The Business Component Test: Defining “Product, Process, Technique, Formula, or Invention” for the Kansas R&D Tax Credit (K.S.A. §79-32,182b)

I. Executive Summary: The Definition and Nexus

A. Simple Meaning

The terms Product, Process, Technique, Formula, or Invention collectively define the Business Component, which is the specific item or methodology a taxpayer seeks to develop or improve. For the Kansas R&D credit, this component must be the subject of research activities aimed at eliminating technical uncertainty through a systematic process of experimentation.1

B. Foundational Principles of Kansas R&D Qualification

The Kansas Research and Development (R&D) Tax Credit, governed by K.S.A. §79-32,182b, is designed to incentivize businesses that invest in qualified research activities performed within the state.3 Fundamentally, the state’s qualification requirements are tethered directly to federal definitions. The Kansas statute explicitly states that Qualified Research Expenditures (QREs) eligible for the credit must be “allowable under the provisions of the federal internal revenue code of 1986”.4

This foundational reliance on the federal code means that for any activity to qualify in Kansas, it must meet the criteria outlined in Internal Revenue Code (IRC) Section 41.3 Specifically, qualified research must be intended to develop or improve a Business Component and must satisfy the rigorous Four-Part Test—which includes requirements for eliminating technical uncertainty and utilizing a process of experimentation—as established under federal regulation.1

C. KDOR’s Confirmation of Scope and Recent Changes

The Kansas Department of Revenue (KDOR) has affirmed this broad scope of qualifying research. In Notice 23-09, released in September 2023, KDOR summarized the legislative changes and confirmed the interpretive link to the federal definition. This guidance clarifies that eligible R&D activities are those intended to discover information that eliminates uncertainty concerning the development or improvement of a product.8 Critically, the notice further states that a “product qualifies as a process, technique, formula, or invention,” thereby confirming the comprehensive scope of the five central components under Kansas law.8

This notice also highlighted significant legislative enhancements effective for tax years beginning after December 31, 2022. These changes include an increase in the credit rate from 6.5% to 10% of excess QREs, the removal of the limitation that previously restricted the credit solely to C corporations, and the introduction of credit transferability.4 This expansion means the credit is now available to all Kansas income taxpayers, including individuals, partnerships, S corporations, and limited liability companies, significantly broadening participation across Kansas’s key economic sectors, such as agriculture, technology, and manufacturing.3

II. Statutory and Regulatory Authority: The Federal Nexus in Kansas

A. Governing Statute and Incentive Mechanics (K.S.A. §79-32,182b)

The Kansas Research and Development Tax Credit is codified in K.S.A. §79-32,182b. The primary function of this statute is to provide an offset against Kansas income tax liabilities for local innovation.3

1. Credit Calculation and Rate

For tax years beginning after December 31, 2022, the credit rate has been increased to 10%.3 The credit is calculated incrementally based on the taxpayer’s historical spending. Specifically, the 10% rate applies to the difference between the actual qualified research and development expenditures for the current taxable year and the taxpayer’s average of the actual expenditures made during the current year and the two preceding tax years.3 If current year spending is less than or equal to the three-year average, no incremental credit is generated for that year.10

2. Utilization Limitation and Carryforward

Despite the high credit rate, the annual utilization is strictly controlled. The amount of the credit allowed in any one tax year is limited to 25% of the total credit generated plus any carryforward amount.3 Any remaining unused credit may be carried forward indefinitely. This carryforward must also be applied in 25% increments annually until the total amount of the credit is fully used.3

3. Expanded Eligibility

A crucial amendment for tax year 2023 and beyond eliminated the prior limitation restricting the credit solely to corporations subject to Kansas corporate income tax.8 This means that the credit is now available to any Kansas income taxpayer, including flow-through entities such as partnerships, S corporations, limited liability companies, and individuals.8 This expansion acknowledges that innovation occurs across all business structures and sectors.

B. KDOR Guidance: Analysis of Notice 23-09 and Procedural Changes

KDOR Notice 23-09 detailed the procedural and substantive changes to the R&D credit program, requiring taxpayers to adapt their compliance procedures.

1. Mandatory Pre-Claim Application (Form K-204)

A significant change introduced by the 2022 legislation is the requirement that taxpayers wishing to claim the credit must now complete and submit Form K-204, the Research and Development Credit Application, prior to claiming the credit.9 This procedural necessity represents a direct enhancement of compliance requirements.

The introduction of this mandatory pre-filing application stems directly from the implementation of the credit’s new transferability rule. Since the credit can now be transferred to a third party for immediate use, the KDOR requires certification and registration of the total generated credit amount before it becomes a highly liquid, transferable asset.9 This step ensures proper tracking and validation of the credit’s basis, mitigating the risk associated with a transferable state tax asset.

2. Credit Transfer Procedures (Form K-260)

For tax years 2023 and beyond, taxpayers with no current Kansas income tax liability may transfer the full generated credit once to any other taxpayer.4 The transfer must be documented using Form K-260, the Tax Credit Transfer Notification Form.4 The transferee then uses the credit and applies the same 25% annual usage limitation that bound the original generating entity.4

Given the inherent restriction of the 25% annual usage cap, the transferability rule functions as a critical liquidity mechanism. Early-stage companies or fast-growing businesses that incur substantial QREs but have little to no immediate tax liability can monetize their credits immediately, injecting crucial capital back into the business for future R&D efforts rather than waiting indefinitely to utilize the credit in annual 25% increments.4

C. The Federal Foundation: IRC §41(d)

Because Kansas defines QREs by direct reference to the federal Internal Revenue Code, the interpretation of the business components relies entirely on IRC §41(d) and associated Treasury Regulations.1

The core technical definition of qualifying research begins with the Business Component Test. IRC §41(d)(1)(B) states that the term “business component” means any product, process, computer software, technique, formula, or invention which is to be—(i) held for sale, lease, or license, or (ii) used by the taxpayer in a trade or business of the taxpayer.13

By adopting the federal definition entirely, Kansas aligns its audit standards with federal case law and Treasury guidance (such as Treasury Regulation 1.41-4). This means that any detailed interpretation or scrutiny of the five key terms during a KDOR examination will invariably rely on precedents and regulatory explanations established through IRS administration and litigation.15

III. Definitional Breakdown of the Business Component

The proper application of the Kansas R&D credit requires precise technical documentation that accurately identifies the specific Business Component being researched and quantifies the Qualified Research Expenses (QREs) associated with that component.

A. The Core Criterion: Commercial Purpose or Internal Use

To qualify, research expenditures must relate to a business component that is either intended to be held for sale, lease, or license to customers, or intended to be used by the taxpayer in their own trade or business.2 This criterion ensures that the R&D activity is connected with a commercial pursuit and is not purely basic research outside the scope of the business’s operations.

B. Deep Dive into the Individual Component Definitions

The five non-software components provide expansive coverage for virtually all tangible or intangible innovations within a company.2

1. Product (The Tangible Result)

The Product refers to the physical or tangible item, or the commercializable deliverable, that the taxpayer intends to sell, lease, or license to external customers. This definition focuses on the final outcome’s technical specifications, material composition, functional characteristics (such as durability, capacity, or performance metrics), or physical design.7 R&D activities related to a product generally involve developing prototypes, testing different designs, and ensuring the final specifications meet required performance criteria. For a manufacturer, this could include the development of a new type of water treatment mechanism.17

2. Process (The Internal Operational Sequence)

A Process refers to the overall, systematic series of steps, procedures, or operations that a taxpayer uses internally in its manufacturing, production, or service delivery environment. R&D on a process seeks fundamental optimization, focusing on increasing efficiency, reducing costs, improving throughput, or enhancing quality within the existing operational framework.16 For instance, researching an entirely new assembly line configuration or optimizing a fermentation process in an agricultural setting would target the Process component. Documentation focuses on production workflow diagrams, machine settings, and data quantifying improvements in operational metrics like reduced cycle time or decreased material waste.

3. Technique (The Specific Methodology)

A Technique is a highly specialized, proprietary methodology, skill, or procedure utilized to achieve a specific technical outcome.14 While a Process is the overall workflow, a Technique is a specific method used within that flow. Examples include developing a proprietary method for precision manufacturing 18, a novel algorithm for non-mechanical quality testing, or a unique data acquisition methodology.14 The research in this area focuses on the development or refinement of the methodology itself. For example, the development of a new statistical approach to quality control represents a Technique, whereas the continuous operation of the assembly line is the Process.

4. Formula (The Compositional Basis)

A Formula represents a precise set of ingredients, chemical compositions, or proportional relationships used to create a substance or mixture.14 This component is particularly relevant in chemical, food science, pharmaceutical, and agricultural industries. Research focusing on a Formula involves evaluating different material ratios, optimizing component stability, and testing the efficacy or composition of the final blend.19 Documentation typically includes lab notebooks, material evaluation reports, and trial results comparing different chemical or ingredient mixtures.7

5. Invention (The Novel Creation)

An Invention refers to a novel device, machine, apparatus, or system that often results in the creation of intellectual property, such as patents.13 While many products are the result of inventions, this category emphasizes the development of something fundamentally new that did not exist previously within the taxpayer’s business or the industry.16 R&D documentation for an Invention often includes patent filings, detailed design renderings, and systematic testing of the new mechanisms or concepts.18

C. Treatment of Computer Software

The federal definition of a Business Component explicitly includes “computer software”.13 Software developed for sale, lease, or license to customers is generally treated identically to a Product, provided it meets the Four-Part Test.

Software developed for internal use (Internal Use Software or IUS) is subject to stricter federal qualification rules that Kansas implicitly follows.15 IUS used primarily for general management functions (like payroll or finance) is typically excluded. However, software developed to control or automate manufacturing equipment, supply chain logistics, or proprietary process control systems (such as the automation software developed for component storage and delivery systems described in manufacturing case studies) often qualifies because it directly supports a manufacturing Process or Technique, and the development involves high technical uncertainty.18

IV. The Four-Part Test: Qualification Criteria for R&D Activities

Identifying a Business Component is necessary, but not sufficient. To qualify for the Kansas credit, the expenditures related to that component must satisfy all four elements of the federal R&D tax credit test.1

A. Test 1: Permitted Purpose (Development or Improvement)

The research activity must be intended to create a new, or significantly improve the functionality, performance, quality, or reliability of an existing Business Component.1 This test establishes the objective of the activity, ensuring that the research is focused on enhancing a technical or physical characteristic of the Product, Process, Technique, Formula, or Invention. If the expenditure does not directly enhance one of these required characteristics, it fails the purpose requirement.

B. Test 2: Elimination of Technical Uncertainty (The Knowledge Gap)

This is one of the most critical elements. The taxpayer must demonstrate that the activity was intended to discover information that would eliminate a technical uncertainty regarding the appropriate design of the component, or the capability or method for developing or improving it.1 The uncertainty must be technical in nature, meaning the resolution must depend on hard sciences or engineering, and not be related merely to market feasibility, financial risk, or aesthetic preference.

Effective compliance requires documenting the technical challenge, establishing the pre-existing “knowledge gap” before the activity began. For example, when attempting to improve a Process, the documentation must explain why standard engineering or scientific principles were insufficient to provide a definitive, predetermined solution for the desired optimization, thereby necessitating the R&D activity.5

C. Test 3: Technological in Nature (Hard Sciences)

The process of experimentation used to eliminate the technical uncertainty must fundamentally rely on the principles of physics, chemistry, engineering, computer science, or biology.1 Activities based on soft sciences, such as routine management studies, market research, or general efficiency analysis, are explicitly excluded from the definition of qualified research.15

D. Test 4: Process of Experimentation (Systematic Methodology)

The research effort must involve a systematic plan designed to evaluate one or more alternatives to achieve the desired result, overcome the technical uncertainty, and develop the Business Component.2 This systematic methodology can include modeling, simulating, prototype development, or rigorous trial-and-error testing.2

For intangible components, such as a Technique or Formula, the experimentation involves systematically testing various parameters—like chemical ratios, processing algorithm inputs, or sensor configurations—and measuring the resulting systematic outcome against the initial technical goals.3 This requirement is the compliance anchor; if the business cannot substantiate the systematic evaluation of alternatives, linking QREs (labor and supplies) to the various test phases, the associated expenditures for the Product, Process, Technique, Formula, or Invention will be disqualified.2

E. Exclusions: Activities that Fail the Business Component Test

Consistent with federal law, Kansas does not allow the credit for certain activities, even if they relate to a Business Component 15:

1. Research After Commercial Production: Activities focused on routine quality control, minor efficiency adjustments, or testing conducted once the component is ready for commercial use.15
2. Adaptation or Duplication: Merely adapting an existing component to a customer’s need or duplicating a public design without eliminating a technological uncertainty.
3. Surveys, Studies, or Management Research: Activities relating to internal management functions, consumer preferences, or organizational studies.15
4. Funded Research: Research funded by a third party via grant or contract, unless the taxpayer retains substantial rights and risk.

V. KDOR Filing and Documentation Requirements

To successfully claim the expanded Kansas R&D credit, taxpayers must navigate several mandatory forms and procedural requirements overseen by the KDOR.

A. Mandatory Pre-Filing Application (Form K-204)

The Form K-204, Research and Development Credit Application, is a critical, mandatory step for tax years 2023 and beyond.9 This form must be filed to secure the certified amount of the credit before the credit is claimed or transferred. This is the mechanism by which KDOR verifies the basis of the credit before it becomes a highly liquid, transferable asset, thus ensuring robust regulatory oversight over the program.

B. Computation and Submission (Schedule K-53)

The Schedule K-53 is the primary form used by the taxpayer to calculate the amount of the credit generated and apply the annual usage limitation.4

The schedule outlines the incremental calculation: QREs are entered on Line 1, the three-year average of QREs is calculated on Line 4, and the excess expenditure amount is determined on Line 5. This excess amount is then multiplied by 10% (.10) on Line 6 to determine the total credit.10 The maximum credit allowed for the current year is calculated on Line 7, which applies the 25% annual limitation to the total credit generated.4

If a credit is transferred, the transferor must complete K-53 through Part A (determining the total credit generated) and provide this documentation to the transferee for their records.10 While K-53 is primarily a numerical form, the underlying substantiation provided by the taxpayer must include detailed qualitative data. This documentation must explicitly link all claimed expenditures (wages, supplies, contract research) to the specific Product, Process, Technique, Formula, or Invention that satisfied the Four-Part Test, aligning with enhanced federal documentation requirements.3

C. Transfer Documentation (Form K-260)

For taxpayers utilizing the transferability provision, the Form K-260, Tax Credit Transfer Notification Form, is required.4 This form documents the one-time transfer of the full, certified credit amount from the earning entity to the transferee.

The transferee, in accepting the credit, assumes the original earning entity’s basis and compliance risk. This necessitates that the original R&D documentation—detailing the Business Component, technical uncertainty, and process of experimentation—must be meticulously maintained and reviewed by the transferee to withstand a potential KDOR audit.

Table 1: Kansas R&D Credit Key Filing Forms and Function

VI. Comprehensive Example: Multi-Component R&D in Kansas Manufacturing

This example demonstrates how a typical R&D project in the Kansas industrial sector can involve expenditures across multiple distinct Business Components, each requiring specific substantiation.

A. Scenario Setup: Industrial Fabrication

The Taxpayer: Midwest Metals Co., an S-Corporation specializing in producing high-tolerance structural components for specialized machinery (eligible for the credit post-2022 due to the removal of the C-Corp limitation).

The Project: Midwest Metals undertakes a project to develop a new, lightweight, high-strength component. The project requires a specialized new alloy, a proprietary method for welding the alloy, and a unique testing methodology to verify structural integrity under extreme conditions.

B. Business Component Identification and R&D Activities

The project involves three distinct business components, each requiring its own technical focus and systematic experimentation:

C. Conclusion on Component Linkage

For Midwest Metals to successfully claim QREs against the Kansas R&D credit, the allocation of employee wages and supplies must be meticulously tracked and tied to the individual component satisfying the Four-Part Test. Time spent by engineers developing and stress-testing physical prototypes belongs to the Product. Time spent calibrating and running trials on the robotic assembly line settings belongs to the Process. Finally, time spent developing and coding the proprietary filtering software belongs to the Technique. Without this granular segmentation and clear evidence that the activity aimed at each component overcame a technical uncertainty through experimentation, the associated expenditures may be disallowed.

VII. Conclusion and Strategic Recommendations

The Kansas R&D tax credit is a powerful economic incentive, particularly since the 2023 legislative changes increased the rate to 10% and expanded eligibility to flow-through entities. However, the rigor of compliance remains defined by the detailed requirements of the federal R&D tax credit.

All qualified research expenditures in Kansas must target the development or improvement of a defined Product, Process, Technique, Formula, or Invention that meets the stringent Four-Part Test. The critical implication of Kansas’s adoption of IRC §41 is that taxpayers must maintain robust documentation, not just of the costs, but of the technical narrative linking the expenditure to the successful elimination of technical uncertainty.

1. Prioritize Definitional Clarity and Segmentation: Taxpayers must clearly define which of the five business components they are researching. All claimed QREs must be segmented and tied directly to the specific component and the technical uncertainties associated with it. Vague descriptions of “R&D” are insufficient for compliance.
2. Maintain Federal Documentation Standards: Due to the explicit adoption of federal law, Kansas compliance requires qualitative support that is exhaustive enough to withstand a federal audit. This includes generating contemporaneous documentation that proves the technical challenge (uncertainty) existed and that a systematic methodology (experimentation) was used to resolve it.
3. Strategically Manage Liquidity: The new transferability provision (Form K-260) offers a vital capital injection mechanism for growth-stage companies with significant QREs. However, this must be managed strategically, given that the 25% annual usage cap applies to the transferee. Furthermore, the transferee must perform adequate due diligence, as they inherit the compliance risk associated with the original earning entity’s substantiation of the Business Component definition and the Four-Part Test requirements.
4. Ensure Procedural Compliance: The mandatory pre-filing of Form K-204 is a critical, non-negotiable step required for certifying the credit amount, irrespective of whether the credit will be claimed by the earning entity or transferred. Failure to comply with this procedural change could jeopardize the entire credit claim.

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