Qualified Cost of Constructing Facilities: An Expert Analysis of the Kentucky R&D Tax Credit (KRS 141.395)

The Kentucky Qualified Research Facility Tax Credit (QRFTC) provides a critical nonrefundable incentive for businesses investing in physical research infrastructure within the Commonwealth. The meaning of Constructing Facilities (Qualified Cost) is the expenditure incurred for building, remodeling, expanding, or equipping a Kentucky facility solely for the purpose of conducting research activities that meet the federal definition of Qualified Research (IRC § 41). These costs must be for tangible, depreciable property and explicitly exclude replacement property or routine operational expenditures.1

A more detailed analysis reveals that this credit, codified in Kentucky Revised Statute (KRS) 141.395, is specifically engineered to stimulate capital investment by offering a straightforward nonrefundable credit equal to five percent (5%) of the qualified costs.3 The focus is distinctly on physical assets—the infrastructure that supports innovation—rather than the recurring operational costs of research. This structure allows taxpayers engaged in qualified research activities to secure tax relief for major capital projects, such as building new laboratories or purchasing specialized equipment, providing a distinct economic advantage for locating or expanding research operations within Kentucky.4

II. The Statutory Mandate and Credit Mechanics

The Kentucky General Assembly established the QRFTC to promote economic development through investment in technical facilities. The tax structure supporting this incentive is defined by the state’s Department of Revenue (DOR) guidance and statutory law.

2.1 Credit Mechanics: Rate, Application, and Carryforward

The calculation of the QRFTC is transparent and favorable to capital-intensive businesses. The credit rate is a static five percent (5%) applied directly to the total qualified costs, requiring no complex base amount calculation or historical averaging typically required under federal R&D credit methodologies.4

This nonrefundable credit may be applied against three distinct state tax liabilities 1:

1. Individual Income Tax (KRS 141.020).
2. Corporation Income Tax (KRS 141.040).
3. The Limited Liability Entity Tax (LLET) (KRS 141.0401).

A significant feature supporting long-term investment planning is the carryforward provision, which permits any unused credit balance to be carried forward for utilization over a period of up to ten (10) years.1

2.2 Kentucky’s Capital Investment Priority

The specific design of the QRFTC underscores a distinct policy priority for the Commonwealth: securing tangible, permanent infrastructure. The statutory framework explicitly limits qualifying expenditures to costs associated with the physical facilities themselves, purposefully excluding typical operational qualified research expenses (QREs) such as researcher wages, supplies, and contract research.4

This structural decision has critical implications for taxpayers, as it allows the Kentucky facility credit to stack synergistically with the federal R&D credit, which largely focuses on operational QREs.4 By incentivizing investments in construction, remodeling, expansion, and equipping activities without requiring a historical base calculation, Kentucky ensures that 100% of newly qualified capital investment immediately generates credit.4 This approach is specifically designed to attract significant capital projects that anchor research activities permanently within the state.

III. Defining Qualified Cost of Construction of Facilities

The legal framework specifies precisely what constitutes a qualified cost under KRS 141.395, focusing on activities, property type, and explicit exclusions.

3.1 Scope of Qualifying Activities

The term “Construction of research facilities” is defined comprehensively to include four categories of capital expenditure occurring within Kentucky 1:

1. Constructing: The erection of new research facilities.
2. Remodeling: Substantial renovations or improvements made to existing structures to adapt them for qualified research.
3. Equipping: The purchase and installation of essential machinery, equipment, and apparatus necessary for the research activities.
4. Expanding: Increasing the size, capacity, or footprint of existing facilities dedicated to qualified research.

3.2 The Criterion of Tangible, Depreciable Property

To qualify, the expenditure must result in only tangible, depreciable property.1 This requirement links eligibility directly to federal cost recovery rules, meaning the assets must be subject to depreciation or amortization under federal tax law. This limitation serves as the primary filter for eligibility:

• Inclusions: Costs for building materials, capitalized installation labor, machinery, HVAC systems integral to the research environment, and other fixtures that are capitalized and depreciated are included.5
• Exclusions: Conversely, assets that are non-depreciable are automatically excluded. For instance, the cost of acquiring the land upon which the facility is built does not qualify.6 Similarly, intangible assets (e.g., permits, licensing fees not capitalized into the tangible asset, or intellectual property) do not qualify.5

3.3 Critical Exclusion: Replacement Property

A critical compliance element is the statutory exclusion for costs paid or incurred for replacement property.1 This clause prevents taxpayers from claiming the credit for routine maintenance or simple modernization where old assets are merely substituted for new ones of similar function or capacity.

The intent behind this exclusion is to reward investments that genuinely add new research capacity or capability, ensuring the credit is applied only to expenditures that materially expand the state’s research infrastructure. Taxpayers must rigorously document that the asset placed in service represents new functionality or capacity, rather than a direct, like-for-like substitution of an asset that was retired.5

Table I: Qualified Research Facility Cost Inclusion and Exclusion Criteria (KRS 141.395)

IV. The Federal Research Nexus: Qualified Research Use

The eligibility of capital expenditures for the QRFTC is entirely dependent upon the facility being used for “Qualified research” as explicitly defined in Section 41 of the Internal Revenue Code (IRC).1 Kentucky adopts this federal standard to determine the nature of the activity supported by the facility, even though the state only subsidizes the facility’s capital costs.

4.1 Applying the IRC Section 41 Four-Part Test

For a facility’s use to be classified as supporting qualified research, the activities conducted within it must satisfy the four cumulative criteria defined under IRC § 41(d) 7:

1. Permitted Purpose: The research must aim for functional, performance, reliability, or quality improvements of a product or process.
2. Technological in Nature: The research must rely on the principles of a hard science, such as engineering or computer science.
3. Elimination of Uncertainty: Technical uncertainty must be present at the outset regarding capability, methodology, or appropriate design.
4. Process of Experimentation: A systematic process must be employed to resolve the identified technical uncertainty.7

If the use of the constructed or equipped facility fails this four-part test—for instance, if the facility is primarily used for routine testing, quality control, or adaptation of existing components for specific customer needs—the associated capital costs are ineligible for the Kentucky credit.8

4.2 Documentation Requirements for Continued Qualified Use

Although the credit is generated when the facility or equipment is placed in service, the determination of qualified cost is based on the facility’s intended and actual use over its depreciable life. This creates a critical documentation requirement for the taxpayer.

The state granting the credit based on the intended qualified use necessitates that the taxpayer maintain robust internal records to prove continuous qualified utilization, especially in the event of a future audit. If a facility initially designated for 80% qualified research is later repurposed for non-qualified administrative or commercial functions, the initial allocation may be challenged. Therefore, taxpayers must retain utilization logs, detailed project records, and facility usage reports that explicitly connect the capital assets claimed (Lines 1 and 2 of Schedule QR) to ongoing activities that satisfy the IRC § 41 requirements.5 The strength of this documentation directly determines the defensibility of the capitalized cost allocation years after the credit is initially claimed.

V. Kentucky DOR Compliance and Administrative Guidance

The Kentucky Department of Revenue (DOR) dictates precise compliance procedures that must be followed to claim and utilize the QRFTC.

5.1 The Mandatory Role of Schedule QR

To claim the credit, taxpayers must file the Schedule QR, Qualified Research Facility Tax Credit, with their income tax return in the year the property is placed in service.1 This schedule is used to compute the total credit available and serves as a running record for tracking the credit utilized each year.

Part I of Schedule QR requires the specific segregation of costs 5:

• Line 1: Cost of construction of qualified research facilities.
• Line 2: Cost of equipment.
• Line 3: Total qualified costs (sum of Lines 1 and 2).
• Line 4: Allowable tax credit (5% of Line 3).

5.2 Documentation and the Placed-in-Service Rule

The DOR mandates strict documentation requirements for cost substantiation. Taxpayers must attach a supporting schedule detailing all tangible, depreciable property included in Lines 1 and 2. This attachment must clearly list the date purchased, the date placed in service, a description of the asset, and its total cost.1

A key compliance mechanism is the placed-in-service rule: the credit is available and the 10-year carryforward period begins only once the tangible, depreciable property is formally placed in service.4 For large, multi-year construction or expansion projects, taxpayers must recognize that costs may be incurred over several years, but the tax credit benefit is realized only when the completed asset becomes operational. This temporal requirement necessitates careful coordination between construction completion dates and tax reporting periods to optimize the timing of credit generation. If a new project qualifies in a subsequent year, a separate Schedule QR must be completed for that project.1

5.3 Credit Ordering and Application Rules

The QRFTC is nonrefundable and subject to the credit ordering rules outlined in KRS 141.0205.3 For corporate and pass-through entities, the credit is first applied against the LLET liability. However, the credit cannot reduce the LLET liability below the mandatory $175 minimum.4 Any remaining credit is then applied against the Corporation Income Tax liability.

For pass-through entities (PTEs) such as partnerships, LLCs, and S-corporations, the calculated credit may be used against the entity-level LLET, and any remainder is passed through to the partners, members, or shareholders via Kentucky Schedule K-1, allocated based on their distributive share of income at the time of credit approval.1 Individuals receiving a passed-through credit must file Schedule ITC, while corporations and other PTEs use Schedule TCS to apply the received credit share.1

VI. Strategic Allocation for Mixed-Use Facilities

When a constructed or remodeled facility serves both qualified research purposes and non-qualified uses (such as administration, manufacturing, or distribution), strategic cost segregation becomes essential for compliance and maximization of the credit.

6.1 The Necessity of Objective Allocation

Because the statute only allows costs incurred “for qualified research” to be claimed, any costs related to non-qualified uses must be excluded.1 In practice, this necessitates the development of a verifiable, objective allocation methodology to apportion shared costs (e.g., the building shell, core utilities, common areas).

The DOR does not publish specific allocation formulas for mixed-use R&D facilities, requiring taxpayers to rely on standard industry practices that can withstand audit scrutiny. The methodology chosen must demonstrate clearly how non-research space costs were separated from research space costs.

6.2 Accepted Allocation Methodologies

Tax professionals generally rely on methods tied to physical utilization or dedicated use:

1. Square Footage Allocation: This is the most common method for apportioning general construction and building costs (Schedule QR, Line 1). It involves calculating the ratio of floor space physically dedicated to qualified research activities (e.g., labs, test bays) versus the total floor area of the facility.6 This percentage is then applied to shared capital costs, such as the facility’s shell, foundation, and roof.
2. Dedicated Use Allocation: Equipment costs (Schedule QR, Line 2) are often allocated based on usage. Equipment used 100% of the time for qualified research activities may be fully included. For equipment utilized partially for R&D and partially for manufacturing or quality control, a reliable metric (such as usage logs or operational hours) must be employed to determine the qualified percentage.

The proper application of allocation methodology, supported by architectural plans and facility utilization reports, is crucial for defending the claim, as this area is often the subject of increased audit scrutiny due to the potential for cost overstatement.

VII. Illustrative Example: Qualified Cost Calculation and Application

To demonstrate the application of the statutory definitions, consider a fictional scenario involving a capital project.

7.1 Scenario: TechStart Innovation Center

TechStart, a Kentucky corporation, completed a major renovation of an existing industrial building, placing the improvements in service in the 2024 tax year. The renovation totaled $2,500,000. Of the total building area, 70% is utilized as a research and prototype lab meeting IRC § 41 standards, while 30% is used for administrative offices and routine quality control.

Total Capitalized Costs Incurred in 2024:

7.2 Step-by-Step Calculation of Qualified Cost

• Step 1: Determine Allocation Percentage for Shared Costs.

• Qualified R&D Area Use: 70%
• Non-Qualified Use: 30%
• Allocation Percentage for shared construction costs: 70%.

• Step 2: Segregate and Calculate Qualified Costs.

• Step 3: Calculate the Allowable Tax Credit.

• Total Qualified Costs: $1,800,000
• Credit Rate: 5%
• Total Allowable Credit (Schedule QR, Line 4): $90,000.

7.3 Application Demonstration

TechStart’s 2024 Tax Liabilities:

• LLET Liability: $5,000
• Corporate Income Tax Liability: $15,000

The $70,000 in unused credit is carried forward and may be applied against TechStart’s LLET or Income Tax liability over the next ten years.

VIII. Conclusion

The Kentucky Qualified Research Facility Tax Credit (KRS 141.395) is a highly valuable, long-term incentive designed to promote infrastructure development by offering a five percent nonrefundable credit on qualified capital expenditures. The definition of “Constructing Facilities (Qualified Cost)” is strictly limited to tangible, depreciable property used for activities meeting the federal IRC Section 41 definition of qualified research.

To successfully leverage this credit, taxpayers must adhere to precise compliance strategies. First, meticulous records must distinguish between capital costs (Line 1: Construction; Line 2: Equipment) and excluded expenditures (land, replacement property, operational costs). Second, for facilities serving mixed uses, the adoption of an objective, verifiable allocation methodology, such as the square footage ratio, is essential to justify the claimed percentage of qualified costs. Finally, documentation must demonstrate that the assets, once placed in service, continue to support genuine technical experimentation and uncertainty resolution throughout their depreciable life, in alignment with the standards adopted from the Internal Revenue Code. By maintaining rigorous internal accounting and satisfying the DOR’s Schedule QR requirements, businesses secure a substantial, ten-year tax reduction benefit for their infrastructural commitment to Kentucky.

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