Maximizing the Iowa Research Activities Tax Credit: A Deep Dive into Contract Research Expenses (65% Rule and Exceptions)

Contract Research Expenses (CREs) are defined as payments made to unrelated third parties for the performance of qualified research activities. The Iowa Research Activities Tax Credit (RAC) generally adopts the federal standard, allowing a taxpayer to include 65% of these costs in their total Qualified Research Expenses (QREs) for credit calculation purposes. This foundational rule is critical for businesses leveraging external expertise in Iowa, though it is subject to important modifications—increasing to 75% and 100% inclusion—based on the type of recipient and the nature of the research.

This report provides an exhaustive analysis of the meaning and application of Contract Research Expenses within the context of the Iowa RAC, detailing the governing statutes, administrative guidance from the Iowa Department of Revenue (IDOR), specific inclusion percentages, and strategic implications for taxpayers.

I. Executive Summary: The Role of Contract Research Expenses in Iowa R&D Tax Strategy

The Iowa Research Activities Tax Credit (RAC), administered under Iowa Code §15.335, is a vital incentive rewarding qualified research and development investments conducted within the state.1 The Iowa credit is fundamentally reliant on the definitions and criteria established under Internal Revenue Code (IRC) Section 41 for calculating Qualified Research Expenses (QREs). CREs, which represent payments to third parties for research, are a major component of these QREs.

The ability to include 65% of CREs is designed to provide a tax incentive for outsourcing technical expertise while preventing taxpayers from claiming a credit on the full contract price, which typically embeds the contractor’s non-qualified general administrative overhead and profit margin.3 The varying inclusion percentages (65%, 75%, 100%) mandated by the state demonstrate that the Iowa legislature utilizes the tax credit mechanism not only for broad R&D stimulation but also to prioritize specific policy goals, such as cooperative research and clean energy development, through enhanced subsidy rates. Providing an increased inclusion percentage translates directly into a higher QRE basis, thus resulting in a larger tax credit for strategically desirable activities.5

For Iowa taxpayers, maximizing the RAC requires meticulous documentation and proper categorization of these external costs. Key takeaways include the necessity of establishing the Iowa nexus for the research activity and strictly adhering to the nuanced inclusion percentages detailed by the Iowa Department of Revenue (IDOR) on Form IA 128, Line 24.5

II. Foundational Context: Defining Qualified Research Expenses (QREs) in Iowa

A. The Dual Mandate: Iowa’s Reliance on Federal IRC §41

Iowa tax law explicitly aligns the definition of “Qualified Research” and the categories of QREs with federal Internal Revenue Code Section 41.2 For a cost to qualify, the underlying research must satisfy the four-part test (developing a new or improved business component, technological in nature, elimination of uncertainty, and process of experimentation).7

QREs generally comprise three statutory categories:

1. In-house wages paid for qualified services performed in Iowa.8
2. Costs of supplies used in conducting qualified research in Iowa.8
3. The applicable portion (65% generally) of contract research expenses.8

B. Industry and Federal Claim Prerequisites for Iowa Eligibility

To claim the Iowa RAC, a business must meet strict eligibility requirements related to both its industry and its federal filing status:

1. Federal Claim Requirement: A foundational requirement is that the business must claim and be allowed the Federal Research Credit for qualified research expenses under IRC Section 41 for the same taxable year.7 The federal Form 6765 must be filed alongside the state return (Form IA 128 or IA 128S) for pass-through entities.5
2. Industry Restrictions: The credit is strictly limited to businesses engaged in specified sectors, including Manufacturing, Life Sciences (covering agriscience, biology, biochemistry, etc.), Software Engineering, Aviation, and Aerospace.10

C. Key Legislative Changes Affecting QREs (Post-2023 Adjustments)

Recent state legislation (House File 2317 and subsequent bills) introduced significant limitations and compliance requirements that affect QRE calculations:

1. Method Consistency: For tax years beginning on or after January 1, 2023, the method used for calculating the Iowa credit (Regular Method or Alternative Simplified Credit—ASC) must be consistent with the method elected or required for federal purposes.7 This removes a historical option for taxpayers to optimize their Iowa credit calculation independently of their federal strategy.
2. Explicit Exclusions: Iowa law explicitly disallows the inclusion of certain expenses that may be qualified federally. Specifically, amounts paid for the right to use computers, as described in IRC Section 41(b)(2)(A)(iii) (rental or lease costs), are not qualified research expenses in Iowa.7

This divergence from IRC Section 41 creates complexity and potential state audit exposure, particularly for software engineering and advanced manufacturing firms that heavily rely on leased computing power for development. If a contract researcher charges a lump sum (CRE), the taxpayer must exercise due diligence to ensure the underlying costs funded by that payment, even after the 65% reduction is applied, do not disproportionately relate to disallowable costs like computer rentals, or the 65% CRE basis may be challenged upon audit.7

III. Contract Research Expenses (CRE): The 65% Default Inclusion Rule

A. Statutory Authority: Tracing the 65% Limitation

The standard inclusion rate for contract research expenses is derived directly from federal statute. IRC Section 41(b)(3)(A) defines contract research expenses as 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.3 Iowa adopts this definition for its state credit.

This limitation serves an administrative function, acknowledging that payments to third-party contractors inherently include non-qualified elements (e.g., general business overhead, marketing, profit margin) that are not directly used for research. The 35% statutory exclusion acts as a uniform proxy for removing these non-qualified costs from the QRE base.

B. Definition and Scope of Contract Research

Contract research involves payments to any unrelated individual or organization to perform qualified research on behalf of the taxpayer.8 It is critical that the research performed under contract meets the strict four-part test for qualified research under IRC §41.7 If a contract includes both qualified and non-qualified activities, only the amounts demonstrably attributable to qualified research can be included before applying the inclusion percentage.

C. The Critical Nexus: Requirement for Research to Be Performed Within Iowa

A fundamental constraint on the Iowa RAC is that only expenses incurred in the state can be captured towards the credit.12 For CREs, this requires that the qualified research activity itself must have been performed in Iowa.

Iowa Department of Revenue (IDOR) guidance on Form IA 128 specifically instructs taxpayers to “Include 65% of qualified research performed on your behalf in Iowa” (Line 24).5

This “in Iowa” requirement for CREs presents a significant audit challenge. For a multi-state taxpayer utilizing a contractor, proving where the contractor’s employees performed the research requires robust contractual language and detailed time/location tracking. While in-house wages are easily verified through Iowa payroll records, contract research payments, which represent payments leaving the taxpayer’s direct control, demand careful substantiation of the physical location of the research activity. If a $500,000 CRE payment is made, the taxpayer must be able to prove that the underlying services were conducted within Iowa borders before the 65% reduction is applied. Failing to do so risks a partial or full disallowance of the qualified expense claimed.5

IV. Comprehensive IDOR Guidance: Applying the Modified Inclusion Rates

The instructions for Line 24 of the Iowa Research Activities Tax Credit form (IA 128) expand upon the federal 65% rule, establishing enhanced inclusion rates for certain strategic activities.5

A. Direct Interpretation of IA 128 (Line 24) Instructions

The following table summarizes the inclusion percentages for contract research expenses, which are essential for calculating Iowa QREs:

Table 1: Iowa Contract Research Expense Inclusion Rates

B. Exception 1: Qualified Research Consortia (75% Inclusion)

Payments made to a qualified research consortium operating in Iowa are subject to a preferential 75% inclusion rate.5 This elevated rate provides an incentive to promote collaborative R&D efforts, encouraging companies to pool resources for shared research and development infrastructure. Taxpayers claiming this rate must verify that the recipient organization meets the federal definition of a qualified research consortium.

C. Exception 2: Qualified Energy Research (100% Inclusion)

The highest inclusion rate, 100%, is available for payments made for qualified energy research.5 This favorable treatment is granted only if the research is performed by specific entities: an eligible small business, a university, or a federal laboratory.5 This enhancement targets high-impact basic or applied research in the energy sector, reinforcing state policy goals related to clean energy technology.

D. Integrating Basic Research Payments (BRP) and Base Amount Limitations

IDOR Form IA 128 includes a critical provision on Line 24 regarding the treatment of payments that might also qualify as Basic Research Payments (BRPs), which are typically payments to universities or qualified organizations for basic research.5

The Line 24 instructions state: “Include payments to those same entities [eligible small business, university, or federal laboratory] to the extent they are included as basic research payments on line 17, not to exceed the base period amount on line 18, subject to the 65% or 75% limitation”.5

This mechanism prevents a taxpayer from receiving two simultaneous favorable treatments for the same expenditure. Payments to universities are often highly favored under the federal Basic Research Credit provisions (which Iowa follows). If a company treats a payment to a university as a BRP (Line 17), the IDOR requires that the same amount, when factored into the standard incremental QRE calculation (Line 24), must be limited by the lesser of the base period amount and restricted to the less favorable 65% or 75% inclusion rates, rather than the 100% energy research rate. This intricate interaction functions as a sophisticated anti-abuse measure, demanding careful segregation of research expenditures (basic research versus standard qualified research) to ensure the total qualified amount is not overstated or double-counted against the base amount calculation.

V. CRE Calculation Mechanics and Integration into the Iowa Research Activities Credit (RAC)

The inclusion of Contract Research Expenses determines the final Qualified Research Expenses (QREs) used to calculate the incremental credit amount. Iowa offers two calculation methods.

A. The Regular Method (6.5% of Incremental QREs)

The Regular Method calculates the credit as 6.5% of the excess of the current year Iowa QREs (which includes the applicable percentage of CREs) over the calculated base amount.8

The calculation of the base amount involves multiplying the taxpayer’s fixed-based percentage (capped at 16.00%) by the average annual gross receipts for the four preceding tax years.10 Crucially, state law clarifies that “in no event shall the base amount be less than fifty (50) percent of the qualified research expenses for the credit year”.8 This 50% QRE floor ensures that a minimum level of current-year spending must be offset before the credit calculation begins, significantly affecting the claims of established companies.

B. The Alternative Simplified Credit (ASC) Method (4.55% Rate)

The Alternative Simplified Credit (ASC) offers a simpler calculation, beneficial for companies experiencing steady growth in R&D.8 The ASC is calculated at a rate of 4.55% of the difference between the current year’s Iowa QREs and 50% of the average Iowa QREs from the prior three tax years.8 This method utilizes a lower statutory credit rate but employs a simplified, lower base (50% of the three-year average QREs) compared to the Regular Method’s often higher fixed-base percentage.

C. Strategic Impact of Consistency

The requirement, effective post-2023, that taxpayers must use the same calculation method (Regular or ASC) for both federal and Iowa purposes restricts strategic optimization.7 Previously, a company could select the method that yielded the maximum benefit based on Iowa-apportioned QREs alone. Now, the federal decision dictates the state outcome. The critical factor remains maximizing the inclusion of CREs (up to 100%), as this directly boosts the current-year QRE base, which is then multiplied by either the 6.5% Regular Rate or the 4.55% ASC rate, providing a magnified effect on the final credit amount.8

VI. Practical Application: A Detailed Calculation Example

The following example illustrates how the varying Contract Research Expense inclusion rates are applied within the framework of the Iowa Research Activities Credit.

A. Scenario Presentation: Advanced Manufacturing Corp. (AMC)

Advanced Manufacturing Corp. (AMC) is an eligible Iowa manufacturer whose average annual gross receipts over the four preceding tax years were $100,000,000. AMC uses the Regular Method for calculating the credit. The current year’s R&D expenditures include internal and contract costs, all performed in Iowa:

• Internal QREs: Wages for qualified services: $1,200,000; Costs of supplies: $300,000.
• Contract Research Incurred (All performed in Iowa):

• Payment to Unrelated Testing Lab (Standard Contract Research): $500,000.
• Payment to Qualified Consortium (for collaborative materials research): $100,000.
• Payment for Qualified Energy Research (paid to Iowa State University): $50,000 (This amount is assumed NOT to be claimed as a Basic Research Payment).
• Total Contract Payments: $650,000.

B. Step-by-Step Determination of Total Qualified Contract Expenses

The total payments of $650,000 must be adjusted using the specific IDOR inclusion rates before they can be added to the QRE pool, as detailed on IA 128, Line 24.5

Table 2: Contract Research Expense Qualification

The calculation demonstrates that only $450,000 of the $650,000 paid to contractors may be included in the total QREs.

C. Comprehensive Calculation of the Final Iowa RAC (Regular Method)

Using the derived QREs, the final credit calculation under the Regular Method (6.5% rate) is performed. The fixed-base percentage is assumed to be 10.00% based on historical activity.

Table 3: Sample Calculation of Iowa Research Activities Credit (Regular Method)

This example illustrates that even with successfully maximized CRE inclusion, companies with high historical gross receipts compared to current R&D spending may receive no benefit under the Regular Method, highlighting why some firms may opt for the Alternative Simplified Credit (ASC) method if their historical QREs permit a lower base calculation.

VII. Compliance, Documentation, and Audit Defensibility

Given the complexity of Iowa’s nexus rules and differentiated CRE rates, the standard for audit documentation is exceptionally high. The credit is particularly sensitive to audit because of its refundable nature.

A. Required Substantiation for Contract Payments

To defend the inclusion of CREs upon IDOR review, a taxpayer must retain documentation that substantiates three core elements: qualification, location, and rate eligibility.

1. Contractual and Technical Clarity: The documentation, including the contract, statement of work (SOW), and project reports, must explicitly define the scope of research and demonstrate how the activity satisfies the qualified research criteria (technological nature, elimination of uncertainty).7
2. Payment and Location Nexus: Invoices and payment records must correlate with the research activity. Most critically, evidence must be maintained to support that the services purchased via the CRE were physically performed in Iowa.5 Since CREs are easily shiftable, auditors focus intensely on verifying the location of the activity.
3. Specific Rate Justification: If claiming the preferential 75% or 100% rates, the taxpayer must maintain records proving the recipient’s status (e.g., as a qualified research consortium or a university) and confirming that the research was indeed qualified energy research.5

B. Audit Focus and Refundability

The Iowa RAC is partially refundable, meaning the excess credit amount exceeding the taxpayer’s liability can be converted into a direct state payment (refund).2 The refundable portion is currently subject to statutory limits (80% of the standard RAC and 90% of the Supplemental RAC).2

This high rate of refundability elevates the compliance burden from merely reducing tax liability to justifying a direct state expenditure. In 2023, the state processed $84.6 million in claims, with $35.3 million (42%) paid as direct tax credit refunds to firms that owed no state income tax.13 This cash outflow motivates the IDOR to rigorously audit the Iowa nexus and qualification of the underlying expense, particularly for CREs. For this reason, taxpayers must ensure that their CRE documentation is treated with the same meticulous rigor applied to direct in-house payroll substantiation.

Furthermore, Iowa’s strict QRE definitions post-2023—such as the explicit disallowance of computer lease costs and specific rules for qualifying employee wages—mean that federal R&D audit documentation may no longer be sufficient to satisfy all Iowa requirements, necessitating state-specific preparation.7

VIII. Strategic Outlook: Utilizing the RAC and Preparing for the 2026 Transition

A. Statistical Insight: Current Utilization and Economic Impact

The Iowa RAC has historically been a highly utilized and substantial incentive. Analysis of claims processed in 2023 shows significant utilization, with major entities receiving large credit awards, such as Deere & Co. with $15.2 million.13 The research credit and supplemental credits resulting from Iowa research expenditures averaged $0.029 per dollar of qualifying research, confirming the incentive’s economic impact.14

B. Senate File 657 and the Future of R&D Incentives (IEDA Program)

Iowa’s tax incentive landscape is poised for a massive restructuring. Senate File 657 eliminates the current Research Activities Tax Credit (RAC) structure effective January 1, 2026.2

The current entitlement-based credit, where any eligible business could claim the statutory percentage based on its calculation, is being replaced by a new, capped program administered by the Iowa Economic Development Authority (IEDA).15

The new IEDA program will significantly narrow eligibility by focusing on four targeted industries: advanced manufacturing, bioscience, insurance and finance, and technology and innovation.6 Critically, certain previously included sectors, such as agriculture producers, contractors, retailers, and wholesalers, will be explicitly excluded.6 The shift from an entitlement-based credit to a discretionary, capped, and application-based program introduces substantial uncertainty and political risk for long-term R&D planning in the state.

C. Strategic Planning for Tax Years 2024 and 2025

For tax years 2024 and 2025, maximizing qualified research activity and associated CREs under the current, automatically calculated RAC is paramount. Businesses must accelerate R&D projects, particularly those that may fall outside the narrower scope of the post-2206 IEDA program.

Companies that expect to be eligible under the new IEDA guidelines must begin preparation for the required application and certification process.6 This means strategic planning must shift from rigorous technical tax compliance (ensuring 65% CRE inclusion, etc.) to satisfying broader economic development criteria and competing for limited, capped funds administered by a state agency, rather than simply claiming a statutory credit.

IX. Conclusion and Expert Recommendations

The Contract Research Expense inclusion rate, typically 65% but increasing to 75% or 100% for specific collaborations and energy research, is a central mechanism for calculating the valuable Iowa Research Activities Tax Credit. The state’s strict requirement that all underlying research services must be performed in Iowa necessitates rigorous compliance measures to document the geographical nexus of external contractors.

Recommendations

1. Immediate Nexus Documentation: For all existing and future contract research payments, taxpayers must obtain documentation (e.g., contractual clauses, contractor time tracking, specific SOWs) that definitively proves the qualified services were performed within Iowa boundaries. The refundability of the credit dictates this high level of audit defense.
2. Optimize Inclusion Rates: Conduct an immediate review of all third-party expenditures to determine if any payments qualify for the preferential 75% (consortium) or 100% (energy research) inclusion rates, leveraging the maximum possible QRE base under current law.
3. Prioritize 2024–2025 R&D Spend: Given the repeal of the current statutory RAC effective January 1, 2026, companies, especially those whose industry sectors may be excluded from the future IEDA program, should accelerate eligible research and development activities and subsequent CRE claims in the remaining years (2024 and 2025) to lock in benefits under the existing, more favorable rules.
4. Evaluate 2026 Eligibility: Businesses must assess their likelihood of fitting into the IEDA’s narrow scope of targeted industries (advanced manufacturing, bioscience, insurance/finance, technology/innovation) and begin preparing for the new application and certification process required for R&D funding under the post-2026 framework.

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