Expert Analysis of Wages for Qualified Services in the Indiana Research Expense Credit (IC 6-3.1-4)

Wages for Qualified Services (WQS) represent the compensation paid to employees for time spent directly performing, supervising, or supporting qualified research activities (QRA) conducted within Indiana. WQS constitute the single largest component of Qualified Research Expenses (QREs) for the Indiana Research Expense Credit (REC), requiring strict adherence to federal definitions (Internal Revenue Code (IRC) Section 41(b) as of 2001) and meticulous, time-based documentation mandated by the Department of Revenue (DOR).

This report delivers a detailed examination of WQS, covering its statutory foundation within the Indiana Code, the operational guidance provided by the DOR, the required allocation methodologies for hybrid employees, and the critical documentation standards necessary to sustain the credit against audit scrutiny.

I. Statutory and Regulatory Framework of the Indiana REC (IC 6-3.1-4)

The Indiana Research Expense Credit (REC), established under IC 6-3.1-4, is a state income tax incentive designed to encourage increased research and development investments within the state. Understanding WQS first requires establishing the legal definition of a Qualified Research Expense (QRE) and the specific criteria set forth in Indiana law.

A. Basis of the Credit: Defining Indiana Qualified Research Expense (IQRE)

An Indiana qualified research expense (IQRE) is defined statutorily as the sum of wages paid to employees, the cost of supplies, and amounts paid for services (contract research) for qualified research or supervision of research activities, provided that these expenses are incurred for research conducted within Indiana.1

The value of the credit is generally determined by measuring the increase in qualified research expenditures over a historical base period. The standard calculation allows for a credit equal to 15 percent of the excess IQRE over the base amount, up to $1 million, with a 10 percent credit applied to any excess above that $1 million threshold.1 Alternatively, for expenses incurred after December 31, 2009, taxpayers may elect the Alternative Incremental Credit (AIC), which generally equals 10 percent of the IQRE for the taxable year that exceeds 50 percent of the taxpayer’s average IQRE for the three preceding taxable years.1 Credits awarded under these provisions may be carried forward for up to ten taxable years, offering long-term tax planning utility.1

B. Mandatory Adoption of Federal Law: IRC Section 41(b) as of January 1, 2001

A critical feature of the Indiana REC is its mandatory adoption of the federal definition of a QRE. Indiana Code defines “Qualified research expense” as the definition found in Section 41(b) of the Internal Revenue Code (IRC) as in effect on January 1, 2001.1

The specific use of the January 1, 2001, fixed date of reference is crucial for compliance. It mandates that Indiana’s criteria for determining if an activity qualifies as research—specifically the four-part test (qualifying purpose, elimination of uncertainty, process of experimentation, and technological nature)—and the foundational definitions of wages and supplies, remain tethered to the IRC and corresponding Treasury Regulations as they existed on that specific date. This provision ensures that the state’s credit mechanism is stable and generally aligned with the established framework of federal R&D tax law, simplifying compliance for taxpayers who are already claiming the federal credit.5

C. State and Federal Non-Conformity Issues (IRC Section 174 Amortization)

Despite adopting the 2001 federal definition for the credit calculation (IRC § 41(b)), Indiana has created a significant decoupling point concerning the deductibility of R&D expenses under IRC Section 174. Federally, under changes effective starting in 2022, R&D expenses, including wages, are required to be capitalized and amortized over five years (or fifteen years if foreign).6

Indiana has explicitly chosen not to conform to this federal change for state tax purposes. Indiana taxpayers can continue to deduct R&D expenses, including qualified wages, in the year they are incurred.6 This non-conformity necessitates that taxpayers engage in complex dual-tracking of R&D expenditures. They must first determine the qualified wages according to the 2001 IRC 41 standards for the state credit calculation, and simultaneously manage the expense deductibility—immediate deduction for Indiana Adjusted Gross Income Tax, but mandatory amortization for federal purposes. This requires highly specialized state and local tax (SALT) analysis to ensure both state compliance and optimal tax treatment.

II. Definitional Analysis of Wages for Qualified Services (WQS)

WQS is the foundational component of IQRE, typically accounting for the largest percentage of the total credit claimed. Defining WQS involves satisfying specific criteria regarding the form of compensation and the nature of the employee’s service.

A. WQS Eligibility Criterion 1: Taxable Compensation (W-2 Wages Only)

To qualify, compensation must be treated as W-2 taxable income.7 The amount used as the wage base for the credit calculation must correspond to the Gross Federal Taxable Wage (Box 1 of the W-2 form).8

This requirement results in mandatory exclusions from the qualified wage base. Any non-taxable elements of an employee’s compensation package must be explicitly excluded. Common examples of non-taxable components that must be removed from the calculation include employer contributions to 401(k) plans, health insurance premiums, and other pre-tax benefit deductions.8 To defend the calculated wage base, taxpayers must retain documentation such as employee W-2s and detailed payroll registers.8

B. WQS Eligibility Criterion 2: The Definition of “Qualified Services”

Wages are qualified only to the extent they are paid for “qualified services.” Drawing directly from IRC Section 41 regulations adopted by Indiana, qualified services fall into three precise categories:

1. Direct Performance of Qualified Research: This involves the activities intended to discover information that would eliminate technical uncertainty concerning the development or improvement of a product or process, conducted through a systematic process of experimentation.3 This includes the actual execution of laboratory tests, the writing and testing of new software code, or the hands-on engineering involved in prototype development.9
2. Direct Supervision of Qualified Research: This covers the immediate, first-line management and oversight of employees who are directly performing the QRAs.7 For compensation to qualify, the supervision must be proximate to the technical activities. Compensation paid to upper-level management who are not directly involved in the technical details of the research—such as management several tiers removed—is generally excluded.9
3. Direct Support of Qualified Research: These are services necessary and closely related to the performance of QRAs. The support must directly facilitate the research activity.7 Examples of qualifying support include a clerk compiling data specifically generated by the research activity or a machinist fabricating a part for an experimental model used in qualified research.3

C. Distinguishing Qualified Support from General Administration (DOR Exclusions)

The Indiana DOR explicitly limits the scope of “Direct Support” by excluding general administrative services, which are deemed only indirectly beneficial to research activities, regardless of the department to which the personnel are assigned.3

Services that the DOR mandates for exclusion as general administration include:

• Payroll personnel who prepare salary checks for laboratory scientists.3
• Accountants responsible for tracking and accounting for research expenses.3
• Janitorial staff who perform only general cleaning and maintenance of a research facility.3

This distinction underscores the requirement that qualified services must be proximately related to the elimination of technical uncertainty. If an activity would continue regardless of whether the specific R&D project was undertaken—such as general accounting, human resources, or routine maintenance—it is typically deemed non-qualified.

The categories of qualified and excluded activities are summarized in the table below:

Qualified Research Activities (QRAs) Defined for WQS Inclusion (DOR Emphasis)

III. Indiana Department of Revenue (DOR) Guidance and Allocation Rules

The most stringent requirements imposed by the DOR relate to the geographical nexus of the research and, more critically, the methodology used to calculate the time spent on qualified activities by hybrid employees.

A. The Nexus Requirement: Ensuring Research is Conducted in Indiana

The core statutory requirement is that only qualified research expense incurred for research conducted in Indiana is eligible for the credit.2 When reviewing expenses, the Department of Revenue may specifically consider factors such as the place where the services are performed and the residence or physical location of the employees.1

This requirement creates compliance complexities for modern companies with geographically dispersed workforces. However, Indiana has provided some regulatory relief regarding non-resident workers: Indiana businesses are not required to withhold Indiana taxes on the wages of out-of-state employees who travel into Indiana for work, provided they are in the state for fewer than 30 days. This contrasts with prior rules that imposed immediate withholding requirements.6 Even with this withholding relief, the underlying requirement for R&D credit purposes is that the time claimed must correspond to QRAs physically performed within the state.

B. The Mandated Allocation Methodology for Hybrid Services

Many R&D employees perform both qualified research activities (QRAs) and nonqualified administrative or production services. The accurate allocation of their wages is the single greatest determinant of audit success.

1. Determining the Qualified Percentage via Time Ratio

The DOR mandates a specific methodology for allocating wages for employees with mixed duties. If an employee performs both qualified and nonqualified services, only the portion of wages allocated to the qualified services is allowed.3

The standard, and preferred, method of allocation is defined by a ratio. Absent another method that the taxpayer can demonstrate is more appropriate, the amount of allowable wages shall be determined by multiplying the total amount of wages by the ratio of the total time actually spent by the employee in performance of qualified services to the total time spent by the employee for all services for the year.3 This resulting “Allocation Percentage” is then applied to the employee’s W-2 taxable wage to determine the calculated WQS amount.9

This stringent reliance on time ratio methodology is inherent to the state’s adoption of the 2001 IRC § 41 regulations, which include the “substantially all” test. This test allows 100% of an employee’s wages to be treated as WQS if 80% or more of their time is spent on qualified services. Whether the taxpayer claims 40%, 75%, or 100% of the wages, the fundamental need remains the same: the claim must be substantiated by a defensible and documented time-based ratio.

2. The Risks of Oral Estimates (The “Hybrid/Nexus Problem”)

The DOR explicitly warns against the pervasive compliance pitfall known as the “hybrid/nexus problem.” This issue arises when the qualified percentage is based on oral testimony from a selected manager’s recollection or estimate of the amount of time particular employees devoted to qualified activity.3 The Department of Revenue considers such retrospective, non-contemporaneous documentation to be inherently unreliable.

This position is reinforced by judicial outcomes. In one example, research tax credits were properly denied to a manufacturer because the company could not provide proper documentation to show the time employees spent conducting qualifying research.2 Similarly, federal case law has affirmed the denial of credits where a taxpayer relied on arbitrary estimates and failed to offer a “principled way to determine what portion of the employee activities” constituted elements of a process of experimentation.10 This demonstrates a clear regulatory conclusion: the failure to provide objective, contemporaneous evidence of time allocation—not merely the existence of the research activity—is a fatal flaw that results in the disallowance of valid expenses. Compliance efforts must therefore prioritize the creation of robust time records over simple confirmation of technical projects.

IV. Advanced Compliance and Documentation for WQS Claims

Because the burden of proof rests entirely on the taxpayer, Indiana mandates that documentation be timely, comprehensive, and compiled in an audit-ready format.

A. The Burden of Proof: Substantiating Timeliness and Usefulness

To ensure the DOR does not disallow a Research Expense Credit claim, it is critical that sufficient and timely documentation be identified, gathered, properly compiled, and retained should an examination become necessary.11 Documentation must be retained in sufficiently usable form and detail to substantiate claimed QREs and Qualified Research Activities (QRAs) at the project level, aligning with federal Audit Technique Guidelines.11

This requirement for timeliness means that documentation must generally be generated as the research occurs, not reconstructed years after the fact. The documentation must link financial expenses (wages) to the technical activities (research) at a granular, project-specific level.11

B. Essential Documentation Elements (DOR and Audit Focus)

Defensible WQS claims require a comprehensive dual-track documentation system covering both the technical legitimacy of the activity and the financial calculation of the wages.

1. Technical and Project Documentation

These records prove that the employee was engaged in activity that meets the four-part definition of qualified research. Examples include complete project lists, design requirements, functional specifications, testing scripts, modification reports, error logs, and laboratory notebooks.11 Other strong forms of evidence include patents or patent applications, due to the rigorous process inherent in obtaining them.11 For software development, information extracted from project management tools or repositories that demonstrates a process of experimentation is appropriate.7

2. WQS Allocation Documentation

These records justify the specific wage amount claimed. Documentation examples include payroll registers, employee W-2s, job descriptions, and time tracking data.8 Time tracking data (e.g., electronic timesheets or similar records) is essential because it provides the objective evidence needed to calculate the time ratio required for hybrid employees.7 Without documented time tracking, the technical evidence of the activity is insufficient to substantiate the financial expense.

C. Post-2019 Compliance: The HEA 1001 Disclosure Requirement

Effective January 1, 2019, Indiana introduced a critical new compliance layer under HEA 1001 (IC 6-3.1-4-8), concerning the relationship between state and federal credit claims.12

A taxpayer claiming the Indiana REC must now report to the DOR whether they have determined a corresponding federal R&D credit (under IRC Sec. 41(a)(1) or (c)(4)) and whether they have claimed it.12

Crucially, if a taxpayer claims the Indiana credit but does not claim the federal credit for those same qualified research expenses, the taxpayer must disclose to the DOR the specific reasons for not claiming the federal credit.12

This disclosure serves as a significant audit filter. Since Indiana’s QRE definition is based on the federal 2001 standard, a valid claim for the Indiana credit implies the activities satisfy the strict technical criteria. If a taxpayer asserts that these activities meet the state standard but simultaneously fails the federal standard, the required disclosure compels the articulation of a defensible rationale. If that rationale suggests a fundamental flaw in the qualification of the underlying activities, it may contradict the state claim. This rule imposes a high standard of consistency between state and federal documentation and analysis, forcing taxpayers to ensure their technical and financial records are robust enough to defend a claim at either level.

V. Practical Case Study: Allocation of Wages for a Hybrid R&D Team

To illustrate the DOR’s mandatory time allocation methodology, consider the following scenario involving an Indiana company, InnovateCorp. The example highlights how WQS must be calculated using contemporaneous time tracking data for employees who perform a mix of qualified and non-qualified duties.

A. Scenario Setup: InnovateCorp Personnel

InnovateCorp is a manufacturer conducting qualified research to improve a business component. The company employs three individuals whose time is split between R&D and non-R&D activities. All employees work 2,000 compensable hours annually, and their compensation is based on their W-2 taxable wage (Box 1).

• Engineer Alex (R&D Director): $180,000 W-2 wage.
• Technician Ben (Lab Machinist): $75,000 W-2 wage.
• Analyst Clara (Data Clerk): $50,000 W-2 wage.

The company uses time tracking software to allocate employee hours accurately.

• Alex’s Time: 800 hours supervising R&D projects (Qualified); 400 hours strategic planning (Non-Qualified); 800 hours general management/budgeting (Non-Qualified).
• Ben’s Time: 1,500 hours fabricating experimental prototypes (Direct Support, Qualified); 500 hours machine maintenance (Non-Qualified).
• Clara’s Time: 700 hours compiling test data and research results (Direct Support, Qualified); 1,300 hours accounts payable and general inventory management (Non-Qualified, general administration).3

B. Step-by-Step WQS Calculation and Allocation

The calculation follows the DOR’s mandated time ratio: (Qualified Time / Total Time) $\times$ W-2 Wage = WQS.3

WQS Allocation Example for Hybrid Employees (InnovateCorp)

The total Qualified Wages for Services that InnovateCorp can claim as part of their IQRE is $145,750.

C. Analysis of Allocation and Risk Mitigation

If InnovateCorp had attempted to estimate these percentages—for instance, if a manager simply recalled that Ben spent “most of his time” on R&D and assigned him 90% qualification—this would be subject to immediate disallowance by the DOR. The regulations explicitly reject allocation based on manager recollection or oral testimony because it fails to provide a factual basis for the time spent.3

The use of documented time tracking data, which verifies that 1,500 hours were spent on prototype fabrication (a qualified support activity) versus 500 hours on non-qualified maintenance, is the only defensible basis for the 75% allocation.7 The financial consequence of relying on estimates is substantial: if the entire $\$145,750$ WQS claim were denied due to inadequate documentation of the time ratio, the resulting lost credit and potential penalties would be significant, illustrating that compliance is ultimately a documentation problem, not just a technical activity problem.2

VI. Conclusion and Policy Synthesis

The Indiana Research Expense Credit provides a robust incentive for companies performing R&D within the state, calculated at a significant rate relative to the federal standard.14 However, the inclusion of Wages for Qualified Services (WQS) as the primary component of Qualified Research Expenses (QREs) is governed by a framework that demands meticulous attention to detail and rigorous substantiation.

Indiana’s statutory architecture leverages the stability of the federal R&D definition (IRC § 41(b) as of January 1, 2001) while imposing its own strict compliance standards, particularly concerning expense allocation. The continuous challenge for taxpayers stems from the complex operational requirements imposed by the DOR, specifically the need to precisely allocate wages for hybrid employees.

The definitive policy position communicated by the DOR is that the allocation of time must be based on objective, contemporaneous records, calculated using the ratio of qualified time to total compensated time. The Department explicitly cautions against the use of retrospective estimates or managerial recollection, identifying these common methodologies as the primary cause for the denial of credits upon examination.3 Furthermore, the HEA 1001 disclosure requirement ensures that taxpayers must maintain analytical consistency between their Indiana credit claims and their federal filing positions, subjecting their claim rationale to greater governmental scrutiny.12

Successful compliance with the Indiana REC fundamentally requires the integration of accounting and R&D operational processes. Taxpayers must transition from treating R&D credit determination as a retroactive tax calculation to implementing a continuous, daily process of time tracking and technical documentation capture. The failure to document WQS time allocation is documented as the single most vulnerable point in the audit defense, demonstrating that the ultimate determination of the credit rests not on the existence of qualified research, but on the defensibility of the time ratio used to calculate the wage expense.

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