Detailed Analysis of Contract Research Expenses and the 65% Statutory Limitation within the Louisiana Research and Development Tax Credit Framework

Contract research expenses are defined as sixty-five percent of the amount paid to third parties for qualified research, a limitation intended to exclude contractor profit and overhead from the credit calculation. In Louisiana, this specific limitation applies only to qualified research activities physically performed within state borders under a written agreement where the taxpayer bears the financial risk.

The conceptual framework for contract research expenses is rooted in the legislative intent to incentivize innovation while preventing the subsidization of non-research costs. When a taxpayer performs research in-house, they are permitted to claim one hundred percent of the wages paid to employees and the cost of supplies used in the research process. However, when a taxpayer chooses to outsource these activities to a third-party vendor, the Internal Revenue Code (IRC) and the Louisiana Department of Revenue recognize that the total invoice price includes components that do not represent direct research expenditures. These components typically comprise the contractor’s profit margin, administrative overhead, facility rent, and other indirect costs that would not qualify if the taxpayer had performed the work internally. Consequently, the sixty-five percent limitation serves as a statutory proxy to isolate the estimated direct research costs embedded within a third-party contract. In the context of the Louisiana Research and Development (R&D) tax credit, this limitation is a primary factor in determining the Qualified Research Expenditures (QREs) that serve as the basis for the state’s tiered credit system.

The Theoretical Foundation of Contract Research under Section 41

The federal definition of contract research expenses, as established in IRC § 41(b)(3), provides the baseline for Louisiana’s tax credit eligibility. The statute defines these expenses as sixty-five percent of any amount paid or incurred by the taxpayer to any person, other than an employee, for qualified research.1 This definition creates a clear distinction between the employment relationship and the contractual relationship. While the wages of a W-2 employee are eligible at their full value, payments to an independent contractor or a separate business entity are subject to the haircut regardless of the contractor’s actual internal cost structure.1

For an expense to qualify as a contract research expense, several stringent conditions must be met. The research must be conducted “on behalf of” the taxpayer, which the Treasury Regulations interpret to mean that the taxpayer must bear the financial risk of the research and retain substantial rights to the results.1 If a contract specifies that the taxpayer only pays upon the successful completion of a technical milestone or the delivery of a working product, the contractor—not the taxpayer—bears the financial risk. In such cases, the payment is categorized as an acquisition of a finished product rather than a funding of research, and the expense is generally disqualified.4 Conversely, if the taxpayer is obligated to pay the contractor for the research effort even if the project fails to reach its technical objectives, the taxpayer is considered to have borne the risk, qualifying the payment for the sixty-five percent inclusion.4

Retention of substantial rights is the second pillar of this federal-state framework. The taxpayer must have the right to use the research results in their trade or business without paying an additional fee or royalty to the contractor.1 While the contractor may also retain rights to the results, the taxpayer’s rights must be “substantial,” meaning they are not merely receiving a restricted license to use a finished product but have ownership or usage rights over the underlying technological discovery.1

Louisiana Statutory Context and Conformity

Louisiana Revised Statute 47:6015 governs the state’s R&D tax credit and generally conforms to the federal research credit provisions as enacted under the Small Business Job Protection Act of 1996.4 This conformity ensures that the definition of “qualified research” and “qualified research expenses” used for the Louisiana credit matches the federal definitions under IRC § 41.4 However, Louisiana introduces specific geographic and administrative requirements that diverge from federal practice.

The In-State Performance Requirement

The most significant divergence from the federal framework is Louisiana’s strict geographic limitation. While the federal credit permits research performed anywhere within the United States, the Louisiana credit is only available for research expenditures incurred for activities conducted within the state.4 For contract research, this means the third-party consultant or laboratory must perform the research services physically within Louisiana borders.4 If a Louisiana company hires a specialized lab in another state to conduct testing or design work, those expenses are completely excluded from the Louisiana credit, even though they may qualify for the federal credit.4 If a contractor performs work both inside and outside the state, only the portion of the invoice attributable to the Louisiana activities is eligible for the sixty-five percent inclusion.4

Tiered Credit Rates and Base Amounts

Louisiana utilizes a tiered system that awards a higher percentage credit to smaller entities, creating an environment that specifically encourages innovation in the small business sector. The credit is calculated based on the excess of current-year Louisiana QREs over a “base amount,” which is determined by the taxpayer’s average spending over the previous three years.8

For a startup with fewer than fifty employees, the thirty percent credit rate is exceptionally generous compared to the federal regular credit of twenty percent.9 However, the base amount calculation also favors smaller firms, as they only need to exceed fifty percent of their historical average, whereas larger firms must exceed eighty percent.9 In years where a company has no prior R&D spending in Louisiana, the base amount is zero, and the credit applies to the full current-year QRE amount.11

Variations in Contract Research Percentages

While the sixty-five percent rule is the standard for commercial contracts, both IRC § 41 and Louisiana law recognize specific types of organizations and research areas where a higher percentage of the contract price may qualify.

The 75% Rule for Research Consortia

Under IRC § 41(b)(3)(C), the limitation is increased to seventy-five percent for payments made to a “qualified research consortium”.1 A qualified research consortium is a tax-exempt organization (under Section 501(c)(3) or 501(c)(6)) that is operated primarily to conduct research and has at least five unrelated contributors, with no single contributor providing more than fifty percent of the total funding.14 This higher threshold acknowledges that research consortia are often non-profit entities where a greater portion of the funding is directed toward actual research activities rather than profit.1

The 100% Rule for Energy Research

A unique provision in the federal code, which Louisiana follows through conformity, allows for one hundred percent of contract research expenses to be qualified if the payments are made for “energy research” to certain small businesses, universities, or federal laboratories.1 To qualify for the one hundred percent inclusion, the research must be related to energy efficiency, renewable resources, or environmental mitigation, and the recipient must be an eligible small business with 500 or fewer employees or a qualified academic institution.14

The Four-Part Test in the Contractor Context

For a contract research payment to be eligible for any inclusion percentage, the underlying activity performed by the contractor must satisfy the federal “Four-Part Test.” This test ensures that the activities represent genuine research and development rather than routine business operations.1

1. Section 174 Requirement

The expenditures must qualify as research and experimental costs in the “experimental or laboratory sense” as defined under IRC § 174.6 This means the contractor’s work must be aimed at eliminating uncertainty regarding the capability, method, or appropriate design of a product or process.6 If the contractor is merely applying known engineering principles to a routine problem without technical uncertainty, the expense is disqualified.6

2. Technological in Nature

The research must fundamentally rely on the “hard sciences,” such as physics, biology, engineering, or computer science.6 In a contract research setting, if a consultant is hired to perform market research, efficiency surveys, or management studies, those activities fail this test as they are based on the social sciences or business logic.2

3. Business Component Test

The information discovered must be intended to be useful in the development of a new or improved “business component” of the taxpayer.6 A business component can be a product, process, software, formula, or technique that the taxpayer intends to hold for sale or use in its trade or business.6 In the contractor model, the taxpayer must demonstrate that the contractor’s work directly contributed to the technical improvement of that specific component.6

4. Process of Experimentation

Substantially all (eighty percent or more) of the activities must constitute a process of experimentation.4 This involves the systematic evaluation of alternatives through modeling, simulation, or physical trial-and-error to resolve the identified technical uncertainty.6 For contract research, the taxpayer should maintain documentation from the contractor, such as test results, prototype revisions, and technical reports, to prove that this iterative process occurred.4

Administrative Guidance and the Certification Process

Unlike the federal R&D credit, which is claimed by filing Form 6765 with the IRS, the Louisiana R&D credit is not self-certified.4 To receive the credit, a taxpayer must first obtain a certification from Louisiana Economic Development (LED).4

Application Timing and Requirements

The application must be submitted to LED within one year after December 31 of the year in which the expenditures were incurred.4 For example, if a business operates on a calendar year and incurs research costs in 2024, it must apply by December 31, 2025.11 The application process typically takes three to six months and requires detailed documentation.4

Taxpayers must provide a breakdown of costs by expenditure category, highlighting the sixty-five percent calculation for contract research.4 Supporting documents for contracted services include:

• Copies of 1099s or K-1s issued to the contractor.4
• Detailed invoices that describe the specific research services performed in Louisiana.4
• Written contracts established prior to the performance of the research, confirming the taxpayer’s financial risk and rights.4
• A narrative explaining how the contractor’s activities met each part of the four-part test.4

Application and Verification Fees

LED mandates an application fee equal to 0.5% (or.005) of the proposed tax benefit, with a minimum fee of $500 and a maximum of $15,000.11 Additionally, for small businesses (fewer than fifty employees) that have not filed for a federal research credit, Louisiana requires an “Expenditure Verification Report” (EVR).7 The EVR is prepared by an LED-assigned independent CPA or tax attorney to ensure the eligibility of the claimed expenses.8 The taxpayer is responsible for the actual cost of this report, which is capped at $15,000 for expenditures up to $1 million and $25,000 for expenditures exceeding that amount.7

Economic Impact and Return on Investment Analysis

The Louisiana Department of Revenue (LDR) is required to perform a comprehensive return on investment (ROI) analysis for the state’s incentive programs.23 The most recent data from the FY 2023 ROI Report indicates that while the R&D credit is a significant tool for encouraging innovation, its fiscal ROI to the state remains negative, reflecting the program’s nature as an investment in long-term economic growth rather than short-term revenue generation.23

The decline in Economic ROI in 2023 was partly due to a significant increase in credits claimed by the Chemical Manufacturing sector, which rose from 9.87% of total credits in 2022 to 33.29% in 2023.23 Conversely, sectors like Railroad Construction and Petroleum Manufacturing saw their shares drop significantly.23 These statistics demonstrate that the credit is highly sensitive to the capital expenditure cycles of Louisiana’s major industrial sectors.

Legislative Reforms and the 2025 Aggregate Cap

The Louisiana legislature has recently introduced significant changes to the R&D credit through Act 11 and Acts 2024, 3rd Ex. Sess., No. 6. These reforms are designed to bring fiscal predictability to the program while aligning it with the state’s broader tax reform goals.8

The $12 Million Fiscal Year Cap

Starting July 1, 2025, the total amount of R&D tax credits allowed per state fiscal year is capped at $12 million.9 Credits are awarded on a first-come, first-served basis.9 This introduces a “race to file” for Louisiana companies, particularly those with large contracted research projects. If a taxpayer’s claim is disallowed solely because the cap has been reached, the claim receives priority in the following fiscal year.9

Sunset and Franchise Tax Elimination

The Louisiana R&D credit is currently scheduled to sunset on December 31, 2029.8 Furthermore, beginning in 2026, the credit can no longer be applied against the corporation franchise tax; it will only be available to offset state income tax.8 This change is part of a larger legislative effort to phase out the franchise tax entirely.

Practical Application: The 65% Limitation in Action

To understand how the sixty-five percent limitation and state rules function in practice, consider the following example of a Louisiana-based software development firm.

Scenario: Bayou Tech Solutions

Bayou Tech Solutions is a software company with forty employees located in New Orleans. In 2024, the company undertakes a project to develop a new AI-driven cybersecurity protocol. They incur the following expenses in Louisiana:

• Wages for Internal Developers: $500,000
• Payments to a Specialized Cybersecurity Firm (Baton Rouge): $200,000
• Payments to a Cloud Architecture Consultant (Texas): $50,000

Step 1: Identify Louisiana QREs

• Internal Wages: $500,000 is eligible at 100%.
• Contract Research (Louisiana): The $200,000 paid to the Baton Rouge firm is eligible at 65%. ($200,000 x 0.65 = $130,000).
• Contract Research (Out-of-State): The $50,000 paid to the Texas consultant is ineligible for the Louisiana credit because the work was not performed in the state.

Step 2: Total Current Year Louisiana QREs

The total QRE amount is $630,000 ($500,000 + $130,000).

Step 3: Base Amount Calculation

Assume Bayou Tech’s average Louisiana QREs for the three preceding years was $400,000. As a company with fewer than fifty employees, their base amount is fifty percent of that average.

• Base Amount: $400,000 x 0.50 = $200,000.

Step 4: Calculate Excess QREs

• Excess: $630,000 – $200,000 = $430,000.

Step 5: Apply Credit Rate

For companies with fewer than fifty employees, the Louisiana credit rate is thirty percent.

• Total Louisiana R&D Credit: $430,000 x 0.30 = $129,000.

In this example, the sixty-five percent limitation on the $200,000 contract effectively removed $70,000 of non-qualifying costs from the calculation. If the company had incorrectly claimed the full $200,000, their credit would have been overstated by $21,000 ($70,000 x 0.30), a discrepancy that would likely be caught during the LED certification review or a subsequent audit.4

Compliance and Documentation Standards for Contractors

Because contract research involves third parties, the documentation requirements are inherently more complex than for in-house R&D. Taxpayers should implement the following standards to ensure their sixty-five percent claims are defensible.

Written Agreement Prior to Performance

Louisiana regulations require that a written agreement be in place before the research activities begin.4 This agreement must define the scope of work and clearly establish that the taxpayer is responsible for payment regardless of whether the research results in a successful product or process.4 If the contract is signed after the work is completed, LED may disallow the expenses.4

Identification of Qualified Services

The taxpayer must be able to prove that the contractor performed “qualified services.” Under IRC § 41(b)(2)(B), qualified services include direct performance of research, direct supervision of research, or direct support of research.2 In a contractor context, this means the taxpayer should have invoices that break down the contractor’s hours or tasks. If a contractor provides an “all-in” monthly fee for general consulting, it is difficult to isolate the qualified research time, making the expense vulnerable to disqualification.4

Retaining Records of “Process of Experimentation”

While the taxpayer may not be performing the work, they are responsible for maintaining the contractor’s documentation. This includes:

• Project Logs: Timelines showing when different design alternatives were tested.12
• Test Results: Data showing the outcome of experiments and how those outcomes led to design changes.6
• Prototype Revisions: Blueprints, code versions, or physical models that demonstrate the technical evolution of the business component.4

The Impact of Federal Section 174 Amortization

A major shift in federal tax law under the Tax Cuts and Jobs Act (TCJA) has indirect consequences for Louisiana R&D credit planning. For tax years beginning after December 31, 2021, taxpayers are no longer permitted to immediately deduct R&D expenses under Section 174; instead, they must capitalize and amortize them over five years for domestic research and fifteen years for foreign research.17

While this change does not alter the calculation of the R&D credit itself, it makes identifying “Section 174 costs” mandatory for all taxpayers, not just those seeking a credit.25 Since the Louisiana R&D credit is based on these same Section 174 definitions, the increased federal scrutiny on what constitutes “research and development” means that Louisiana companies will have a more robust dataset to support their state credit claims.10 However, the unfavorable federal capitalization rules may reduce the immediate cash-flow benefit of performing R&D, making the state credit even more critical as a source of liquidity.12

Conclusion

The sixty-five percent limitation on contract research expenses is a cornerstone of the Louisiana R&D tax credit, serving as a statutory boundary that ensures incentive dollars are directed toward genuine technical discovery rather than vendor overhead. For Louisiana businesses, navigating this limitation requires a dual focus on federal conformity and state-specific administrative mandates. By ensuring that contracted research is performed within Louisiana borders, that the taxpayer bears the financial risk of failure, and that all activities are supported by contemporaneous documentation of a process of experimentation, companies can maximize their credit potential under the state’s generous tiered system.

As Louisiana moves toward the 2025 aggregate cap and the 2029 program sunset, the importance of rigorous compliance and early certification cannot be overstated. The shift toward a $12 million first-come, first-served limit means that companies must be more efficient in their application processes, often relying on detailed Expenditure Verification Reports to validate their sixty-five percent inclusions. Ultimately, the contract research rules reward those businesses that engage in structured, risky, and technologically advanced innovation, providing a vital offset to the high costs of developing the next generation of Louisiana-made products and processes. Consistent adherence to both the IRC § 41 framework and the LED’s specific guidance will ensure that Louisiana remains a competitive hub for scientific and engineering excellence in the years to come.

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