The Permitted Purpose: Deconstructing the “New or Improved Business Component” Test for the Kansas R&D Tax Credit (K.S.A. 79-32,182b)

The “New or Improved Business Component” standard serves as the threshold Permitted Purpose test of qualified research. It strictly requires that research and development activities must be directed toward creating or enhancing the functionality, performance, reliability, or quality of a defined product, process, formula, or software used in the trade or business.

This rigorous definition is imported directly from the federal Internal Revenue Code (IRC) Section 41, which Kansas mandates for state tax credit qualification. Successful claims under the Kansas Research and Development (R&D) Tax Credit (K.S.A. 79-32,182b) depend entirely on demonstrating technical activities aimed at achieving these specific qualitative improvements, supported by robust documentation and formalized through the mandatory state pre-certification process.

Statutory Foundation: The Federal Nexus in K.S.A. 79-32,182b

The foundation of the Kansas R&D tax credit lies in K.S.A. 79-32,182b, which provides an incentive for expenditures in R&D activities conducted within the state.1 While the credit is administered by the Kansas Department of Revenue (KDOR), its eligibility criteria are tethered directly to federal tax law, establishing a necessary nexus with IRC Section 41.

Kansas R&D Credit Structure and Legislative Updates

Recent legislative changes have significantly increased the value and accessibility of the Kansas R&D credit, making stringent compliance more crucial than ever. For taxable years commencing after December 31, 2022, the credit rate was increased from 6.5% to 10%.1 This substantial rate enhancement applies to the incremental increase in Qualified Research Expenses (QREs).

The calculation methodology for the Kansas credit is incremental, defined as 10% of the amount by which current-year QREs exceed the taxpayer’s average QREs for the current year and the two preceding tax years.1 This base calculation leverages available data if fewer than two prior years exist. Furthermore, eligibility was broadened effective 2023, allowing any Kansas income taxpayer—including individuals, partnerships, S corporations, limited liability companies, and C corporations—to claim the credit, removing a prior restriction that primarily benefited C corporations.4

In addition to the rate increase, the credit is now transferable for new credits generated in 2023 and all years thereafter.2 This allows taxpayers without current Kansas tax liability (such as growing startups or companies currently operating at a loss) to monetize the credit by transferring it to another entity.4 However, the total credit allowable in any single tax year is limited to 25% of the total generated credit plus any applicable carryforward amount. Any unused credit may be carried forward until the total amount is fully utilized.1

The following table summarizes the key operative parameters of the Kansas R&D Tax Credit post-2022 reforms:

Kansas R&D Tax Credit Parameters (Post-2022)

The Legal Requirement for Federal Qualification

The decisive factor for state qualification stems from K.S.A. 79-32,182b(c), which explicitly defines “expenditures in research and development activities” as those expenses “allowable for deduction under the provisions of the federal internal revenue code of 1986, as amended”.1

This statutory conformity means that the Kansas R&D credit is essentially a state-level premium applied to a federally qualified claim. Since the state adopts the federal definition entirely, taxpayers benefit from compliance efficiency: the rigorous documentation prepared to satisfy the IRS’s standards for the four-part test is precisely the documentation required to secure the Kansas credit. This integration reduces compliance complexity for multi-state businesses, ensuring that the Kansas sourcing requirement is the only major distinction from the federal claim.3 The success of the state claim is thus predicated on the fundamental qualification of the activity under federal law.

The Permitted Purpose: Deconstructing the Business Component Test

The Business Component (BC) test, often referred to as the Permitted Purpose test, is the initial and foundational requirement within the four-part federal standard adopted by Kansas. This test defines the scope and intent of the research activity.

The Four-Part Test Context

To be considered “Qualified Research” for tax credit purposes, an activity must concurrently satisfy four distinct criteria derived from IRC $\S41$ 3:

1. Permitted Purpose: The activity must aim to create a new or improved Business Component.
2. Elimination of Uncertainty: The activity must be intended to discover information that resolves technical uncertainty regarding the development or improvement of that component.
3. Process of Experimentation: Substantially all the activities must constitute systematic testing or evaluation of alternatives to resolve the technical uncertainty.
4. Technological in Nature: The experimentation process must fundamentally rely on the principles of hard sciences, such as engineering, physics, biology, or computer science.

Defining the Business Component

The Business Component (BC) identifies the specific output of the research efforts. It is defined broadly, covering any product, process, formula, technique, invention, or computer software.3 This wide scope is essential because it allows the credit to be claimed by diverse industries—from traditional manufacturing and pharmaceuticals to modern technology and agriculture.3

To qualify, the BC must be something that is held for sale, lease, or license, or, critically, something used by the taxpayer in their own trade or business.5 This requirement ensures that the research directly contributes to the commercial operation of the business, excluding purely academic or non-commercial internal inquiries. Furthermore, the evaluation of R&D expenses is conducted at the level of the smallest functional unit that meets the four tests. This component-level analysis recognizes that complex projects often involve qualified research on specific subsystems, even if the entire overarching product does not meet the standard.

The Standard of Innovation: “New or Improved”

The “New or Improved” aspect of the BC test is central to the Permitted Purpose. It requires that the research must be aimed at a qualitative enhancement of the BC, specifically targeting improvements in one of four attributes: functionality, performance, reliability, or quality (FPRQ).7

• Functionality: Research to add a new capability or feature to the component (e.g., adding automated self-diagnosis features to a machine).
• Performance: Research to increase operational metrics, such as speed, capacity, efficiency, or output (e.g., developing a process that allows a production line to increase throughput by 15%).
• Reliability: Research focused on durability, consistency, or longevity, leading to fewer failures or reduced maintenance needs (e.g., testing new material compositions to prevent fatigue failure in industrial equipment).
• Quality: Research to improve the precision, purity, or conformance to technical specifications (e.g., tightening tolerance limits in a precision manufacturing process).

It is crucial to understand that the improvement does not need to be revolutionary; incremental innovation qualifies. Improving an existing component—for example, releasing “Version 2.0, 3.0, etc.” of a production software or product 5—is perfectly allowable, provided the improvement resolves a technical uncertainty and directly enhances one of the FPRQ characteristics.

The primary compliance challenge associated with the BC test is demonstrating the intent of the research. When the Kansas Department of Revenue (KDOR) reviews the technical narrative submitted with the pre-approval application, they focus intensely on whether the stated objective was an FPRQ improvement. If documentation suggests the objective was solely cost reduction, compliance with existing regulatory standards, or changes purely for aesthetics or market differentiation, the claim will fail the Permitted Purpose test, regardless of the technological effort involved. Taxpayers must clearly articulate the link: they faced technical challenges that required experimentation to achieve a specific, measurable improvement in the component’s function or performance.

Alignment with Kansas Department of Revenue Guidance and Exclusions

The guidance provided by the Kansas Department of Revenue consistently points back to the federal standard, avoiding the creation of dual compliance standards that would unnecessarily burden Kansas businesses.

KDOR’s Stance on Qualification Standards

The KDOR’s public statements affirm that R&D expenditures must be “allowable under the provisions of the federal internal revenue code of 1986”.2 This wholesale adoption of federal law simplifies the qualification process but places a high premium on meeting the often complex federal Treasury Regulations governing the four-part test. Because Kansas has not promulgated unique administrative regulations or issued numerous Private Letter Rulings (PLRs) that redefine the BC test, tax professionals rely heavily on established federal case law and IRS guidance to support Kansas R&D claims.

This adherence to federal standards dictates the state’s audit strategy. KDOR auditors typically rely on the IRS’s established R&D examination guidelines as their principal manual for review. If a taxpayer has successfully prepared documentation that withstands federal scrutiny—specifically proving that the activities meet the requirements of the BC test, the uncertainty test, and the process of experimentation test—the Kansas component of the claim becomes inherently defensible.

Statutory and Implicit Exclusions

Through its adoption of IRC $\S41$, Kansas implicitly incorporates several key exclusions that restrict what activities can be considered qualified research:

• Funded Research: Activities where the taxpayer is not “at risk” for the research results because the cost is paid for by another party under contract are excluded.5
• Post-Commercial Production: Research activities conducted after the business component is ready for commercial sale or use (e.g., routine testing or quality control) are excluded.
• Adaptation and Duplication: Activities aimed merely at adapting an existing BC to a particular customer’s need or reproducing an existing BC are excluded.
• Out-of-State Research: A fundamental state requirement is that all qualified R&D activities must be performed “within this state”.1

Additionally, K.S.A. 79-32,182b(c) contains a specific statutory carve-out unique to Kansas, stating that R&D expenditures shall not include any expenditures for the performance of any abortion.1 This statutory provision demonstrates the state’s ability to impose limited, public policy-driven exceptions to the otherwise adopted federal rules.

Case Application: The New or Improved Business Component in Practice

To illustrate how the Permitted Purpose test applies, the following scenarios detail qualified R&D activities common within the Kansas economy.

Example Scenario: Automation Software for a Kansas Manufacturer

A Kansas-based electronics manufacturer sought to significantly upgrade its operational efficiency by developing proprietary automation software for its component storage and delivery systems.8 The previous commercial software was customized for generic use and caused unacceptable latency issues when integrated with the manufacturer’s specialized machinery, creating system bottlenecks.

The manufacturer’s development team spent substantial time engineering custom architecture and algorithms to achieve the required speed and reliability in the unique production environment.

Qualification Analysis:

1. Business Component: The proprietary automation software is defined as a “computer software” component used in the taxpayer’s trade or business.5
2. New or Improved Purpose: The activity was performed to improve the performance (reducing lag and increasing data throughput) and the reliability (ensuring consistent and error-free component delivery) of the manufacturing process.7
3. Elimination of Uncertainty: Technical uncertainty existed regarding the optimal design and methodology required to integrate the new software with the existing proprietary machinery and synchronize data flow seamlessly.3
4. Process of Experimentation: The team conducted extensive systematic testing, modeling, and multiple design iterations, relying on computer science and engineering principles to resolve the integration challenges.8

Because the research was directed at enhancing the performance and reliability of an essential business component through a systematic resolution of technical uncertainty, the related employee wages, supplies, and contract research expenses incurred in Kansas qualify as QREs.

Example Scenario: Precision Agriculture Process Improvement

A large-scale farm operator in Kansas, utilizing advanced agricultural technology (Ag-Tech), investigated novel methods for optimizing fertilizer usage. The project involved developing a specialized, data-driven soil treatment formula and an innovative application technique aimed at optimizing consumption while maintaining or increasing crop yield.9

Qualification Analysis:

1. Business Component: The newly developed soil fertility treatment formula and the accompanying application technique both qualify as “formula” and “technique” business components used in the farming trade or business.5
2. New or Improved Purpose: The research was undertaken to improve the quality (sustainable yield maintenance) and performance (optimized resource consumption) of the farming process.6 The aim was specifically to boost yield or protect against environmental factors like chemical drift.9
3. Elimination of Uncertainty: Uncertainty existed regarding how the new formula and application technique would perform across varying Kansas soil types and environmental conditions, specifically regarding efficacy and stability in the field.3
4. Process of Experimentation: The farmer conducted multiple controlled field trials, laboratory analyses, and data collection over several growing seasons, relying on principles of chemistry, biology, and data science to systematically evaluate alternative solutions and refine the optimal application technique.9

The development and systematic testing of the new formula and technique satisfy the Permitted Purpose and other three tests, making the associated costs allowable for the Kansas R&D credit.

Compliance and Documentation: The Mandatory KDOR Pre-Certification Process

The most significant procedural change in Kansas R&D credit law is the introduction of a mandatory pre-certification process for tax years beginning after 2022. This formal requirement elevates the need for robust documentation, particularly concerning the validation of the Business Component test.

The Mandatory K-204 Application and Certification

For credits generated in tax years 2023 and beyond, taxpayers must submit Form K-204, the Research and Development Credit Application, to the KDOR for formal certification before claiming the credit on their income tax return.3

The K-204 serves as the state’s mechanism for preliminary approval and certification of the R&D activities. To complete the K-204, the taxpayer must specify the type and computation of each expenditure, and detail any flow-through to shareholders, partners, or members.10 Crucially, the application requires the submission of a copy of the taxpayer’s federal Form 6765 (Credit for Increasing Research Activities) and supporting data.10

The submission of Form 6765 means that the technical narrative and financial computation used to satisfy the IRS is directly reviewed by KDOR. The state is effectively using the federal documentation to verify that the taxpayer has, in fact, met the core requirements of the four-part test, including the Permitted Purpose of creating a New or Improved Business Component. Upon approval, the KDOR issues a tax credit certificate number, which confirms the credit is certified and ready to be claimed or transferred.10

Claiming, Limitation, and Transferability

Once the credit is certified via K-204, it is claimed on the annual Kansas income tax return using Schedule K-53, noting the certificate number.3 The annual claim remains subject to the maximum 25% limitation.2

The new transferability provision is a major economic feature for Kansas innovation. A taxpayer may transfer the full, newly generated R&D tax credit to any person if the original taxpayer does not have a current tax liability.2 The credit may only be transferred in full and only one time. The transaction must be documented using Form K-260, which is filed with the Department.2 The transferee then claims the credit and is subject to the same carryforward limitations that were in place when the credit was originally earned.4

The institution of this transferability creates an enhanced due diligence requirement for potential credit purchasers. Although the state certifies the credit through K-204, the underlying technical claim remains subject to audit. A sophisticated transferee, looking to purchase this valuable, transferable credit, must meticulously examine the transferor’s K-204 submission and the supporting technical documentation to confirm that the research activities demonstrably meet the “New or Improved Business Component” standard. This technical scrutiny is necessary because if the original claim is later disallowed in an audit, the credit claimed by the transferee is jeopardized.

Key Documentation Requirements for KDOR Certification (Post-2022)

Conclusion and Strategic Recommendations

The Kansas R&D tax credit (K.S.A. 79-32,182b) represents a significant financial incentive for businesses conducting innovative activities within the state, offering a robust 10% incremental credit and the valuable option of transferability. However, accessing this benefit requires uncompromising adherence to the core qualifying principle: the “New or Improved Business Component” test.

Since Kansas’s statute demands conformity with IRC $\S41$, the taxpayer’s compliance strategy must center on demonstrating that research expenditures were directed toward enhancing the functionality, performance, reliability, or quality (FPRQ) of a specific product, process, formula, or software. The absence of a unique state definition ensures that the rigorous technical documentation necessary for the federal credit is directly applicable to the Kansas claim.

To successfully navigate the regulatory environment and maximize the utilization of this credit, the following strategic recommendations are essential:

1. Define the Business Component Qualitatively: Taxpayers must move beyond vague research goals and clearly define the technical objectives of all R&D projects. Documentation must specifically link expenditures to an anticipated or achieved improvement in the component’s Functionality, Performance, Reliability, or Quality. Activities whose primary goal is cost reduction or market research will inevitably fail this fundamental test.
2. Prioritize the K-204 Application: The K-204 application is the state’s formal gatekeeper for the R&D credit, requiring submission of the federal Form 6765 and substantiating data. Businesses should view the preparation of this application as the primary state-level audit defense and ensure the technical documentation supporting the four-part test is comprehensive and ready for review before submission.
3. Monetize Through Transferability: Companies generating significant QREs but lacking sufficient Kansas tax liability should proactively utilize the Form K-260 transfer mechanism. The ability to monetize the 10% credit immediately provides critical working capital for ongoing innovation, making Kansas a particularly attractive state for R&D intensive startups.

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