Analysis of IRC Section 41(d) Qualified Research and its Application within the Maryland Research and Development Tax Credit Framework

Internal Revenue Code Section 41(d) defines qualified research as a four-part evaluation of technological activities aimed at eliminating technical uncertainty through a systematic process of experimentation for functional improvements. Within the Maryland regulatory framework, this federal standard is strictly adopted to identify and certify the eligible innovation expenditures that qualify for the state’s 10% Growth Research and Development Tax Credit.

The intersection of federal tax law and state-level economic incentives represents a critical nexus for businesses operating in the innovation economy. At the heart of this intersection is Internal Revenue Code (IRC) Section 41, specifically subsection (d), which provides the comprehensive definition of what constitutes “qualified research.” For Maryland-based enterprises, understanding the nuances of Section 41(d) is not merely a matter of federal compliance but is the prerequisite for unlocking one of the state’s most significant corporate tax benefits. The Maryland Research and Development (R&D) Tax Credit program, administered by the Maryland Department of Commerce and monitored by the Comptroller of Maryland, leverages the federal definition to ensure that state resources are directed toward genuine technological advancement. This report explores the rigorous requirements of Section 41(d), the administrative guidance provided by Maryland revenue authorities, the structural mechanics of the state credit, and the implications of recent legislative overhauls intended to focus these incentives on high-growth sectors.

The Federal Foundation: Deconstructing IRC Section 41(d)

The federal research credit was originally introduced to encourage domestic investment in innovation, recognizing that the social returns on research often exceed the private returns for individual firms. Section 41(d) serves as the primary filter for this incentive, establishing a “Four-Part Test” that every research activity must satisfy to be eligible for tax credits.1 The definition is functional rather than industry-specific, meaning that a software developer, a pharmaceutical researcher, and a manufacturing engineer must all satisfy the same fundamental criteria to claim the credit.3

The Four-Part Test of Qualified Research

To qualify under Section 41(d), an activity must be undertaken for a permitted purpose, be technological in nature, seek to eliminate technical uncertainty, and involve a systematic process of experimentation.2

The Permitted Purpose Test requires that the research be conducted to develop a new or improved “business component”.1 Under the code, a business component is defined as any product, process, computer software, technique, formula, or invention that the taxpayer holds for sale, lease, or license, or uses in its trade or business.4 Crucially, the improvement sought must be functional. Research aimed at enhancing the performance, reliability, quality, or functionality of the component meets the test, while activities focused on aesthetic or cosmetic changes do not.1

The Technological in Nature Test mandates that the research process must rely on the “hard sciences.” Specifically, the experimentation must fundamentally utilize principles of engineering, physics, chemistry, biology, or computer science.2 This requirement explicitly excludes research in the social sciences, humanities, arts, or management techniques.1 This distinction ensures that the tax credit supports the advancement of the physical and digital infrastructure of the economy rather than behavioral or organizational studies.

The Elimination of Uncertainty Test establishes the technical threshold for the credit. The taxpayer must demonstrate that, at the outset of the project, the information available did not establish the capability of developing the component, the method for doing so, or the appropriate final design.2 Uncertainty in this context is not merely a lack of knowledge by a specific individual that could be resolved through basic research; it must be a technical uncertainty that requires a process of discovery to resolve.3

The Process of Experimentation Test is perhaps the most rigorous of the four. It requires that substantially all of the activities—typically interpreted as 80% or more—constitute a process of experimentation.7 This involves the systematic evaluation of one or more alternatives to achieve a result where the method or design was initially uncertain.4 This process often includes modeling, simulation, systematic trial and error, or the testing of multiple prototypes to determine which configuration best meets the technical requirements.6

Statutory Exclusions Under Section 41(d)(4)

The breadth of the Four-Part Test is tempered by several statutory exclusions. These are activities that might otherwise appear to be research but are deemed by Congress to be outside the scope of the credit’s intent.1

The exclusion for “Funded Research” is particularly relevant for Maryland’s defense and aerospace sectors. If a government contract provides for payment regardless of the research outcome, or if the government retains all rights to the intellectual property, the taxpayer generally cannot claim those expenditures for the R&D credit, as the economic risk and ownership reside with the funding entity.2

Maryland’s Legislative Adoption and Administrative Framework

Maryland law explicitly adopts the federal definition of “qualified research” and “qualified research expenses” provided in IRC Section 41.9 This alignment is formalized in the Tax-General Article of the Maryland Code and further detailed in the Code of Maryland Regulations (COMAR).

The Regulatory Definition of Maryland Qualified Research

COMAR 03.04.10.01 provides the definitions that govern the state credit, ensuring they remain tethered to the federal standard while adding a geographical nexus.11

• Maryland Qualified Research and Development: This term refers to “qualified research” as defined in IRC Section 41(d) and its associated regulations, with the additional requirement that the research must be conducted specifically within the State of Maryland.10
• Maryland Qualified Research and Development Expense (MQRE): These are the expenses defined under IRC Section 41(b) that are incurred for research and development conducted in Maryland.11

By incorporating the federal definitions, Maryland ensures that its revenue offices do not need to create a separate body of case law regarding the technicalities of “experimentation” or “uncertainty.” Instead, the Maryland Department of Commerce and the Comptroller’s Office can rely on decades of federal Treasury Regulations and U.S. Tax Court decisions to interpret these terms. However, the requirement that the research be conducted in Maryland is absolute. A company headquartered in Bethesda that conducts its laboratory testing in Virginia cannot include the Virginia-based laboratory costs in its Maryland credit application, even if those costs are eligible for the federal credit.9

Administrative Oversight and the Certification Process

Unlike the federal R&D credit, which is generally a self-reported item on a taxpayer’s return, the Maryland R&D tax credit is a “certified” credit.6 This means that a business must proactively apply to the Maryland Department of Commerce for a certification of its eligible expenses before it can claim the credit on a tax return.10

The gap between the close of the tax year and the application deadline (November 15) allows companies to complete their federal R&D credit studies and reconcile their financial records before submitting state-specific data.9 However, because the certification letter is issued in February of the second year following the research (e.g., a letter for 2023 expenses is issued in February 2025), most companies must file an amended tax return to claim the credit for the year the expenses were actually incurred.6

Eligible Expenditures: The § 41(b) Component in Maryland

For an expense to be included as a Maryland Qualified Research Expense (MQRE), it must first satisfy the federal criteria for a “Qualified Research Expense” under IRC Section 41(b). Maryland auditors look for three primary categories of costs: wages, supplies, and contract research.2

Qualified Research Wages

Wages paid to employees for “qualified services” constitute the bulk of most R&D claims. Qualified services include the direct conduct of research, the direct supervision of research, and the direct support of research.1

In Maryland, the definition of wages follows the federal definition under Section 3401(a), which includes all remuneration for services performed by an employee for their employer.1 For the purposes of the credit, only the portion of the employee’s time spent on qualified activities is includable. However, Maryland adopts the federal “substantially all” rule: if an employee spends 80% or more of their time on qualified research services, 100% of their wages may be treated as MQREs.7

Supplies and Computer Rental Costs

Supplies used in the conduct of qualified research are also eligible. This includes tangible property, such as materials for prototypes or chemicals for laboratory testing, provided they are not land, improvements to land, or property subject to depreciation.1

Maryland also recognizes computer rental or leasing costs, which in the modern technical environment frequently encompasses cloud computing and hosting costs for development and testing environments.1 These costs must be specifically attributable to the conduct of qualified research and must not be for routine administrative or general business purposes.

Contract Research Expenses

When a Maryland company hires a third party to perform research on its behalf, the associated costs are classified as contract research expenses. Only 65% of these expenses are typically eligible for the credit.7 To include these costs, the Maryland entity must maintain the economic risk of the research—meaning they pay for the effort even if it fails—and retain substantial rights to the results of the research.2 Maryland revenue guidance specifically prohibits a taxpayer from including expenses paid to a contractor if the contractor is also claiming a Maryland R&D credit for the same work, preventing a “double-dipping” scenario.12

Structural Evolution: From the Two-Tier System to the 10% Growth Credit

The Maryland R&D tax credit has undergone a significant structural evolution since its inception in 2000. For most of its history, the program offered two distinct types of credits: the Basic R&D Credit and the Growth R&D Credit.6

Historical Context: The Pre-2021 Model

Prior to the 2021 legislative session, Maryland businesses could apply for both a 3% Basic Credit and a 10% Growth Credit.6

• The Basic Credit: This was equal to 3% of the MQREs that did not exceed the “Maryland Base Amount”.13
• The Growth Credit: This was equal to 10% of the MQREs that exceeded the “Maryland Base Amount”.5

This structure was designed to provide a small benefit for maintaining R&D levels while offering a much larger incentive for increasing those levels. However, because both credits were subject to separate annual caps ($5.5 million for the basic and $6.5 million for the growth), they were routinely oversubscribed, leading to significant proration.14

The 2021 Overhaul: Senate Bill 196

Recognizing that the 3% Basic Credit often acted as a “windfall” for companies that were not actually expanding their innovation footprint, the Maryland General Assembly passed Senate Bill (SB) 196 in 2021.17 This legislation fundamentally restructured the program for tax years beginning after December 31, 2020.

The primary change was the elimination of the Basic Credit.18 Effective with tax year 2021, Maryland businesses can only claim the Growth Credit, which remains set at 10% of the MQREs in excess of the Maryland Base Amount.9 To compensate for the elimination of the basic tier, the state increased the total annual funding for the Growth Credit to $12 million.17

This shift toward a pure “Growth” model signals a strategic policy decision to focus state resources on businesses that are actively scaling their research activities.17

Calculating the Maryland Base Amount

The calculation of the Maryland Base Amount is the most technically demanding aspect of the credit application. Because the credit is now exclusively a “Growth” credit, the Base Amount serves as the essential threshold that a company must cross to receive any benefit.5

The Fixed-Base Percentage and Gross Receipts

Maryland adopts the federal concept of the “base amount” but modifies it for the state level. Under COMAR 03.04.10.01, the Maryland Base Amount is determined by multiplying a “Maryland base percentage” by the average annual Maryland gross receipts for the four taxable years immediately preceding the credit year.10

The Maryland base percentage is calculated as:

$$\text{Maryland Base Percentage} = \frac{\sum \text{MQREs for the preceding 4 years}}{\sum \text{Maryland Gross Receipts for the preceding 4 years}}$$

For companies that have been in business for fewer than four years, the calculation uses the number of years the business has existed.11 If a business has never incurred R&D expenses in Maryland before the credit year, its Maryland Base Amount is treated as zero, allowing it to claim the 10% credit on its entire first-year research expenditure.9

Adjustments for Short Tax Years

When a company undergoes a merger, acquisition, or simply has a short tax year (less than 12 months), the Base Amount must be adjusted. COMAR 03.04.10.03 requires that the Maryland Adjusted Base Amount be calculated by multiplying the base amount by a fraction, the numerator of which is the number of days in the short year and the denominator of which is 365.10 This ensures that the growth threshold is proportionate to the duration of the tax period being evaluated.

Maryland Gross Receipts Definition

Determining “Maryland Gross Receipts” requires careful accounting. These are receipts reasonably attributable to the conduct of a trade or business within Maryland.11 This is generally determined using the same apportionment rules applied to the state income tax, focusing on where the benefit of the service is received or where the sale of property is delivered.10 Inaccurately reporting gross receipts—either by including non-Maryland sales or excluding relevant Maryland revenue—can lead to an incorrect base amount, potentially disqualifying a legitimate credit claim.

Small Business Benefits: Refundability and the Asset Test

Maryland recognizes that small, innovation-focused startups often operate at a loss during their research-intensive years and thus cannot benefit from a non-refundable tax credit. To address this, the state provides unique provisions for “small businesses.”

The Asset Threshold for Small Business Status

To qualify for small business benefits, an entity must have “net book value assets” of less than $5,000,000 as of the beginning or end of the taxable year in which the MQREs were incurred.9

Maryland’s definition of “net book value assets” is specific: it is the total of a business’s net value of assets (including intangibles) minus depreciation and amortization, as reported on the balance sheet.9 Crucially, liabilities are not subtracted from this total; the test is based on the gross value of the assets, not the equity of the company.23 This means a company with $6 million in equipment but $4 million in debt would not meet the small business definition, as its asset total exceeds $5 million.

The Power of Refundability

For companies that meet the small business definition, the R&D tax credit is refundable.5 If the certified credit exceeds the company’s Maryland income tax liability for that year, the state will issue a refund check for the difference.5 This provides an immediate cash infusion that is vital for startups in sectors like biotechnology, where a decade of research may precede the first dollar of commercial revenue.18

Set-Aside and Proration Rules for Small Businesses

To protect smaller firms from being crowded out by large multinational corporations, SB 196 established a $3.5 million set-aside within the $12 million total cap specifically for small businesses.5 If the total credits applied for by small businesses exceed $3.5 million, those credits are prorated among the small business applicants. If the small business pool is underutilized, the remaining funds shift to the general pool for larger companies.24

Example: Growth Credit Calculation and Proration Impact

The following example illustrates the calculation of a Maryland R&D credit for a hypothetical growing software firm, “NovaFlow Systems,” which conducts all its research in Maryland.

Step 1: Establishing the Baseline (2020-2023)

NovaFlow must first look at its preceding four years to determine its base percentage.

Fixed-Base Percentage: $2,600,000 / $12,500,000 = 20.8%

Step 2: Calculating the 2024 Base Amount

NovaFlow’s average gross receipts for the prior four years are $12,500,000 / 4 = $3,125,000.

Maryland Base Amount: $3,125,000 * 20.8% = $650,000

Step 3: Determining the Growth Credit for 2024

In 2024, NovaFlow invests heavily in a new machine learning project and incurs $1,000,000 in MQREs.

Excess QREs: $1,000,000 – $650,000 = $350,000

Tentative Growth Credit: 10% * $350,000 = $35,000

Step 4: The Reality of Proration

NovaFlow submits its application by November 15, 2025. In February 2026, the Department of Commerce informs NovaFlow that while their calculation was correct, the total credits requested by all businesses in the general pool (non-small businesses) was $24,000,000, while only $8,500,000 was available (after the small business set-aside).14

Proration Fraction: $8,500,000 / $24,000,000 = 0.3541

Certified Credit: $35,000 * 0.3541 = $12,393.50

NovaFlow will receive a certification for $12,393.50, which it can then use to amend its 2024 tax return.16

Aggregation Rules and Controlled Groups

To prevent companies from splitting into multiple entities to circumvent the $250,000 individual cap or to manipulate the $5 million small business asset test, Maryland strictly follows federal aggregation rules under IRC Section 41(f).8

Defining a Controlled Group

In the context of the R&D credit, a controlled group exists when multiple entities share more than 50% common ownership.8 This includes parent-subsidiary relationships and brother-sister groups where a small number of individuals control multiple businesses. For these purposes, corporations, LLCs, and partnerships are all subject to aggregation if they meet the ownership threshold.8

Unified Application and Allocation

A controlled group is treated as a single taxpayer for the purpose of the Maryland R&D credit.5 Typically, for corporations with multiple Maryland subsidiaries, only the parent company applies for the credit. The Department of Commerce issues a single certification for the entire group.

The credit is then allocated to each member of the group based on their share of the group’s total MQREs. This ensures that the state does not award more than $250,000 to a single economic interest and that the small business refundability is only granted to groups that are truly small in their aggregate form.9

Documentation Standards and Audit Readiness

Given that the Maryland R&D credit is certified based on self-reported data that integrates complex federal definitions, it is a high-priority area for audits by the Maryland Comptroller. A certification from the Department of Commerce does not preclude the Comptroller from auditing the underlying technical and financial data at a later date.23

Technical Substantiation

A successful R&D claim must be supported by contemporaneous technical documentation that proves the project met the Section 41(d) Four-Part Test.6 Reliance on “recurrent memories” of engineers years after the fact is generally insufficient.

• Project Lists and Descriptions: For each business component, the taxpayer should have a summary of the technical objectives and the specific uncertainties involved.
• Design and Testing Records: Blueprints, CAD drawings, software source code revision logs, and laboratory testing protocols provide the evidence for the “Process of Experimentation.”
• Failed Experiments: Records of what did not work are often the best evidence of technical uncertainty and a systematic research process.

Financial Substantiation and the Nexus

Taxpayers must also maintain a clear “nexus” between their expenses and the research projects. This is most often achieved through time-tracking records that identify the number of hours specific employees spent on specific R&D projects.6

For the Maryland credit, the financial records must also substantiate the geographical nexus. Payroll reports must confirm that the employees were based in Maryland, and invoices for supplies and contract research must show that the activity was conducted within the state.12 The Comptroller’s Office typically requires taxpayers to retain these records for at least four years following the filing of the return on which the credit was claimed.23

Statistical Insights: The 2024 DLS Evaluation

The Maryland Department of Legislative Services (DLS) is required to periodically evaluate the state’s tax credits to determine if they are achieving their intended policy goals. The 2024 DLS evaluation provided a comprehensive look at the program’s recent performance and fiscal impact.20

Participation and Funding Trends

Since the 2021 overhaul, the program has reached a steady state of $12 million in annual funding. However, the DLS noted that the program is consistently oversubscribed.

The report found that while the $12 million cap is fully utilized every year, the impact of the credit on overall statewide R&D activity is difficult to measure.20 Because the credit amount is often prorated down to a fraction of the requested 10%, some firms may view it more as a “bonus” than a primary driver for increasing their research budgets.17

Sectoral Distribution and Innovation Impact

DLS found that recent changes have successfully increased the diversity of industries participating in the program. While life sciences and defense remain dominant, there has been a significant increase in participation from software development and advanced manufacturing firms.20 This suggests that the elimination of the basic credit and the focus on “growth” has moved the incentive away from legacy companies and toward newer, scaling technology firms.

Future Outlook: Termination Dates and Legislative Risk

The Maryland R&D tax credit is not a permanent fixture of the tax code; it is subject to a “sunset” provision. Under current law, the program is scheduled to terminate on June 30, 2027.9

Potential Extensions and Reforms

Historically, the Maryland General Assembly has extended the program every few years. However, the 2024 DLS evaluation included a recommendation that the General Assembly consider terminating the credit and exploring alternative policies, such as direct matching grants for federal SBIR (Small Business Innovation Research) grants.20 The rationale for this recommendation is that direct grants may provide more “certainty” for small businesses than a prorated tax credit that is received two years after the expenses are incurred.

Businesses planning long-term R&D investments in Maryland must factor in this legislative risk. While the program is currently stable through 2027, the structure of the credit could change again—potentially through adjustments to the $250,000 cap or further refinements to the small business asset test—as the state seeks to maximize its return on investment in the innovation economy.

Conclusion: Strategic Value of the § 41(d) Standard in Maryland

The Maryland Research and Development Tax Credit remains a cornerstone of the state’s economic strategy, providing a tangible incentive for businesses to push technical boundaries. By anchoring the program to the rigorous federal standards of IRC Section 41(d), Maryland ensures that its tax benefits are reserved for genuine, technological innovation rather than routine business improvements.

For the modern Maryland enterprise, the path to maximizing this benefit requires a dual focus: technical excellence in the laboratory and administrative precision in the accounting office. The shift to a pure “Growth” credit underscores the state’s desire to reward companies that are expanding their research footprint. While the reality of proration means that the effective credit rate may be lower than the statutory 10%, the refundability for small businesses provides a crucial lifeline for the state’s most promising startups. As the program nears its 2027 sunset, businesses that can demonstrate a clear, documented path through the Section 41(d) Four-Part Test will be best positioned to benefit from this, and any future, innovation incentives offered by the State of Maryland.

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