Qualified Research Expenses (QREs) in Iowa: Detailed Analysis of the Research Activities Tax Credit (RAC) and 2026 Program Transition

Qualified Research Expenses (QREs) in Iowa are defined as in-state expenditures for research activities that align with federal standards under Internal Revenue Code (IRC) Section 41, primarily encompassing wages, supplies, leased property, and contract research. The Iowa Research Activities Tax Credit (RAC) is a state-level, incremental, and refundable incentive designed to reward businesses for increasing these qualified expenditures above a statutory historical base.

This report provides an exhaustive, expert-level analysis of the definition, calculation, regulatory compliance requirements, and future structural changes affecting QREs within the context of the Iowa Research Activities Tax Credit (RAC), integrating current guidance from the Iowa Department of Revenue (IDR) and recent legislative changes, notably Senate File 657 (SF 657) and House File 2317 (HF 2317).

II. Statutory Foundation and Eligibility Requirements

The foundation of the Iowa Research Activities Tax Credit (RAC) is built upon federal tax law, necessitating rigorous adherence to IRC guidelines while navigating specific, state-imposed industry and expense limitations.

A. The Research Activities Credit (RAC) Overview

The RAC is available to eligible businesses claiming a credit against individual income and corporate income taxes.1 Iowa has historically been a pioneer in state-level R&D incentives, adopting its credit in 1985.2 The program is enabled by Iowa Code, which cross-references 26 U.S.C. §41 for the foundational definition of “qualified research”.1

Prior to the overhaul commencing in 2026, the RAC has operated as an incremental credit.3 This mechanism is structured to reward only those research expenditures that exceed a calculated historical base amount, thereby ensuring that the state incentivizes genuine growth in research activity rather than subsidizing baseline operational costs.3

B. Prerequisite: Alignment with Internal Revenue Code (IRC) Section 41

A fundamental requirement for claiming the Iowa RAC is synchronization with federal tax compliance. Iowa law explicitly mandates that the researching entity must claim and be allowed the Federal Credit for Increasing Research Activities under IRC Section 41 for the same taxable year in which the Iowa credit is claimed.3 This establishes a critical compliance prerequisite: failure to meet the federal four-part test for qualified research—that the activity must be technological in nature, intended to develop or improve a product or process, eliminate uncertainty, and utilize a process of experimentation—invalidates the Iowa claim.5

The credit is available to a variety of organizational structures, including C corporations, S corporations, and pass-through entities such as partnerships and limited liability companies. In the case of pass-through entities, credits are allocated to owners via Schedule K-1.6

C. Eligible Industries (Iowa Code §15.329) and Mandatory Exclusions

Unlike the federal credit, which applies broadly across trade or business activities, Iowa imposes strict industry limitations, referencing Iowa Code section 15.329.7 This focused approach is designed to target R&D investment toward sectors deemed high-growth, high-tech, and scalable for the Iowa economy.

1. Mandatory Eligible Industries (Pre-2026)

For tax years prior to 2026, eligibility is generally restricted to businesses engaged in one of the following specialized fields 3:

• Manufacturing: Including refining, purifying, combining materials, and activities subsequent to the extractive process (e.g., crushing, washing of aggregates).8
• Life Sciences: This broad category includes agriscience, biology, botany, zoology, microbiology, physiology, and biochemistry.8
• Software Engineering: Defined as the detailed study of the design, development, operation, and maintenance of software.8
• Aviation and Aerospace: Encompassing the design, development, or production of aircraft, rockets, missiles, spacecraft, and related equipment.8

2. Mandatory Exclusions (Ineligible Businesses)

Iowa maintains an exhaustive list of excluded business types, reinforcing the state’s intent to channel incentives away from general commercial and service activities. Businesses engaged in the following activities are explicitly ineligible 3:

• Agricultural production or agricultural cooperatives.
• Financial or investment companies, including those organized or licensed under Iowa Code chapters 524, 533, or 533D.9
• Retailers, wholesalers, publishers, and transportation companies.
• Real estate companies, collection agencies, accountants, and architects.
• Contractors, subcontractors, builders, or contractor-retailers engaged in commercial and residential repair and installation (e.g., HVAC installation, plumbing, electrical installation).3

The existence of such a detailed exclusion list serves as a regulatory firewall, ensuring the limited pool of credit resources is concentrated exclusively in designated sectors like manufacturing and software engineering.

III. Detailed Definition of Qualified Research Expenses (QREs) in Iowa: Statutory and Administrative Deviations

Iowa’s definition of Qualified Research Expenses (QREs) fundamentally adopts the structure of IRC Section 41, encompassing four categories of expenses. However, the Iowa Code and associated Administrative Rules introduce specific, critical deviations that significantly impact the calculation of the qualified base. These state-specific modifications are essential compliance considerations, as they often result in an Iowa QRE base that is smaller than the federal QRE base.

Iowa QREs must be expenses incurred within Iowa.3 Based on fiscal reporting for Calendar Year 2023, Iowa businesses reported over $3.1 billion in QREs, with wages constituting the majority (56.5%), followed by supplies (32%).2

A. QRE Category 1: Qualified Wages and the “Majority Services” Rule

Wages paid for employees performing, supervising, or directly supporting qualified research are qualified expenditures.6 Wages represent the largest component of R&D spending reported in Iowa.3

The Critical Rejection of the “Substantially All” Rule

A major compliance divergence exists in the treatment of employee wages. For the purpose of the Iowa RAC, the “substantially all” rule defined in IRC section 41(b)(2)(B) and Treasury Regulation section 1.41-2(d)(2) does not apply.11 Federally, if 80% or more of an employee’s time is dedicated to qualified services, 100% of that employee’s wages allocated to qualified services may qualify.

The Iowa “Majority Services” Requirement

In place of the federal shortcut, Iowa enforces a stricter standard: wages paid to an employee for qualified services constitute qualified research expenses in Iowa only if the services are performed in Iowa and if, during the period of the tax year that the business is engaging in one or more research projects, a majority of the total services performed by the employee for the business are directly related to those research projects.11

This strict rule compels taxpayers to adopt meticulous, contemporaneous time-tracking to defend their wage allocation. A business relying on the federal “substantially all” concept risks having those wages disqualified or adjusted downward, forcing a precise allocation based on actual time spent performing qualified services, provided the employee clears the $>50\%$ overall research threshold during the project period.

B. QRE Category 2: Qualified Supplies and the Phase-Out Schedule

Supplies include materials, prototypes, and equipment consumed during the research process (e.g., chemicals for testing).3 Qualified supply costs must directly relate to research performed in Iowa.11

The Legislative Supply Phase-Out (HF 2317)

One of the most significant changes introduced by HF 2317 involves a rapid legislative phase-out of qualified supply expenditures, a strategic maneuver to reduce overall credit utilization and redirect incentives. Historically accounting for nearly one-third of all reported QREs 2, supply costs are being systematically removed from the eligible QRE base according to the following schedule 11:

Table 1: Iowa QRE Phase-Out Schedule for Qualified Supplies

This phase-out immediately decreases the return on investment for capital-intensive R&D sectors, particularly manufacturing firms that rely heavily on materials for prototyping and testing. The policy decision is designed to reduce reliance on material-based R&D expenditures and place overwhelming priority on incentivizing human capital (wages) and contracted expertise.

C. QRE Category 3 & 4: Contract Research Expenses and Leased Property

Contract research expenses involve payments made to unrelated third parties or qualified research consortiums for qualified research performed in Iowa.3 Federal rules regarding inclusion rates (typically 65%) generally apply, though payments to qualified research consortiums may be included at 75%, and payments for qualified energy research to universities or federal laboratories may be 100% includible.4

The rental or lease cost of tangible personal property, such as specialized machinery or equipment used directly in qualified research, is also a QRE.3 However, specific guidance limits this category: amounts paid for the right to use computers, as referenced in IRC section 41(b)(2)(A)(iii), do not qualify as research expenses in Iowa.11

IV. The Incremental Calculation Framework (Current RAC: Tax Years Before January 1, 2026)

The current Iowa RAC structure relies on an incremental calculation, meaning the credit is generated only on QREs that exceed a statutory base amount.3 Taxpayers must elect one of two methodologies: the Regular Research Activities Credit (RAC) method or the Alternative Simplified Credit (ASC) method, provided they adhere to the corresponding federal election.13

A. Method 1: The Regular Research Activities Credit (RAC)

The Regular Credit calculation uses the traditional method defined under IRC Section 41, applying a state rate of 6.5%.6

1. Defining the Base Amount

The core complexity of the Regular Method lies in determining the base amount, which serves as the threshold for credit eligibility. The base amount is calculated as the product of the fixed-base percentage multiplied by the average annual gross receipts of the taxpayer for the four preceding taxable years.6

2. The 50% Floor Rule

A critical statutory provision in Iowa is the application of the 50% QRE floor. The Iowa Code mandates that the calculated base amount shall not be less than fifty percent (50%) of the current year’s qualified research expenses.11 This floor acts as a strong financial constraint, ensuring that even rapidly growing companies or those with minimal historical gross receipts must offset at least half of their current-year QREs before generating a credit.

3. Calculation Methodology

The credit is calculated as follows:

$$\text{Credit} = 6.5\% \times (\text{Current Iowa QREs} – \text{Actual Base Amount}) + 6.5\% \times \text{Qualified Basic Research Payments} \quad \text{[6]}$$

The Actual Base Amount is the greater of the calculated fixed-base amount or 50% of current Iowa QREs.11

B. Method 2: The Alternative Simplified Credit (ASC)

The Alternative Simplified Credit (ASC) method is available only if the taxpayer elects to claim the federal ASC.4 This method offers a streamlined calculation at a reduced rate.

1. Rate and Base Calculation

The state rate applied under the ASC method is 4.55%.6 The corresponding base amount is significantly simpler: 50% of the average Iowa QREs incurred during the three immediately preceding tax years.6 For companies with no QREs in the preceding three years, the base is zero, allowing them to claim the credit on all current-year QREs at the ASC rate.2

2. Strategic Modeling

Taxpayers must conduct strategic modeling of both methods. The choice between the two is highly dependent on the stability and historical growth of QREs and gross receipts. While the Regular Method offers a higher rate (6.5%), the stringent 50% QRE floor often results in a smaller eligible excess QRE base compared to the ASC, which uses a three-year average of QREs for its base calculation. This financial dynamic explains why, despite the statutory rates, the average credit earned per dollar of QREs in Iowa often sits closer to $0.029$ 3, indicating that the incremental base calculation effectively filters out a substantial portion of total QREs.

Table 2: Comparison of Iowa R&D Credit Calculation Methods (Pre-2026)

V. The Supplemental Research Activities Tax Credit (IEDA Program)

In addition to the standard RAC, companies participating in certain state economic development initiatives, such as the High Quality Jobs (HQJ) program or Enterprise Zone programs, may be awarded the Supplemental Research Activities Tax Credit.3 This credit is a powerful tool used by the Iowa Economic Development Authority (IEDA) to further incentivize targeted R&D activities within the state.

A. Differential Rates Based on Gross Revenues

The rate of the Supplemental Credit is conditional upon the annual gross revenues of the eligible business, demonstrating a policy focus on bolstering R&D investment within smaller, emerging firms.7

• Small Firms (Annual Gross Revenues $\le \$20$ Million): These businesses can claim a supplemental credit of up to an additional 10% of qualifying incremental research expenditures.6
• Large Firms (Annual Gross Revenues $>\$20$ Million): For these larger firms, the supplemental tax credit is available at a reduced rate of up to an additional 3% of qualifying incremental research expenditures.6

This tiered structure maximizes the financial leverage provided to small businesses that may be in the early stages of R&D capitalization. Companies claiming the Supplemental Credit must use the same calculation method (Regular or ASC) employed for the standard RAC.16

B. Refundability and Use Limitations

A major advantage of the Iowa RAC, including the Supplemental Credit, is its refundable nature.1 Refundable credits provide a direct cash flow benefit to the taxpayer when the credit amount exceeds the total tax liability.

However, recent legislation has implemented limits on the refundable portion 6:

• Standard RAC Refund Limit: 80% of the computed RAC excess is refundable.6
• Supplemental RAC Refund Limit: 90% of the computed Supplemental RAC excess is refundable.6

These partial caps retain a portion of the credit, limiting the state’s immediate budget liability while still offering a substantial cash incentive. Furthermore, the credit cannot be carried forward, except for specific nonrefundable portions which may be carried forward for up to 7 years, reinforcing the state’s goal of providing immediate economic liquidity.5

VI. IDR Guidance on Compliance, Filing, and Audit Management

Compliance with the Iowa RAC requires strict adherence to IDR filing procedures and meticulous management of audit risk, which is intrinsically linked to federal examinations.

A. Required Tax Forms and Filing Procedures

Eligible taxpayers must timely file the appropriate Iowa form: either Form IA 128 (Regular Credit) or IA 128S (Alternative Simplified Credit).4

For credits earned by pass-through entities (e.g., partnerships), the allocated share of the credit must be reported to the members via Schedule K-1, including the tax credit certificate number if a Supplemental Credit was issued by the IEDA.4

B. Nexus to Federal Audits and the One-Year Notification Rule

The dependency of the Iowa RAC on federal eligibility creates a critical administrative linkage concerning audits. The IDR has established a mandatory notification rule that affects the state’s statute of limitations for examination.17

• Mandatory Notification: Taxpayers are required to notify the Department of Revenue once all issues related to a specific federal audit or examination concerning research activities become final.17
• Audit Trigger: This notification serves as the trigger for a specific one-year period during which the IDR may examine the affected Iowa returns.17

This rule significantly extends the state’s potential audit window, compelling businesses to maintain documentation for R&D claims well beyond the normal state statute of limitations. A favorable outcome in a federal audit does not guarantee immunity from state scrutiny; the IDR retains the authority to examine the Iowa claims, focusing specifically on state-centric compliance issues (e.g., the majority services rule, QRE limits, and base amount calculation).17

C. Documentation Requirements and Standards

While explicit public guidance from the IDR detailing specific documentation formats (such as mandatory time tracking systems or specific project narrative templates) is limited 8, the strong linkage to IRC Section 41 dictates the required standard. To survive an IDR examination, taxpayers must possess documentation sufficient to validate the federal claim. This typically requires:

1. Project Documentation: Technical narratives establishing the use of the process of experimentation to eliminate technical uncertainty.
2. Labor Documentation: Contemporaneous records (e.g., time sheets, interviews, organizational charts) supporting the allocation of employee wages, particularly proving the $>50\%$ “majority services” threshold for Iowa compliance.11
3. Financial Records: Detailed general ledger entries, invoices for supplies (adjusted for the phase-out), and contract payments.

VII. Case Study Example: Calculating the Iowa R&D Credit (Tax Year 2025)

This example illustrates the application of the Regular Credit Method for a small manufacturing firm in the 2025 tax year, demonstrating the impact of the supply phase-out and the benefit of the Supplemental Credit.

Scenario Parameters (For Tax Year Beginning January 1, 2025):

A. Step 1: Adjusting Total Iowa QREs for Supply Phase-Out (2025)

The total QRE base must be reduced due to the legislative limit on supply costs for the 2025 tax year (40% inclusion).11

1. Original Total QREs: $\$1,200,000$
2. Supply Costs Subject to Phase-Out: $\$300,000$
3. Adjusted Supply QREs: $\$300,000 \times 40\% = \$120,000$
4. Other QREs (Wages, Contract, Lease): $\$1,200,000 – \$300,000 = \$900,000$
5. Total Adjusted Iowa QREs (A): $\$900,000 + \$120,000 = \mathbf{\$1,020,000}$

The legislative limitation has resulted in a $\$180,000$ reduction in the eligible QRE base compared to federal or pre-2023 Iowa calculations.

B. Step 2: Calculating the Regular Research Activities Credit (RAC)

The base amount is determined by the greater of the fixed-base amount or the 50% QRE floor.11

1. Total Adjusted Iowa QREs (A): $\$1,020,000$
2. Fixed-Base Amount (B): $\$550,000$ (Given)
3. 50% QRE Floor (C): $\$1,020,000 \times 50\% = \$510,000$
4. Actual Base Amount Used (Higher of B or C): $\mathbf{\$550,000}$
5. Excess QREs (Incremental QREs): $\$1,020,000 – \$550,000 = \mathbf{\$470,000}$
6. Regular RAC Earned ($470,000 \times 6.5\%$): $\mathbf{\$30,550}$ 6
7. Basic Research Credit ($\$50,000 \times 6.5\%$): $\mathbf{\$3,250}$
8. Total RAC (Incremental): $\$30,550 + \$3,250 = \mathbf{\$33,800}$

C. Step 3: Calculating the Supplemental Research Activities Tax Credit

The firm qualifies for the small-firm rate (10%) because its gross receipts are below the $\$20$ million threshold.16 The supplemental rate applies to the same incremental QRE base.

1. Supplemental Credit Rate: $10.0\%$
2. Supplemental Credit Base: Excess QREs $(\$470,000)$
3. Supplemental RAC Earned ($470,000 \times 10\%$): $\mathbf{\$47,000}$ 6

D. Step 4: Final Credit Value and Refundability

The ability to access the Supplemental Credit significantly amplifies the overall incentive, demonstrating the financial advantage of securing IEDA certification, especially for smaller businesses.

VIII. Strategic Outlook: The 2026 R&D Tax Credit Program Overhaul (SF 657)

Senate File 657 (SF 657), set to repeal the current RAC and establish a new program starting January 1, 2026, represents the single most significant overhaul of Iowa’s R&D incentives in decades.6 This legislative transition fundamentally alters the operational structure, financial predictability, and compliance pathway for businesses investing in research within the state.

A. Transition of Authority: IDR to IEDA

The administrative oversight of the R&D credit program is shifting from the Iowa Department of Revenue (IDR) to the Iowa Economic Development Authority (IEDA).1 This change signifies a move away from a traditional tax entitlement model—where a credit is claimed on a tax form if statutory requirements are met—to a discretionary economic development program.

Under the new regime, businesses must formally apply to the IEDA.21 This process requires the submission of CPA-verified QRE reports for review and certification, adding a significant step to the compliance workflow.21

B. Shift to a Capped, Allocated Program

The historical uncapped nature of the RAC, which created budget projection uncertainty for the state, is being replaced by a strict financial limit.

• Annual Cap: Beginning in Fiscal Year 2026, the total combined amount of tax credits available across all taxpayers is limited to a maximum of $40.0 million annually.1
• Allocation Risk: The introduction of an annual cap means the program is no longer an entitlement. If the demand from qualified applicants exceeds the $40 million limit, the credits will be allocated pro rata.21 This introduces significant financial uncertainty, as a firm’s calculated credit value may be reduced based on the volume of claims filed by other businesses in the same year.

C. New Calculation Rate and Structure

The core incremental calculation methodology—which required computing a complex base amount—is eliminated in the new program.

• New Rate: The new credit is non-incremental, calculated based on total qualifying in-state QREs, but at a reduced maximum rate of up to 3.5%.20 This reduction from the previous 6.5% incremental rate must be analyzed in combination with the removal of the incremental base; depending on historical QRE stability, some firms may find the non-incremental 3.5% calculation more favorable, while highly incremental firms will see a net decrease in benefit.
• Program Duration: Credits can be secured for up to five consecutive years, although annual reapplication and certification by the IEDA are required.21 The credit remains refundable but is non-transferable.1

D. Updated Industry Eligibility Criteria (SF 657)

The 2026 program further refines industry eligibility, focusing on highly defined sectors.21

• Eligible Sectors: Advanced Manufacturing, Bioscience, Finance and Insurance, and Technology and Innovation (the latter requiring IEDA approval).6
• Notable Inclusion: The explicit inclusion of the Finance and Insurance sectors is a significant expansion, as these industries were previously excluded.9 This change broadens the state’s incentive focus to include R&D efforts within financial technology and insurance modernization.
• Continued Exclusions: The program continues to exclude activities such as real estate, agricultural production, construction, retail, and wholesale.6

IX. Conclusion and Compliance Recommendations

The Iowa R&D tax credit, encompassing QRE definitions and the calculation methodology, stands at a critical juncture. Prior to 2026, the complexity is derived from navigating the strict incremental structure and state-specific QRE limitations, particularly the mandatory wage allocation rule and the supply phase-out. Post-2026, the challenge shifts to managing budget uncertainty and navigating the application-based system administered by the IEDA.

A. Current Compliance Imperatives (Pre-2026)

1. Strict Allocation of Wages: Taxpayers must recognize that Iowa’s “majority services” requirement for wages enforces a stricter standard than the federal “substantially all” rule.11 Compliance requires detailed, contemporaneous documentation to prove that a majority of an employee’s services during the research project period were qualified, thus mitigating audit risk from the IDR.
2. Financial Forecasting of QREs: The phase-out of qualified supply expenditures, accelerating to total elimination by 2027, necessitates immediate recalculation of the eligible QRE base for 2025 (40% inclusion) and 2026 (20% inclusion).11 R&D investment decisions must anticipate that the QRE foundation will increasingly be limited to labor and contracted costs.
3. Optimal Method Modeling: Given the restraining effect of the 50% QRE floor under the Regular Method, comprehensive modeling of both the Regular (IA 128) and Alternative Simplified (IA 128S) credit methodologies is mandatory to maximize the incremental credit earned.13

B. Strategic Transition Recommendations (Post-2026)

1. Managing Program Uncertainty: Businesses must adjust their long-term financial planning to account for the $\$40$ million annual cap and the reduced maximum rate of $3.5\%$.20 The new program, managed by the IEDA, introduces pro-rata allocation risk, meaning the realized credit rate may fall below $3.5\%$ if the program is oversubscribed.
2. Prioritized IEDA Engagement: Companies in the newly eligible Finance and Insurance sectors must prepare application and compliance protocols for the IEDA, which will now govern certification.21 For all firms, early and meticulous preparation of CPA-verified QRE reports is essential to secure an allocation within the competitive, capped pool.
3. Audit Preparedness: Maintain all documentation to federal standards, as the IDR’s one-year lookback period, triggered upon the final resolution of a federal audit, ensures that state claims remain subject to examination for specific Iowa-centric adjustments long after the original filing.17 The integrity of the Iowa claim is fundamentally reliant on the defensibility of the IRC §41 claim.

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