fulfill the IC 6-3.1-4-8(b) compliance mandate. The high quality and technical specificity of this narrative directly reduce the likelihood of audit scrutiny from the DOR.

V. Conclusion and Proactive Compliance Recommendations

The mandatory Disclosure of Reasons for Not Claiming the Federal Credit represents a crucial checkpoint in Indiana tax administration, necessitated by the unique interaction of fixed federal conformity dates, state decoupling from federal amortization rules, and the DOR’s statutory oversight of federal credit determinations.

The analysis confirms that the requirement is not merely a formality but a necessary mechanism for the DOR to assess the integrity of state-only claims that often arise from sophisticated tax planning. By demanding an explicit explanation, Indiana shifts the burden of justification to the taxpayer, ensuring that a state credit claim is based on legitimate technical or economic factors rather than a misrepresentation of QREs.

To ensure robust compliance and mitigate audit exposure, taxpayers must implement comprehensive documentation and reporting protocols:

1. Develop Dual Documentation Standards: Taxpayers should maintain a rigorous R&D study that quantifies QREs according to both current federal IRC standards and the historically fixed Indiana standard (IRC § 41(b) as of January 1, 2001). This dual tracking is essential for justifying QRE divergence, particularly concerning Internal Use Software.
2. Mandate Federal Calculation: Regardless of the outcome, a complete federal R&D credit calculation utilizing both the RRC and ASC methodologies must be performed annually. This calculation forms the basis of the required Form 6765 attachment and substantiates claims of calculation failure due to base period constraints.
3. Formalize the Disclosure Narrative: The written disclosure required by IC 6-3.1-4-8(b) should be treated as a formal tax position memorandum. This document must clearly cite the statutory authority, explicitly detail the determined federal credit status (even if zero), and provide a concise, technical explanation for non-claim, emphasizing the impact of IRC § 174 non-conformity and any QRE eligibility differences. Legal or highly experienced tax specialists should review and approve this narrative prior to filing.

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