Analyzing Contract Research Expenses and the Strategic Advantage of the Kansas R&D Tax Credit (K.S.A. 79-32,182b)

I. Executive Summary: The Strategic Value of Contract Research Expenses in Kansas

Contract Research Expenses (CRE) represent costs paid by a taxpayer to a non-employee third party for performing qualified research activities, such as product testing, material analysis, or specialized contract development services. Under federal rules adopted by Kansas, only 65 percent of the amount paid for such contract research services generally qualifies toward the calculation of the total Qualified Research Expenses (QREs).

The ability to accurately define and calculate Contract Research Expenses is a foundational element in maximizing the Kansas Research and Development (R&D) Tax Credit. The Kansas credit, codified in K.S.A. 79-32,182b, relies directly on the federal definition of QREs found in Internal Revenue Code (IRC) Section 41. This strict reliance necessitates that taxpayers adhere to specific federal eligibility requirements regarding outsourcing, intellectual property rights, and economic risk before applying Kansas’s specific calculation formula. The recent legislative enhancement, which increased the credit rate to 10% for taxable years commencing after December 31, 2022, significantly elevates the financial incentive to properly quantify every eligible dollar of CRE, as maximizing the QRE base directly increases the potential state credit capture.1 Strategic tax planning in Kansas requires a detailed understanding of how contracted R&D work intersects with both federal qualification criteria and state-level compliance mandates.

II. The Federal Standard: Defining Contract Research Expenses (CRE) Under IRC § 41(b)(3)

The definition and inclusion percentage of Contract Research Expenses originate entirely from the federal framework established under IRC $\S 41$. Since Kansas law explicitly mandates that “expenditures in research and development activities” must be those “allowable for deduction under the provisions of the federal internal revenue code of 1986, as amended,” the state credit calculation must begin with rigorous federal compliance.1

A. The Critical 65% Inclusion Rule and Exclusions

The statutory basis for CRE is articulated clearly in 26 U.S. Code $\S 41$, which defines the term “contract research expenses” as 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.3 This 65% inclusion rate is a critical distinction from in-house research expenses, such as wages paid to employees performing qualified services or the cost of supplies used in research, which generally qualify at 100%.5

The rationale for the partial 65% inclusion is rooted in the assumption that the total amount paid to a contractor includes components that are not directly qualified research costs. These typically include the contractor’s internal overhead, administrative expenses, and profit margin, none of which are intended to be incentivized by the R&D credit. By limiting the qualifying expense to 65%, the statute attempts to approximate and incentivize only the direct research labor and materials component of the contracted service.6

The federal definition also addresses the timing of expenses, noting that prepaid amounts are eligible if the expense is paid or incurred during the taxable year and is attributable to qualified research activities.3

A critical exception to the 65% rule exists for outsourced research performed by specific non-profit and educational entities. IRC $\S 41(b)(3)(C)$ provides for a higher inclusion rate of 75% for amounts paid to qualified educational institutions, scientific research organizations, or nonprofit institutions for contracted research.6 Taxpayers must ensure proper segregation of payments made to these specialized institutions from standard third-party contractors to maximize the qualified expense base.

B. Prerequisites for Qualification: Substantial Rights and Economic Risk

For any contract payment to be recognized as a Qualified Contract Research Expense, the transaction must meet strict IRS guidelines designed to ensure that the taxpayer—the entity claiming the credit—is the genuine beneficiary and driver of the research. Simply paying an invoice is insufficient; the relationship must satisfy two core requirements: bearing economic risk and retaining substantial rights.7

1. Bearing the Economic Risk: The taxpayer must assume the risk that the research project may fail or prove technically unfeasible. This requirement is typically met if the taxpayer is contractually obligated to pay the contractor regardless of whether the research yields a successful or desired outcome. If payment is contingent upon the successful delivery of a finished, marketable product, the economic risk often rests with the contractor, potentially disqualifying the expenditure as CRE for the taxpayer.6
2. Maintaining Substantial Rights: The taxpayer must retain substantial rights in the research results, which usually translates to ownership of the Intellectual Property (IP), patents, proprietary data, or licenses resulting from the contracted work. This ensures that the entity claiming the credit is the ultimate economic and legal owner of the innovation derived from the expenditure.6

Since Kansas tax law adheres precisely to the IRC definition, an audit by the Kansas Department of Revenue (KDOR) concerning R&D expenses will necessarily hinge on the strength of the taxpayer’s compliance with these federal eligibility requirements. Consequently, the quality and specificity of the contractual agreement with the third-party researcher are paramount. A contract that fails to explicitly document the allocation of economic risk or the retention of IP rights by the taxpayer creates significant audit risk and may lead to the full disallowance of the claimed CRE at both the federal and state levels. The foundation for claiming the Kansas credit is therefore laid in the precise legal documentation governing the outsourced research activities.

C. Strategic Consideration of Contract vs. In-House Research

The varying inclusion rates between in-house and contract research expenses introduce a critical strategic trade-off for companies conducting R&D. While in-house expenses (wages, supplies, computer lease costs) are generally included at 100%, CRE is included at only 65%.3 This difference necessitates that CPAs and tax directors carefully model the cost-benefit of outsourcing. While using a third-party laboratory or specialized contractor may accelerate a business’s R&D timeline and reduce immediate capital expenditure on internal personnel (a strategic business objective), it inherently reduces the percentage of the total expenditure that qualifies for the tax credit (a tax objective). Effective tax strategy requires modeling projected R&D growth and the resulting credit generation under various internal versus external execution scenarios.

The table below summarizes the three primary components of Qualified Research Expenses (QREs) as defined by IRC Section 41 and their applicability to the Kansas R&D credit:

Table Title: Components of Qualified Research Expenses (QREs)

III. Statutory Framework of the Kansas R&D Credit (K.S.A. 79-32,182b)

The Kansas R&D credit provides an income tax credit for taxpayers who make expenditures in qualified research and development activities conducted entirely within the state.1 The credit is calculated based on the increase in these expenditures over a defined historical baseline.

A. Linking State Expenditures to Federal IRC Section 41

The foundation of eligibility is explicitly tied to federal tax law. K.S.A. 79-32,182b requires that expenditures must be those “allowable for deduction under the provisions of the federal internal revenue code of 1986, as amended”.1 This mandate confirms that the rigorous federal requirements for defining qualified research, including the four-part test (developed for a functional purpose, technical uncertainty, process of experimentation, and qualified purpose), must be met. Furthermore, it ensures that the federal treatment of CRE—specifically the 65% inclusion rate—is automatically incorporated into the state calculation.2

A critical state-specific limitation is the location requirement: the R&D activities must be “conducted within this state”.1 This means that while a Kansas-based company may pay for contract research, if the third-party research laboratory or contractor performs the work outside of Kansas borders, the associated CRE is excluded from the Kansas credit calculation, even if it might qualify for the federal credit.

B. Calculation Methodology: The Enhanced Excess Credit

Kansas employs an incremental methodology, calculating the credit based on the amount by which current-year expenditures exceed a historical average. This structure is intended to reward companies that increase their R&D spending within the state.

The core calculation involves determining the taxpayer’s average expenditures (the base) for the current taxable year and the two next preceding taxable years.1 The creditable amount is then calculated on the excess of the current year’s Total Qualified Research Expenses (QREs) over this three-year average base.

The effective base calculation methodology reveals a complex dynamic regarding the sustained use of CRE. Because the base is calculated using an average of the current year and the two preceding years, aggressive utilization of CRE (at the 65% qualified rate) in a high-spending year inflates not only the current year’s QREs but also the base for the following two years. If R&D spending growth slows in subsequent years, this artificially high base can significantly reduce the amount of the excess QREs, thereby shrinking the available credit. Tax planners must project multi-year R&D growth trajectories to determine the optimal timing and consistency of high CRE utilization, ensuring that the short-term benefit does not erode future credit generation potential by inflating the base period.

Rate Enhancement

The Kansas Legislature has significantly enhanced the incentive rate. The credit amount is calculated as a percentage of the difference between the actual qualified R&D expenses for the year and the three-year average.2

• Historical Rate: Prior to January 1, 2023, the credit rate was 6.5% of the excess amount.2
• Current Enhanced Rate: For taxable years commencing after December 31, 2022, the credit rate has increased to 10% of the excess amount.1

This change represents a legislative commitment to stimulate R&D investment within the state. The increase from 6.5% to 10% makes the Kansas credit dramatically more valuable and competitive, especially when coupled with the ability to transfer the credit (discussed in Section IV). This policy shift positions Kansas to better attract and retain high-growth technology and manufacturing enterprises that rely heavily on R&D expenditure for innovation.

Table Title: Evolution of the Kansas R&D Tax Credit Rate (K.S.A. 79-32,182b)

IV. Kansas Department of Revenue (KDOR) Compliance and Procedures

The administration of the Kansas R&D credit requires adherence to specific procedural steps and forms mandated by the KDOR. These requirements, particularly the processes implemented for tax year 2023 and beyond, streamline verification and facilitate the transferability of the credit.

A. Mandatory Filing and Certification Requirements

Taxpayers seeking the credit must complete and submit Schedule K-53, titled “RESEARCH AND DEVELOPMENT CREDIT,” with their annual Kansas income tax return (e.g., Form K-40, K-41, or K-120).9 This schedule serves as the calculation mechanism. Line 1 of the K-53 requires the input of “machinery and equipment, payroll, and other expenditures for activities conducted within Kansas for the tax year”.9 This is where the qualified expenditures, including the calculated 65% portion of the Contract Research Expenses, must be accurately reported.

In a recent procedural change aimed at enhancing verification, the KDOR introduced a mandatory pre-claim step. For tax years 2023 and later, taxpayers must first submit Form K-204 (Application for Certification of Research and Development Tax Credit) to the Department for official certification of the credit amount before claiming it on their income tax return using Schedule K-53.10 This procedural change ensures the KDOR verifies the eligibility and calculated amount of the generated credit prior to its utilization, promoting compliance and reducing post-filing audit risk.

B. Credit Limitations and Carryforward Strategy

Once the total credit amount is calculated, its immediate usability is restricted by an annual limitation. The amount of the credit allowable for deduction from the taxpayer’s tax liability in any one taxable year is capped at 25% of the total amount of such credit generated, plus any applicable carryforward amount.1

This 25% annual limitation dictates that, even for highly profitable corporations with substantial tax liability, it will take a minimum of four years to fully utilize a newly generated R&D credit. This restriction necessitates meticulous long-term tax provision planning and accurate tracking of carryforward amounts (which are accounted for on Lines 17 and 18 of Schedule K-53).9 Any remaining unused portion of the credit may be carried forward indefinitely until the total credit is fully claimed by the taxpayer.1

C. Transferability of Credits (Post-2022)

A major legislative enhancement for tax year 2023 and all subsequent years is the introduction of credit transferability.2 This policy allows the new R&D tax credit to be transferred by a taxpayer without a current tax liability to any person.1

This feature is particularly beneficial for startups and early-stage growth companies. These businesses, often generating significant R&D expenses but simultaneously incurring operating losses, historically faced the prospect of carrying forward tax credits for many years before achieving profitability sufficient to utilize them. By allowing the credit to be transferred, Kansas provides a pathway for these companies to immediately monetize their R&D investments by selling the credit to a third party, generating immediate working capital.2

Specific restrictions govern the transfer process:

1. Only the full credit may be transferred, and the credit may be transferred only one time.2
2. Only the entity that originally earned the credit is permitted to perform the transfer.2
3. The transferee (the buyer) claims the credit against their own Kansas income tax liability in the tax year it was transferred. The transferee may also carry forward any unused credit, subject to the original limitations and requirements in place when the credit was earned.2

Formal documentation is required for all transfers: Form K-260 must be completed and submitted to the KDOR to document the transaction, and the transferor must include the Schedule K-53 for the credit being transferred with their own income tax return.2

V. Practical Application: Calculating CRE and the Kansas R&D Credit

The following example demonstrates the integration of Contract Research Expenses into the overall Kansas calculation formula, applying the current 10% rate and the statutory 25% limitation.

A. Step-by-Step CRE Quantification Example

Consider Innovate KS Corp., a Kansas-based entity, which contracts with a third-party, non-employee research firm in Topeka to conduct proprietary material fatigue testing in 2024. Innovate KS Corp. mandates in the contract that it will retain ownership of all resulting data and IP, and the payment is required regardless of whether the tests meet the technical specifications.

1. Total Contract Payment: Innovate KS Corp. pays the third party a lump sum of $\$200,000$.
2. Federal Inclusion Rate (Standard CRE): Since this is a standard third-party contractor and not an educational institution, the 65% inclusion rate applies.
3. Qualified Contract Research Expense (CRE): The amount eligible for inclusion in the QRE base is calculated as $\$200,000 \times 65\% = \$130,000$.6

This $\$130,000$ represents the portion of outsourced costs that will be aggregated with the company’s internal Qualified Research Expenses (QREs, such as employee wages and supplies) to determine the Total QREs for the current tax year.

B. Comprehensive Kansas R&D Tax Credit Calculation Example (10% Excess Method)

Innovate KS Corp. is calculating its R&D credit for Tax Year (TY) 2024, utilizing the current 10% rate. The company’s historical QRE data, including the 65% CRE component for each year, is presented below.

Credit Calculation (TY 2024):

1. Calculate the Average QRE Base: The average of the current year (2024) and the two preceding years (2023 and 2022) must be determined:
   
   $$\text{Average Base} = \frac{(\$530,000 + \$447,500 + \$365,000)}{3} = \$447,500$$
2. Determine Excess QREs: The current year’s QREs must exceed the calculated average base:
   
   $$\text{Excess QREs} = \$530,000 – \$447,500 = \$82,500$$
3. Calculate Total Credit Generated: Apply the enhanced 10% Kansas credit rate (applicable post-2022) to the excess QREs 1:
   
   $$\text{Total Credit Generated} = \$82,500 \times 10\% = \$8,250$$
4. Apply Annual Limitation: The credit claimable in TY 2024 is capped at 25% of the total generated credit 2:
   
   $$\text{Maximum Credit Claimable (TY 2024)} = \$8,250 \times 25\% = \$2,062.50$$

C. Strategic Carryforward Analysis

Innovate KS Corp. successfully generated a credit of $\$8,250$ in TY 2024. Due to the statutory 25% limitation, the company can only claim $\$2,062.50$ this year, assuming sufficient Kansas tax liability exists. The remaining balance of the generated credit, $\$6,187.50$, is carried forward to TY 2025.

This structured limitation means that even highly profitable entities that maximize their QREs, including CRE, must plan for a multi-year realization cycle. This protracted claim process reinforces the importance of long-term forecasting and careful multi-year modeling to ensure maximum efficiency in utilizing the benefit.

VI. Program Utilization, Strategic Implications, and Conclusion

A. Program Utilization Data

Data collected by the Kansas Department of Commerce and the KDOR confirms the active utilization of the R&D credit across the state’s business landscape. For example, during Tax Year 2020, various projects claimed specific amounts, including $\$36,547$, $\$24,815$, $\$9,570$, and amounts as low as $\$130$ and $\$298$.11 The total amount of R&D credits claimed across reported projects in TY 2020 exceeded $\$2$ million.11

A review of the transparency reporting reveals that many claims consistently fall below the $\$50,000$ reporting threshold.11 This structured reporting suggests a policy decision to aggregate or protect the specific claim details of smaller claimants. The observation that a significant volume of claims remains below this public reporting threshold strongly suggests that the Kansas R&D tax credit is utilized extensively by small and medium-sized enterprises (SMEs) rather than being dominated solely by a few large corporate claimants. This wide distribution indicates the credit serves its intended purpose of supporting a broad range of R&D activities across various business sizes in Kansas.

B. Strategic Implications of Legislative Enhancements

The Kansas legislature’s decision to simultaneously increase the credit rate from 6.5% to 10% (post-2022) and introduce credit transferability represents a deliberate, potent strategy to enhance the economic impact of the program.2 This combination makes the Kansas R&D credit exceptionally attractive for two distinct corporate profiles:

1. For Growing Companies (Maximizing Value): The higher 10% rate significantly increases the return on investment for marginal R&D spending, particularly for companies that are consistently growing their QRE base year over year.
2. For Early-Stage Companies (Liquidity): The transferability feature fundamentally alters the financial reality for loss-generating companies. Since they can immediately monetize their earned credits by selling them via Form K-260, they transform a future tax asset (the carryforward) into immediate working capital. This acts as a non-dilutive funding mechanism, encouraging greater investment in research infrastructure and contracted R&D services within Kansas.1

This simultaneous legislative action is designed to address both the profitability and liquidity of R&D-focused businesses, strengthening Kansas’s position in regional economic competition, particularly compared to neighboring states.12

VII. Conclusion

The effective utilization of the Kansas Research and Development Tax Credit hinges on a deep understanding of its federal foundation and adherence to stringent state procedural requirements. Contract Research Expenses, while only qualifying at 65% of the total expenditure, represent a crucial component of the total Qualified Research Expenses base, particularly for firms leveraging specialized external expertise. The eligibility of CRE is entirely contingent upon meticulous adherence to federal IRC $\S 41$ stipulations, specifically the contractual allocation of economic risk and the retention of substantial rights to the resulting intellectual property.

The strategic landscape of the Kansas R&D credit has been significantly improved by the increase to a 10% credit rate and the introduction of credit transferability for post-2022 tax years. These changes necessitate that taxpayers not only focus on correctly calculating the 65% CRE inclusion but also engage in careful multi-year planning to manage the effect of the three-year average base calculation and the 25% annual utilization limitation. To successfully capture and monetize the maximum allowable benefit, taxpayers must ensure mandatory certification is obtained via Form K-204 and file the necessary documentation, including Schedule K-53, with the Kansas Department of Revenue.

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