Analyzing Iowa’s Substantially All Rule Repeal: Mandating Actual Allocation for R&D Tax Credit Wages (Post-2022)

I. Executive Summary: The Principle of Actual Allocation

The Federal “Substantially All Rule” (SAR), codified under Internal Revenue Code (IRC) Section 41, allowed businesses to claim 100% of an employee’s wages as Qualified Research Expenses (QREs) if the employee spent 80% or more of their time on qualified research activities. For tax years beginning on or after January 1, 2023, Iowa explicitly disallowed this “round-up” provision for its Research Activities Tax Credit (RAC), mandating that businesses use the employee’s actual percentage of qualified time for QRE calculation.1

This legislative divergence marks a significant shift away from federal conformity regarding R&D wage calculation. The repeal of the SAR was one of two concurrent, restrictive changes to the Iowa RAC, working alongside the introduction of the mandatory “Majority Work” limitation, which requires employees and contractors to spend greater than 50% of their time on qualified research to be eligible at all.2 This shift necessitates that businesses claiming the Iowa RAC implement meticulous, high-resolution time-tracking documentation to support the proportional allocation, effectively eliminating the administrative convenience and financial benefit of the federal 80% “safe harbor” provision.1 Furthermore, these limitations coincided with the systematic phase-out of other key QRE categories, specifically eligible supply costs.3

II. The Federal Standard: Understanding the Substantially All Rule (SAR)

Defining Qualified Research Expenses (QREs) and Wages under IRC $\S$41

Qualified Research Expenses (QREs) under federal law, established in IRC $\S$41, form the basis for the federal Research and Experimentation (R&E) Tax Credit. QREs are fundamentally categorized into three components: (1) wages paid to employees performing qualified services, (2) costs for supplies used in the research, and (3) contract research expenses.4 State R&D credits, including Iowa’s RAC prior to 2023, traditionally adhered closely to these federal definitions and standards.5

The 80% Threshold: Mechanism and Rationale

The federal SAR, defined by IRC $\S41(b)(2)(B)$ and Treasury Regulation $\S1.41-2(d)(2)$, dictates that if “substantially all”—interpreted as at least 80%—of the services performed by an employee during the tax year fit the criteria of qualified research, then 100% of that employee’s annual wages are eligible as QREs.4 This rule was designed as a means of administrative convenience and tax optimization for key personnel deeply involved in the R&D process. For example, if an engineer spent 85% of their time developing and testing a new material (a qualified R&D activity), the business could count 100% of that engineer’s wages toward the federal QRE calculation, even though 15% of their time might have been spent on non-R&D tasks like administrative duties or general maintenance.4 Conversely, if an employee spent less than 80% of their time on qualified activities, only the actual percentage of wages attributable to qualified activities could be claimed.4

The federal SAR provided an implicit administrative buffer, simplifying compliance by minimizing the need for granular time tracking for employees whose R&D involvement was near total (between 80% and 99%). This allowed companies to maximize their credit base while streamlining the documentation process for their most dedicated research personnel.

Contextual Application to Business Components

It is important to note that the “substantially all” requirement is also applied at the project level to determine if a business component—such as a product, software feature, or process—qualifies for the credit.4 To qualify, at least 80% of the research activities related to that business component must constitute elements of a process of experimentation that meets the four-part test established under IRC $\S$41.4 This component-level application is separate from the wage calculation, but reinforces the prominence of the 80% threshold in federal R&D tax law.

III. Iowa’s Legislative Reform: Repeal of the Substantially All Rule (Post-2022)

Statutory Authority and Effective Dates

The Iowa legislature enacted changes to the Research Activities Credit (RAC), making significant modifications effective for tax years beginning on or after January 1, 2023.3 Under Iowa Code $\S422.33(17)(b)$, the state explicitly mandated that the federal “substantially all” rule, as described in IRC $\S41(b)(2)(B)$ and Treasury Regulation $\S1.41-2(d)(2)$, “does not apply” for the calculation of the Iowa RAC.3

The Proportional Allocation Mandate

The removal of the SAR eliminates the ability of businesses to “round up” the percentage of qualified research time. Iowa Department of Revenue (IDR) guidance and tax forms clearly articulate the resulting mandate: if an employee’s wages allocated to qualified services constitute at least 80% of their total wages during the tax year, the business is expressly “not permitted to round such wage allocation up to 100%.” Instead, the business must use the employee’s actual wage allocation.1

This proportional allocation rule means that a highly dedicated employee who spends 95% of their time on qualified research activities can only have 95% of their wages included in Iowa QREs, contrasting with the 100% claim permitted under the federal rule. This mandate forces taxpayers to abandon the simplifying administrative buffer provided by the federal SAR, necessitating the application of the exact, lower percentage for these key R&D personnel. The implication for multi-state businesses is that the QRE calculations required for Iowa non-conformity introduce additional complexity; taxpayers must perform two distinct QRE calculations—one following the federal rules (including SAR) and a separate, more granular proportional calculation unique to Iowa—thereby increasing internal compliance burdens and the potential for calculation errors during apportionment.

Policy Context: The Drive for Fiscal Precision

The repeal of the SAR was not an isolated adjustment but part of a broader, restrictive strategy implemented by the Iowa legislature to reduce the overall tax expenditure associated with the RAC and impose stricter fiscal controls.10 These 2023 modifications served as an immediate mechanism to reduce the Qualified Research Expenditure base claimed by businesses before the program was restructured entirely. This trend of fiscal tightening culminated in later legislation, Senate File 657 (SF 657), which ultimately repealed the formula-based RAC effective January 1, 2026, replacing it with a competitively capped, industry-specific program managed by the Iowa Economic Development Authority (IEDA).10

IV. Iowa’s Dual Constraint: The Mandatory “Majority Work” Qualification Threshold

The All-or-Nothing Gatekeeper

The non-applicability of the SAR is coupled with a second, distinct eligibility hurdle that further limits QRE wages: the “Majority Work” limitation.2 This requirement acts as an all-or-nothing gatekeeper that must be satisfied before proportional allocation can even be considered.

Iowa law dictates that wages paid to an employee for qualified research services performed in the state will only qualify as Iowa QREs if, during the period of the tax year that the business is engaging in research projects, a majority (greater than 50%) of the total services performed by that employee are directly related to those research projects.2

Impact on Partially Qualified Employees

This “Majority Work” rule is significantly more restrictive than the federal standard for lower-percentage employees. Under the federal standard, an employee who spends 45% of their time on qualified R&D could claim 45% of their wages as QREs. However, in Iowa, such an employee would be entirely disqualified because their qualified time falls below the $50\%$ threshold.3

The legislature implemented two highly restrictive constraints: the Majority Work filter, which entirely excludes low-percentage workers (those below $50\%$), and the Proportional Allocation mandate, which reduces the claim for high-percentage workers (those $80\%$ or more). This combination restricts the QRE pool at both the low end (disqualification) and the high end (reduced allocation), ensuring a comprehensive tightening of the QRE calculation base.

Application to Contract Research

The Majority Work limitation is also applied to contract research expenses.3 Contract research expenses paid to a third party for the performance of qualified research services in Iowa will only qualify if a majority of the total services performed by the contractor for the third party are directly related to the business’s specific research projects during that tax year.3 This stringent requirement places a high documentation burden on taxpayers to verify and substantiate the internal labor distribution of their contracted researchers, beyond merely documenting the contract and payment.

The distinctions between the federal and Iowa rules for qualified wage calculation are summarized in the table below:

Iowa QRE Wage Calculation: Federal SAR vs. Iowa Proportional Rule (2023-2025)

V. Iowa Department of Revenue (IDR) Compliance Guidance and Reporting

Official IDR Pronouncements on Proportional Allocation

The Iowa Department of Revenue formally incorporated the repeal of the SAR and the mandate for proportional allocation into its guidance materials. Specific instructions for forms such as the IA 128S (Iowa Alternative Simplified Research Activities Tax Credit) detail these requirements.1

The IDR guidance explicitly states that the “substantially all” rule… does not apply to the calculation of Iowa qualified research expenses.1 The guidance continues, specifying that if an employee’s wages allocated to qualified services constitute at least 80% of the employee’s total wages, “the business is not permitted to round such wage allocation up to 100% for purposes of calculating Iowa qualified research expenses. Instead, the business must use the employee’s actual wage allocation”.1

Form Reporting Requirements

Taxpayers utilizing the RAC must accurately compute their Iowa QRE base (reported on specific lines of Forms IA 128 or IA 128S, depending on the tax year and calculation method) by strictly applying the proportional rule and the initial Majority Work limitation.1 Compliance requires that the proportional allocation be fully supported by time-tracking data—whether measured in hours, days, or other consistent metrics—that clearly separates qualified R&D activities from all non-qualified tasks (e.g., training, administrative overhead, manufacturing activities).4 Given the elimination of the 80% buffer, the burden of documenting every percentage point of time spent on R&D for high-time employees is heightened.

VI. Related QRE Limitations: The Phased Reduction of Supply and Computer Costs

Systematic Reduction in Eligible Supplies

The modifications to the wage rules were introduced concurrently with systematic reductions in other QRE categories. Iowa initiated a phase-out of eligible supply costs (as defined in IRC $\S41(b)(2)(C)$) for tax years 2023 through 2025.3 Supply costs directly related to research performed in Iowa remain qualified, but are limited by a declining percentage, further reducing the overall QRE base:

• For tax years beginning in 2023, 80% of supply costs were eligible.3
• For tax years beginning in 2024, 60% of supply costs were eligible.3
• For tax years beginning in 2025, the eligible portion dropped to 40% of supply costs.2

The final phase-out schedule underscores the legislative intent to restrict the RAC aggressively before the full program replacement in 2026.

Supply Cost Eligibility Phase-Out for Iowa RAC (2023-2026)

Disallowance of Computer Lease/Rental Costs

Furthermore, Iowa law explicitly excludes amounts paid for the right to use computers, as described in IRC $\S41(b)(2)(A)(iii)$, from being considered QREs for the state credit.3 This non-conformity point primarily impacts businesses, particularly those in software engineering and technology fields, that rely heavily on cloud services or specialized hardware rentals, which often represent a significant portion of their federal QRE claims.

The combined effect of reducing eligible supply costs and eliminating computer lease/rental costs means that the Iowa QRE calculation base becomes heavily weighted toward qualified wages. This magnification of the wage component means that any reduction or error in wage QREs—whether resulting from the SAR repeal or failure to pass the Majority Work test—has a much larger proportionate impact on the final eligible credit amount. Consequently, the financial risk associated with non-compliance regarding employee time tracking is substantially increased.

VII. Case Study: Calculating QRE Wages Under Iowa’s New Regime

To illustrate the financial impact of Iowa’s non-conformity regarding wages, a comparative analysis is necessary for the 2025 tax year (when the 40% supply limitation applies, but focusing here on the wage component).

Scenario Setup

A company operating in Iowa is calculating its Qualified Research Expenses for the 2025 tax year. The company employs three R&D professionals with annual wages totaling $\$330,000$. The goal is to compare the QRE wages includable under the Federal SAR rules versus the Iowa Proportional Allocation and Majority Work rules.

Employee QRE Calculation Methodology (Wages)

The Iowa methodology requires two sequential steps for each employee: (1) Applying the Majority Work Test, and (2) Applying the Actual Proportional Allocation for those who pass the first test.

Analysis of Credit Disparity

The example demonstrates a total reduction of $\$49,500$ in qualified wage QREs due solely to Iowa’s non-conformity.

1. Impact of SAR Repeal (Employee E1): The Lead Engineer, spending 85% of time on qualified activities, would have qualified for 100% of wages federally ($150,000). Under Iowa’s actual allocation mandate, only 85% ($127,500) qualifies, resulting in a $22,500 reduction attributed directly to the repeal of the SAR.
2. Impact of Majority Work Rule (Employee E3): The Research Assistant, spending 45% of time on qualified research, would have claimed 45% of wages federally ($27,000). Because 45% is less than the required majority ($50\%+$), this employee fails the Iowa gatekeeper test, resulting in a full $27,000 reduction.

This combined effect—reducing the claim for high-percentage workers and eliminating the claim for moderately involved workers—significantly lowers the QRE base subject to Iowa’s credit rate (6.5% for 2025).6

VIII. Strategic Outlook: Preparing for the Post-2025 R&D Tax Landscape

The Repeal of the Current RAC Structure

The restrictions placed on QRE calculation starting in 2023 were precursor changes to a complete overhaul of the state’s R&D incentive structure. Senate File 657 (SF 657), passed in May 2025 and approved by Governor Kim Reynolds on June 6, 2025, repeals the existing, formula-based Research Activities Credit (RAC), effective for tax years beginning on or after January 1, 2026.6

Transition to the IEDA-Managed Competitive Program

The new R&D Tax Credit Program shifts oversight from the automatic, formula-based system administered by the Iowa Department of Revenue (IDR) to a competitive application process managed by the Iowa Economic Development Authority (IEDA).10 This transition fundamentally changes the mechanism by which incentives are obtained.

• Fiscal Controls: The previous RAC had grown significantly, sometimes exceeding $70 million in annual claims.10 The new IEDA program tightens fiscal control by capping total annual awards for all businesses at $\$40$ million.10
• Reduced Rate and Narrowed Eligibility: The credit rate for the new program is substantially reduced, offering up to 3.5% of qualifying in-state QREs, down from the previous regular rate of 6.5%.10 Eligibility is now restricted to specific sectors identified as “high growth drivers,” including advanced manufacturing, bioscience, specific finance/insurance segments, and technology/innovation.10 Explicit exclusions apply to sectors such as agriculture producers, real estate, retail, and construction.14
• Compliance and Certification: Under the new structure, businesses must formally apply to the IEDA, often annually, and are required to secure independent CPA validation of their QRE claims.10

The long-standing RAC, despite its inherent complexity, offered taxpayers certainty because it was formula-based and automatically available to qualifying filers. The new program, with its $\$40$ million cap and competitive application requirements, introduces high operational uncertainty. Taxpayers who maximized their credits under the 2023-2025 proportional rules must now shift to a resource-intensive application process with no guarantee of receiving the limited funds, fundamentally altering the risk/reward analysis for conducting R&D activities within the state of Iowa.

IX. Conclusion: Ensuring Compliance in a Changing Regulatory Environment

The elimination of the federal Substantially All Rule for the Iowa Research Activities Credit, effective 2023, coupled with the introduction of the Majority Work limitation, represents a definitive move by Iowa to establish a strict, low-tolerance standard for Qualified Research Expense qualification. This approach requires that every dollar of wage claimed must be substantiated by detailed, high-resolution documentation demonstrating the employee’s actual proportional time spent on qualified R&D activities.

For multi-state businesses, this divergence necessitates maintaining a calculation methodology unique to Iowa that incorporates both the proportional allocation mandate and the $>50\%$ qualification threshold, while simultaneously navigating the systematic phase-out of eligible supply costs and the disallowance of computer rental expenses.

While the formula-based RAC sunsets at the end of the 2025 tax year, the compliance rigor established by the 2023 rule changes—particularly the demand for precise proportional allocation—sets the necessary documentation standard for businesses seeking to participate in the successor IEDA-managed competitive R&D tax credit program beginning in 2026. Businesses must ensure that their QRE documentation systems are sophisticated enough to withstand the scrutiny of Iowa audits for prior RAC claims and to satisfy the CPA verification requirements of the future IEDA program.

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