The Dual Mandate: Navigating Government-Funded Research Exclusion in the Kansas R&D Tax Credit

The Government-Funded Research Exclusion (GFRE) dictates that research costs are ineligible for the R&D tax credit if the associated expenditures are financially backed by grants, contracts, or other funding sources.

This exclusion requires a detailed analysis of whether the taxpayer retains economic risk for the research and holds substantial rights to the resulting intellectual property, a crucial prerequisite for claiming both the federal and Kansas R&D tax credits, augmented by a specific Kansas statutory exclusion for governmental moneys.

This expert report provides a comprehensive compliance guide for Kansas businesses, detailing the federal and state statutory requirements for excluding government-funded expenses when calculating the expanded 10% Kansas Research and Development (R&D) Tax Credit, governed by K.S.A. 79-32,182b, effective for tax years commencing after December 31, 2022.1 Understanding and properly applying the GFRE is essential, as the Kansas credit relies heavily on federal definitions while simultaneously imposing a distinct state-level requirement regarding the source of funds.

Section 1: The Federal Nexus – Defining Qualified Research and the GFRE (IRC §41)

The foundation of the Kansas R&D tax credit rests entirely on definitions established in the Internal Revenue Code (IRC) Section 41. Consequently, any taxpayer seeking the Kansas credit must first meet all federal requirements for qualified research activities and expenses, including strict adherence to the exclusions stipulated under federal law.

1.1 Statutory Authority: IRC Section 41(d)(4)(H) and Conformity

The Kansas statute governing the R&D credit, K.S.A. 79-32,182b, mandates that “expenditures in research and development activities” must be “treated as expenses allowable for deduction under the provisions of the federal internal revenue code of 1986, as amended”.1 This establishes a requirement for state-level compliance to all federal definitions of Qualified Research Expenses (QREs).

The federal exclusion for funded research is explicitly stated in IRC $\S41(\text{d})(4)(\text{H})$, which specifies that qualified research activities do not include research “to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)”.5 This rule ensures that a taxpayer only claims a credit for research expenses for which they genuinely bear the financial burden and possess proprietary rights. The GFRE is one of several exclusions defined under federal law, alongside exclusions for research conducted after commercial production, adaptation, duplication, and research in the social sciences.7

1.2 The Definitional Framework: Grants, Contracts, and Other Arrangements

The term “funded research” within the context of IRC $\S41$ is intentionally broad. The exclusion is not limited solely to formal government grants or dedicated research contracts. Treasury regulations specify that “all agreements (not only research contracts) entered into between the taxpayer performing the research and other persons are to be considered in determining the extent to which the research is funded”.6 This expansive definition means that revenue derived from any arrangement—whether governmental or private—must be scrutinized to determine if the associated research costs are ineligible for the credit.

For research to qualify for the federal R&D tax credit, and thus the Kansas R&D tax credit, the taxpayer must demonstrate that they satisfy two foundational criteria related to the funding arrangement: they must bear the economic risk associated with the research, and they must retain substantial rights to the results of the research.

1.3 The Two Critical Prongs of the GFRE Analysis

The determination of whether research is “funded” requires a rigorous two-pronged analysis, focusing on economic risk and intellectual property rights. If a taxpayer fails either of these tests regarding the funded portion of the research, the related expenses are excluded from QREs.8

1.3.1 Economic Risk (The “Risk of Loss” Test)

The economic risk test determines who ultimately bears the financial cost if the research activity proves unsuccessful or is terminated. The taxpayer is deemed not to have borne the economic risk if they are entitled to payment for the research regardless of the technical success or failure of the project.9

If a funding entity—be it the federal government, a state agency, or a private entity—guarantees the payment of research expenses incurred by the taxpayer, the taxpayer has not incurred a sufficient risk of loss, and the associated expenditures are excluded. Taxpayers must scrutinize contract terms to identify clauses that shield them from financial loss. To retain the economic risk, the taxpayer must be able to demonstrate that they would suffer a genuine financial loss (i.e., not be reimbursed) if the research activity fails to meet its goals or is aborted early.

1.3.2 Substantial Rights (The “Intellectual Property” Test)

The second critical prong requires the taxpayer to retain substantial rights to the research results, including the right to exploit the intellectual property (IP) commercially.8 Intellectual property is defined broadly and includes creations protected by patents, copyrights, and trade secrets.10

If the funding contract requires the taxpayer to assign all ownership rights to the funding entity, or if the taxpayer retains only a non-exclusive, non-transferable license to the IP, the research is considered funded and therefore excluded. Retention of substantial rights is crucial because the federal credit is intended to incentivize taxpayers who invest in innovation that will primarily benefit their own commercial endeavors. The inability to fully exploit the IP commercially constitutes a failure of this test, regardless of whether the taxpayer bore the economic risk.11 Taxpayers must ensure that contractual language grants them sufficient rights to the resulting patents, data, and commercial processes.

1.4 Regulatory Requirements for Allocation (Treasury Regulation §1.41-4A(d))

If research is only partially funded, the exclusion is not absolute; it is applied proportionally. Treasury Regulation $\S1.41-4\text{A}(\text{d})$ outlines the methodology for this proration. If the total amount of funding received for a specific research project is less than the total amount of research expenditures for that project, the research is deemed funded only to the extent of the funding received.12

This requires meticulous cost accounting. Taxpayers must track funded costs separately from internally financed Qualified Research Expenses (QREs). Failure to properly allocate expenses between funded and unfunded portions can lead to the entire project being disqualified during an audit, or an incorrect credit calculation. This complexity emphasizes the necessity of maintaining detailed, usable records to substantiate which expenditures were not reimbursed or guaranteed by any external party.13

The regulatory framework for the federal GFRE sets the essential compliance baseline for Kansas claimants, as demonstrated in the table below:

Federal GFRE Requirements (IRC §41)

Section 2: Mapping Federal GFRE to Kansas Law (K.S.A. 79-32,182b)

While Kansas follows the federal definitions for determining which activities qualify as R&D, the state statute introduces a specific, independent exclusion that is crucial when dealing with funding from federal or state governmental entities. This creates a compliance requirement known as the “Dual Exclusion.”

2.1 Kansas R&D Credit Structure and Mechanics

The Kansas R&D tax credit incentivizes businesses to invest in qualified research activities conducted strictly within the state.14

For tax years commencing after December 31, 2022, the credit saw several favorable legislative changes, including an increase in the credit rate from 6.5% to 10%.2 The credit is calculated incrementally, based on the growth in R&D investment: it is equal to 10% of the amount by which the current year’s Kansas-apportioned QREs exceed the taxpayer’s average QREs over the current year and the two next preceding taxable years (a three-year average calculation).1 Furthermore, eligibility was expanded post-2022 from C corporations to include all Kansas income taxpayers, such as individuals, S corporations, partnerships, and limited liability companies.14

2.2 The Explicit Kansas State Exclusion: K.S.A. 79-32,182b(c)

The most significant distinction for Kansas R&D credit claimants engaged in government contracts lies in the specific statutory definition of qualifying expenditures. K.S.A. 79-32,182b(c) defines “expenditures in research and development activities” as expenses allowable under the federal IRC, with a key caveat: they must exclude “expenditures of moneys made available to the taxpayer pursuant to federal or state law”.1

This language imposes a mandatory state-level test that focuses on the source of funds, which can be simpler, and potentially broader, than the federal GFRE analysis that hinges on economic risk and retained rights.

• Dual Exclusion Requirement: For research funded by a governmental entity (federal or state), Kansas taxpayers must satisfy both the federal GFRE criteria (risk/rights) and the Kansas statutory exclusion (source of funds). In practice, if the expenditures are directly traceable to cash received via a federal or state grant or program, the expense is prohibited from the QRE base for the Kansas credit regardless of the outcome of the complex federal risk/rights test.
• Contrasting Focus: If a private entity funds the research, only the federal risk/rights analysis applies. However, when governmental funding is involved, the Kansas statute acts as a direct carve-out, explicitly excluding the dollar amount corresponding to the funded money. This often simplifies compliance by focusing on the monetary source, thus bypassing the granular federal allocation required under Treasury Regulation $\S1.41-4\text{A}(\text{d})$ for that specific governmental money. This direct source exclusion ensures that state tax incentives are not provided for R&D activities already subsidized by public funds.

2.3 KDOR Administrative Stance and Compliance Burden

The Kansas Department of Revenue (KDOR) relies on the statutory requirement of K.S.A. 79-32,182b(c).15 KDOR’s administrative guidance, including the general information section in the instructions for Schedule K-53 (Research and Development Credit), reiterates the necessary exclusion: “Qualifying expenditures are expenditures made for research and development purposes (other than expenditures of moneys made available to the taxpayer pursuant to federal or state law)”.17

While KDOR guidance does not provide separate administrative rulings defining the federal risk or substantial rights tests, the state’s conformity statute means taxpayers must apply the federal framework to confirm the activity is fundamentally “qualified research.” They must then ensure the Kansas source-of-funds exclusion is applied to derive the appropriate state QRE base.

The necessary steps for compliance involve meticulous documentation to differentiate federally or state-funded QREs from self-funded QREs, a task made challenging by existing concerns regarding the reliability of tracking data for state tax incentives.18

Comparison of Funded Research Exclusion Mechanisms

Section 3: KDOR Administrative Guidance and Procedural Compliance

Recent legislative changes have substantially altered the procedural requirements for claiming the Kansas R&D credit, specifically increasing the compliance burden and introducing new tracking needs related to credit utilization and transferability.

3.1 Procedural Requirements for Claiming the Credit

The process begins with the establishment of eligibility based on federal standards (the four-part test for qualified research) and the successful application of the GFRE.

Mandatory Application (Form K-204)

Effective for tax year 2023 and thereafter, taxpayers wishing to claim the credit must complete and submit Form K-204, the Research and Development Credit Application, prior to claiming the credit.15 This requirement formalizes the state’s validation process and is necessary due to the credit’s new transferability feature, which necessitates pre-approval or registration of the credit amount generated.

Computation Schedule (Form K-53)

The actual credit calculation is performed on Schedule K-53. The computation follows the formula defined in K.S.A. 79-32,182b:

1. Current Year QREs (Line 1): Enter the eligible expenditures for machinery and equipment, payroll, and supplies for activities conducted within Kansas.21 Crucially, the QRE total entered on this line must already reflect the exclusion of all government-funded research expenditures as defined by K.S.A. 79-32,182b(c).17
2. Average Expenditures (Line 4): The average of the current year’s QREs and the QREs from the two preceding tax years is computed and entered as the base amount.21
3. Total Credit (Line 6): The excess QREs (Line 5) are multiplied by the 10% credit rate.1

3.2 Credit Utilization and Transferability

The legislative changes implemented in 2023 enhanced the economic value of the credit but added complexity to its deployment.

Annual Limitation and Carryforward

The credit allowed for deduction in any single tax year is statutorily capped at 25% of the total credit generated plus any applicable carry forward amount.1 Any remaining unused credit amount is carried forward indefinitely in 25% increments until the total amount is fully utilized.2

Transferability

A significant change commencing in tax year 2023 allows a taxpayer without a current Kansas income tax liability to transfer the full generated credit one time to any other person (the transferee).2

This transferability provision necessitates strict adherence to all foundational compliance rules, including the GFRE. If an audit determines that the generating taxpayer (transferor) failed to properly exclude government-funded research, the credit could be clawed back, placing the transferee at financial risk. The transferor must submit Schedule K-53, and the transferee must use Form K-260 to claim the credit.2 The existence of a market for these credits, created by transferability, logically increases the likelihood of scrutiny from the KDOR to validate the foundational eligibility requirements, particularly the proper exclusion of funded research.

3.3 Meticulous Tracking and Apportionment

Taxpayers operating across multiple states must rigorously apportion QREs to ensure only activities conducted within Kansas are included in the credit calculation.1 This geographical limitation requires specific internal tracking mechanisms for wages, supplies, and contract research performed locally.4

For multi-state firms with complex R&D portfolios, this documentation is critical. When dealing with funded research, a taxpayer must first exclude the GFRE portion of the expense (federal/state source money) and then ensure the remaining, internally funded QREs are correctly allocated to Kansas activities, which typically involves time allocation for personnel and location tracking for supplies and contract work.22 This dual layer of filtering—funded exclusion and geographical apportionment—must be clearly auditable to support the claim on Schedule K-53.

Section 4: Strategic Impact and Case Study Application

The strategic management of R&D contracts, especially those involving government entities, dictates whether a taxpayer can maximize their Kansas R&D tax credit. Understanding the explicit exclusion requirements mitigates audit risk and ensures the QRE base is accurately calculated.

4.1 Strategic Importance of Documentation and Contract Review

Before entering into any contract involving research, taxpayers should conduct a thorough review to ensure compliance with the GFRE. For governmental funding, this review is twofold:

1. Federal Test Review: Confirming that the taxpayer retains substantial rights to the IP and bears sufficient economic risk for the unfunded portions of the work. If the economic risk is borne by the funding entity, the associated expenses are excluded federally.8
2. Kansas Source Exclusion Review: Identifying the specific dollar amount of QREs directly paid for by federal or state funds, ensuring those dollar amounts are systematically excluded from the Kansas QRE base, as mandated by K.S.A. 79-32,182b(c).

By employing separate accounting methods for internally funded R&D versus grant-funded R&D, taxpayers can establish a clear, documented audit trail that substantiates the exclusion of expenditures mandated by federal and state law, which is vital for defending a claim during an audit.

4.2 Case Study: KS Innovate Inc. and the Dual Exclusion Mechanism

This example demonstrates how the GFRE and the Kansas source-of-funds exclusion interact to determine the creditable base for a Kansas taxpayer.

4.2.1 Scenario Setup:

KS Innovate Inc., a Kansas-based manufacturing firm, conducts R&D activities entirely within the state. In 2024, the company received a federal grant of $\$200,000$ to develop a specific manufacturing component. These grant moneys were used to pay for specific wages and supplies associated with the project.

The contract terms specify that KS Innovate retains ownership of all intellectual property, satisfying the federal substantial rights test. However, the $\$200,000$ payment was guaranteed by the federal agency, meaning KS Innovate did not bear the economic risk of failure for those specific expenditures.

4.2.2 Step 1: Applying the Federal GFRE (IRC §41)

Because the payment of $\$200,000$ was guaranteed regardless of the technical success of the research, KS Innovate failed the economic risk test for that portion of the expenses. Therefore, the $\$200,000$ must be excluded from the federal QRE base. The remaining $\$600,000$ ($800,000 – $200,000) is considered federally qualified.

4.2.3 Step 2: Applying the Kansas Statutory Exclusion (K.S.A. 79-32,182b(c))

The Kansas statute explicitly excludes “expenditures of moneys made available to the taxpayer pursuant to federal or state law”.1 Since the $\$200,000$ expense was paid using moneys sourced from a federal grant, the state exclusion confirms that this amount must be excluded from the Kansas QRE base.

4.2.4 Step 3: Calculating the Kansas R&D Tax Credit (2024)

The total amount excluded under the GFRE and the Kansas source-of-funds rule is $\$200,000$.

Case Study Calculation: Impact of GFRE on Kansas R&D Credit (2024)

4.2.5 Step 4: Applying Annual Limitation (Line 7)

Based on the calculation, KS Innovate Inc. generated a total credit of $\$10,000$. However, due to the 25% annual utilization limit, the maximum credit claimable in 2024 is $\$2,500$. The remaining $\$7,500$ of the credit may be carried forward indefinitely until used.2

Section 5: Conclusion and Recommendations

The Kansas R&D tax credit provides a substantial incentive for in-state innovation, particularly with the 2023 increase to a 10% rate and the introduction of transferability.14 However, maximizing this benefit requires expert navigation of the Government-Funded Research Exclusion, which involves a complex interaction between federal regulatory definitions and explicit state statutory exclusions.

5.1 Summary of GFRE Compliance Best Practices

Effective GFRE compliance for Kansas taxpayers requires recognizing the dual compliance nature of the exclusion:

1. Mandatory Dual Review: Taxpayers must adhere to the federal IRC $\S41$ GFRE analysis (economic risk and substantial rights) for all external funding sources, as mandated by Kansas conformity. For funding sourced from federal or state governmental entities, K.S.A. 79-32,182b(c) imposes an additional, and often simpler, exclusion based on the source of the moneys.
2. Contractual Due Diligence: Prior to commencing research, all contracts, especially those with government agencies, must be reviewed by tax professionals to ensure clear language regarding the retention of intellectual property rights and the assumption of economic risk. This analysis dictates which expenditures remain qualified for the credit.
3. Separation of Cost Tracking: To facilitate accurate calculation on Schedule K-53 and provide robust audit defense, taxpayers should implement systems that rigorously track R&D expenses. This tracking must segregate expenditures funded by governmental grants or contracts from those funded internally, enabling precise application of the Kansas source-of-funds exclusion.
4. Procedural Fidelity: Strict adherence to KDOR requirements, including the mandatory submission of Form K-204 prior to claiming the credit, is essential. Any subsequent transfer of the credit requires careful documentation via Form K-260 to ensure the transferee is protected from future audit adjustments related to foundational eligibility issues, such as the GFRE.2

5.2 Final Note on Maximizing the Kansas Advantage

The increase in the Kansas credit rate and the introduction of transferability provide a powerful tool for improving cash flow and encouraging R&D investment.14 The ability to transfer the credit provides immediate liquidity for startups or companies without current tax liability. However, the enhanced value and marketability of the credit heighten the audit exposure, meaning the exclusion of government-funded research must be performed with absolute precision. Proper application of the GFRE, meticulous apportionment of QREs to Kansas activities, and rigorous documentation are non-negotiable prerequisites for taxpayers seeking to realize the full economic potential of the Kansas R&D tax credit.

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