The Kansas R&D Tax Credit Base Average: Analysis of the Prior Two Income Tax Years Methodology

The concept of Prior Two Income Tax Years (for Base Average) in the Kansas Research and Development (R&D) Tax Credit refers to the statutory requirement that the base amount is calculated by averaging the actual qualified research expenditures (QREs) of the current tax year and the two preceding tax years. This creates a rolling three-year average calculation, which defines the threshold that current-year R&D spending must exceed to generate the 10% state income tax credit.

This calculation mechanism is pivotal because it includes the current period’s spending, establishing a dynamic base that continually adjusts upward with growth, meaning the credit is fundamentally designed to reward accelerated or incremental R&D investment within the state of Kansas, particularly benefiting new research operations.

Statutory Foundation: K.S.A. 79-32,182b and the Calculation Base

The legal foundation for the Kansas R&D Tax Credit is found in K.S.A. 79-32,182b, which defines the eligible activities, the credit rate, and the unique methodology for determining the Base Average.

Legislative Context and Credit Modernization

The state of Kansas significantly modernized its R&D incentive structure through House Bill 2239, effective for tax years beginning after December 31, 2022. This legislation increased the credit rate from the previous 6.5% to a more substantial 10% of the eligible excess expenditures.1 This legislative action demonstrates a strong policy commitment to accelerating technological advancement and innovation within the state.2

Furthermore, the eligibility for claiming the R&D credit was dramatically expanded. Previously, eligibility was often confined to C corporations, but the updated statute broadened access to all Kansas income taxpayers. This change is crucial, as it allows pass-through entities—such as individuals, partnerships, S corporations, and limited liability companies (LLCs)—to claim the credit against their Kansas income tax liability.2

The dual action of increasing the credit rate and expanding taxpayer eligibility goes beyond merely favoring established industries. This shift provides greater accessibility to smaller and medium-sized high-growth technology firms, many of which are structured as LLCs or S-corporations. By catering to a wider spectrum of business entities, the policy aims to diversify the state’s R&D base, ensuring that the incentive structure captures investments across the entire business ecosystem, rather than focusing solely on large, established corporate manufacturing or pharmaceutical operations.

The Core Base Calculation Mechanism

The statute specifies that the income tax credit is calculated on the amount by which current-year expenditures “exceeds the taxpayer’s average of the actual expenditures for such purposes made in such taxable year and the next preceding two taxable years”.1 This clause defines the three-year rolling average methodology.

Qualified Expenditures (QREs) must adhere to specific criteria: they must be for R&D activities conducted exclusively within Kansas and must meet the requirements for deduction under the provisions of the federal Internal Revenue Code (IRC) of 1986, as amended.1 This means that federal standards under IRC §41 regarding technological nature, seeking to eliminate uncertainty, and following a process of experimentation must be met for Kansas expenditures.5

An important state-specific limitation exists regarding QREs. While the general definition mirrors federal rules, the Kansas statute explicitly excludes expenditures related to the performance of any abortion, as defined in K.S.A. 65-6701, for tax years commencing after December 31, 2013.1 This unique, non-federal state exclusion necessitates careful review by taxpayers, especially those in the life sciences and medical research sectors, to ensure all claimed QREs comply with this specific statutory limitation. State-level vetting must confirm that QREs meet the standard of federal allowability while strictly observing this unique state-mandated exclusion.

Defining the Base Average: Prior Two Income Tax Years

The base calculation is the most distinguishing feature of the Kansas R&D tax credit, acting as a crucial hurdle that current investment must surpass to yield a benefit.

The Mechanics of the Three-Year Rolling Average

The term “Base Average” dictates that the credit is earned only on the incremental increase in R&D investment above a predetermined average of recent expenditures. The required calculation formula is explicitly defined by the state’s guidance:

$$\text{Base Amount} = \frac{\text{Current Year QREs} + \text{Year -1 QREs} + \text{Year -2 QREs}}{3}$$

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The Kansas Department of Revenue (KDOR) formalizes this process through Schedule K-53, the dedicated form for claiming the Research and Development Credit. The instructions for this schedule confirm the methodology: Line 3 aggregates the total QREs from the current year (Line 1), the immediate preceding tax year (Line 2a), and the second preceding tax year (Line 2b). Line 4 then requires the taxpayer to divide Line 3 by three (3) to arrive at the Base Average.6

This Base Average differs substantially from the federal Regular Research Credit (RRC), which relies on a fixed-base percentage derived from historical gross receipts, or the Alternative Simplified Credit (ASC), which uses a three-year average of prior QREs but multiplies it by 50%.8 The Kansas approach, by contrast, is simpler but inherently more sensitive to year-over-year spending fluctuations.

Strategic Benefit for New R&D Operations

A significant benefit of this unique base calculation arises for new companies or those initiating R&D activities within Kansas. The state’s guidance instructs taxpayers to use zero ($0) for any preceding tax year in which Kansas-apportioned QREs were nonexistent or not applicable.3

For an emerging company with QREs only in the current year (Year 0), the Base Average calculation is:

$$\text{Base Average} = \frac{\text{Current QREs} + \$0 + \$0}{3}$$

This results in an effective base equal to one-third (approximately 33.33%) of the current year’s QREs.3 Consequently, the remaining two-thirds (approximately 66.67%) of the current year’s expenditures are immediately classified as “excess” and become eligible for the 10% credit. This structure provides the maximum proportional benefit during the initial year of R&D investment.

The decision to include the current year’s QREs in the base means the calculation functions as a measurement of R&D investment velocity. A company with accelerating QREs is highly rewarded, while a company whose QREs are plateauing or declining, even if high in absolute terms, will see its credit generation reduced or eliminated. This distinguishes the Kansas credit as a pure incentive for growth in R&D investment.

Handling Non-Incremental Expenditures

The statutory structure ensures that the credit is strictly granted for incremental growth. Schedule K-53 requires the taxpayer to subtract the Base Average (Line 4) from the Current Year QREs (Line 1) to find the expenditures eligible for the credit (Line 5).6

If the current year’s QREs are equal to or less than the calculated Base Average, the taxpayer must enter zero ($0) on Line 5.6 This zero-credit floor validates the intent of the statute: to provide a tax incentive only when a business invests beyond its established three-year average level of activity. Taxpayers must manage their QREs to ensure sustained growth, as any year of declining R&D investment relative to the historical three-year period will preclude claiming the credit.

The base calculation’s integrity also depends on the consistency of Kansas apportionment. For multi-state taxpayers, QREs must be Kansas-apportioned.3 If the state’s apportionment factor changes due to shifts in the three-factor formula (property, payroll, and sales 10), stable absolute R&D spending could still result in volatile Kansas-apportioned QREs across the three base years. Therefore, sophisticated tax planning must coordinate the R&D credit calculation with the overall state income tax apportionment methodology to ensure the Base Average accurately reflects research activity within the state and to prevent potential audit adjustments.

Compliance and Guidance: Kansas Department of Revenue (KDOR)

The KDOR provides essential guidance for implementing the statute through required forms and specific documentation rules, ensuring the accurate calculation and administration of the credit.

Required KDOR Forms and Documentation

To claim the R&D credit, taxpayers must complete and submit Schedule K-53, Kansas Research and Development Credit, alongside their Kansas income tax return.3 Part A of this schedule is dedicated to the precise calculation of the Base Average and the resulting eligible credit amount.6

In addition to filing K-53, beginning in tax year 2023, taxpayers must also complete and submit Form K-204, the Research and Development Credit Application, further formalizing the process of claiming the incentive.2

Crucially, KDOR mandates robust record-keeping. The department specifically requires taxpayers to maintain and be ready to provide an “itemized schedule of expenditures” for all amounts claimed in the three years used for the base calculation (Lines 1, 2a, and 2b of K-53).6 This requirement highlights that the verification process for the credit extends backward two years to validate the historical expenditures that comprise the Base Average. Therefore, companies must ensure that documentation supporting QREs—including detailed records of activities, payroll, and supplies—remains intact and compliant with federal and state standards for all open tax years within the three-year rolling average calculation period.13

Transferability Documentation (Post-2023)

A notable modernization is the introduction of transferable credits for those earned in tax year 2023 and thereafter. This allows taxpayers, particularly those without a current tax liability (e.g., startups or companies in heavy investment phases), to transfer the full credit amount to another person.1

The transfer is subject to several strict conditions enforced by the KDOR: the credit may only be transferred once, and the full amount must be transferred.3 To legally document the transfer, KDOR requires the completion and submission of Form K-260.6 The credit claimed by the transferee is subject to the original 25% annual utilization limitation and the carryforward requirements that were in place when the credit was originally earned.4

This transferability mechanism, coupled with legislative transparency mandates, places additional public scrutiny on the incentive program. K.S.A. 74-50,227 requires the KDOR to collect and publish certain tax incentive information on a database managed by the Kansas Department of Commerce. This includes the name, address, and annual amount of incentive claimed or received.6 For businesses engaged in highly visible R&D, this mandatory public disclosure is an important factor in deciding whether to claim the credit or pursue a transfer, as their incentive utilization becomes a matter of public record.

Practical Application and Scenarios

The varying results of the Base Average calculation necessitate careful strategic planning, particularly when a company experiences significant QRE fluctuations.

Scenario 1: New Market Entry (Maximizing the Credit)

This scenario illustrates the substantial initial benefit derived from utilizing zero QREs in the base period, followed by the subsequent decline in credit as those large expenditures enter the average.

Table 1: New R&D Operation Base Calculation

The analysis of this progression demonstrates that the highest relative proportional benefit occurs in Year 1, emphasizing the need for robust planning during the market entry phase to maximize the initial credit generation. As the large QREs from earlier years are incorporated into the three-year average, the base inflates, leading to a decreasing percentage of creditable excess QREs, even with sustained absolute growth.

This dynamic illustrates the principle of base inflation: the success of generating high QREs in Year 1 directly increases the base for Year 2 and Year 3. This inherently diminishes the marginal credit generated for steady subsequent spending, thereby requiring companies to sustain accelerating QRE growth year over year to continue generating substantial credits.

Scenario 2: Steady State R&D (High Hurdle Rate)

For established entities where R&D spending is consistent, the hurdle to generate excess QREs becomes significantly higher.

Consider an established firm with the following Kansas QREs:

• Current Year (Year 0) QREs: $1,000,000
• Year -1 QREs: $950,000
• Year -2 QREs: $1,050,000

The Base Average calculation is:

$$\frac{\$1,000,000 + \$950,000 + \$1,050,000}{3} = \$1,000,000$$

Since the Current Year QREs equal the Base Average, the Excess QREs equal $0. For established companies, the Base Average acts as a moving three-year average of investment. If current spending does not exceed this average, no credit is generated. The Base Average rewards acceleration and growth, not maintenance of activity level. Companies that experience plateauing R&D spending must find ways to ensure their QREs accelerate above the rolling average to secure the incentive.

Utilization and Carryforward Limitations

While the Base Average calculation determines the amount of credit generated, the utilization and carryforward rules govern the realized value of the tax incentive.

Utilization Cap and Calculation

K.S.A. 79-32,182b mandates a strict annual utilization cap. The amount of credit that may be deducted from the taxpayer’s liability in any one taxable year cannot exceed 25% of the total generated credit plus any applicable carryforward amount.1

For example, if a taxpayer generates a total credit of $100,000 in the current year, the maximum amount that can be utilized against the tax liability is $25,000 ($100,000 multiplied by 25%). If the taxpayer’s actual Kansas tax liability is less than $25,000, the deduction is limited to that lower liability. This annual cap prevents the immediate depletion of the incentive, ensuring the credit provides sustained, multi-year relief and manages the impact on state tax revenue.

Indefinite Carryforward and Tax Asset Management

Any portion of the calculated credit that remains unused due to the 25% annual utilization cap may be carried forward indefinitely until the total amount of the credit is fully utilized.1

The provision for an indefinite carryforward is a significant advantage for taxpayers, transforming the R&D credit into a highly stable, long-term deferred tax asset. This indefinite duration simplifies financial reporting under Generally Accepted Accounting Principles (GAAP) and provides certainty for long-term tax planning, especially when compared to tax credits that feature restrictive expiration dates.

Transferability: Monetizing the Tax Asset

The transferability provision, effective post-2023, offers a crucial mechanism for non-profitable entities to monetize their tax asset. By allowing businesses without current tax liability to transfer the full credit to another party, Kansas provides a source of immediate working capital.1

However, the liquidity derived from transferability is constrained by the utilization cap. Because the transferee inherits the 25% annual limitation and must wait potentially four years to realize the full value of the credit, the market price for these transferred credits is typically set at a substantial discount from the face value. This transaction effectively provides immediate capital to the credit earner, paid for by the recipient who takes on the time value of money risk and the deferred realization of the tax benefit.

Furthermore, a significant compliance consideration for transferees exists. The statute dictates that the transferee must utilize the credit subject to the limitations and requirements that were in place at the time the credit was originally earned.6 This means the transferee inherits the original earner’s audit risk. If the transferor made calculation errors related to the Base Average (e.g., failed to properly document or classify QREs in Year -1 or Year -2), the transferee may face audit adjustments and potential loss of the credit years later. Therefore, comprehensive due diligence on the transferor’s Base Average calculation and all supporting K-53 itemized schedules is critically required before purchasing a Kansas R&D credit.

Conclusion

The Kansas R&D Tax Credit, as detailed in K.S.A. 79-32,182b, relies on a unique Base Average definition—the current year plus the two immediately preceding tax years—which dictates its policy effectiveness. This calculation method fundamentally focuses the incentive on rewarding incremental and accelerating R&D investment, particularly favoring new market entrants that benefit from a 33.33% statutory base.

Strategic planning must focus on two primary objectives: generating the maximum excess QREs by managing growth trajectory against the rolling three-year average, and optimizing the utilization of the resulting credit against the restrictive 25% annual cap. The indefinite carryforward and transferability provisions provide long-term flexibility and immediate liquidity, respectively, but mandate meticulous adherence to KDOR compliance rules, including rigorous documentation of QREs across the entire three-year calculation window. Taxpayers must proactively manage their historical QRE documentation, not just the current year’s expenditures, to withstand scrutiny and ensure the validity of the credit claimed or transferred.

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