The Cost of Supplies Phase-Out Limitation: A Nuanced Analysis of the Iowa Research Activities Tax Credit (RAC) Transition

The Cost of Supplies (Phase-Out Limitation) is a legislative restriction that progressively reduces the amount of qualified supply expenditures eligible for the Iowa Research Activities Credit (RAC) during the transitional period of 2023 through 2025. This measure significantly decreased the potential value of the credit for companies relying heavily on raw materials and prototypes, signaling a calculated shift in Iowa’s R&D incentive philosophy ahead of the program’s scheduled replacement in 2026.

Legislative Framework and Contextualizing the RAC Evolution

The Iowa Research Activities Credit (RAC) has historically been one of the most substantial state R&D incentives in the Midwest, particularly due to its refundable nature and generous rate structure.1 Until recent legislative changes, the Iowa RAC largely mirrored the federal credit outlined in Internal Revenue Code (IRC) Section 41, adopting the same fundamental definitions for Qualified Research Expenses (QREs), including wages, contract research, and supplies.2

Overview of the Pre-2026 Iowa Research Activities Credit (RAC)

Before the recent statutory modifications, businesses conducting qualified research in Iowa were eligible for a refundable credit, often calculated at 6.5% of the state’s apportioned share of qualifying expenditures that exceeded a defined base amount.2 The base amount calculation typically relied on a fixed-base percentage multiplied by the average annual gross receipts of the taxpayer for the four preceding taxable years.4 In no event, however, could this base amount be less than 50% of the qualified research expenses for the credit year.4

Eligible industries for the RAC included manufacturing, life sciences, agriscience, software engineering, aviation, and aerospace.2 Taxpayers also had the option to elect the Alternative Simplified Credit (ASC) method, which provided a credit equal to 4.55% of expenditures exceeding 50% of the average of the prior three-year qualified research expenses.2

The Genesis of the Supplies Limitation: House File 2317 (HF 2317)

The generous nature and uncapped structure of the legacy RAC led to rising fiscal pressure on the state budget. The total claims for the RAC reached $77.6 million in fiscal year 2024, prompting the legislature to implement significant modifications.6 In 2022, Iowa Governor Kim Reynolds signed House File 2317 (HF 2317), which introduced substantial modifications designed to raise revenue and constrain the credit’s cost.2

HF 2317 introduced several restrictive changes, including limiting the amount of the research activity credit that could be refunded (phasing down 10 percentage points annually starting in 2023).2 Concurrently, the legislation phased out certain qualified research expenditures, specifically targeting costs related to supplies used in qualified research.2

The supplies phase-out, combined with the phase-down of refundability, represents a deliberate strategy for budgetary contraction. By simultaneously limiting the QRE calculation base through supplies and reducing the refundable percentage, the state ensured that the rapidly growing cost of the uncapped RAC was fiscally constrained. This action prepared the state’s budget for the eventual elimination and replacement of the RAC with a new, capped program, effectively smoothing the financial transition and managing liability prior to the 2026 overhaul.

Defining Qualified Research Supplies under Iowa Statute

To understand the phase-out limitation, it is first necessary to confirm the definition of “supplies” eligible for inclusion in QREs. Iowa statute maintains strong conformity with the federal definition established under IRC Section 41.

Federal Definition Conformance

Under IRC § 41(b)(2)(C), Qualified Research Expenses include amounts paid or incurred for “supplies” used or consumed in the conduct of “qualified research”.3 These tangible properties must be directly used in the research activities. For example, raw materials utilized in the fabrication and testing of prototypes are considered qualified supply expenses.9

It is crucial to note the explicit exclusions maintained at both the federal and state levels. Supplies specifically exclude items such as land, improvements to land, general administrative office supplies, and, critically, any property subject to an allowance for depreciation (e.g., equipment or research facilities).9

The Iowa-Specific Scope Requirement

For a supply cost to be included in the Iowa RAC calculation, the expenditure must meet an Iowa-specific geographic scope requirement. The Iowa Department of Revenue (DOR) guidance specifies that amounts paid for supplies defined in IRC Section 41(b)(2)(C) constitute qualified research expenses in Iowa only if the supplies directly relate to research performed in Iowa.10 This requirement necessitates rigorous state-specific tracking and apportionment of materials consumed during experimentation, ensuring that only costs directly attributable to Iowa-based research activities are subject to the phase-out calculation.

The Mechanics of the Cost of Supplies Phase-Out Limitation and DOR Guidance

The Cost of Supplies Phase-Out Limitation mandates that only a predetermined, declining percentage of the total costs incurred for qualified supplies performed in Iowa may be included in the calculation of Iowa QREs (Iowa Code Section 15.335).

The Fixed Reduction Schedule (Tax Years 2023–2025)

The progressive limitation began with the 2023 tax year and is structured to reduce the eligible percentage of supply costs by 20 percentage points annually until the legacy RAC is retired:

Table 1: Iowa Research Activities Credit (RAC) Supplies Phase-Out Schedule

For example, for a tax year beginning in 2025, only 40 cents of every dollar spent on qualified supplies used in Iowa research can be counted toward the total QRE base for credit computation.11

Iowa Department of Revenue (DOR) Compliance Guidance

The Iowa Department of Revenue (DOR) formalized this limitation through specific line instructions on the relevant tax forms, such as the IA 128 (Iowa Research Activities Tax Credit). The instructions clearly delineate the requirement for calculating the limitation.

Reviewing the instructions for the 2025 IA 128 form provides a clear example of the compliance mechanics 11:

• Line 24: Cost of supplies used in conducting qualified research in Iowa. The taxpayer is directed to enter the total, unlimited cost of supplies incurred for qualified research in Iowa on this line.
• Line 25: Eligible cost of Iowa supplies. The instruction for this line explicitly states to “Multiply line 24 by 40% (.40)”.11

The resulting product from Line 25—the eligible, limited amount—is then aggregated with qualified wages and contract research expenses to determine the Total Eligible Iowa QREs, which serves as the foundation for the credit calculation.

Compounded Reduction Impact on the QRE Base

The financial consequences of the supplies phase-out extend beyond the simple exclusion of the expense itself. The structure of the legacy Iowa RAC calculation formula is designed so that the final credit benefit is profoundly sensitive to changes in the total QRE base.

The calculation of the Iowa credit requires computing the excess QREs, defined as the total current Eligible Iowa QREs less the determined Base Amount.4 A crucial statutory requirement dictates that the Base Amount must be at least 50% of the current year’s QREs.4

The supplies limitation mechanically lowers the Total Eligible Iowa QREs. This reduction immediately reduces the amount of expense eligible for the 6.5% credit. Furthermore, for companies operating near the 50% minimum base threshold, lowering the total QREs figure (the reference point for the 50% minimum) may trigger the minimum base calculation sooner, or at a lower dollar amount, thereby shrinking the resulting “Excess QREs” disproportionately. Therefore, a reduction in supply QREs may result in not only the lost 6.5% credit on the excluded supply amount but also a secondary reduction in the amount of other QREs (wages, contract research) that are deemed “excess” and thus creditable. Taxpayers must view the supplies limitation not as a simple expense exclusion but as a strategic adjustment that potentially shrinks the entire creditable base.

Illustrative Example: Calculation Impact (Tax Year 2024)

To fully demonstrate the combined effect of the Cost of Supplies Phase-Out Limitation on the overall credit value, a scenario utilizing the Tax Year 2024 limitation of 60% is analyzed.

Example Setup: Manufacturing Company (Tax Year 2024)

A qualified Iowa manufacturing company incurs the following Iowa QREs for the tax year beginning January 1, 2024:

The company has calculated its Fixed-Base Amount (based on the fixed-base percentage and prior gross receipts) to be $350,000.

Step 1: Applying the Cost of Supplies Phase-Out Limitation (60% for 2024)

Since the tax year begins in 2024, the eligible percentage for supply costs is 60%.10

Table 2: Calculation of Eligible Iowa QREs (Tax Year 2024)

The phase-out immediately disqualifies $80,000 ($200,000 – $120,000) of otherwise qualified research supplies.

Step 2: Determining the Base Amount and Calculating Excess QREs

The Iowa RAC calculation uses the greater of the Fixed-Base Amount or 50% of the current year’s Eligible Iowa QREs.4

1. Fixed-Base Amount (Assumed): $350,000
2. Minimum Base (50% of Current QREs): 50% $\times$ $720,000 = $360,000

The greater of the two is $360,000. This $360,000 becomes the Base Amount used in the calculation.

• Excess QREs: Total Eligible Iowa QREs ($720,000) – Base Amount ($360,000) = $360,000

Step 3: Calculating the Final Iowa RAC

The standard Iowa RAC rate of 6.5% is applied to the excess QREs 4:

• Iowa RAC = 6.5% $\times$ $360,000 = $23,400

Comparative Analysis (Impact Assessment)

If the supplies limitation did not exist, the Total QREs would be $800,000.

• Minimum Base: 50% $\times$ $800,000 = $400,000
• Base Used (Greater of $350k or $400k): $400,000
• Excess QREs: $800,000 – $400,000 = $400,000
• Credit: 6.5% $\times$ $400,000 = $26,000

By implementing the 60% supplies limitation, the company’s final credit decreased from $26,000 to $23,400. This $2,600 reduction demonstrates the direct and compounding financial pressure the phase-out places on businesses whose research heavily involves material consumption.

Strategic Implications and the Transition to the New R&D Credit Program (Post-2025)

The Cost of Supplies Phase-Out Limitation serves as more than just an interim tax calculation; it is a critical preparatory step for the wholesale replacement of the Research Activities Credit. This transition is formalized by Senate File 657 (SF 657), which repeals the existing RAC and institutes a new, fundamentally different R&D Tax Credit Program, effective for tax years beginning on or after January 1, 2026.7

The Sunset of the RAC and the Shift in Incentive Focus

The progressive phase-out schedule (80% $\to$ 60% $\to$ 40%) preceding the 2026 program change strongly indicates the state’s intent to permanently de-emphasize, or eliminate, supply costs as a component of its R&D tax incentives. The legislature has often “tinkered” with the RAC in recent years, changing calculation methods and gradually phasing out supplies.6 The supplies limitation aligns with a strategic governmental effort to better target the economic benefits of the tax credit.12

While the new 2026 program run by the Iowa Economic Development Authority (IEDA) may technically reference QRE definitions under IRC § 41 (which includes supplies) 7, the structured pre-2026 phase-out suggests that Iowa is deliberately shifting the weight of its incentive structure towards labor (wages) and contracted services. This move favors high-wage, intellectual property creation over R&D processes that involve significant material consumption and prototyping.

Key Changes under the New IEDA-Administered Program

The new R&D Tax Credit Program, commencing in 2026, presents a complete departure from the previous structure.6

• Administration and Cap: The program shifts administration from the Department of Revenue (DOR) to the IEDA. Crucially, the program is capped, with total credits issued statewide limited to $40 million per fiscal year.7 This is a major change from the previous uncapped RAC, which cost the state $77.6 million in FY 2024 alone.6
• Reduced Rate and Refundability: The maximum credit rate will be reduced to 3.5% of Iowa research expenses, down from the 6.5% rate under the regular RAC method.2 The credit remains refundable, subject to the new $40 million annual cap.7
• Targeted Industries and Application: Eligibility is significantly narrowed. Businesses must be engaged in specific, targeted sectors, including advanced manufacturing, bioscience, technology and innovation, and insurance/finance.6 Furthermore, businesses must pre-apply with IEDA to determine eligibility, and approved businesses must reapply every five years and have their expenses reviewed by a CPA.6 Explicitly excluded from the new program are industries such as farming, real estate, construction, and retail.12

Compliance and Planning Recommendations

The temporary nature of the supplies phase-out limitation necessitates proactive compliance and long-term strategic planning for tax professionals:

1. Immediate Compliance for Tax Year 2025: Taxpayers must ensure they apply the 40% limitation to all qualified supply costs incurred in 2025, utilizing the specific line instructions provided on the IA 128 form.11 Detailed documentation separating qualified supplies (consumed materials) from disqualified capital assets (depreciable equipment) is paramount, given the substantial loss of credit value associated with supplies.
2. Future QRE Optimization (Post-2025): Businesses should recognize that the utility of supply costs as a QRE component has likely expired in Iowa. Strategic planning for 2026 and beyond must pivot to maximize qualified wages and contract research expenditures, as these expenses are expected to constitute the primary, if not sole, components of the QRE base eligible for the 3.5% IEDA credit. Furthermore, businesses in marginal or excluded industries must explore alternative incentive programs, such as the Business Incentives for Growth (BIG) Program, which replaced the High-Quality Jobs (HQJ) initiative, to offset the loss of the RAC.13

Conclusion

The Cost of Supplies (Phase-Out Limitation) is a definitive policy measure implemented by the Iowa legislature (via HF 2317) that targeted a key component of the legacy Research Activities Credit (RAC). By systematically reducing the eligible amount of supply expenditures from 80% in 2023 to 40% in 2025, Iowa has successfully reduced its tax credit expenditure while signaling a fundamental shift in its economic development priorities.

This phase-out forces companies, particularly those in manufacturing and biosciences with significant raw material consumption, to adapt their internal cost accounting and R&D strategy. For the final year of the legacy program (Tax Year 2025), adherence to the 40% rule is mandatory for DOR compliance. More broadly, the supplies phase-out serves as a crucial transition mechanism, preparing the corporate tax landscape for the introduction of the new IEDA-administered R&D Tax Credit Program in 2026—a program that is capped, requires application approval, has a lower rate, and targets a much narrower set of industries. Taxpayers must proactively adjust their R&D financial modeling to focus on maximizing labor-related QREs to ensure maximum utilization of the limited incentives available under the state’s revised R&D fiscal regime.

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