The Software Engineering Qualifying Industry in Iowa: Navigating the Research Activities Credit (RAC) and the Looming 2026 Overhaul

The Iowa Research Activities Credit (RAC) permits businesses primarily engaged in Software Engineering—defined as the detailed study of the design, development, operation, and maintenance of software—to claim a credit against state income tax liability for qualified research expenses incurred in Iowa.1

Eligibility mandates simultaneous adherence to the federal Internal Revenue Code (IRC) Section 41 research credit requirements and strict compliance with Iowa’s enumerated industry classification and exclusion tests.2

I. Foundational Structure of the Iowa Research Activities Credit (RAC)

The Iowa Research Activities Credit (RAC) is a state-level tax incentive designed to encourage investment in research and development activities occurring within the state. This credit functions as a critical component of Iowa’s strategy to promote growth in specific high-tech and innovation sectors.

A. Statutory Authority and Scope

The authority for the RAC is derived primarily from Iowa Code §422.10 for individual income tax and §422.33 for corporate income tax.2 The underlying principle of the RAC is that it is an incremental credit.3 This means that the credit is not based on total research spending, but only on Qualified Research Expenditures (QREs) that exceed a statutory base amount.1 The credit system also interacts with other economic development tools, offering a Supplemental Research Activities Credit (SRAC) authorized under Iowa Code Section 15.335 for businesses approved through programs such as the High Quality Jobs (HQJ) program.2

B. The Two Pillars of Eligibility: Federal Mandate and State Industry Status

Eligibility for the Iowa RAC is conditional upon meeting two distinct, non-negotiable requirements, forming the foundation of the state’s research incentive framework.

1. Pillar 1: Federal Claim Requirement

First, a business must successfully claim and be allowed the Federal Research Credit for qualified research expenses under Internal Revenue Code (IRC) Section 41 for the exact same taxable year.1 This provision establishes a direct linkage to federal tax law, effectively importing the rigorous definition of “qualified research” (the four-part test) and “qualified research expenses” (QREs) into the Iowa framework.3 If a taxpayer cannot substantiate a valid claim at the federal level, the state claim automatically fails.

2. Pillar 2: Qualifying Industry Status

Second, the business must be engaged in one of five specific, targeted industries.2 This state-level constraint, which became effective for tax years beginning on or after January 1, 2017 1, demonstrates a legislative intent to focus incentive spending on sectors deemed critical for Iowa’s future economic growth.

The currently eligible industries are:

• Manufacturing
• Life Sciences
• Agriscience (added in 2019) 8
• Software Engineering
• Aviation and Aerospace 2

This statutory limitation imposed for tax years beginning on or after January 1, 2017, was a significant modification to the program, which was previously available to a much broader range of industries.1 The determination to apply this limitation retroactively to January 2017 required claimants who filed returns during that transition period to re-evaluate their eligibility based on industry classification, underscoring the Iowa Department of Revenue’s (IDR) commitment to enforcing this strict, targeted approach.

C. Historical Context and Current Calculation Mechanics

The calculation of the credit is generally performed using one of two methods, similar to the federal structure. The Iowa credit rate and calculation methods have undergone several revisions in recent years, impacting the value and accessibility of the incentive.9

1. Regular Method Calculation

The Regular Credit Method is calculated at a rate of 6.5% of the excess of Iowa QREs over the calculated base amount, plus an additional 6.5% of any qualified basic research payments.11 The base amount calculation is complex and uses the same mechanism as the federal calculation, but applied only to Iowa data.1

2. Alternative Simplified Credit (ASC)

Alternatively, taxpayers may elect the Alternative Simplified Credit (ASC) method. This rate is set at 4.55% of expenditures occurring in Iowa that exceed 50% of the average of the prior three years’ qualified research expenses.9 For tax years beginning in 2023, Iowa law mandates that taxpayers who elected or were required to use the ASC method for federal purposes must also use this method for the Iowa research credit calculation.11 This ensures conformity in calculation methodology at both the state and federal levels, reducing administrative complexity for compliant taxpayers.

The RAC has historically been viewed as one of the most competitive R&D credits in the nation, primarily due to its refundability feature.8 However, legislative changes, culminating in the major restructuring announced in 2025, indicate a shift toward greater fiscal control and industry targeting.10

II. Definitive Guidance: Software Engineering as a Qualifying Industry

For a company operating in the technology sector to claim the RAC, its primary business must align with the state’s definition of Software Engineering, while simultaneously ensuring it does not fall into any of the statutory exclusion categories.

A. The Official State Definition: Interpreting “Detailed Study”

The Iowa Department of Revenue (IDR) and Administrative Code provide a clear, concise definition for eligibility: Software Engineering is defined as “The detailed study of the design, development, operation, and maintenance of software”.1

This definition is expansive, covering the full product lifecycle and emphasizing the requirement for systematic inquiry. The use of the term “detailed study” reinforces the need for documented, systematic research that relies on the principles of computer science, rather than routine or mechanical activities.11 This criterion aligns the industry definition with the requirement for technical uncertainty and experimentation inherent in the federal IRC Section 41 qualification rules.

B. Navigating the Prohibited List: Statutory Exclusions and Compliance Risk

A crucial element of the Iowa RAC framework is the extensive list of excluded industries. Even if a business conducts research that would otherwise qualify under IRC Section 41, it is statutorily ineligible if it is primarily engaged in one of these excluded activities.2

Key statutory exclusions that present compliance challenges for technology-adjacent firms include, but are not limited to:

• Retailers and Wholesalers.2
• Finance or Investment companies.2
• Transportation companies.2
• Publishing companies.1
• Real estate companies.1
• Contractors, subcontractors, builders, or contractor-retailers engaging in commercial and residential repair and installation (e.g., HVAC, plumbing, security systems, electrical work).1
• Accountants and Architects.2
• Agricultural production or agricultural cooperatives.1

C. Distinguishing Software Engineering from Excluded Activities

The fundamental compliance challenge for software-focused companies lies in demonstrating that they are primarily engaged in Software Engineering, rather than being an excluded business (e.g., a retailer or finance company) that merely develops software to support its core, non-qualifying business function.

Iowa law mandates that the person claiming the credit must not be considered engaged in the excluded activities listed in the statute.2 For example, a major financial institution (a Finance or Investment company, which is excluded 15) that spends millions developing a proprietary trading algorithm (which is technical R&D) cannot claim the RAC, because the entity itself is statutorily prohibited based on its primary economic identity.

The Iowa Department of Revenue (IDR) is known to scrutinize the claimant’s gross receipts and business operations during audits to confirm primary industry classification.10 If a company’s vast majority of revenue is generated through sales of physical goods (Retailer) or providing excluded services (Accountant), the claim will likely be disallowed, even if an internal division performs high-quality software development. This requirement functions as a stringent statutory gatekeeper, ensuring that the incentive is directed only toward entities whose core mission is innovation in one of the five targeted sectors, rather than merely subsidizing operational improvements in excluded sectors.

III. Application of the Federal Qualified Research Standard (IRC §41)

Once a business satisfies the Iowa industry classification test, the activities themselves must meet the strict standards for qualified research established under IRC Section 41, which Iowa law incorporates by reference.6

A. Adoption of the Four-Part Test by Iowa Law

The activities must successfully navigate the federal Four-Part Test, which applies equally to research conducted in software engineering, manufacturing, and life sciences.11

1. Permitted Purpose

The activity must be undertaken for the purpose of developing a new or improved business component, specifically aiming to improve the component’s functionality, performance, reliability, or quality.11 For software, this typically involves enhancing user interface capabilities, backend processing speeds, or data security architecture.

2. Technological in Nature

The research must rely fundamentally on principles of physical science, biological science, engineering, or computer science.11 Simple programming or routine integration of existing technologies does not meet this threshold; the activities must address technical challenges rooted in computer science principles.

3. Elimination of Technical Uncertainty

The research must be intended to discover information that eliminates technical uncertainty regarding the appropriate design, method of manufacture, or capability of the business component.11 The firm must document the specific technical risks that existed at the start of the project—risks that could not be resolved through merely applying existing public information.

4. Process of Experimentation

The firm must demonstrate that the technical uncertainties were resolved through a systematic process of experimentation.11 This includes systematic trial and error, modeling, testing, and simulation to evaluate alternatives and achieve the desired results.11

It is important to note that while Iowa generally adopts IRC Section 41, there is data suggesting that the state’s administration of the credit may require a stricter interpretation of the experimentation requirement.9 For federal purposes, a firm meets the “substantially all” rule if 80% or more of the research constitutes a process of experimentation. However, some interpretations of Iowa’s RAC suggest a requirement that potentially 100% of the taxpayer’s research activities must constitute a process of experimentation.9 If enforced, this potentially higher standard demands exceptionally rigorous time tracking and documentation to isolate experimental tasks from non-experimental, supporting activities performed by the same staff, significantly elevating compliance burden for software development teams.

B. Qualified Research Expenditures (QREs) in a Software Context

QREs are generally limited to expenses paid or incurred in Iowa for wages, costs of supplies, and contract expenses.3

• Wages: Wages paid to employees who directly perform, directly supervise, or directly support the qualified research within Iowa are eligible.11
• Contract Research Expenses: Amounts paid to outside contractors for conducting qualified research are generally eligible at 65% of the expense.11
• Cost of Supplies: Non-depreciable items consumed in the research process are eligible.3

Key Deviation: Exclusion of Computer Lease/Rental Costs

A significant modification introduced by state law disallows the inclusion of computer lease or rental costs described in IRC §41(b)(2)(A)(iii) as QREs for purposes of the Iowa credit after January 1, 2023.7 This is a major divergence from the federal definition of QREs.

This specific exclusion disproportionately affects Software Engineering firms, which rely heavily on leased or rented computing power, particularly large-scale cloud computing services, for testing, development, and modeling.9 By eliminating these infrastructure costs from the QRE base, the state has effectively reduced the pool of eligible expenses for many modern, cloud-native technology companies, potentially diminishing the intended financial incentive for large-scale, high-infrastructure R&D operations in Iowa.

IV. Compliance and Calculation Mechanics (The Current RAC Framework)

The current Iowa RAC structure (pre-2026) is formula-based, requiring strict procedural compliance for reporting to the IDR.

A. Mandatory Forms and Documentation

To claim the RAC, a taxpayer must first file the federal Form 6765 (Credit for Increasing Research Activities) to confirm federal eligibility.6 Subsequently, the taxpayer must file the specific Iowa tax form: Form IA 128 for the Regular Credit Method, or Form IA 128S if the Alternative Simplified Credit method is used or required.6 Pass-through entities (such as partnerships, S corporations, and LLCs electing to have income taxed directly to the individual) must file the IA 128 and report the apportioned credit to their members on Schedule K-1 or an attachment.4

B. Apportionment Rules and Base Amount Determination

The calculation is confined to activities within the state borders. Only research expenses incurred within Iowa can be captured toward the Iowa RAC.11 The state’s apportioned share of the qualifying expenditures is determined by the ratio of QREs in Iowa to total QREs.16

The current calculation method for the Regular Credit uses a Base Amount to ensure the credit is incremental.3 The Base Amount is calculated by taking the product of the fixed-base percentage multiplied by the average annual gross receipts for the four preceding taxable years.1 However, a key protection for the state revenue system is the statutory floor: in no event shall the base amount be less than fifty percent (50%) of the qualified research expenses for the credit year.1 This 50% floor prevents businesses from claiming a credit on the entire QRE amount and ensures that the incentive truly targets increases in research spending, rather than sustained, ongoing expenditures.12

C. Refundability and Limitations

Historically, the RAC has been highly valued because it was fully refundable.8 A refundable credit allows any amount exceeding the taxpayer’s liability for the year to be either refunded directly as cash or credited to the subsequent year’s tax liability.17

However, recent legislative adjustments have introduced limitations to control the cash flow impact of the credit. Currently, only 80% of the excess Research Activities Credit (RAC) and 90% of the Supplemental Research Activities Credit (SRAC) is refundable.12 Critically, the remainder—the 20% or 10% portion that is not refunded—cannot be carried forward to future tax years.12

For innovative Software Engineering firms, particularly startups or firms in high-growth phases that may not yet have substantial state tax liability, this limitation poses a significant liquidity risk. The forfeited portion represents a substantial reduction in the potential cash benefit of the incentive. This loss forces CFOs and tax directors to assess the effective return on R&D investment in Iowa with the awareness that 20% of the calculated credit value is permanently lost if not absorbed by current year tax liability.

D. Supplemental Research Activities Credit (SRAC)

In addition to the Regular or Alternative Simplified Credit, companies awarded tax incentives under specific programs, such as the High Quality Jobs (HQJ) program, may qualify for a Supplemental Research Activities Credit (SRAC).11 This credit provides an additional incentive calculated as a percentage of the company’s qualifying incremental research expense.12 The SRAC percentage is tiered: up to 10% of incremental QREs for small firms (gross revenues less than or equal to $20 million per year) and up to 3% for larger firms.4 The SRAC must be calculated and claimed separately, though its total amount is combined with the regular credit for purposes of the refundable calculation.5

V. Case Study: Qualification of a Software Engineering Firm

To illustrate the necessary synthesis of the Iowa industry requirement and the federal technical qualification criteria, an analysis of a hypothetical software firm’s eligibility is provided.

A. Hypothetical Scenario: “AgriSense Software, Inc.”

AgriSense Software, Inc., is an Iowa-based technology company whose core operation is the design, development, and commercial licensing of advanced proprietary software. The company’s primary focus is creating machine learning applications that analyze multi-spectral data captured by aerial drones to provide prescriptive recommendations for crop management (e.g., precise fertilizer application, early disease detection). AgriSense’s gross annual receipts are $5 million, derived entirely from software licensing fees and maintenance contracts.

During 2024, AgriSense undertook a project to develop a novel predictive algorithm designed to identify specific pest infestation patterns earlier and with greater accuracy than current industry standards. This project required continuous systematic development and experimentation to overcome technical uncertainties related to pattern recognition accuracy and ensuring the computational model was efficient enough to run on standard, field-deployed hardware.

1. Industry Qualification Test

AgriSense’s sole business activity is the design, development, and licensing of proprietary software solutions. This activity fits precisely within the IDR definition of Software Engineering: “The detailed study of the design, development, operation, and maintenance of software”.1 Furthermore, AgriSense is not engaged in any of the prohibited activities; specifically, it is not engaged in agricultural production (an excluded activity), nor is it a retailer, wholesaler, or finance company.2 Conclusion: The company meets the Iowa qualifying industry requirement.

B. Application of the Four-Part Test to the Project

The development of the novel predictive algorithm must satisfy all four parts of the IRC §41 test to generate Qualified Research Expenditures:

Conclusion: The activities undertaken by AgriSense on this specific algorithm development project qualify as “qualified research” under IRC §41.

C. Example Calculation (Regular Method)

Assuming AgriSense incurred $1,000,000 in Iowa-apportioned wages and supply costs (QREs) for this project, the Regular Credit calculation proceeds as follows:

Example Calculation: AgriSense Software, Inc. (Regular Method)

In this scenario, the 50% QRE floor dictated the Statutory Base Amount. The reliance on the 50% floor is typical for young or fast-growing software companies where the historical gross receipts base calculation (Line A) is relatively small. Conversely, for highly mature software firms with consistently high historical QREs and long operating histories, the calculated fixed-base percentage multiplied by average gross receipts (Line A) may exceed the 50% floor. This structural mechanism ensures that successful, mature firms receive credit only for increasing their R&D spend beyond historical norms, thereby promoting continued competitive investment rather than simply providing a subsidy for sustained maintenance-level research.

VI. Future Landscape: The R&D Tax Credit Program Under SF 657 (Effective 2026)

Iowa’s legislative framework for R&D incentives is undergoing a monumental change. Senate File 657 (SF 657), enacted in 2025, repeals the existing formula-based Research Activities Credit (RAC) and replaces it with a new, fundamentally different R&D Tax Credit Program, which is slated to go into effect on January 1, 2026.10

A. Legislative Mandate and Structural Transition

The restructuring was necessitated by the escalation of RAC claims, which exceeded state budgetary targets, reaching approximately $77.6 million in fiscal year 2024.10 SF 657 aims to replace the previous open-ended entitlement program with a system characterized by increased fiscal control, reduced rates, and competitive allocation.13

The core shift is from an automatic, formula-based eligibility model overseen by the Department of Revenue (IDR) to an economically targeted, competitive application process managed by the Iowa Economic Development Authority (IEDA).13

B. Transitioning from “Software Engineering” to Targeted Sectors

The explicit statutory designation of “Software Engineering” as a qualifying industry under Iowa Code §422.10 is being eliminated. Under the new program, software development will be integrated into the broader Technology and Innovation targeted industry.10

To be eligible, a business must not only be primarily engaged in one of the new targeted industries (Advanced Manufacturing, Bioscience, Insurance and Finance, Technology and Innovation) but must also specifically fit into a defined sector, such as the “Software and technology” sector.10

This introduces a significant procedural hurdle: businesses must formally pre-apply to the IEDA to obtain certification that they meet the specific sector requirements and are engaged in qualifying research.10 Approved businesses will be required to reapply for certification every five years.10

C. Program Dynamics: Application, Cap, and Rate Reduction

The new structure alters nearly every aspect of the credit:

• Annual Cap and Proration: The new R&D Tax Credit Program will operate under a strict, centralized statewide annual cap of $40 million.13 If the total qualified and certified claims submitted to the IEDA exceed this limit, the credits will be allocated pro rata.13 This shift eliminates the certainty of receiving the full calculated credit amount, introducing substantial variability into financial planning for R&D investments.
• Reduced Rate: The credit rate is significantly lowered to up to 3.5% of qualifying in-state QREs.13 This represents a near 50% reduction from the previous 6.5% Regular Credit rate.9
• Application Process: Eligibility requires businesses to formally apply to the IEDA, submitting CPA-verified QRE reports. The initial deadline for 2026 claims is scheduled for January 31, 2027.13

The following table summarizes the strategic differences between the current and future R&D incentive programs in Iowa:

Key Differences: Current RAC vs. 2026 R&D Tax Credit Program

D. Strategic Implications for Technology Firms

The transition introduces a complex layer of political and economic scrutiny to the R&D process. Under the current RAC, audit risk focuses purely on technical tax compliance: correct calculation of QREs and confirmation of industry status by the IDR.10

Post-2026, the application process through the IEDA shifts the audit focus. While technical compliance remains essential, the IEDA process requires the firm to justify its inclusion within a targeted sector and demonstrate its contribution to state economic objectives. Even if a software firm perfectly satisfies all technical tax compliance rules, it must still successfully compete for an allocation under the $40 million cap. This means that future R&D investment decisions must be supported by documentation that substantiates both adherence to tax law and clear alignment with Iowa’s strategic economic development goals.

VII. Strategic Recommendations for Software Businesses

Given the impending legislative overhaul and the current program’s complexities, software firms must undertake immediate strategic measures to optimize 2025 claims and prepare for the 2026 transition.

A. Immediate Action: Maximizing Claims under the Current RAC (Pre-2026)

Software firms should maximize their eligible R&D activities and fully document QREs through the end of the 2025 tax year. The current RAC provides a significantly higher calculated return (6.5%) than the future rate (3.5%) and offers the certainty of a formula-based credit amount, subject only to the 80% refundability cap.

It is paramount to rigorously review the business model to confirm airtight qualification as a “Software Engineering” firm.1 Businesses with diversified revenue streams must ensure their primary industry classification avoids the statutory exclusions (Retailer, Wholesaler, Finance, etc.) as the IDR strictly enforces these limitations.2 This validation is critical because the existing formula-based, higher-rate credit will sunset after 2025.12

B. Preparation for IEDA Application and Certification (Post-2026)

Preparation for the new R&D Tax Credit Program must begin immediately due to the shift in governing authority and the competitive application structure.

1. IEDA Engagement and Certification: Businesses should proactively monitor the Iowa Economic Development Authority (IEDA) for forthcoming administrative rules and application procedures related to the “Software and technology” sector.10 Successful compliance will depend on securing IEDA certification, a new prerequisite for receiving the credit.
2. Developing Economic Justification: Future applications will require demonstrating that the R&D activity aligns with the state’s targeted economic strategy. Firms must be prepared to substantiate not only the technical R&D compliance but also metrics related to job creation, sustained capital investment, and contribution to the overall “Technology and Innovation” sector.

C. Documentation Requirements for Audit Defense

The stringent nature of the Iowa RAC, combined with the new IEDA oversight, requires elevated documentation standards.

• Federal Compliance Documentation: Comprehensive, contemporaneous documentation satisfying the federal IRC §41 Four-Part Test remains mandatory for every claimed project.11 Narratives must clearly articulate the technical uncertainties addressed, the hypotheses tested, and the reliance on principles of computer science.
• Cost Exclusion Tracking: Detailed records must be maintained to segregate and exclude computer lease or rental costs incurred after January 1, 2023, from Iowa QREs, as this represents a key deviation from federal QRE definitions.7
• Time Allocation Rigor: Due to the potential for the IDR to enforce a stricter interpretation of the “process of experimentation,” software firms must implement rigorous time-tracking methodologies to ensure that only hours spent on core experimental research activities are claimed, minimizing the risk of non-compliance stemming from the inclusion of routine, non-experimental work.

VIII. Conclusion

The Iowa Research Activities Credit (RAC) currently offers businesses primarily engaged in Software Engineering a robust state-level incentive, utilizing a refundable credit rate of 6.5% on incremental research expenditures. Successful utilization of this credit demands stringent adherence to dual compliance requirements: first, demonstrating technical qualification under the federal IRC Section 41 Four-Part Test, and second, satisfying Iowa’s restrictive industry classification rules and navigating the statutory list of excluded professions and sectors.

The most critical factor impacting the future landscape is the passage of Senate File 657, which will repeal the current RAC and institute the new R&D Tax Credit Program beginning January 1, 2026. This overhaul fundamentally shifts the program from a formula-based entitlement to a targeted, competitive system managed by the IEDA. Software firms will face a reduced credit rate of up to 3.5% and must contend with a hard statewide cap of $40 million, introducing significant financial uncertainty due to the risk of pro rata allocation.

For businesses in the software and technology sector, the immediate imperative is twofold: maximizing the benefits of the higher-rate, formula-based RAC before its sunset in 2025, and proactively preparing the necessary economic and compliance documentation to compete successfully for certification and funding under the highly constrained 2026 IEDA program.

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