Analyzing the Indiana Qualified Research Expense (IQRE) and the Research Expense Credit (REC) Framework

The Indiana Qualified Research Expense (IQRE) refers to in-house and contract research costs that meet stringent federal criteria (IRC §41) but are exclusively for research activities physically performed within Indiana state lines. These expenses form the basis for calculating the state’s generous Research Expense Credit (REC), a critical incentive against state adjusted gross income tax liability designed to stimulate in-state innovation.

The Indiana Research Expense Credit (REC), codified under IC 6-3.1-4, is a central component of the state’s strategy to encourage corporate investment in science and technology. The incentive is highly valuable, offering a dollar-for-dollar reduction against state income tax liability for eligible activities. While the state’s definition of qualified activities (Qualified Research Activities or QRAs) relies heavily on the federal Internal Revenue Code (IRC) Section 41, the strict geographical restriction to activities conducted within Indiana necessitates robust compliance and precise tracking systems that often exceed federal standards.1 This report provides an exhaustive analysis of the IQRE, detailing applicable state guidance, compliance requirements, and calculation methodologies.

II. Statutory Foundation and the Meaning of Indiana Qualified Research Expense (IQRE)

A. Statutory Basis: IC 6-3.1-4 and Alignment with IRC §41

The statutory foundation for the Indiana Research Expense Credit is established under Indiana Code (IC) 6-3.1-4. For the purpose of determining eligibility, the State of Indiana strategically aligns the fundamental definition of Qualified Research Expense (QRE) directly with Section 41(b) of the Internal Revenue Code (IRC).1 Legislative amendments, notably HEA 1472-2015, were enacted to ensure the state’s definitions remain consistent with the federal standard, offering continuity for taxpayers navigating complex research and development (R&D) tax law.3

Entities eligible to claim the credit include corporations and pass-through entities such as S corporations, partnerships, Limited Liability Companies (LLCs), and Limited Liability Partnerships (LLPs). Trusts and estates may also claim the credit against their liabilities, and S corporations and partnerships are authorized to pass the credit through to their shareholders and partners.3

B. The Foundational Difference: The In-State Nexus Requirement

The crucial element that differentiates the IQRE from the federal QRE is the mandate for geographical nexus. IQREs are explicitly defined as the sum of in-house and contract research expenses incurred for research activities that are exclusively conducted in Indiana.1 The research expenditures must also directly relate to a particular trade or business carried on by the taxpayer.1

For multi-state companies, this geographical restriction creates a specific compliance challenge that prevents simply using a portion of the federal QRE calculation. Taxpayers are required to demonstrate, through meticulous internal systems, the exact allocation of labor (wages), supplies, and contract expenses to qualified activities that occurred within Indiana. This requires robust payroll and time tracking records that handle geographical apportionment at the employee and project level to substantiate the claim upon audit.

C. The Four-Part Test: Defining Qualified Research Activity (QRA)

To qualify as an IQRE, the underlying activity must satisfy the definition of “qualified research” outlined in IRC §41(d)(1), which Indiana strictly enforces. A taxpayer must establish that the research activity meets all four requirements simultaneously for each business component that is the subject of the research 3:

1. The Section 174 Test (R&E Expense): The expenditures must be for activities that are of a type that can be treated as an expense under IRC §174 (research and experimentation). These activities must be intended to discover information that eliminates technical uncertainty concerning the development or improvement of a product.3 This generally excludes expenses for land and depreciable property.3
2. Discovering Technological Information Test: The research must be undertaken to discover information intended to eliminate uncertainty. Furthermore, the process of experimentation must be technological in nature, meaning it fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.3 The Indiana Department of Revenue (DOR) notes that the issuance of a patent is considered conclusive evidence of meeting this requirement for discovering technological information and eliminating uncertainty, though it does not automatically prove all other requirements are met.3
3. Business Component Test: The research must pertain to the development of a new or improved business component of the taxpayer. A business component is defined broadly as any product, process, computer software, technique, formula, or invention that is held for sale, lease, or license, or used by the taxpayer in a trade or business.3 Taxpayers must ensure they can link the research activity directly to the specific business component claimed for the credit.3
4. Process of Experimentation Test: This test requires that substantially all (defined as 80% or more) of the activities for each business component constitute a process of experimentation. This process is one designed to evaluate one or more alternatives to achieve a result where the capability, method, or appropriate design of the final outcome was uncertain at the beginning of the research.3

III. Comprehensive Guide to Eligible IQRE Costs and Exclusions

Indiana defines qualified expenses using the standard federal categories but applies the geographical filter and specific exclusions.

A. Definition of Qualified In-House Research Expenses

Qualified in-house expenses are typically wages and supplies that meet the federal definition and are incurred for research performed in Indiana.2

1. Qualified Wages: These include W-2 taxable income paid to an employee who performs, directly supports, or directly supervises qualified research activities. The employee’s time must meet the “substantially all” test, meaning at least 80% of their activity is devoted to qualified research.3
2. Qualified Supplies: These cover tangible personal property consumed during the research process, extraordinary utilities, and certain computer leasing expenses. These must be segregated from general administrative supplies or capital expenditures.3
3. Computer Leasing: Specifically, payments made to a cloud service provider for hosting software during its development phase are considered qualified expenses.3

B. Contract Research Expenses (The 65% Rule)

IQRE includes 65% of amounts paid to outside contractors for research services.3 For these contract expenses to qualify, two specific criteria must be strictly met:

1. The research must be of a nature that would qualify if performed by the taxpayer’s own employees.3
2. The contractual agreement must subject the taxpayer to financial risk while simultaneously granting it substantial rights over the final research product or result.3

C. Special Topic: Internal Use Software (IUS) Guidelines

The DOR provides specific guidance for research related to developing computer software, particularly that developed for the taxpayer’s internal use (IUS).3 While software research generally meets the definition of qualified research under IRC §41(d)(4), internal use software requires compliance with an additional layer of eligibility criteria known as the “High-Threshold-of-Innovation Test” (HTIT).3

High-Threshold-of-Innovation Test (HTIT)

Internal use software is defined as software developed primarily for use in the taxpayer’s general and administrative functions, such as financial management, human resource management, or day-to-day data processing services.3 To qualify for the credit, IUS must satisfy three cumulative criteria:

1. Innovative: The resulting software must yield a measurable improvement, such as a substantial and economically significant reduction in cost or improvement in speed.3
2. Significant Economic Risk: The development must involve significant economic risk, requiring the commitment of substantial resources despite substantial uncertainty that those resources will be recovered within a reasonable timeframe.3
3. Not Commercially Available: The software cannot be purchased, leased, or licensed off-the-shelf and used for the intended purpose without complex modifications that themselves satisfy the innovation and economic risk requirements.3

Exceptions to the HTIT apply to software used directly in the performance of other qualified research activities or software used in a production process.3

Dual-Function Software Allocation

For software developed for both internal functions and interaction with third parties (dual-function software), the DOR establishes a presumption that it is primarily for internal use.3 However, the DOR provides a specific allocation method if the taxpayer can identify a third-party subset—elements enabling interaction with external parties or allowing third parties to initiate functions or review data on the system.

If, after identifying and separating the third-party subset, there remains a dual-function subset, the taxpayer may include 25% of the qualified research expenditures of that remaining subset when computing the credit.3 This fractional inclusion is permitted only if the taxpayer can reasonably anticipate that the third-party functions will account for at least 10% of the software’s use.3 This approach moves the compliance requirement from a binary test of qualification to a necessity for rigorous, quantifiable data on projected and actual usage metrics, demanding a sophisticated level of tracking and forecasting by the taxpayer.

D. Research Activities Explicitly Excluded

Indiana adheres to standard federal exclusions (IRC §41(d)(4) and §174). Activities that do not constitute qualified research include routine testing or inspection for quality control, management studies, efficiency surveys, consumer surveys, advertising or promotions, and research related to style, taste, or cosmetic factors.3 Crucially for the IQRE, research conducted outside of Indiana is ineligible, as is “funded research,” where the taxpayer does not retain the economic risk or substantial rights.3

IV. Detailed Calculation Methodologies for the Indiana REC

Taxpayers may elect one of two methods to calculate the REC: the Standard Research Credit (SRC), based on a comparison to historical gross receipts, or the Alternative Simplified Credit (ASC), based on historical IQREs.2

A. Standard Research Credit (SRC) Calculation

The SRC calculation is designed to incentivize increasing research activities by comparing current year expenditures against a calculated base amount.1

1. Determining the Indiana Base Amount: The base amount is calculated by multiplying the Indiana fixed-base percentage (FBP), computed under IRC §41(c), by the taxpayer’s average Indiana gross receipts for the four preceding years.3 The final base amount is subject to a strict floor: it cannot be less than 50% of the current taxable year’s total IQREs.3
2. Application of Tiered Credit Rates: The credit is calculated on the amount of current IQREs that exceed the calculated base amount. This excess is subject to tiered rates:

• 15% Rate: Applied to the excess IQREs up to the first $1,000,000.2
• 10% Rate: Applied to any remaining excess IQREs above $1,000,000.2

B. Alternative Simplified Credit (ASC) Calculation

The ASC is available at the taxpayer’s election and generally offers a simpler calculation, basing the credit solely on historical IQREs.5

1. The 10% Formula: The credit is equal to 10% of the part of the current year’s IQREs that exceeds 50% of the average IQREs from the three preceding taxable years.2 This method often proves beneficial for businesses experiencing inconsistent or volatile R&D spending patterns.
2. The 5% Fallback Rate for New Claimants: The ASC mechanism accounts for new or recently inactive research enterprises. If the taxpayer did not incur Indiana QREs in any one of the three taxable years preceding the credit year, the credit defaults to 5% of the current year’s total IQREs.2 This fallback ensures that startup companies or those re-establishing research operations are not penalized by a lack of historical data, providing a tangible incentive from the first year of qualifying expenditures.

C. Credit Utilization and Administration

The Indiana REC is claimed using DOR Form IT-20REC.4 Taxpayers are granted a significant opportunity to monetize the credit over time, as any amount of credit not entirely offset against Indiana income taxes may be carried forward for up to 10 subsequent taxable years.2 Indiana explicitly prohibits carryback claims.4

Table 1: Indiana Research Expense Credit Calculation Methods (Comparison)

V. Indiana Department of Revenue (DOR) Compliance, Documentation, and Audit Readiness

The Indiana Department of Revenue requires extensive compliance efforts, often mirroring the detailed requirements of the Internal Revenue Service (IRS) Audit Technique Guidelines. The DOR has produced detailed resources, including the Indiana Research Expense Credit (REC) Handbook and several information sheets, which outline the state’s rigorous expectations for substantiation.3

A. Critical Documentation Requirements for Nexus

The core compliance mandate is the requirement for contemporaneous documentation. Taxpayers must maintain records in an “IRS audit-ready format” that is sufficiently usable and detailed to substantiate both the Qualified Research Expenses (QREs) and the Qualified Research Activities (QRAs) at the project level.3

The DOR explicitly rejects retrospective methods for substantiation, viewing them as insufficient to establish the required connection (nexus) between the research activities and the qualified expenses.3 Specifically, the DOR and IRS have held that reliance solely on surveys, interviews, post-facto estimates, or data manipulation performed after the research period is unacceptable.3 A common practice rejected by the DOR is using a percentage of W-2 wage amounts provided by a cost center based only on oral testimony without corroborating records.1

To mitigate audit risk, the DOR recommends gathering strong, timely proof. Examples of highly probative documentation include records generated under government regulatory mandates (such as FDA or DCAA forms) or documents related to intellectual property (e.g., patents or patent applications), given the inherently rigorous processes involved in their creation.3 Other best-practice examples of timely documentation include:

• Complete project lists detailing the scope of research projects.
• Annual R&D or technology plans.
• Internal correspondence regarding R&D.
• Design requirements or functional specifications.
• Testing scripts, modification reports, or error logs.
• Laboratory notebooks or ingredient consumption records.3

B. Legislative Compliance: HEA 1001 Disclosure Requirements

Effective January 1, 2019, HEA 1001, Section 121 introduced mandatory reporting changes that closely link the state credit claim to the federal credit position.3 This requirement is intended to foster consistency and manage audit risk for the state.

A taxpayer claiming the Indiana credit for IQREs must report to the DOR whether they have determined or claimed a corresponding credit for those expenses under the federal IRC Section 41.3 If the taxpayer claims the Indiana credit but chooses not to claim the federal credit for the same expenses, they are required to disclose to the DOR the specific reasons for the non-claim.3 This disclosure must be made in the manner specified by the DOR.

The legislative framework further specifies that any change to the federal credit claimed under IRC Section 41 is considered a modification under Indiana Code.3 This provision formalizes the linkage between the two jurisdictions’ audit outcomes, meaning that a successful federal audit challenge resulting in a reduction of the federal QRE will precipitate a mandatory adjustment and potentially a state audit challenge to the Indiana credit. Taxpayers must therefore manage their Indiana claim with the same level of conservatism as their federal position.

C. DOR Administrative Guidance: Statistical Sampling Procedures

For large claims involving substantial volumes of data, the DOR has issued highly technical Sampling Guidelines (effective since January 1, 2019) for statistical estimates.3 These guidelines are highly prescriptive and limit the use of sampling to specific variable sampling methodologies.3

1. Scope and Criteria: Statistical sampling is generally only considered appropriate when the research credit involves more than 100 sampling units (e.g., Indiana Projects, Wages, Contract Research Expenses, or Supplies).3 The use of sampling is contingent on facts and circumstances, such as the time and cost required to analyze large data volumes, and is inappropriate if more accurate evidence is readily available from other sources.3
2. Mandatory Statistical Rigor: The DOR mandates that the statistical procedures outlined in the guidelines be followed precisely. Specifically, any final estimate must be computed at the least advantageous 95% one-sided confidence limit.3 This requires a specialized statistical approach aimed at minimizing the estimated benefit to the taxpayer to ensure accuracy and confidence in the result.
   Furthermore, the DOR prescribes highly specific requirements for generating the sample, including the use of the Mersenne Twister algorithm for random number generation and requiring the seed number used to be the 10-digit business phone number of the individual preparing the sample.3 The failure to meet the Relative Precision (RP) test—for instance, if the RP for a sampling plan exceeds 15%—requires that the estimate must be calculated between the point estimate and the least advantageous 95% one-sided confidence limit, unless the RP is below 10%, in which case the point estimate may be used.3 Failure to comply with these detailed statistical requirements constitutes a fatal error in methodology, precluding the use of the statistical estimate altogether and requiring reliance only on examined units.3
3. Permitted Estimators: Only the following variable estimators will be accepted for substantiation: Mean (direct projection), Difference, (combined) Ratio, and (combined) Regression.3 The use of Ratio or Regression methods requires the taxpayer to first demonstrate that the inherent statistical bias is negligible by meeting criteria such as a minimum total sample size of 100 units and a coefficient of variation of 15% or less for the paired variables.3

Table 2: Indiana DOR Requirements for Supporting IQRE Documentation and Audit Risk Mitigation

VI. Practical IQRE Calculation Example

A comparison of the SRC and ASC methodologies is necessary to determine the optimal credit for a given tax year. The following example demonstrates how the different base rules affect the final credit amount.

A. Scenario Setup and Data Points

Consider Hoosier Innovations Inc., an established Indiana manufacturer, with the following financial data for the Current Tax Year (CY 2024):

B. Step-by-Step Calculation using the Standard Research Credit (SRC)

The SRC calculation is designed to incentivize investment above a statutory minimum threshold.

1. Calculate Fixed Base Amount: The Fixed Base Percentage (FBP) is multiplied by the average gross receipts: $4\% \times \$20,000,000 = \$800,000$.
2. Determine Minimum Base: The base amount cannot be less than 50% of the current year’s IQREs: $50\% \times \$2,500,000 = \$1,250,000$.5
3. Establish Actual Base Amount: The Actual Base Amount is the greater of Step 1 or Step 2: $\mathbf{\$1,250,000}$.
4. Calculate Excess IQREs: Current IQREs minus the Actual Base Amount: $\$2,500,000 – \$1,250,000 = \$1,250,000$.5
5. Apply Tiered Credit Rates:

• Tier 1 (15% Rate up to $1M$): $1,000,000 \times 15\% = \$150,000$.5
• Tier 2 (10% Rate on excess over $1M$): $(\$1,250,000 – \$1,000,000) \times 10\% = \$25,000$.5

1. Total SRC: $\$150,000 + \$25,000 = \mathbf{\$175,000}$.

C. Step-by-Step Calculation using the Alternative Simplified Credit (ASC)

The ASC is based on a simpler comparison to the average of the three prior years’ IQREs.

1. Calculate ASC Base: 50% of the average IQREs from the three prior years: $50\% \times \$1,200,000 = \$600,000$.5
2. Calculate Excess IQREs: Current IQREs minus the ASC Base: $\$2,500,000 – \$600,000 = \$1,900,000$.5
3. Apply ASC Credit Rate: The excess is multiplied by the flat 10% rate: $\$1,900,000 \times 10\% = \mathbf{\$190,000}$.5

D. Comparison

In this specific scenario, the Alternative Simplified Credit (ASC) results in a credit of $190,000, which is greater than the Standard Research Credit (SRC) of $175,000$. The primary reason for the difference is the application of the SRC’s 50% minimum base rule, which mandated a base of $1,250,000$. The ASC, utilizing a base of only $600,000 (50% of the historical IQRE average), allowed a much larger proportion of the current-year expenses to qualify as incremental research spending.

Table 3: Illustrative IQRE Calculation Comparison (Hoosier Innovations Inc. Example)

VII. Strategic Value of Related Indiana R&D Incentives

In addition to the income tax credit based on IQREs, Indiana offers an essential parallel incentive aimed at reducing the capital cost of establishing and expanding research facilities. This approach suggests a cohesive state strategy designed to encourage both human capital investment (labor) and fixed capital investment (equipment).1

A. The 100% Sales and Use Tax Exemption for R&D Equipment

The state offers a 100% sales tax exemption for qualified research and development equipment and property purchased for use in Indiana (IC 6-2.5-5-40).1 This exemption applies to tangible personal property that is directly devoted to research and development activity, such as laboratory equipment, specialized consumables, hand-powered tools, and repair parts used in R&D.1

Property not directly used in the research, such as general office furniture, furnishings, or storage equipment, remains subject to sales tax.1

For growth companies, particularly those in capital-intensive sectors like advanced manufacturing or life sciences, the sales tax exemption provides an immediate, transactional cash flow benefit, which often proves more valuable than an income tax credit that may only be utilized years later due to tax losses or insufficient liability.1 Taxpayers may claim this exemption at the time of purchase or file a timely claim for refund for sales tax paid post-transaction.1

VIII. Conclusion and Recommendations for Indiana Taxpayers

The Indiana Qualified Research Expense (IQRE) is the cornerstone of Indiana’s Research Expense Credit (REC), providing a competitive, tiered incentive structure for innovation conducted within the state. The effectiveness of this credit is maximized when taxpayers navigate the complex intersection of federal requirements (IRC §41) and Indiana’s specific geographical and compliance mandates.

The state’s approach is defined by its rigorous demand for accountability, particularly regarding the geographical nexus of activities and the necessity for contemporaneous, detailed recordkeeping. The DOR explicitly rejects methodologies built upon post-facto estimation or oral testimony, requiring sophisticated project-level tracking to substantiate claims. Furthermore, the mandatory disclosures required by HEA 1001 effectively link the state’s audit risk to the federal claim viability, necessitating that taxpayers treat their Indiana R&D position with the highest level of compliance conservatism.

For optimal strategic utilization, taxpayers must:

1. Mandate Contemporaneous Tracking: Implement internal systems that track qualified employee time and supplies consumption directly to specific projects and, crucially, to activities physically performed within Indiana. This minimizes the risk of audit disallowance based on insufficient nexus documentation.
2. Model Both Calculation Methods Annually: Due to the complexity of the SRC’s 50% minimum base rule, taxpayers must model both the Standard Research Credit and the Alternative Simplified Credit using Indiana-specific data to determine the maximum benefit each tax year.
3. Integrate Dual Incentives: Ensure that capital expenditures for R&D equipment are tracked meticulously to claim the separate 100% sales tax exemption, providing immediate cash flow relief alongside the income tax credit.
4. Engage Statistical Expertise: If claims are substantial enough to warrant statistical sampling, engage specialized tax statisticians to ensure strict adherence to the DOR’s highly detailed guidelines regarding confidence limits, precision tests, and specific algorithmic requirements, thereby mitigating the risk of wholesale claim rejection.

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