Navigating Innovation: An Expert Guide to the Qualified Research (Four-Part Test) and the Kansas R&D Tax Credit (K.S.A. 79-32,182b)

I. Executive Summary: The Definition and Value of Qualified Research

The determination of Qualified Research (QR) hinges on meeting the Federal Four-Part Test, requiring activities to be technological in nature and systematic experimentation designed to eliminate technical uncertainty for new or improved business components. The Kansas R&D Credit (K.S.A. 79-32,182b) adopts this rigorous federal definition, offering a substantial 10% credit on increased research expenditures conducted within the state, significantly enhancing innovation funding.

The Kansas R&D tax credit is a crucial economic incentive designed to reward taxpayers operating within the state who invest in innovation. The credit functions as an offset against Kansas income tax liability, allowing businesses to recoup a portion of the expenses incurred during the development or improvement of products, processes, or formulas.1 The recent enhancement of the credit rate to 10% for taxable years commencing after December 31, 2022, dramatically increases the potential financial return on in-state research and development activities.2

The Strategic Advantage of the Kansas R&D Credit

The core value of the Kansas credit lies in its structural conformity with the federal definition of Qualified Research (IRC §41) while offering unique state-level benefits, particularly regarding credit utilization and transferability. The credit is calculated based on the difference between the actual qualified research and development expenses for the year and a specifically defined average of expenditures made during the current year and the two preceding tax years.1

For tax years beginning after December 31, 2022, the credit stands at 10% of this calculated excess, a significant increase from the previous 6.5% rate.1 This substantial rate increase, coupled with the critical provision allowing taxpayers without current liability to transfer the full credit, transforms the incentive from a simple liability offset into a crucial cash-flow mechanism, especially for nascent technology or manufacturing firms engaged in high-investment, high-risk R&D cycles.1 The administrative framework, governed by the Kansas Department of Revenue (KDOR), emphasizes strict adherence to the federal qualification standards, requiring meticulous documentation of all claimed activities.

II. The Foundational Link: Federal Conformity and the Kansas Mandate

The statutory basis for the Kansas R&D tax credit, codified in K.S.A. 79-32,182b, explicitly links the definition of qualifying research activities and associated expenditures to federal tax law. This conformity ensures consistency but also imports all the complexity and rigor associated with the Internal Revenue Service’s (IRS) standards for research credits.

A. The Federal Mandate

The Kansas statute establishes a fundamental requirement: expenditures made for R&D purposes must be “treated as expenses allowable for deduction under the provisions of the federal internal revenue code of 1986, as amended”.1 This mandate necessitates that any company claiming the Kansas credit must first meet the qualifications for the federal research credit, which are defined under IRC Section 41. In practice, the state follows the Section 41 definitions for qualified research expenses (QREs) and the associated activities.2

This conformity means that successful preparation for the Kansas credit is synonymous with preparing a defenseable federal R&D credit claim. The technical evaluation required to support a Kansas claim, therefore, must satisfy the highest standards set by the IRS regarding the Four-Part Test, documentation, and expense allocation.

B. The Section 174 Test (The Gatekeeper Requirement)

The initiation of the Four-Part Test—the definition of Qualified Research—begins with the requirement that expenditures must be ones “with respect to which expenditures may be treated as expenses under section 174”.6 This provision ensures that the costs are genuinely related to research and experimental activities undertaken in connection with the taxpayer’s trade or business.

The Section 174 test acts as a gatekeeper: if an expense is not considered a Research and Experimental (R&E) expenditure under federal law, it is immediately disqualified from receiving the R&D credit, regardless of whether the activity itself is technological or experimental in nature. This test anchors the credit to core accounting principles regarding innovation investment.

Financial Implications of Section 174 Conformity

The requirement for strict adherence to IRC §174 classification carries a profound and complex financial implication following the Tax Cuts and Jobs Act of 2017 (TCJA). Prior to 2022, most companies could immediately deduct R&E expenses under IRC §174. However, starting in 2022, TCJA provisions require that these R&E expenditures must be capitalized and amortized over a period of 5 years (60 months).8

The activity of generating the Kansas R&D credit (by incurring QREs that satisfy the Four-Part Test) simultaneously creates a negative financial consequence at the federal level: the loss of the immediate deduction and the introduction of a mandatory five-year amortization schedule. This immediate increase in federal taxable income imposes significant financial strain on innovative companies that previously relied on deducting these expenses.8

Consequently, the enhanced 10% Kansas credit, combined with the new transferability rules, becomes significantly more important than it was prior to 2022. The credit acts as a necessary offset to mitigate the financial burden imposed by the federal capitalization requirement. The strategic management of the state credit is thus inextricably linked to managing the complex financial consequences of federal R&E capitalization rules.

C. Geographic Scope

An essential requirement of K.S.A. 79-32,182b is that the expenditures must be in research and development activities “conducted within this state”.3 Unlike the federal credit, which applies nationally, the Kansas credit strictly limits eligible QREs to those costs directly associated with R&D performed physically within Kansas borders. For multi-state operators, rigorous allocation of QREs—particularly wages and contract research—is mandatory to isolate Kansas-specific activities from those conducted elsewhere.

III. Detailed Analysis of the Qualified Research (QR) Four-Part Test

To constitute “Qualified Research,” an activity must satisfy four distinct but interconnected requirements, commonly referred to as the Four-Part Test. This structure is designed to isolate genuine technological advancement from routine engineering or cosmetic changes. The taxpayer must establish that the research activity meets all four of these tests, which must be applied separately to each specific business component.6

A. Test 1: Technological in Nature (Discovery Requirement)

The second component of the overall Four-Part Test mandates that the research must be undertaken for the purpose of discovering information that is technological in nature.6 This is often interpreted as the requirement for a foundation in hard science.

The activity must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science.9 This requirement excludes research based purely on social sciences, humanities, or soft fields such as marketing, finance, or efficiency studies.7 The focus is not merely on the resulting product, but on the method used to achieve it—the inquiry into the underlying principles must be rooted in technical disciplines. For instance, developing a new chemical coating (physical science) or writing proprietary algorithms for machine learning (computer science) would typically satisfy this test.

B. Test 2: Elimination of Uncertainty

The research activities must seek to resolve or eliminate technical uncertainty related to the capability, methodology, or appropriate design of a new or improved business component.9

Uncertainty is defined as a situation where the taxpayer cannot know, based on information readily available at the start of the project, whether the component can be developed, precisely how it should be developed, or what the optimum design or process specifications should be.7 If the outcome is achievable through routine application of known principles, or if the uncertainty relates only to factors like cost, timing, or aesthetic preferences, the activity is not qualified.

The Role of Uncertainty in Audit Defense

The requirement to resolve technical uncertainty is the single most critical, conceptual driver of the entire R&D credit claim. In the event of a KDOR or IRS audit, examiners concentrate their efforts on whether the taxpayer adequately defined the technical risk before commencing the activity. The rationale is that if the technical challenge was already understood and the solution was readily apparent, the subsequent expenditure merely represents routine production engineering, not qualified research.

Therefore, for any taxpayer utilizing the Kansas credit, the quality of documentation defining the specific technical uncertainty that necessitated the research—as opposed to, for example, market uncertainty or financial uncertainty—forms the cornerstone of a successful audit defense.10 Without a clearly defined technical unknown, subsequent claims regarding experimentation are fundamentally undermined.

C. Test 3: Process of Experimentation

Substantially all of the activities of the research must constitute elements of a process of experimentation.6 This systematic requirement proves that the taxpayer pursued a rigorous, organized approach to resolve the technical uncertainties identified in Test 2.

A process of experimentation requires a deliberate, step-by-step approach involving modeling, simulation, trial-and-error, or systematic testing. The purpose of this methodical evaluation is to assess various alternatives to achieve the desired new or improved result. The process must be demonstrable, showing that the company did not rely on accidental discovery or routine failure, but rather deployed a scientific method to validate hypotheses and refine the design or methodology.7 The systematic documentation of failed trials, testing methodologies, and analytical adjustments provides direct evidence that this test has been met.

D. Test 4: Permitted Purpose (Business Component Test)

The final test requires that the application of the research must be intended to be useful in the development of a new or improved business component of the taxpayer.6

Defining the Business Component

The term “business component” is broadly defined and includes any product, process, computer software, technique, formula, or invention. This component must either be held for sale, lease, or license, or be used by the taxpayer in their own trade or business.6

The research must be conducted for a “qualified purpose,” which is defined as relating to an improvement in the component’s function, performance, reliability, or quality.6 Research related solely to style, taste, cosmetic factors, or seasonal design does not meet the permitted purpose test.7 For example, a manufacturer improving the tensile strength (performance/reliability) of a composite material qualifies, whereas merely changing the color or shape for aesthetic reasons does not.

Component-Specific Application

A crucial procedural element is the requirement that the Four-Part Test must be applied separately to each business component.6 This prevents taxpayers from claiming credit for a large project if only a minor, defined subprocess within that project qualifies. For instance, if a manufacturing firm is building a new plant (a large project), only the specific development of a unique, proprietary machine or process (the business component) used within that plant, which meets all four tests, is eligible for the credit. Any standard construction or installation work is excluded. Furthermore, any plant process, machinery, or technique used for commercial production is treated as a separate business component, distinct from the product being produced.6

E. Activities Explicitly Excluded from Qualified Research

Even if the four core tests are met, federal statutes, adopted by Kansas, explicitly exclude several categories of activities from qualifying for the credit 7:

1. Efficiency Surveys and Management Studies: Activities related to internal management functions, such as optimization of personnel workflows or general administrative studies.
2. Market Research: Research focused on consumer taste, market potential, or sales analysis.
3. Foreign Research: Activities conducted outside the state of Kansas are not eligible for the state credit, regardless of their nature.3
4. Routine Quality Control: Standardized testing or inspection of materials or products for quality control purposes after commercial production has begun.

IV. Qualified Research Expenses (QREs) and Kansas Specificity

Qualified Research Expenses (QREs) are the costs incurred by the taxpayer directly in the performance of Qualified Research activities. Kansas uses the federal definitions under IRC §41 to determine which costs are eligible, provided they are incurred within the state.2

A. Defining Eligible Costs (QREs)

QREs fall into three main categories, and precise record-keeping is required to allocate costs only to the research portion of an employee’s time or a supply’s use:

1. Wages

Wages paid to employees who perform, supervise, or support the qualified research activities are eligible for a 100% inclusion rate.2

• Direct Performance: Employees physically conducting the experiments, programming, or designing the prototypes (e.g., testing a prototype).11
• Direct Supervision: First-line managers directly overseeing the research team (e.g., managing a team of software developers).11
• Direct Support: Personnel providing immediate, necessary assistance to the research activities (e.g., organizing test results or maintaining specialized research equipment).11

Wages must be meticulously tracked via timekeeping records or other verifiable documentation to prove the time spent on qualifying activities.12

2. Supplies

Qualified supply expenses are tangible properties consumed or used directly in the course of qualified research, subject to a 100% inclusion rate.11

The key limitation is that these supplies cannot be capitalized or subject to depreciation. This typically includes raw materials used to fabricate and test prototypes, but explicitly excludes items like general office supplies, land, or depreciable research facilities or equipment.11

3. Contract Research

Payments to unaffiliated third parties for conducting qualified research on the taxpayer’s behalf are eligible, but only at a 65% inclusion rate.2 Furthermore, payments to qualified research consortia may be eligible at a 75% inclusion rate.2 The research must be performed within Kansas for the state credit to apply.

4. Computer Rentals

Costs incurred for the rental or lease of computers or specialized equipment used directly in qualified research activities are also eligible.2

B. Unique Kansas Statutory Exclusions

While the structure of QREs is federal, K.S.A. 79-32,182b introduces two specific statutory limitations that restrict the definition of “expenditures in research and development activities” 5:

1. Exclusion of Public Funds: Expenditures cannot include any moneys made available to the taxpayer pursuant to federal or state law.5 If a project is funded by a government grant, the associated costs are disqualified from the Kansas R&D credit.
2. Exclusion of Abortion Expenditures: For tax years commencing after December 31, 2013, R&D expenditures shall not include any expenditures for the performance of any abortion, as defined under K.S.A. 65-6701.5

The exclusion of abortion-related expenditures places a unique and specific compliance burden on life science, biotechnology, and medical research firms operating within Kansas. These organizations must maintain extremely detailed, segregated financial records to demonstrate that no claimed QREs are functionally related to the excluded activities. This requirement demands a sophisticated accounting system capable of tracking expenses not just based on the Four-Part Test, but also based on the specific nature and outcome of the research topic.

V. Kansas Department of Revenue (KDOR) Administrative Guidance and Procedure

The administrative guidance issued by the KDOR, particularly concerning the calculation and utilization rules, determines the ultimate financial benefit of the credit.

A. Credit Rate and Calculation Formula

For taxable years commencing after December 31, 2022, the Kansas R&D credit rate is 10%.1

The credit is computed based on the incremental increase in qualified research expenses over a statutory base amount. K.S.A. 79-32,182b defines the calculation of the excess QREs as the amount by which the expenditures in the current taxable year exceed:

$$\text{Average QREs} = \frac{\text{QRE}_{\text{Current Year}} + \text{QRE}_{\text{Year}-1} + \text{QRE}_{\text{Year}-2}}{3}$$

The credit is then:

$$\text{Credit} = 10\% \times (\text{QRE}_{\text{Current Year}} – \text{Average QREs})$$

This calculation method is highly specific to Kansas and differs significantly from the federal approach. By including the current year’s QREs in the three-year moving average base, Kansas sets a notably higher threshold for generating a credit.

This calculation structure means that companies with stable, non-growing R&D budgets may generate little or no credit. If a company spends $\$1.5$ million annually on QREs for three consecutive years, the base will equal the current expenditure, and the excess QREs will be zero. The mechanism is designed to incentivize rapid, non-linear growth in R&D spending, rewarding companies that substantially increase their investment in innovation year-over-year. Taxpayers must understand that maintaining a stable R&D presence, while beneficial for innovation, will quickly erode the available tax credit benefit under the current statute.1

B. Utilization, Carryforward, and Filing

The utilization of the earned credit is subject to strict annual limitations, reflecting a desire by the state to pace the financial impact of the incentive over time.

Limitation and Carryforward

The amount of credit allowable for deduction from the taxpayer’s liability in any one taxable year cannot exceed 25% of the total credit earned for that year, plus any applicable carry forward amount.1

The statute permits an indefinite carryforward of any unused credit amount. The remaining credit must be carried forward and applied in subsequent years, but still subject to the 25% incremental utilization rule until the total amount of the credit is fully used.1 This indefinite carryforward provides certainty that the credit will eventually be utilized, making it a valuable long-term asset, but the slow utilization schedule requires careful long-range tax planning.

Procedures and Forms

The Kansas R&D tax credit is claimed by filing Schedule K-53 with the taxpayer’s income tax return.1 For taxpayers who transfer the credit, the transferor must submit the Schedule K-53 for the credit amount that has been transferred along with the transferor’s tax return.1

C. Credit Transferability

The provision allowing for the transfer of the R&D credit is a major enhancement implemented for tax year 2023 and all subsequent tax years.1

Mechanics of Transfer

The income tax credit can be transferred by a taxpayer without a current tax liability to any person.5 This provision is particularly beneficial for startups and pre-profit companies that incur significant QREs but have no immediate tax liability to offset. The ability to monetize the credit through a one-time sale offers immediate capital infusion.2

The KDOR requires the entire, full credit to be transferred at once; partial transfers are not permitted. Furthermore, the credit may only be transferred one time by the entity that originally earned it.1 To document the transaction, Form K-260 must be completed and submitted to the KDOR.1

Due Diligence and Transferee Risk

The transferability provision shifts significant compliance risk to the transferee. The statute clarifies that the credit claimed by the transferee remains subject to the limitations and requirements that were in place at the time the credit was originally earned.1

This mandates that transferees conduct rigorous tax due diligence on the transferor’s activities. If the KDOR audits the transferred credit years later and determines that the original R&D activities failed the Four-Part Test due to insufficient documentation or non-qualifying expenses, the credit can be retroactively disallowed. The transferee would then be responsible for the deficiency, including potential interest and penalties. Therefore, the market price of the transferred credit must reflect the audit risk associated with the original earning entity’s compliance with the Four-Part Test standards.

VI. Practical Application Example: A Kansas Manufacturing Case Study

The following example illustrates how a typical Kansas-based company—a heavy equipment manufacturer, Midwest Industrial Systems (MIS)—applies the Four-Part Test to a qualifying project and performs the complex Kansas credit calculation.

A. Project Overview and Four-Part Test Application

Project Objective: MIS undertakes a project in 2024 to redesign and test a critical hydraulic coupling component intended to improve equipment reliability and durability (qualified purpose) in extreme weather conditions. The current component fails prematurely under high pressure and low temperatures.

QREs Incurred in 2024:

Application of the Four-Part Test to the Hydraulic Coupling Redesign

B. The Calculation Example (Tax Year 2024)

Since MIS meets all compliance requirements, the credit can be calculated based on the following historical QRE data:

Step 1: Calculate the 3-Year Average Base

The Kansas formula requires the inclusion of the current year:

$$\text{Average QREs} = \frac{\text{QRE}_{2024} + \text{QRE}_{2023} + \text{QRE}_{2022}}{3}$$

$$\text{Average QREs} = \frac{\$850,000 + \$600,000 + \$500,000}{3} = \frac{\$1,950,000}{3} = \$650,000$$

Step 2: Calculate Excess QREs (Credit Base)

$$\text{Excess QREs} = \text{QRE}_{2024} – \text{Average QREs}$$

$$\text{Excess QREs} = \$850,000 – \$650,000 = \$200,000$$

Step 3: Calculate the Kansas R&D Credit

The credit rate is 10% 1:

$$\text{Credit Earned} = 10\% \times \$200,000 = \$20,000$$

Step 4: Annual Utilization

MIS earned a $\$20,000$ credit in 2024. The maximum amount MIS can use to offset its 2024 Kansas income tax liability is 25% of the total credit:

$$\text{Allowable Credit Use} = 25\% \times \$20,000 = \$5,000$$

The remaining $\$15,000$ of the credit is carried forward indefinitely, to be used in future tax years, subject again to the 25% annual utilization cap.1

VII. Conclusion and Compliance Recommendations

The Kansas R&D tax credit provides a necessary and enhanced incentive for businesses committed to technological advancement within the state. However, the rigor of the underlying Federal Four-Part Test, coupled with specific Kansas administrative and statutory requirements, demands a disciplined and strategic approach to compliance. For CFOs and Tax Directors, success hinges on robust documentation and a clear understanding of the tax consequences beyond the state credit itself.

A. Documentation as the Primary Audit Defense

The core risk in claiming the R&D tax credit, whether federal or state, lies in the ability to substantiate that the expenditures meet the technological and experimentation standards defined by the Four-Part Test. Taxpayers cannot rely on generalized expenses; rather, records must directly link claimed QREs to activities resolving specific technical uncertainties.

Comprehensive, contemporaneous records are the primary line of defense.12 These records should include, but are not limited to: detailed payroll allocation registers, project management notes defining initial uncertainty and experimentation methods, design drawings, blueprints, trial logs, and general ledger accounts segmented by project.12 Where hard documentation is sparse, the KDOR and IRS expect companies to supplement their records with detailed oral testimony captured in technical narratives, ensuring that the personnel directly involved can articulate the systematic process used to overcome technical challenges.12

B. Strategic Tax Planning and Risk Mitigation

1. Managing the Amortization Challenge

The most critical strategic consideration for any business claiming the Kansas R&D credit is the federal compliance consequence: the mandatory capitalization and amortization of R&E expenses under IRC §174.8 Since Kansas mandates conformity to Section 174, the very activities that generate the state credit concurrently trigger an increase in federal taxable income. Companies must calculate the true net benefit of their R&D spending, balancing the immediate increase in tax liability from amortization against the long-term value of the Kansas credit and indefinite carryforward.

2. Optimization of the Kansas Calculation Base

Given that the Kansas calculation includes the current year’s expenditures in the three-year base average, companies should recognize that maintaining level R&D spending will quickly negate the credit. Strategic financial planning should focus on achieving sustained, substantial growth in QREs year-over-year to maintain a valuable “excess QRE” base. Businesses with stable R&D investment must focus on maximizing the accurate capture of all QREs to minimize the chance of reducing the current year’s expenditures relative to the base.

3. Due Diligence in Credit Transferability

The transferability of the credit for pre-profit companies is a substantial financial advantage, enhancing cash flow.2 However, the recipient (transferee) assumes the full audit risk associated with the credit’s original substantiation. Any party considering acquiring Kansas R&D credits must engage in thorough tax due diligence on the transferor, reviewing the underlying Four-Part Test documentation for each claimed project. Failure to ensure the quality of the original claim exposes the transferee to potential tax recapture and penalties long after the transfer has occurred.1

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