Comprehensive Analysis of the Business Component Test within the Nebraska Research and Development Tax Credit Framework

The Business Component Test serves as the foundational unit of analysis for the Research and Development (R&D) tax credit, requiring that research activities be evaluated specifically in relation to a unique product, process, software, formula, invention, or technique intended for sale or trade. In the context of the Nebraska Advantage Research and Development Act, this test ensures that state-level tax incentives are precisely targeted toward technological advancements that enhance the functionality, performance, reliability, or quality of specific commercial assets within the state’s borders.

Theoretical and Statutory Foundations of the Business Component

The Business Component Test is not a standalone concept but represents the second pillar of the “Four-Part Test” mandated by Internal Revenue Code (IRC) Section 41(d). For any expenditure to qualify for the Nebraska R&D credit, the underlying activity must first satisfy the federal criteria for “qualified research”.1 Nebraska law adopts these federal definitions wholesale, creating a symbiotic relationship between federal tax theory and state tax administration.2 Under IRC § 41(d)(2)(B), a business component is defined as any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer.6

The significance of this definition cannot be overstated in a professional tax context. It establishes the “unit of analysis” for the entire credit claim. Rather than evaluating a company’s R&D department as a whole, auditors and taxpayers must “shrink back” their analysis to each specific component.9 This ensures that the tax benefit is tied directly to the innovation of discrete assets rather than general business improvements. For instance, if a manufacturing firm is developing a new harvester, the harvester itself is the business component. However, if the harvester as a whole fails the other parts of the four-part test, the firm may “shrink back” to evaluate the specific hydraulic system or the GPS-guided steering software as independent business components.10

The Nebraska Advantage Research and Development Act: Legislative Context

The Nebraska Advantage Research and Development Act was enacted to improve Nebraska’s competitive position in attracting and retaining knowledge-based industries.12 Unlike many state programs that require a pre-approval process or competitive application, Nebraska’s R&D credit is entitlement-based, meaning any business that meets the statutory requirements may claim the credit on its annual tax return.12

The credit is structured to provide a direct percentage of the federal R&D tax credit allowed under IRC § 41.2 This structural choice means that the strength of a Nebraska claim is entirely dependent on the taxpayer’s ability to defend their “qualified research activities” (QRAs) and “qualified research expenditures” (QREs) under federal standards.5 The Nebraska credit primarily offers two distinct rates, which are summarized in the following table.

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A critical administrative feature of the Nebraska credit is its refundability. Business firms can elect to receive the credit as a refund of sales and use taxes paid or as a refundable income tax credit.5 This is a powerful liquidity tool for startups and agribusinesses that may be in a loss position during their initial years of intense product development.5

The Business Component Test: The Permitted Purpose Requirement

In professional tax literature, the Business Component Test is often referred to as the “Permitted Purpose Test”.3 This title reflects the requirement that the research must be undertaken for a purpose that the law deems “permitted.” Specifically, the research must relate to a new or improved function, performance, reliability, or quality of the business component.2

This test effectively filters out activities that do not contribute to the technological advancement of the product. For example, research conducted for the purpose of improving the aesthetic appeal of a product—such as changing the color or style of a consumer electronic device—does not satisfy the Permitted Purpose Test because aesthetics do not relate to function, performance, or reliability.1 Similarly, activities related to market research, consumer surveys, or efficiency studies are excluded because they do not involve the discovery of technological information to solve a technical uncertainty.1

The table below outlines the relationship between common research objectives and their eligibility under the Business Component Test.

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Administrative Guidance from the Nebraska Department of Revenue

The Nebraska Department of Revenue (DOR) provides clarity on the application of the R&D credit through Revenue Rulings and General Information Letters (GILs). These documents are essential for taxpayers to understand how the state interprets specific nuances of the Business Component Test.

Revenue Ruling 29-10-2 and the Campus Definition

A major point of contention for many taxpayers is the definition of a “campus” for the purpose of the 35% enhanced credit. Revenue Ruling 29-10-2 clarifies that the enhanced credit is available only if the research activity physically takes place on the campus of a Nebraska college or university, or at a facility owned by such an institution.15 The ruling explicitly states that the phrase “in this state” refers to the location of the research, not the headquarters of the university.15 This means that a business partnering with a remote branch of a university may still qualify for the 35% rate, provided the work is conducted within the physical boundaries of that Nebraska-based facility.15

The E-Verify Compliance Mandate

Nebraska is unique in its strict integration of labor law and tax incentives. Since 2009, any business firm claiming the R&D tax credit must use the federal E-Verify system to confirm the work eligibility of all new employees hired in Nebraska during the tax year.12 Revenue Ruling 29-13-3 and subsequent guidance emphasize that non-compliance with the E-Verify mandate is a fatal error that can lead to the total disqualification of the credit for that period.5 This serves as a critical administrative hurdle that necessitates contemporaneous HR recordkeeping alongside technical research logs.

Apportionment and Multi-State Activity

For enterprises with research activities spanning multiple states, Nebraska law requires that the credit be apportioned.5 The DOR provides two primary methods on Form 3800N Worksheet RD:

1. Method I (Property and Payroll): This method uses a traditional two-factor apportionment formula based on the ratio of Nebraska research property and payroll to total research property and payroll.19
2. Method II (Actual Expenditures): This method allows for direct tracing of qualified expenses incurred specifically within Nebraska.19

The selection of the apportionment method is made annually on the tax return and is generally irrevocable for that year.5 This creates a strategic decision point for tax directors to determine which method maximizes the state-level benefit based on their specific operational footprint in the state.

Strategic Analysis of the Shrinking-Back Rule

The “Shrinking-Back Rule” is perhaps the most misunderstood yet vital component of the Business Component Test. Treas. Reg. § 1.41-4(b)(2) provides that the four-part test is first applied at the level of the entire product or process. However, if the entire product fails to meet the criteria, the test is applied to the next most significant subset of elements.10

This rule is a double-edged sword. While it allows a taxpayer to save a portion of their credit if the overall project is deemed “routine,” it also requires a much higher level of documentation.10 Taxpayers must be able to segregate labor hours, supply costs, and contractor payments at the sub-component level.7 In a Nebraska manufacturing context, if a company is developing a new specialized tractor, and only the transmission system involves a new technological discovery while the rest of the chassis uses existing technology, the “business component” for the purpose of the credit must be shrunk back to the transmission.11

The implications for the Nebraska state credit are significant. Since the state credit is a percentage of the federal credit, any “shrinking back” that reduces the federal QREs will lead to a proportional reduction in the Nebraska refundable credit. This underscores the importance of granular project tracking from the outset of the research initiative.

Statistical Trends in Nebraska’s Innovation Economy

The Nebraska Advantage Research and Development Act has been a cornerstone of the state’s economic development strategy. A comprehensive performance audit through 2020 highlights the program’s reach and the types of companies utilizing the credit.13

Participation and Economic Impact

Between 2006 and 2020, 460 companies were awarded approximately $72.3 million in credits.13 The high utilization rate (93.7%) suggests that the credit is a reliable source of capital for innovative firms.13 However, the audit also identified that Nebraska’s R&D spending intensity remains lower than neighboring states like Iowa and Kansas, prompting ongoing legislative discussions about the effectiveness of the current 15% rate.13

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The dominance of the Agriculture and Manufacturing sectors (collectively 72% of awarded credits) reflects Nebraska’s industrial base. For these companies, the Business Component Test often focuses on process improvements—such as the development of more efficient chemical formulations for fertilizers or the invention of new precision-planting techniques.5

Detailed Example: Agricultural Engineering at “Nut & Co.”

To bridge the gap between theory and practice, consider the case of “Nut & Co.,” a Nebraska-based firm that specializes in the design and construction of pecan shelling equipment.4

Identifying the Business Component

Nut & Co. launches a project to develop an “Automated Precision Shelling System” that uses high-speed sensors to detect nut size and adjust shell-cracking pressure in real-time. The Business Component is identified as the entire integrated shelling system.4

Applying the Four-Part Test

• Section 174 (Uncertainty): The team is uncertain whether the sensors can operate at the speeds required without creating excessive dust that blinds the optical lens.1
• Technological in Nature: The project relies on principles of mechanical engineering and computer science (the algorithm used for pressure adjustment).2
• Permitted Purpose: The goal is to improve the functionality (efficiency) and quality (reducing broken nut meats) of the system.4
• Process of Experimentation: Nut & Co. engineers develop conceptual drawings, build three different iterations of the sensor housing, and conduct trial-and-error testing with different air-flow configurations to clear dust.4

Quantitative Application of the Nebraska Credit

The company determines that 100% of the project activities take place in Nebraska. They allocate $1,100,000 in QREs to this project, resulting in a federal credit of $96,250.2

$$Federal\ Credit\ = \$1,100,000 \times 8.75\% = \$96,250$$

Because the research was conducted in their own private lab (off-campus), the 15% Nebraska rate applies:

$$Nebraska\ State\ Credit\ = \$96,250 \times 15\% = \$14,438$$

Nut & Co. claims this $14,438 as a refundable credit on their Nebraska Form 1120N, providing them with immediate cash flow to fund the next phase of their prototype development.2

New Federal Compliance Realities: Form 6765 Modifications

For tax years 2024 and beyond, the IRS has significantly increased the reporting requirements for R&D credits through modifications to Form 6765.7 These changes make the Business Component Test the central unit of compliance reporting.

Section G: The Business Component Breakdown

Under the new rules, many taxpayers must now explicitly list each business component on Form 6765 and allocate wages, supplies, and contract research costs to each one individually.7 For a Nebraska firm, this means that the aggregate “R&D expense” line on their internal books is no longer sufficient for tax purposes.9 They must maintain a system that maps every hour of engineer labor to a specific “business component” identified in their technical logs.7

This “Business Component as the Unit of Analysis” approach is intended to help the IRS (and by extension, the Nebraska DOR) identify “deficient analyses” where taxpayers fail to meet the 80% “substantially-all” threshold for experimentation.7 If a business defines its components too broadly to minimize the reporting burden, they risk the entire project being disqualified during an audit.9

Judicial Precedents and Audit Defense Strategies

The Business Component Test is frequently the focal point of tax court litigation. In Grigsby v. Commissioner (2023), the Fifth Circuit emphasized that the four-part test must be applied separately to each business component and that the taxpayer bears the burden of clearly defining these components in their documentation.8

Similarly, in Phoenix Design Group, Inc. v. Commissioner (2024), the court disallowed credits because the taxpayer’s “six-stage design process” was found to be a linear, routine engineering workflow rather than a truly iterative process of experimentation intended to resolve a technological uncertainty.11 The court’s imposition of a 20% accuracy-related penalty serves as a stark warning to firms that rely on “standard calculations” rather than documented experimental iterations.11

Best Practices for Nebraska Taxpayers

To mitigate the risk of credit disallowance, Nebraska businesses should implement the following strategies:

1. Contemporaneous Documentation: Document technical uncertainties and alternative evaluations as they occur. Emails, meeting minutes, and project logs are far more persuasive than post-hoc narratives created years later during an audit.9
2. Granular Time Tracking: Utilize project management software (such as Jira or specialized R&D tracking tools) to link employee time directly to specific business components.9
3. Third-Party Oversight: For contract research, ensure that contracts explicitly state that the taxpayer retains the “substantial rights” to the research and bears the “financial risk,” as these are prerequisites for the Business Component Test in a contract setting.9

Conclusion

The Business Component Test is the critical filter through which all R&D innovation must pass to achieve tax-favored status in Nebraska. By adopting the federal standard, the Nebraska Advantage Research and Development Act creates a high bar for technical substantiation, requiring a deep alignment between a firm’s engineering efforts and its tax reporting. As federal documentation requirements become more granular with the advent of the revised Form 6765, the ability of Nebraska firms to precisely identify, track, and defend their unique business components will differentiate successful innovators from those who face costly audit adjustments. In an increasingly competitive national landscape, the Nebraska R&D credit remains a potent, refundable incentive for those willing to commit to the rigorous documentation and technological experimentation that the law demands.

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