The Critical Nexus: Interpreting the “Process of Experimentation” for the Iowa Research Activities Tax Credit (RAC) Compliance

The Process of Experimentation (POE) is a systematic approach required to claim R&D tax credits, mandating that the research activities involve the testing of alternatives to resolve technical uncertainties. Substantially all qualified research expenditures must relate to this iterative, documented testing process aimed at achieving a new or improved business component.

The POE is defined federally under Internal Revenue Code (IRC) Section 41(d)(1) and represents the critical compliance threshold necessary to substantiate the state-level Iowa Research Activities Tax Credit (RAC). To constitute qualified research, substantially all of the activities must constitute elements of a documented process of experimentation related to developing a new or improved function, performance, reliability, or quality of a business component.1 For tax compliance purposes, “substantially all” is generally interpreted to mean 80% or more of the research activities within a project must relate to this systematic experimentation. If resources are overwhelmingly dedicated to non-experimental tasks, such as routine quality control, general management, or activities where the outcome is known in advance, the entire project may fail the “substantially all” test, leading to a zero credit calculation. The rigor of the systematic process must therefore be the dominant feature of the claimed Qualified Research Expenses (QREs).

II. Statutory and Regulatory Authority: Bridging Federal and State Law

The Iowa RAC is structured as an incremental credit designed to incentivize research expenditures within the state. Critically, Iowa Code explicitly links state eligibility to federal standards, meaning a business must first comply with the foundational requirements set forth in IRC Section 41.

2.1. The Federal Mandate: IRC Section 41 and the Four-Part Test

Iowa formally adopts the federal R&D tax credit definition for determining whether research activities qualify for the state credit.2 The process of experimentation is the final and often most scrutinized element of the mandatory four-part test for Qualified Research Activities (QRA) under federal law.

The Four Essential Tests, which must all be satisfied simultaneously for research to be considered qualified, are as follows:

2.1.1. Requirement 1: Permitted Purpose (Functionality Test)

The activity must relate to the development or improvement of a business component (product, process, software, technique, formula, or invention) regarding its functionality, performance, reliability, or quality.4 Research focused solely on cosmetic features, style, or seasonal design is explicitly excluded from qualified research activities.5

2.1.2. Requirement 2: Elimination of Uncertainty

The research activity must seek to discover information that would eliminate uncertainties regarding the appropriate design of the business component, or the capability or method of its development.4 This requirement serves as the fundamental trigger for the POE. If the outcome or method of achieving the desired result is known or readily ascertainable by skilled professionals working in the field, no uncertainty exists, and therefore, no qualified experimentation is deemed necessary or performed.

2.1.3. Requirement 3: Technological in Nature

The process of experimentation used to discover information must fundamentally rely on principles of hard science. This includes physical sciences, biological sciences, chemistry, engineering, or computer science.4 This criterion prevents research based on social science, humanities, or general management practices from qualifying for the credit.

2.1.4. Requirement 4: The Process of Experimentation (POE)

As detailed in subsequent sections, substantially all activities must constitute elements of a systematic process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result is uncertain at the outset of the research activities.1

2.2. Iowa Code’s Adoption and Simplification of the Standard

Iowa mandates that research activities must be conducted “in accordance with Internal Revenue Code Section 41”.2 While the Iowa Department of Revenue (IDR) guidance often simplifies the federal framework into three points—that the research must be “Experimental,” “Undertaken to discover information that is technological in nature,” and “Aimed at the development of a new product” 2—this phrasing effectively merges the POE requirement (“Experimental”) with the Technological and Permitted Purpose tests. Taxpayers cannot satisfy the state requirement simply by labeling an activity as “experimental”; they must meet the federal standard of structured, systematic resolution of technical uncertainty documented through the POE.

Table 1 provides a consolidated view of the federal requirements as applied to the Iowa RAC.

Table 1: The Four-Part Test for Qualified Research (Federal & Iowa)

III. The Process of Experimentation (POE): Detailed Compliance Framework

The POE criterion ensures that the claimed research is genuine, systematic, and targeted at resolving technical unknowns, differentiating it from routine product development or engineering.

3.1. Defining Systematic: Scientific Method vs. Iterative Revision

A qualified POE must represent a disciplined, systematic plan designed to overcome specific technical obstacles. This process does not require a rigid, linear structure but demands documentation that proves structure and purpose.

The systematic plan may take one of two forms:

1. Scientific Method: This involves the classical steps of making observations, formulating a hypothesis regarding how to resolve the uncertainty, conducting experiments to test that hypothesis, analyzing the resulting data, and drawing conclusions based on the empirical results.7 This method is typically employed in controlled environments such as clinical trials (life sciences) or complex materials research.7
2. Trial-and-Error Experimentation (Iterative Revision): This approach focuses on incrementally revising alternatives based on empirical results.7 For example, in software engineering, a programmer might design a new user interface (UI) to minimize the number of customer clicks required for an action. The programmer then launches the site, tracks real-life metrics, and subsequently revises the UI design based on those observed results to improve application functionality. This iterative feedback loop constitutes a valid POE when the optimal design was initially uncertain.7

For audit readiness, the documentation must explicitly connect three points: the identified technical uncertainty, the alternatives/hypotheses chosen to address it, and the empirical results used to dictate the subsequent steps in the iteration.6

3.2. Distinguishing POE from Non-Qualifying Activities

Compliance requires recognizing research activities specifically excluded from qualification under IRC Section 41(d)(4) that the IDR also upholds. These exclusions are necessary to ensure the credit is targeted solely at fundamental technical risk resolution.

Excluded activities include:

• Research relating to style, taste, cosmetic design, or seasonal design. POE must relate to function or performance, not merely aesthetics.5
• Market research, consumer surveys, or management efficiency studies.5
• Activities such as accounting tasks (e.g., bookkeeping, payroll), customer service support, training, recruiting employees, or attending industry conferences.5 These tasks, while necessary for the business, are not elements of the technical experimentation process.

Furthermore, because Iowa includes “software engineering” as an eligible industry 2, taxpayers developing internal-use software (IUS) must recognize that the federal rules impose a highly restrictive three-part high threshold test for IUS qualification, demanding a superior level of POE rigor and technological novelty. Since the IDR relies on the IRC framework, meeting these heightened federal IUS standards is essential for state compliance in this sector.

IV. Iowa Department of Revenue (IDR) Administrative Guidance and State-Specific Constraints

While the POE provides the technical compliance framework, Iowa imposes strict eligibility limitations that define who may claim the credit and where the activities must occur.

4.1. Local State Revenue Office Directives on RAC Eligibility

The state revenue office has implemented statutory constraints that drastically narrow the pool of eligible taxpayers.

4.1.1. Industry Eligibility Restrictions (Post-2017 Amendments)

One of the most crucial Iowa-specific constraints is the industry restriction, which was applied retroactively for tax years beginning on or after January 1, 2017.2 This legislative decision focused the subsidy on high-capital, innovative sectors, regardless of a business’s compliance with the technical POE requirements.

Eligible Sectors: To qualify for the RAC, businesses must be engaged in one of the following fields: manufacturing, life sciences, agriscience, software engineering, or the aviation and aerospace industry.2

Explicitly Ineligible Sectors: The law specifically excludes, but is not limited to, those engaged in agricultural production, agricultural cooperatives, finance or investment companies (including those licensed under Iowa Code chapters 524, 533, or 533D), retailers, wholesalers, transportation companies, publishers, real estate companies, collection agencies, accountants, architects, or contractors/subcontractors engaging in construction-related activities.2 The intent behind this limitation is to ensure the refundable state subsidy targets sectors that generate measurable physical or digital innovation in Iowa.

Table 2: Iowa Research Activities Tax Credit (RAC) Eligibility Restrictions (Post-2017)

4.1.2. Definition of Qualified Research Expenditures (QREs)

QREs must be incurred in Iowa.2 The specific expenses that qualify include:

• Wages: Wages and salaries paid for services performed directly in qualified research, or for the direct supervision or direct support of qualified research services.2
• Supplies: The cost of supplies used directly in conducting qualified research, such as materials and prototypes consumed during testing.2
• Rental Costs: The rental or lease cost of personal property, such as computers or testing equipment, used directly to conduct qualified research.2
• Contract Expenses: For contract research funded by the taxpayer but performed by unrelated third parties, only 65 percent of amounts paid are eligible. This percentage increases to 75 percent if the research is performed by a qualified non-profit research organization.3

4.2. Calculating and Monetizing the RAC

The financial structure of the Iowa RAC provides a powerful incentive for businesses that successfully satisfy the POE and industry requirements.

4.2.1. The Incremental Nature

The RAC is an incremental credit, meaning only research expenditures that exceed a calculated base amount are eligible for the credit.2 The base amount is calculated as the product of the fixed-based percentage multiplied by the average annual gross receipts of the taxpayer for the four preceding taxable years.11

A crucial clarification in Iowa law is that the base amount shall never be less than fifty (50) percent of the qualified research expenses (QREs) for the current credit year.11 This 50% floor ensures that only substantial increases in research spending, relative to prior activity, receive the credit.

4.2.2. The Refundable Component

The RAC’s value is significantly enhanced by its refundable status. Generally, 80% of the excess RAC, or 90% of the Supplemental Research Activities Tax Credit (SRAC), is refundable.9 This refundability is significant because it assures the recipient receives the majority of the credit amount even if the company owes little or no state income tax, eliminating the need for tax carryforwards.9

The utilization data confirms the impact of this feature. In 2023, the Iowa Department of Revenue (IDR) processed $84.6 million in total RAC subsidy claims. Of this total, $35.3 million—representing 42% of the total claims processed—was paid directly to firms that owed no state income tax as “tax credit refunds”.12 This high refund rate confirms the credit functions as a direct cash-flow subsidy, rather than just a tax reduction tool, providing a strong incentive for R&D investment regardless of corporate profitability in Iowa.

4.3. Strategic Tax Planning: Leveraging the IRC 280C(c) Election for State Savings

For taxpayers claiming both the federal and state R&D credits, a key strategic consideration involves the interaction between the federal credit and the deduction for research expenses.

The IRC Section 280C(c) mandates that taxpayers who claim the federal credit generally must reduce their Section 174 deduction for research expenses by an amount equal to the credit claimed.10 However, taxpayers may elect to take a reduced federal credit (where the 20% statutory rate becomes effectively 13%) and, in exchange, claim a full deduction for all research expenses.10

This election is strategically advantageous in Iowa. Since Iowa uses Federal Taxable Income (FTI) as the starting point for calculating Iowa taxable income 10, making the reduced federal credit election allows the taxpayer to deduct the full amount of QREs federally, thereby reducing the FTI that flows to Iowa. Crucially, this maneuver reduces the taxpayer’s Iowa taxable income without impacting the amount of the Iowa RAC the taxpayer can claim.10 This optimization strategy allows the taxpayer to benefit maximally from both the federal deduction and the non-dependent, refundable state credit.

V. Practical Case Study: Applying POE to a Qualified Iowa Business Component

The following example illustrates how the POE is applied and documented within an eligible Iowa industry, ensuring compliance with the systematic requirement.

5.1. Case Setup: Advanced Manufacturing R&D Project

• Company Profile: A manufacturing company based in Iowa, involved in the design and production of industrial components (an eligible industry sector 2).
• Technical Uncertainty (Test 2 Trigger): The company is developing a new Generation 3 motor designed for superior performance (Test 1 Purpose 4). A known technical uncertainty is the winding geometry of the motor’s stator coils: it is uncertain whether Geometry 1, Geometry 2, or a proprietary Geometry 3 will provide the target efficiency output (the capability uncertainty). Additionally, the manufacturing process required to reliably produce the chosen geometry without material degradation is unknown (method uncertainty).
• Technological Basis (Test 3): The project relies fundamentally on mechanical engineering, electromagnetism, and advanced manufacturing principles (Hard Sciences 6).

5.2. Step-by-Step Documentation of the Systematic Experimentation Process (POE)

The research team must execute and document a structured approach designed to resolve the stator winding uncertainty.

1. Phase I: Hypothesis Formulation: The engineering team establishes a working hypothesis: Geometry 2, manufactured using a standard 3D-printing process (Process A), will achieve the target efficiency. The alternatives to be evaluated include Geometry 1 (known but insufficient) and Geometry 3 (a novel, high-risk approach), coupled with Process B (casting) and Process C (modified printing).
2. Phase II: Systematic Testing (Trial-and-Error): The R&D personnel dedicate their time (ensuring “substantially all” time is on QRA) to designing and running empirical tests. Prototypes incorporating Geometry 2 manufactured via Process A are built and rigorously tested in the Iowa facility (QREs incurred in Iowa 2). Data collected includes thermal resistance and efficiency metrics.
3. Phase III: Data Analysis and Iterative Refinement: Initial testing reveals that Geometry 2 fails to meet the thermal requirements after 100 hours of continuous load, disproving the initial hypothesis. The failure analysis report identifies stress points. This analysis (a qualified research activity) prompts the team to shift focus to Geometry 3, hypothesizing that a specialized coating application (Process D) might resolve the thermal issue. The team then designs and executes the next iteration of testing, focusing on Geometry 3 and Process D. The resulting documentation, including testing protocols, failure reports, and engineering change orders, demonstrates the systematic, iterative POE used to eliminate the technical uncertainty.

5.3. Example Calculation of RAC Claim

The following data, adapted from an example involving automotive development (an eligible manufacturing/engineering activity 6), demonstrates the potential financial impact of successfully documented qualified research.

Table 3: Example RAC Calculation and Financial Benefit (Incremental Credit Model)

The resulting Iowa RAC of $33,452, which is often claimed as a refundable credit, represents a direct return on investment into the Iowa-based R&D activities that adhered to the rigorous POE standards.6

VI. Utilization Trends, Compliance, and Audit Readiness

The financial significance and refundable nature of the RAC necessitate robust compliance procedures focused primarily on substantiating the POE.

6.1. Iowa RAC Utilization Statistics (2023 Data)

Utilization trends indicate that the RAC is a critical component of R&D funding for Iowa’s largest companies.

Table 4: Recent Iowa RAC Claim Utilization Statistics (2023 Data)

The $84.6 million in total claims processed in 2023 highlights the volume of the state’s tax subsidy.12 The fact that $35.3 million (42%) was paid as refundable credits to firms owing no state tax underscores the state’s use of the credit as an economic development subsidy rather than a traditional tax offset.12

The concentration of large claims, such as the $15.2 million reported for Deere & Co. in a recent year 12, makes these substantial corporate claims highly visible to the IDR. This high visibility and the large sums involved require that IDR audits of the POE criterion are exceptionally stringent. Taxpayers must ensure meticulous compliance to avoid multi-million dollar adjustments.

6.2. Critical Documentation Requirements for IDR Audits

The primary focus of an IDR audit concerning the RAC will be verifying that the systematic POE was performed and that the claimed QREs align directly with the documented experimental activity. All supporting documentation must be contemporaneous.9

Key audit evidence must include:

1. Evidence of Uncertainty: Initial project documents, proposals, or engineering narratives that clearly establish the specific technical unknowns (design, capability, or method) that existed at the commencement of the research. These documents confirm the necessity of the POE.
2. Evidence of Systematic Process: Detailed project logs, internal meeting minutes, and white papers that describe the hypothesis formulated, the specific design of experiments conducted, and the alternatives that were systematically evaluated.
3. Evidence of Iteration: Test results (empirical data), failure reports, and subsequent engineering change orders (ECOs) demonstrating how the analysis of one experimental outcome led directly to a change in design or methodology for the next trial. This iterative cycle is the core demonstrable component of a successful POE.7
4. Evidence of QRE Alignment: Detailed time-tracking records for personnel must confirm they spent “substantially all” of their working time (80% or more) on tasks directly related to the experimentation process, such as designing trials, executing tests, or analyzing results, and not on routine production or administrative duties.1

VII. Conclusion and Strategic Recommendations

The Iowa Research Activities Credit provides a valuable, often refundable, financial incentive for businesses conducting qualified research within the state. However, accessing this benefit is strictly contingent upon satisfying two major hurdles: adherence to Iowa’s narrow industry eligibility criteria and rigorous documentation proving compliance with the federal Process of Experimentation (POE).

For businesses seeking to maximize their RAC benefit and minimize audit risk, three strategic recommendations are essential:

1. Prioritize Industry Eligibility Screening: Compliance begins with a prerequisite check. Taxpayers must confirm that their operations fall within one of Iowa’s restricted eligible industries (manufacturing, life sciences, agriscience, software engineering, or aviation/aerospace) before allocating resources to POE documentation. POE compliance is moot if the business operates in a statutorily excluded sector, such as retail or general finance.2
2. Operationalize Documentation to Substantiate POE: R&D tracking systems must be integrated into the product development life cycle. These systems must capture not only what technical tasks were performed but, more importantly, why (the technical uncertainty) and how the outcome of one step led to the redesign of the next (the systematic process). Robust, contemporaneous documentation is the only defense against audit adjustments concerning the “substantially all” requirement.9
3. Utilize Federal Tax Strategy (IRC Section 280C(c) Election): Taxpayers should strategically evaluate making the reduced federal credit election under IRC Section 280C(c). This permits a full deduction of research expenses federally, which in turn reduces the starting point (FTI) for calculating Iowa taxable income. This sophisticated maneuvering ensures optimal overall federal and state tax savings, providing a benefit against Iowa income tax without negatively affecting the state’s Research Activities Credit claim.10

R&D Tax Credit Preparation Services

Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states.

If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725.
Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.

R&D Tax Credit Audit Advisory Services

creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.

Our Fees

Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/about-us/research-tax-credit-consulting/our-fees/