Indiana R&D Expense Decoupling: Analysis of IC § 6-3-2-29 and Its Context with the State Research Tax Credit

I. Executive Summary: Indiana R&D Expense Decoupling

Indiana Code (IC) § 6-3-2-29 establishes mandatory state-level modifications for Specified Research and Experimental (R&E) expenditures, effectively allowing taxpayers to claim a current-year, full expense deduction on their Indiana Adjusted Gross Income (AGI). This critical provision ensures Indiana taxpayers are shielded from the federal mandate under Internal Revenue Code (IRC) § 174 that requires R&E costs to be amortized over five years, thereby significantly lowering the Indiana corporate and individual income tax base immediately.

This analysis details the statutory function of IC 6-3-2-29, which was enacted retroactively for tax years beginning after December 31, 2021, to restore the pre-2022 federal treatment of R&E expenses for state tax purposes.1 The decisive action by the Indiana legislature to decouple from the federal rule signaled a clear state policy priority: to affirm the state’s commitment to maintaining a competitive tax environment for innovation and to restore the immediate cash flow benefits for R&D-intensive businesses that were abruptly curtailed by federal law changes. The delay in enacting the law (passed in 2023 but effective 2022) necessitated specific guidance from the Department of Revenue (DOR) for the transition period.

II. The Federal Catalyst: Understanding IRC § 174 Amortization

The Mandatory Amortization Rule Post-TCJA

The impetus for Indiana’s legislative action lies in the changes introduced by the Tax Cuts and Jobs Act of 2017 (TCJA). Prior to 2022, IRC § 174 permitted taxpayers to expense all Specified Research or Experimental Expenditures (SREs) in the year incurred. However, the TCJA mandated that, for tax years beginning after December 31, 2021, SREs must be capitalized and amortized.4 Domestic research must be amortized over five years, while foreign research must be amortized over fifteen years.

For a taxpayer incurring $1 million in R&D costs domestically in 2022, the federal deduction would be limited to $200,000 (one-fifth of the cost), sharply increasing Federal Adjusted Gross Income (AGI).

The Necessity of State Decoupling

Because Indiana’s income tax structure generally utilizes Federal AGI as the starting point for state tax calculations, the mandatory amortization rule significantly increased the state tax base for R&D businesses starting in 2022.5 Absent IC 6-3-2-29, Indiana AGI would reflect only the partial amortization deduction claimed federally. This substantial increase in state taxable income would have effectively negated the intended benefits of local R&D incentives and increased the tax burden significantly, prompting state lawmakers to consider decoupling to protect local economic investment.5

Defining Specified Research or Experimental Expenditures

IC 6-3-2-29(a) clarifies the scope of the decoupling measure by defining SREs via reference to IRC § 174(b).3 Critically, the Indiana statute explicitly maintains the federal limitation that SREs do not include expenditures for which a deduction is disallowed under IRC § 280C(c).3 This ensures that R&D expenses used to calculate the federal (and subsequently, the Indiana) R&D tax credit are not simultaneously deducted as current expenses.

III. Statutory Analysis of IC § 6-3-2-29: Achieving Full Expensing

IC § 6-3-2-29 mandates specific modifications to a taxpayer’s Federal AGI to arrive at the Indiana AGI, thereby achieving full current-year expensing for SREs.

The Required Modifications to Indiana AGI (IC 6-3-2-29(b))

For taxable years beginning after December 31, 2021, the decoupling mechanism involves two mandatory modifications that must be applied to Federal AGI 2:

1. Deduction (Full Expensing): The taxpayer must deduct an amount equal to the full SREs that were required to be charged to a capital account under IRC § 174(a)(2)(A).3 This restores the 100% current-year deduction at the state level.
2. Add-Back (Federal Amortization Removal): The taxpayer must add to AGI the amount deducted under IRC § 174(a)(2)(B) for the taxable year.3 This modification neutralizes the partial deduction (the 1/5th or 1/15th amortization amount) claimed federally.

The combined effect of these modifications results in a net reduction in Indiana AGI equal to 80% of the SREs in the first year (for domestic research), restoring the economic benefit of full current expensing that existed prior to 2022.

Indiana Department of Revenue (DOR) Compliance and Reporting

Following the enactment of IC 6-3-2-29 (via HEA 1001), the Indiana Department of Revenue (DOR) provided specific guidance, primarily through Information Bulletin 116, detailing the exact modification codes required for tax filings.1 Practitioners must pay close attention to the filing year, as the DOR designated different codes for the retroactive 2022 year versus subsequent years. This change in code numbering reflects the complexity of administering retroactive legislation and requires heightened attention from tax professionals to ensure compliance.

The following table summarizes the mandatory modification codes for reporting the R&D decoupling adjustment:

Table: Required AGI Modification Codes for IC 6-3-2-29

IV. Nuanced Rules for Pass-Through Entities (PTEs) and Basis Limitations

Indiana’s decoupling statute incorporates highly specific limitations when the taxpayer receives the deduction through an ownership interest in a pass-through entity (PTE), such as a partnership or an S-corporation.3 These rules are designed to prevent the utilization of accelerated state deductions that would exceed the taxpayer’s economic investment or violate federal loss utilization principles.

Basis Limitation Rule (IC 6-3-2-29(c))

For a taxpayer owning an interest in a PTE, the amount of the full R&E deduction allowed under IC 6-3-2-29(b)(1) is capped.2 This limitation ensures the deduction cannot create excessive losses.

The allowable deduction cannot exceed the sum of:

1. The taxpayer’s adjusted basis in the PTE for federal tax purposes, determined at the end of the taxable year, after the application of any expenses, deductions, or losses; plus
2. The amount of any indebtedness of the PTE to the partner, shareholder, or member.3

This provision upholds the principle that state tax deductions should not exceed the economic investment (basis) in the entity.

Carryforward Treatment of Disallowed Deductions (IC 6-3-2-29(d))

Any deduction, or portion thereof, disallowed because it exceeds the PTE basis limitation must be carried forward to the subsequent taxable year.3 The disallowed amount is then treated as an SRE expenditure paid or incurred in that subsequent year, subject once again to the basis limitation rule of subsection (c).3 This carryforward mechanism prevents the permanent loss of the deduction while respecting the annual basis cap.

Passive Activity Loss (PAL) Restriction (IC 6-3-2-29(e))

If the R&E deduction arises from an activity that is classified as passive under IRC § 469, a secondary limitation applies after the basis rules have been addressed.3

The deduction is constrained such that it cannot exceed the sum of:

1. The taxpayer’s passive income, as determined for federal tax purposes, after applying any passive losses or passive loss carryovers for the taxable year (but not less than zero); plus
2. The amount of SREs claimed as a deduction under IRC § 174 in determining the taxpayer’s federal AGI for the taxable year (i.e., the federal amortization amount).3

By allowing the taxpayer to include the federal amortization deduction amount (Item 2) in the passive income ceiling calculation, Indiana ensures that taxpayers receive credit for the portion of the expense already utilized federally. The state is primarily subjecting only the accelerated portion of the expense (the remaining 80%) to the passive income limitation. This sophisticated approach grants the maximum benefit of decoupling while preventing the improper utilization of passive losses. Any deduction disallowed under this PAL restriction must also be carried forward to the subsequent taxable year as an SRE from a passive activity.3

Compliance for PTE owners is exceptionally complex, necessitating a three-step analysis: first, determining the gross R&E expense; second, applying the federal basis limitation (IC 6-3-2-29(c)); and third, applying the state-specific passive loss limitation (IC 6-3-2-29(e)). This demands accurate tracking of federal basis and passive income pools year-over-year.

V. The Indiana R&D Tax Credit (IC § 6-3.1-4): Mechanics and Static Conformity

It is crucial to understand that IC 6-3-2-29 (the deduction) operates entirely separate from the Indiana R&D Tax Credit established under IC 6-3.1-4. While the deduction reduces the state tax base, the credit reduces the final tax liability dollar-for-dollar.6 The existence of the decoupling deduction makes the nonrefundable credit substantially more valuable, as it ensures the taxpayer’s initial AGI liability is minimized before the credit is applied.

Defining Qualified Research Expense (QRE) for Credit

Unlike the decoupling statute, which relies on the current IRC § 174 definition for the amortization requirement, the definition of Qualified Research Expense (QRE) for the purpose of calculating the Indiana credit relies on static conformity. QRE is defined by IRC § 41(b) as in effect on January 1, 2001.8 This fixed date ensures that the criteria for qualifying activities, including wages paid to employees, supplies, and services for qualified research conducted in Indiana, remain consistent regardless of subsequent federal amendments to IRC § 41.9

Credit Calculation Methods

Taxpayers incurring Indiana QREs are entitled to the Research Expense Tax Credit.8 Indiana offers two primary methods for calculating the credit: the Regular (Standard) Method and the Alternative Simplified Credit (ASC).

A. Regular (Standard) Credit Calculation

The standard calculation method is based on the federal “Base Amount” concept, modified to use only Indiana QREs and Indiana gross receipts.8 The credit amount is calculated as follows:

1. Subtract the “Base Amount” from the current year’s Indiana QREs.
2. The credit equals 15% of the excess QRE over the base, up to the first $1 million of that excess.9
3. Any remaining excess QRE above $1 million is multiplied by 10%.9

B. Alternative Simplified Credit (ASC) Election

For Indiana qualified research expenses incurred after December 31, 2009, an alternative method is available.9 This method simplifies the calculation for businesses with fluctuating R&D expenditures.

1. The taxpayer elects the ASC method.
2. The base is determined as 50% of the average Indiana QREs for the three preceding taxable years.9
3. The credit is equal to 10% of the portion of the current year’s Indiana QREs that exceeds this 50% average base.9
4. If the taxpayer had no Indiana QREs in any one of the three preceding years, a fallback rate applies: the credit is equal to 5% of the current year’s Indiana QREs.9

Credit Utilization

The Indiana research credit is nonrefundable but highly valuable, allowing unused credit amounts to be carried forward for up to ten taxable years.9 For pass-through entities (S corporations, partnerships, LLCs, and LLPs), the entity calculates the credit and must prorate it among its partners or shareholders.12

Table: Summary of Indiana Research Expense Tax Credit Methods (IC 6-3.1-4)

VI. Detailed Application Example: Integrating Decoupling and Credit

This example illustrates how a calendar-year C-Corporation simultaneously applies the IC 6-3-2-29 decoupling adjustment and claims the IC 6-3.1-4 R&D Tax Credit for the 2023 tax year.

A. Example Scenario Setup (Tax Year 2023)

A C-Corporation operates solely within Indiana (5.5% corporate tax rate).

• Federal Taxable Income (Pre-R&D deduction/amortization): $5,000,000
• Total Specified R&D Expenses (QREs incurred in Indiana): $1,000,000
• Federal IRC § 174 Amortization Deduction (1/5th): $200,000
• Indiana R&D Credit Base Amount (calculated using IC 6-3.1-4 standard method): $400,000

B. Step 1: Federal AGI Calculation (Starting Point)

The taxpayer begins with the income determined under federal law:

$$\text{Federal AGI} = \$5,000,000 – \$200,000 = \$4,800,000$$

C. Step 2: Indiana Decoupling Modification (IC 6-3-2-29)

The taxpayer applies the required modifications to the Federal AGI to arrive at the Indiana AGI (using 2023 modification codes):

• Start with Federal AGI: $4,800,000
• Add-Back (Code 154): Remove Federal Amortization Deduction: +$200,000
• Deduct (Code 641): Full Indiana Expensing Deduction: -$1,000,000
• Indiana Adjusted Gross Income (AGI) (Tax Base): $4,000,000

The decoupling provision resulted in a net state deduction of $800,000 ($1,000,000 full deduction less the $200,000 federal amortization removal). This reduction in the taxable base provides an immediate tax savings of $44,000 ($\$800,000 \times 5.5\%$).

D. Step 3: Indiana R&D Tax Credit Calculation (IC 6-3.1-4)

The taxpayer calculates the R&D credit using the standard method:

• Indiana QREs: $1,000,000
• Less: Base Amount: ($400,000)
• Excess QRE: $600,000
• Credit Calculation: Since the excess QRE ($600,000) is less than the $1 million cap, the 15% rate applies.
• $$\text{Credit Amount} = \$600,000 \times 15\% = \$90,000$$
• Total Indiana R&D Tax Credit: $90,000

E. Step 4: Final Indiana Tax Liability Calculation

• Indiana AGI (Tax Base): $4,000,000
• Gross Tax Liability ($\$4,000,000 \times 5.5\%$): $220,000
• Less: R&D Tax Credit (IC 6-3.1-4): ($90,000)
• Net Indiana Tax Liability: $130,000

Table: Numerical Example: Federal Amortization vs. Indiana Expensing and Credit Application

VII. Conclusion and Strategic Recommendations

IC § 6-3-2-29 is a critical component of Indiana’s strategy to support innovation, providing immediate and substantial tax base relief for companies engaging in qualified R&D activities. The statute successfully achieves the legislative goal of shielding Indiana taxpayers from the negative cash flow consequences of federal IRC § 174 mandatory amortization.

Strategic Stacking of Incentives

The greatest financial advantage is realized when the IC 6-3-2-29 deduction (AGI reduction) is strategically combined with the IC 6-3.1-4 credit (liability reduction). Taxpayers benefit from a dual incentive structure that first minimizes the tax base and then provides a direct offset against the resulting tax liability. Taxpayers must, however, confirm eligibility for both incentives based on the separate definitions of R&D expense used for the deduction (current IRC § 174) versus the credit (static IRC § 41, 2001 version).

Mandatory Compliance Warnings

Taxpayers must be meticulous in adhering to compliance requirements. The need for different DOR modification codes (Code 147/120 for 2022 and Code 641/154 for 2023 and later) following the retroactive passage of the law is a potential area for administrative error.1

Furthermore, taxpayers utilizing the deduction through pass-through entities (PTEs) face substantial complexity. They must meticulously track federal basis and passive income limitations (IC 6-3-2-29(c) and (e)). Specifically, the application of the passive loss limitation requires factoring in the federal amortization deduction when calculating the available passive income ceiling.3 Failure to adhere to these complex, tiered limitations will result in disallowed deductions, requiring careful tracking of carryforward amounts.

By adopting this comprehensive decoupling measure, Indiana has reinforced its position as a jurisdiction highly supportive of technology and innovation, making the acceleration of R&D expense deductions a crucial differentiator in state tax planning.

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