Exhaustive Analysis of Wages for Qualified Services (WQS) for the Kansas R&D Tax Credit: Compliance and Application under K.S.A. §79-32,182b and IRC Section 41

I. Executive Summary: The Definition of Qualified Wages

Wages for Qualified Services (WQS) represent the salaries and related payroll costs paid to employees in Kansas who are directly engaged in the performance, direct supervision, or direct support of qualified research activities. The State of Kansas strictly follows federal Internal Revenue Code (IRC) Section 41 definitions and regulations to determine which expenditures, including wages, qualify for the state credit.

Detailed Introductory Analysis

The Kansas Research and Development (R&D) tax credit, governed by K.S.A. §79-32,182b, is a crucial mechanism designed to incentivize businesses that invest in qualified research activities conducted within the state.1 These incentives provide a direct offset against Kansas income tax liabilities administered through the Kansas Department of Revenue (KDOR).

Effective for tax years commencing after December 31, 2022, the credit rate was significantly increased to 10% of the excess of current-year Qualified Research Expenses (QREs) over the statutorily defined base period average.1 This enhancement, coupled with new transferability provisions, has elevated the economic significance of the state credit.

The identification and quantification of WQS is the foundational step in calculating the total R&D credit base. Kansas law dictates that “expenditures in research and development activities” must be those that are “allowable for deduction under the provisions of the federal internal revenue code of 1986, as amended”.2 This direct link requires adherence to the detailed definitions and regulations found under IRC Section 41. WQS includes salaries for employees who directly perform the research, those who directly supervise the research, and those who directly support the research.1 Since payroll typically constitutes the largest expense component in an R&D claim, robust documentation supporting the allocation of employee time to qualified functions is essential for maximizing and substantiating the final credit amount.

II. Statutory Context and Program Mechanics

A. K.S.A. §79-32,182b: Kansas R&D Credit Foundation

The Kansas R&D tax credit provides a powerful fiscal tool for businesses that innovate locally. The statute sets forth several critical compliance parameters:

• Credit Calculation and Rate: For taxable years commencing after December 31, 2022, the credit is 10% of the difference between the actual QREs incurred during the taxable year and the average of the actual expenditures made during the current year and the two preceding tax years.2 This structure necessitates reliable record-keeping over a continuous three-year period to correctly establish the base amount.
• Eligibility Expansion: For tax year 2023 and subsequent years, K.S.A. §79-32,182b(d) expanded eligibility beyond C corporations to include any Kansas income taxpayer, such as individuals, partnerships, S corporations, and limited liability companies.4 This change significantly broadened the universe of businesses able to utilize the incentive.
• Limitation and Carryforward: The statute imposes a maximum allowable deduction: in any one taxable year, the credit claimed cannot exceed 25% of the total amount of the credit generated (including any applicable carryforward amount).2 The amount of unused credit that exceeds the tax liability limitation can be carried forward indefinitely in 25% annual increments until the total amount of the credit is used.1
• Transferability: Another significant amendment effective for tax year 2023 and thereafter allows a taxpayer without a current tax liability to transfer the full credit once to any person.1 This allows early-stage or unprofitable companies to monetize their R&D investments immediately. This process requires administrative filings with KDOR (see Section V).

B. The Federal Mandate: Defining Qualified Research Expenditures (QREs)

The Kansas credit’s reliance on federal definitions means that the state credit is claimed on QREs that are “allowable under the provisions of Internal Revenue Code Section 41”.3 This deference ensures consistency in expenditure identification but subjects Kansas claims to all federal regulatory nuances. QREs generally include wages, supplies consumed in the research, contract research expenses (65% for unaffiliated third parties, 75% for consortia), and costs for computer rentals used directly in qualified research.1

The Four-Part Test for QRA

Before any wage expenditure can be deemed qualified, the underlying activity must meet the strict federal definition of Qualified Research Activities (QRA). This QRA is defined by the rigorous Four-Part Test 5:

1. Technological in Nature: The activity must rely fundamentally on the principles of physical or biological science, engineering, or computer science.
2. Permitted Purpose: The research must be aimed at improving the functionality, performance, reliability, or quality of a new or existing business component (product, process, formula, or software).
3. Eliminate Uncertainty: The activity must be undertaken to discover information that resolves technical uncertainty regarding the capability, design, or method required for developing or improving the business component.
4. Process of Experimentation: The research must involve systematic experimentation, which includes evaluating alternatives, testing, or modeling to resolve the technical uncertainties identified.

Risk: The Federal Conformance Risk and Section 174

A critical consideration for businesses claiming the Kansas credit stems from federal changes enacted by the Tax Cuts and Jobs Act (TCJA). Historically, R&D expenditures, including wages, were immediately deductible under IRC Section 174.7 However, effective for tax years beginning after December 31, 2021, Section 174 now requires organizations to capitalize and amortize R&D expenses over five years (or fifteen years for foreign research).8

Because Kansas law ties its credit basis to expenditures “allowable for deduction” under the IRC 2, taxpayers must track whether Kansas fully conforms to this federal Section 174 capitalization requirement for state taxable income calculation. While Section 41 still governs the calculation of the credit base, the underlying treatment of the expense for state income tax purposes may be affected by Section 174 conformity. Companies with multistate operations must conduct thorough R&D tax credit studies to manage this dual compliance requirement, ensuring that the classification of wages is consistent across the credit calculation (Section 41) and the income tax calculation (Section 174 conformity).8

III. Deconstructing Wages for Qualified Services (WQS)

WQS are wages paid to employees who perform services that directly support the QRA as defined by IRC Section 41. These services fall into three specific, mutually exclusive categories.7

A. The Three Tiers of Qualified Services

The wage component of QREs is restricted to compensation paid for services that are:

1. Actual Conduct of Qualified Research (Direct Performance): This category includes the salaries of employees actively engaged in meeting the Four-Part Test, such as engineers developing new product architecture, scientists testing experimental formulas, or software developers writing new, uncertain code.10
2. Direct Supervision: This refers strictly to the immediate, first-line management of individuals performing the actual conduct of qualified research.9 For example, a research team leader who directly oversees the technical work of the engineers and scientists on a specific project may qualify. Higher-level executives or managers whose responsibilities are primarily administrative or strategic, not technical, generally do not qualify unless they are heavily involved in technical problem-solving or concept development.11
3. Direct Support: These are services that directly support persons engaged in the actual conduct or direct supervision of qualified research.12 Examples of qualified direct support include a laboratory worker cleaning specialized equipment used in the research, a machinist fabricating an experimental model part, a clerk compiling technical research data, or a secretary typing reports derived directly from laboratory results.11

B. Nuance in Classification: Direct vs. Indirect Services

The primary compliance requirement is demonstrating a functional link between the employee’s activities and the QRA. The determination of qualified services must rely on a functional analysis, not merely the employee’s job title or departmental assignment. For instance, an employee titled “engineer” may perform a mix of qualified activities (testing new materials) and non-qualified activities (routine maintenance of commercialized products).13

General and administrative (G&A) services or other services that only indirectly benefit research are explicitly excluded, even if performed by personnel within the R&D department.11 For example, a Human Resources employee processing payroll for the entire R&D department is performing an indirect, administrative service and does not qualify as direct support.

IV. The Substantially All Rule: Compliance and Allocation

The allocation of wages is governed by strict federal regulations that Kansas observes. The “Substantially All” rule is paramount in determining whether an employee’s wages are included entirely or must be apportioned.

A. Mechanics of the 80% Threshold

Under Treas. Reg. §1.41-2(d)(2), if an employee spends “substantially all” of their time performing qualified services for the taxpayer during the taxable year, then 100% of that employee’s wages are considered WQS.12

The threshold for “substantially all” is defined as 80% or more of the employee’s total compensated time being dedicated to qualified research activities.13 This rule simplifies compliance greatly for highly involved technical personnel, as a software architect spending 85% of their time on QRA may count their full salary, eliminating the need to track the non-qualified 15%.14

B. Apportionment Requirement Below the Threshold

If an employee’s time dedicated to qualified services falls below the 80% threshold, the wages paid to that employee cannot be fully included as WQS. Instead, the wages must be apportioned, or multiplied by the percentage of time spent on QRA.13

The acceptable apportionment method involves multiplying the employee’s total wages for the year by a fraction, where the numerator is the annual qualified activity hours and the denominator is the total annual hours worked in all activities.13

This system creates a significant financial impact known as the “cliff effect.” A professional who documents 79% qualified time must apportion 79% of their wages, while a similar professional who documents 80% qualified time may include 100% of their wages. Due to this substantial difference in inclusion, companies should proactively monitor time-tracking data throughout the year to ensure key employees meet or exceed the 80% threshold where feasible.

V. Kansas Department of Revenue (KDOR) Guidance and Procedures

Taxpayers claiming the Kansas R&D credit must adhere to specific KDOR filing requirements outlined in state guidance.

A. Required KDOR Tax Forms

1. Schedule K-53 – Research and Development Credit: This schedule is mandatory for all taxpayers claiming the credit. It is used to calculate the actual credit amount, including aggregating WQS (reported in Part A, Line 1) with other QREs, determining the base amount, and applying the 25% annual limitation.15 The completed Schedule K-53 must be submitted with the income tax return (Form K-40, K-41, or K-120).15
2. Form K-204 – Research and Development Credit Application: Effective for tax year 2023, the KDOR introduced a new administrative step related to the credit’s transferability. Taxpayers must complete and submit Form K-204 prior to claiming the credit if they intend to utilize the transfer option.4 This form allows KDOR to validate the credit amount before it becomes a transferable asset.
3. Schedule K-260 – Tax Credit Transfer Notification Form: If the taxpayer chooses to transfer the credit, this form must be filed to notify KDOR of the transfer to the transferee.16 It is essential to remember that only the full credit may be transferred, and it can only be transferred one time.5

B. KDOR Oversight and Carryforward Tracking

KDOR manages the credit utilization through the structure of Schedule K-53. The credit allowed is limited to 25% of the total available credit plus carryforwards.2 The KDOR form includes sections (Part D) specifically dedicated to tracking prior year credits, amounts previously used, and calculating the available carryforward amount.15 This system requires accurate accounting of historical credit usage and limitations to ensure that the current year’s claim is within the allowable 25% limit.

The new procedural requirement of filing Form K-204 emphasizes KDOR’s focus on controlling the transfer of the credit.4 The decision to monetize the credit via transfer requires careful procedural planning; failure to comply with the K-204 filing requirement risks losing the transfer option, even if the underlying WQS were properly documented and qualified.

VI. Case Study: Calculating and Apportioning Kansas Qualified Wages (Example)

Consider a Kansas-based manufacturing company, KS-MFG, that designs and develops specialized robotics equipment. The analysis focuses on three employees for a tax year, examining how the 80% Substantially All rule dictates the inclusion of their annual wages in QREs.

Scenario Setup:

KS-MFG documents 2,000 compensated hours annually for all salaried employees.

Analysis and Application of the 80% Rule

1. Employee A. Taylor (Lead Robotics Engineer):

• QRA Percentage: $1,700 \div 2,000 = 85\%$. Taylor’s work includes actual research conduct and direct supervision of testing protocols.9
• Rule Application: Since 85% exceeds the 80% threshold, the Substantially All rule applies.12
• WQS Included in QRE: $150,000 \times 100\% = \$150,000$.

2. Employee B. Chen (Design Technician):

• QRA Percentage: $1,500 \div 2,000 = 75\%$. Chen spends significant time on R&D but also 500 hours on routine equipment calibration and maintenance of non-experimental production tools (non-QRA).
• Rule Application: The QRA percentage (75%) is below 80%. Apportionment based on time is required.13
• WQS Included in QRE: $80,000 \times 75\% = \$60,000$.

3. Employee C. Garcia (Laboratory Support):

• QRA Percentage: $1,600 \div 2,000 = 80\%$. Garcia performs direct support services, such as maintaining research equipment and compiling testing results.10
• Rule Application: The percentage exactly meets the 80% threshold. The Substantially All rule applies.
• WQS Included in QRE: $60,000 \times 100\% = \$60,000$.

Detailed Wage Calculation Summary

The inclusion of WQS for these three employees must accurately reflect the application of the 80% rule to ensure compliance when reporting total QREs on the Kansas Schedule K-53.

Calculation of WQS Using the 80% Rule (Case Study)

VII. Conclusion and Strategic Recommendations

The Kansas R&D tax credit provides a significant incentive, enhanced by the 10% rate and new transferability provisions for tax years 2023 and beyond. Successful realization of this credit hinges on meticulous compliance with the federal definition of Wages for Qualified Services (WQS) under IRC Section 41.

Key Compliance Conclusions

1. Federal Definitions are Absolute: Kansas legislation defers all definition of qualified expenditures to the Internal Revenue Code. Therefore, the WQS claim must withstand scrutiny based on the stringent federal Four-Part Test and the three defined tiers of qualified services (performance, direct supervision, direct support).
2. The Substantially All Rule is Paramount: The 80% threshold acts as a crucial differentiator for maximizing the credit base. Failure to accurately track activities that cross the 80% line results in significant lost credit opportunity due to mandatory apportionment below that threshold.
3. Transferability Requires Forethought: The new ability to transfer the credit provides a major economic advantage, especially for growth companies without current tax liability. However, this is contingent on the timely filing of Form K-204, transforming procedural compliance into an upfront strategic necessity.4

Strategic Recommendations for Optimizing WQS Claims

1. Institutionalize Functional Time Tracking: Businesses should implement or refine time-tracking systems that capture activities at the project level, allowing for accurate segregation of QRA hours versus non-QRA hours. This data is the primary evidence for supporting both the 80% qualification claims and the necessary apportionment calculations.
2. Formalize Functional Analysis: Periodically interview technical personnel, including first-line supervisors, to confirm their specific duties align with the federal definition of direct performance, supervision, or support. Documentation must clearly distinguish these activities from excluded general and administrative functions.
3. Proactively Manage the 80% Threshold: Review time data throughout the year to identify high-wage employees who are nearing but falling short of the 80% requirement. Adjusting administrative or non-qualified duties can strategically push these employees into the 100% inclusion category, yielding substantial additional WQS.
4. Integrate State and Federal Compliance: Due to the potential state-level implications of federal Section 174 capitalization, companies must ensure that the treatment of R&D wages is harmonized for both the Kansas credit calculation (Section 41) and the determination of state taxable income (Section 174 conformity). External tax expertise specializing in R&D and State and Local Tax (SALT) is critical for navigating this complex interplay.

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