Technical Report: Navigating the Integration of IRC § 41(d) and the Kentucky Research Facility Tax Credit (KRS 141.395)

I. Executive Summary: The Dual Definition of Qualified Research

Internal Revenue Code (IRC) $\S 41(d)$ defines research activities that eliminate technological uncertainty through a systematic process of experimentation to develop or improve a business component.

Kentucky adopts this federal definition of activity but limits qualified tax credit expenditures strictly to costs associated with constructing or equipping in-state research facilities, excluding operational expenses like wages and supplies.

The definition of “Qualified Research” under IRC $\S 41(d)$ serves as the mandatory foundation for claiming the federal Research and Development (R&D) Tax Credit. By direct statutory reference in KRS 141.395(1)(b), this definition is imported wholesale into the requirements for the Kentucky Qualified Research Facility Tax Credit (KRFCTC).1 This creates a unique compliance landscape where the activity must meet the rigorous federal standard, but the eligible expenditures are drastically restricted by state law.

The KRFCTC is fundamentally a capital investment incentive, distinct from the federal credit which primarily incentivizes operational costs such as wages and supplies. The Kentucky credit offers a nonrefundable credit equal to five percent (5%) of qualified facility costs and may be carried forward for up to 10 years.3 Therefore, a successful claim requires satisfying a dual compliance strategy: first, establishing that the underlying activities meet the IRC $\S 41(d)$ four-part test, and second, ensuring the calculated cost base strictly includes only tangible, depreciable property located within Kentucky.2 If the research activity fails the federal gatekeeper test, any associated capital investment, regardless of its cost, is ineligible for the Kentucky credit.1

II. Foundational Analysis: Decoding IRC § 41(d) for Qualified Research Activity

IRC $\S 41(d)$ is the regulatory mechanism used by the IRS to distinguish genuine scientific or technological innovation from routine engineering or production improvements. For any investment in a Kentucky research facility to be eligible for the state credit, the taxpayer must be able to demonstrate that the purpose of that facility is to conduct activities that satisfy this detailed federal definition.

A. The Mandated Four-Part Test (IRC $\S 41(d)(1)$)

To be designated as “Qualified Research,” activities must satisfy a comprehensive four-part test. Substantially all of the activities must collectively fulfill these requirements, ensuring that the research efforts are directed toward genuine technical risk resolution.2

1. Section 174 Requirement (The Trade or Business Nexus)

This prerequisite dictates that expenditures must be eligible for treatment as expenses under Section 174 of the IRC.2 This connects the research directly to the taxpayer’s existing or future trade or business, ensuring the research is performed with a commercial objective and represents R&D in an “experimental or laboratory sense”.6 Even if the taxpayer is not yet actively engaged in sales, the trade or business requirement can be met if the principal purpose is to use the research results in the active conduct of a future trade or business.8

2. Technological in Nature Test

The research must be undertaken for the purpose of discovering information that is “technological in nature”.2 This information is considered technological if the process of experimentation used to discover it relies fundamentally on the principles of the physical sciences, biological sciences, engineering, or computer science.9 This requirement excludes research based merely on artistic, marketing, or financial methodologies, thus focusing the credit on hard sciences and applied technology.10

3. Elimination of Uncertainty Test (Permitted Purpose)

The R&D activity must aim to eliminate uncertainties regarding the appropriate design, capability, or method of developing or improving a new or existing business component.6 Uncertainty is present if the available information does not readily establish the capability or appropriate design of the component. The underlying purpose of the research must relate to achieving an improvement in the function, performance, reliability, or quality of that business component.2

4. Process of Experimentation Test

The final and most critical component demands that substantially all of the research activities constitute elements of a rigorous process of experimentation.2 This requirement necessitates a systematic methodology—such as modeling, simulation, or structured trial and error—to evaluate alternatives and confirm the resolution of the technological uncertainty identified in the previous step.12 This structure prevents routine testing, quality control, or simple engineering revisions from qualifying, thereby placing a high burden of proof on documentation.

B. Defining the “Business Component” and Project Scope

The four-part test must be applied at a granular level, specifically “separately with respect to each business component of the taxpayer”.2 A “business component” is broadly defined as any product, process, computer software, technique, formula, or invention which is either held for sale, lease, or license, or used by the taxpayer in a trade or business.2

An important administrative distinction is the Special Rule for Production Processes. Under this rule, any plant process, machinery, or technique used for the commercial production of a business component is treated as a separate business component, distinct from the product being manufactured.2 This provision is highly relevant for Kentucky’s capital expenditure focus, as it allows manufacturers to qualify capital investments (such as new machinery or facility remodeling) aimed at developing improved internal production techniques. If the goal is to resolve technological uncertainty regarding improved efficiency or reliability of the manufacturing method, the capital expense related to that machinery or process area can qualify as “equipping facilities… for qualified research” under KRS 141.395.1

C. Statutory Exclusions from Qualified Research (IRC $\S 41(d)(4)$)

IRC $\S 41(d)(4)$ specifies activities that are inherently disqualified from constituting “qualified research.” Kentucky taxpayers must ensure that the facilities for which they claim the state credit are not used primarily for these excluded activities.2 Key exclusions include:

• Research After Commercial Production: Any research conducted after the commencement of commercial production of the business component.8
• Adaptation of Existing Components: Research solely related to adapting an existing component to a particular customer’s specific requirement or need.11
• Duplication of Existing Components: Efforts aimed at reproducing an existing business component.9
• Surveys, Studies, and Management Functions: Activities such as efficiency surveys, routine data collection, market research, and research related to management techniques or functions.9
• Foreign Research: Research conducted outside the United States, Puerto Rico, or U.S. possessions.2
• Social Sciences, Arts, and Humanities: Research performed in these fields is explicitly non-qualifying.11
• Funded Research: Research to the extent that it is funded by any grant, contract, or payment from another person or governmental entity.2

The incorporation of these federal exclusions into Kentucky law means that a company building a specialized lab in Louisville for a research project largely funded by a federal grant or an unrelated external contract would find the facility cost ineligible for the KRFCTC due to the “Funded Research” exclusion, regardless of the technological intensity of the activity itself.1

III. Kentucky’s Legislative Divergence: Focusing on Infrastructure (KRS 141.395)

While IRC $\S 41(d)$ establishes the technological eligibility criteria, the Kentucky credit, codified in KRS 141.395, is sharply delimited by the type of expenditure it targets. The state explicitly focuses on incentivizing capital investment in infrastructure, creating a distinct and narrow qualified cost base.

A. Statutory Adoption and Calculation Mechanics

Kentucky law mandates that the credit must be based on “qualified research as defined in Section 41 of the Internal Revenue Code”.1 The calculation mechanics for the state credit are straightforward yet unique. The credit rate is set at five percent (5%) of the qualified costs.3

A significant difference from the federal structure is the calculation methodology. The Kentucky credit applies the 5% rate directly to the total eligible facility costs incurred in the tax year.3 There is no requirement for a complex base amount calculation, fixed-base percentage determination, or prior-year averaging, simplifying the computation for taxpayers compared to federal requirements.3

B. Restriction of Qualified Costs to Facilities

The defining element of the KRFCTC is the definition of “Construction of research facilities,” which serves as the core of the qualified cost determination.

1. Defining Eligible Capital Costs

“Construction of research facilities” includes the costs associated with constructing, remodeling, and equipping facilities in Kentucky or expanding existing facilities in Kentucky, provided these actions are undertaken for qualified research.1

The cost must relate exclusively to tangible, depreciable property.2 This aligns the credit with long-term capital investments that are capitalized under federal tax rules. The credit becomes available once the property is placed in service.5

2. Explicit Exclusions and Focus

Kentucky law explicitly excludes several types of costs, notably those that constitute the core of the federal R&D tax credit.3 These exclusions underscore the state’s intent to incentivize infrastructure development over operational subsidy:

• Operational Costs: Wages paid to employees, supplies, raw materials consumed in testing, contract research expenses, and computer rental or lease costs are all explicitly excluded from the Kentucky qualified cost base.3
• Replacement Property: Any amounts paid or incurred for the replacement of existing property are disqualified.2 This restriction encourages net new capital investment and technological upgrades, rather than subsidizing routine maintenance or substitution of old assets with similar new ones.

C. Strategic Impact of Expense Divergence

The structural differences between the federal and state credit bases necessitate specialized accounting and project tracking. The compliance approach must manage two entirely distinct expense methodologies based on the same qualifying activity.

The requirement that costs must involve “tangible, depreciable property” substantially narrows the credit’s application. Although software development may constitute qualified research activity under IRC $\S 41(d)$, the labor costs associated with that development are excluded.3 Furthermore, if the software is considered an intangible asset (even if capitalized), it would not meet the “tangible” property requirement of KRS 141.395, limiting the benefit for digital R&D facilities primarily to hardware, servers, and physical structures, not the intellectual capital investment itself.

The “replacement property” exclusion is critical for long-term planning. It compels businesses to document the specific technological or capacity improvement associated with new assets. If an asset is simply an outdated piece of equipment being swapped out, it is deemed ineligible. Conversely, if a new piece of equipment is procured as part of a significant facility expansion or as an essential component for conducting a newly qualified research activity, it constitutes “equipping facilities” and can be included in the QFC calculation.5

IV. Kentucky Department of Revenue (DOR) Guidance and Compliance Requirements

The Kentucky DOR administers the KRFCTC and has established specific procedures for claiming and substantiating the credit, emphasizing meticulous tracking of capital assets and utilization.

A. Credit Mechanics and Carryforward Provisions

The KRFCTC is a nonrefundable credit, meaning it can only offset tax liability and cannot generate a cash refund.3 It can be applied against multiple types of Kentucky tax liabilities 2:

• Individual Income Tax (KRS 141.020).
• Corporation Income Tax (KRS 141.040).
• Limited Liability Entity Tax (LLET) (KRS 141.0401).

The application of the credit is governed by the ordering clause specified in KRS 141.0205.2 Any unused portion of the credit may be carried forward for a period of 10 years.3

The inclusion of the Limited Liability Entity Tax (LLET) in the allowable offsets provides a distinct advantage for pass-through entities and corporations. Since the LLET imposes a minimum tax obligation based on gross receipts or assets, businesses incurring large capital expenses during initial, loss-generating R&D phases can still monetize the credit immediately against this guaranteed liability, ensuring the state incentive is valuable even when net income tax liability is zero.2

B. Documentation and Filing Procedures

The DOR requires annual, project-specific filing and comprehensive supporting documentation for facility costs.

1. Mandatory Forms

The central form for claiming the credit is Schedule QR, Qualified Research Facility Tax Credit.2 This form is used both to compute the initial 5% credit based on construction and equipment costs and to record the annual utilization of the credit. A separate Schedule QR must be filed for each new project that qualifies.2

For businesses operating as pass-through entities (PTEs) such as S-corporations or LLCs, the credit may be passed through to the owners.17 Taxpayers receiving a share of the credit via a Kentucky K-1 must then file Schedule TCS (for corporations and PTEs) or Schedule ITC (for individuals) to reflect their proportional share and attach a copy of the originating Schedule QR.2

2. Supporting Documentation Requirements

To substantiate the qualified costs, the taxpayer must attach a supporting schedule listing every piece of tangible, depreciable property included in the calculation.2 This schedule must detail the date purchased, the date placed in service, a description of the asset, and its cost.2

This requirement mandates meticulous reconciliation between the company’s capital asset management system (fixed asset ledger) and the tax documentation. This precision is necessary because the audit focus shifts heavily toward validating the classification of the expense—ensuring it is tangible, depreciable, and not replacement property—and proving the date it was placed in service for R&D purposes.5 Furthermore, although the costs are capitalized, the taxpayer must be able to produce the underlying IRC $\S 41(d)$ documentation (e.g., technical reports, testing logs, prototypes) to legally demonstrate that the facility and equipment were acquired for the purpose of conducting qualified research activities, thereby bridging the federal activity test to the state capital expense claim.10

V. Case Study: Maximizing the Kentucky Qualified Research Facility Credit

The following case study illustrates the necessity of reconciling the broad federal activity definition with Kentucky’s restrictive capital expenditure rules.

A. Scenario: Battery Technology Development Center

Company: Kinetic Energy Corp. (KEC), a corporation located in Lexington, Kentucky, specializing in advanced battery chemistries.

Goal: KEC constructs a new 10,000 square foot facility to systematically test and improve a novel solid-state electrolyte (a new product/business component) intended to increase battery capacity by 50%.

Project Costs Incurred in 2024:

IRC § 41(d) Activity Analysis

The battery improvement project requires systematic evaluation of chemical interactions under varied thermal conditions, relying heavily on principles of chemistry and engineering. This effort seeks to eliminate uncertainty regarding the viability and performance of the new electrolyte design through a defined process of experimentation. Since the activity relates to improving the performance of a business component (the battery) and passes all four parts of the IRC $\S 41(d)$ test, the research activity is qualified.

KRS 141.395 Expense Calculation and Credit Generation

KEC must filter its total project investment based on the Kentucky facility requirements (tangible, depreciable property for research):

Credit Calculation and Utilization

• Total Qualified Kentucky Facility Costs (QFCs): $5,300,000
• Credit Rate: 5%
• Total KRFCTC Generated (2024): $5,300,000 $\times$ 5% = $265,000

If KEC’s total Kentucky tax liability (LLET and Corporate Income Tax) for 2024 is only $15,000, KEC claims $15,000 of the credit and carries forward the remaining $250,000 for up to 10 years, utilizing the credit against the LLET.3 KEC must file Schedule QR annually, providing detailed schedules of the $5,300,000 in capitalized assets, demonstrating their placement in service in 2024.2

VI. Conclusion: Strategic Implications for Kentucky Taxpayers

The Kentucky Qualified Research Facility Tax Credit is a highly focused fiscal tool designed to enhance the state’s physical R&D infrastructure. It provides substantial benefits for companies making large capital investments, but its complexity arises from its bifurcated structure: absolute adherence to the federal standard for the activity, coupled with a state-imposed restriction on the expense base.

For businesses engaging in capital-intensive R&D projects in Kentucky, the following strategic mandates are essential for compliance and maximization:

1. Substantiate the Activity (IRC $\S 41(d)$): Taxpayers must proactively ensure that all research conducted within the constructed or equipped facility adheres to the four-part test, proving the discovery of technological information through a process of experimentation aimed at eliminating uncertainty. The integrity of the state credit claim hinges entirely on the quality of the federal R&D substantiation, even though the costs claimed are different. This includes verifying that the research is not excluded due to commercial production, foreign location, or external funding.1
2. Isolate the Expense (KRS 141.395): Financial tracking systems must be capable of isolating costs to only tangible, depreciable property used for constructing, remodeling, or equipping the facility. This necessitates rigorous separation of eligible capital expenditures from ineligible operational expenditures (wages, supplies, contract fees) and avoiding the inclusion of replacement property costs.3

The fact that the credit is applied against the LLET is particularly valuable for capital-heavy startup companies or businesses undergoing expansion, allowing them to realize the credit benefit against minimum tax obligations even during periods of unprofitability. By diligently documenting the technical merits of the research activity and maintaining precise records of the associated tangible capital investment, Kentucky taxpayers can effectively utilize the 5% credit on their infrastructure spending, carrying forward any unused benefit for a decade.3

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