Comprehensive Analysis of the Process of Experimentation within the Maryland Research and Development Tax Credit Framework

The Process of Experimentation is a systematic trial-and-error procedure designed to evaluate alternatives and resolve technical uncertainties through modeling, simulation, or testing. Under Maryland’s R&D tax credit framework, this requirement ensures that incentives are directed toward rigorous scientific investigation rather than routine design or aesthetic modifications.

The Maryland Research and Development (R&D) Tax Credit is a cornerstone of the state’s economic strategy, designed to foster a robust environment for innovation and high-tech growth.1 Administered by the Maryland Department of Commerce in coordination with the Comptroller of Maryland, the credit provides significant financial relief to businesses that engage in qualified research activities within the state’s borders.3 To qualify for these incentives, a taxpayer’s activities must strictly adhere to the federal definition of “qualified research” as set forth in Section 41(d) of the Internal Revenue Code (IRC), a definition that centers on a rigorous “Four-Part Test”.5 Among these four criteria, the Process of Experimentation (POE) often represents the most complex hurdle for taxpayers to overcome, requiring not just the presence of a technical challenge, but a structured, iterative methodology to resolve it.7

Statutory Framework and the Intersection of State and Federal Law

The legal authority for the Maryland R&D tax credit is found in § 10-721 of the Tax-General Article of the Annotated Code of Maryland.1 This statute establishes the program’s dual-credit structure, consisting of the Basic R&D Tax Credit and the Growth R&D Tax Credit.4 The Maryland General Assembly has specifically designed this credit to be “conformity-based,” meaning the state adopts the federal definitions of “qualified research” and “qualified research expenses” (QREs) as they appear in the IRC.3

A critical nuance of Maryland’s law is its “static conformity” provision: even if the federal R&D tax credit under IRC § 41 were to be repealed or allowed to expire, the Maryland statute specifies that the state credit would continue to operate as if the federal provisions remained in effect.1 This provides a layer of legislative stability for Maryland-based firms that is often absent in other state incentive programs. However, the state imposes its own unique limitations, most notably a $12 million annual cap on the total amount of credits approved for all businesses, with $3.5 million specifically set aside for small businesses.3

The Bifurcated Credit Structure

Maryland’s R&D credit rewards both foundational investment and incremental growth. The Basic Credit is calculated at 3% of the QREs that do not exceed the taxpayer’s “Maryland base amount,” while the Growth Credit provides a 10% incentive for expenses that exceed that base amount.4

The “Maryland base amount” is a critical calculation that anchors the credit to the taxpayer’s historical performance in the state. It is determined by multiplying the taxpayer’s “fixed-base percentage”—the ratio of Maryland QREs to Maryland gross receipts over the preceding four taxable years—by the average annual Maryland gross receipts for those same four years.2 For startups in their first year of claiming the credit, the base amount is treated as zero, meaning the full 10% Growth Credit applies to all eligible expenses.2

The Four-Part Test: A Technical Deep Dive

The Maryland Department of Commerce follows the federal standard requiring that all research activities satisfy the Four-Part Test to be considered “qualified research”.5 These tests must be applied at the level of the “business component,” which the law defines as any product, process, computer software, technique, formula, or invention to be held for sale, lease, or license by the taxpayer.5

1. The Section 174 Test (Elimination of Uncertainty)

The first requirement is that expenditures must be eligible for treatment as research and development costs in the experimental or laboratory sense under IRC § 174.5 This means the research must be undertaken to discover information that would eliminate “uncertainty” concerning the development or improvement of the business component.5

Technical uncertainty exists if the information available to the taxpayer at the project’s outset does not establish the capability of achieving the result, the method for achieving it, or the appropriate design of the product.5 It is vital to distinguish technical uncertainty from business uncertainty; knowing whether a product will be profitable is not R&D, but knowing whether a specific material will withstand a particular heat threshold is.16

2. The Technological in Nature Test

The second test requires that the process used to discover information must fundamentally rely on principles of the “hard sciences”.4 This includes engineering, computer science, biological sciences, chemistry, or physics.4 If the research relies on the social sciences, arts, humanities, or management studies, it is explicitly disqualified.5 In the context of Maryland’s software sector, this requires that code development must be rooted in computer science principles—such as optimizing algorithms or managing complex data structures—rather than just the aesthetic design of a user interface.7

3. The Permitted Purpose Test

The research must relate to a “qualified purpose,” which is defined as the development of a new or improved function, performance, reliability, or quality of a business component.7 Activities that are excluded under this test include research conducted after the beginning of commercial production, adaptation of an existing business component to a particular customer’s needs, and the duplication of an existing business component.5

4. The Process of Experimentation (POE) Test

The final and most rigorous requirement is that “substantially all” of the research activities must constitute a process of experimentation.8 This is defined as a systematic process designed to evaluate one or more alternatives to achieve a result where the capability, method, or design is uncertain.4

A valid POE generally involves the following iterative phases:

1. Hypothesis Formulation: Identifying a potential solution or design path based on scientific principles.20
2. Design and Modeling: Creating a theoretical framework or computer-aided model to predict outcomes.7
3. Testing and Simulation: Executing physical tests, prototypes, or software simulations to gather data.2
4. Evaluation of Alternatives: Comparing the results of different iterations to determine which best resolves the technical uncertainty.7

The “substantially all” requirement is a quantitative threshold, meaning at least 80% of the activities related to a business component must involve the POE.8 If a project fails this 80% threshold at the aggregate level, taxpayers may use the “shrinking-back rule” to identify smaller sub-components that independently satisfy the test.9

Maryland Revenue Office Guidance and Regulatory Compliance

The administration of the R&D credit in Maryland involves two primary agencies: the Maryland Department of Commerce, which certifies the eligibility of activities and expenses, and the Comptroller of Maryland, which processes the tax returns and audits claims.2

Department of Commerce: Certification and Proration

Maryland law requires taxpayers to apply for certification before claiming the credit on their tax returns.2 The Department of Commerce accepts applications until November 15 of the calendar year following the year in which the R&D expenses were incurred.3 For example, expenses incurred in 2024 must be submitted for certification by November 15, 2025.3

A unique aspect of Maryland’s guidance is the proration of credits. Because the $12 million annual cap is frequently exceeded, the Department of Commerce prorates the certified amounts based on the total volume of applications.2 This is divided into two pools: an $8.5 million pool for large businesses and a $3.5 million pool for small businesses.2 If the small business pool is not exhausted, the remaining funds are reallocated to the large business pool.3

Comptroller of Maryland: Filing and Audit Requirements

Once certified, the credit must be claimed on the Maryland income tax return for the year the expenses were incurred.1 This typically requires filing an amended return (Form 500 for corporations or Form 502 for individuals) and attaching the Department of Commerce’s certification letter.4

The Comptroller’s Office, in its Administrative Release No. 42 and subsequent bulletins, emphasizes that documentation must be “contemporaneous”.2 This means records must be created at the time the research is being performed. Auditors focus heavily on the “nexus” between the expense and the activity: a taxpayer must be able to prove that specific employees spent a specific amount of time on a specific business component that met the POE test.18

Judicial Precedents and the “POE” Burden of Proof

Recent tax court decisions, while federal in origin, are the primary guiding light for Maryland auditors and tax professionals. These cases underscore that “complexity” does not equal “experimentation”.16

Phoenix Design Group, Inc. v. Commissioner (December 2024)

In this pivotal case, the U.S. Tax Court disallowed R&D credits for an engineering firm because it failed to demonstrate a systematic process of experimentation.8 The court found that the firm’s work was largely “routine design” and code compliance.16

• Implication for POE: The court held that performing routine calculations on available data is not experimentation because the necessary information was already known to the engineers.8 To pass the POE test, a firm must show it evaluated multiple, distinct alternatives where the outcome was truly unknown.16

Little Sandy Coal Co., Inc. v. Commissioner (2023)

This case focused on the “substantially all” requirement.20 The taxpayer, a shipbuilding company, claimed that because they were building a new prototype (a “pilot model”), all activities related to its construction were experimentation.20

• Implication for POE: The court rejected this “all-or-nothing” approach, stating that the construction of a pilot model still includes many routine tasks (e.g., standard welding or painting) that do not involve experimentation.20 Taxpayers must be able to break out the time spent on the uncertain parts of the prototype versus the routine parts.9

The 2025 Legislative Shift: The “One Big Beautiful Bill Act” (OBBBA)

The most significant change in the R&D landscape in 2025 is the federal “One Big Beautiful Bill Act” (OBBBA), signed into law on July 4, 2025.17 This act fundamentally alters the tax treatment of R&D expenses by reversing the capitalization requirements of the 2017 Tax Cuts and Jobs Act (TCJA).7

Restoration of Immediate Expensing

Under the TCJA, businesses were forced to capitalize and amortize R&D expenses over 5 years for domestic research and 15 years for foreign research.7 The OBBBA restores the ability for businesses to immediately deduct 100% of their domestic R&D expenses in the year they occur.17

For Maryland businesses, this means that the tax benefit of the R&D credit is no longer diluted by the requirement to spread deductions over several years. Furthermore, the OBBBA provides a “safe harbor” or retroactive relief for small businesses (average receipts under $31M), allowing them to amend 2022-2024 returns to claim immediate deductions and potentially unlock significant cash flow.17

The Maryland “Tech Tax” Interplay

Parallel to federal changes, Maryland implemented a 3% sales and use tax on certain information technology services (IT/software publishing) effective July 1, 2025.31 According to the Comptroller’s Technical Bulletin 56, this tax applies to services classified under NAICS codes for data processing, web hosting, and software publishing.32 While this creates a new tax burden, it simultaneously clarifies the definitions of these activities, often helping businesses align their R&D claims with their sales tax exemptions (e.g., for “custom software” development that involves substantial experimentation).31

Detailed Example: Maryland Medical Device Innovation

To see how the POE test applies in practice, we examine “Sonavex Inc.,” a Maryland-based company that recently won the 2024 Patent of the Year.4 They developed an innovation titled ‘Microcavity-containing polymeric medical devices for enhanced ultrasonic echogenicity’.4

The Technical Uncertainty

Surgical implants are often invisible to ultrasound, making monitoring difficult. Sonavex hypothesized that by embedding tiny air cavities within the polymer structure of an implant, they could create “echoes” that make the device visible on an ultrasound screen.4 The uncertainty involved the “appropriate design”: what size and distribution of cavities would provide maximum visibility without making the polymer too brittle for surgical use?.4

The Process of Experimentation

Sonavex did not simply build one device. They engaged in a systematic process:

• Alternative Evaluation: They tested various polymer blends and cavity geometries (e.g., spheres vs. tubes).4
• Modeling and Simulation: They used acoustic modeling to predict how ultrasound waves would bounce off the microcavities.4
• Iterative Testing: They manufactured several prototypes and tested them in “phantom” tissue models, measuring the acoustic reflection against baseline standards.2
• Documentation: To prove this to the Maryland Department of Commerce, Sonavex maintained “Innovation Logs,” testing protocols, and results from trial runs.4

Because Sonavex could show a clear progression from a hypothesis (microcavities) to a systematic test (acoustic measurements) to a final design, they successfully satisfied the POE requirement.4

Essential Documentation Checklist for Maryland Audits

Documentation is the only defense a taxpayer has during a Maryland Comptroller audit. The burden of proof is entirely on the taxpayer to substantiate that a process of experimentation occurred.18

The most common failure in Maryland audits is the use of “retrospective estimates” where managers guess how much time employees spent on R&D after the year is over.18 Auditors strongly prefer contemporaneous time tracking that names the specific business component being researched.9

Calculating the Benefit: A Mathematical Perspective

The value of the Maryland R&D tax credit depends on the taxpayer’s “fixed-base percentage.” For a mature company, the calculation of the Maryland Growth Credit follows this LaTeX-formatted logic:

$$Maryland\ Base\ Amount = \left( \frac{\sum Maryland\ QREs_{Prior 4 Years}}{\sum Maryland\ Gross\ Receipts_{Prior 4 Years}} \right) \times Average\ Maryland\ Gross\ Receipts_{Prior 4 Years}$$

2

The credit is then:

$$Credit = 0.10 \times (Current\ Year\ QREs – Maryland\ Base\ Amount)$$

2

If a company is a “Small Business” (net book value assets under $5M), the credit is fully refundable if it exceeds the tax liability for the year.2 For larger firms, the credit is non-refundable but can be carried forward for 7 years to offset future Maryland income tax.1

Strategic Analysis: The Future of R&D in Maryland

As Maryland approaches the June 30, 2027 expiration date of the current R&D tax credit program, the legislative and economic environment remains volatile.1 The Board of Revenue Estimates (BRE) recently lowered revenue forecasts due to federal government spending reductions, which may impact future state budget allocations for the $12 million credit cap.36

However, the passage of the OBBBA at the federal level acts as a powerful tailwind. By removing the financial drag of Section 174 amortization, the federal government has made it significantly cheaper for Maryland firms to invest in the systematic processes required by the POE test.17 For Maryland manufacturers and tech firms, the 2025-2027 window represents a unique “double-dipping” opportunity: immediate federal expensing combined with a state-level 10% Growth Credit.17

Concluding Synthesis

The Process of Experimentation is the vital pulse of the Maryland Research and Development Tax Credit. It is not merely a box to be checked, but a demanding standard that requires a narrative of scientific failure and subsequent refinement. Maryland’s regulatory guidance, from the Department of Commerce’s certification proration to the Comptroller’s emphasis on contemporaneous nexus, creates a landscape where documentation is as important as the innovation itself.2

For a business to thrive under these rules, it must move beyond viewing “R&D” as a general department and start viewing it as a specific, documented sequence of technical events. By aligning their internal project tracking with the Four-Part Test—and particularly the systematic POE requirement—Maryland enterprises can secure their share of the $12 million credit pool and drive the state’s innovation economy forward into 2026 and beyond.2 Successful navigation of these requirements, supported by the new favorable rules of the OBBBA, provides a significant competitive edge in an increasingly digital and technically complex marketplace.

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