The Integration of Internal Revenue Code Section 174 and the Nebraska Research and Development Tax Credit: A Comprehensive Regulatory and Statutory Analysis

Internal Revenue Code Section 174 establishes the federal definitional baseline for identifying research and experimental expenditures, serving as the essential criteria for determining eligibility under the Nebraska Advantage Research and Development Act. By anchoring state tax incentives to this federal standard, Nebraska provides a predictable framework for businesses to claim a credit equal to 15 percent of their federal research credit, or an enhanced 35 percent for activities conducted on a local college or university campus.1

The relationship between Section 174 and Nebraska tax law is both foundational and dynamic, as it bridges the gap between federal tax policy and state-level economic development goals. Historically, Section 174 allowed for the immediate expensing of research and development (R&D) costs, a policy that significantly reduced the after-tax cost of innovation for companies operating within the state. However, the implementation of the Tax Cuts and Jobs Act (TCJA) of 2017 fundamentally altered this landscape by mandating the capitalization and amortization of these expenses over a five-year period for domestic research and a fifteen-year period for foreign research, beginning in the 2022 tax year.4 For Nebraska businesses, this federal shift created a mismatch between the timing of cash expenditures and tax deductions, prompting the Nebraska Legislature to intervene. The subsequent passage of Legislative Bill 1023 in 2024 marked a pivotal moment of decoupling, allowing Nebraska taxpayers to restore the immediate expensing of these costs for state income tax purposes starting in 2025.8 To navigate this complex environment, firms must understand not only the technical definitions of qualified research but also the rigorous administrative mandates of the Nebraska Department of Revenue, particularly concerning electronic verification, multi-state apportionment, and the evolving treatment of software development costs.

Technical Foundations: The Meaning of IRC Section 174 in the Experimental Sense

At its core, Section 174 of the Internal Revenue Code (IRC) is the primary vehicle through which the federal government identifies costs incurred for innovation. Unlike Section 41, which provides a credit for increasing research activities, Section 174 governs the deductibility of the underlying expenses.4 Nebraska law explicitly adopts the Section 174 definition to define the universe of activities that qualify for state incentives.1

The Scope of Research and Experimental Expenditures

The Treasury Regulations under Section 1.174-2 define research and experimental expenditures as those incurred in connection with a taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.5 This definition is intentionally broad, encompassing costs incident to the development or improvement of a product, formula, invention, or plant process.11 It is important to distinguish these from ordinary business expenses; the “experimental sense” requires that the activities be intended to discover information that would eliminate uncertainty concerning the development or improvement of a business component.11

Uncertainty exists if the information available to the taxpayer does not establish either the capability or method for developing or improving the product, or the appropriate design of the product.11 Consequently, Section 174 expenses include:

• Wages for personnel directly involved in research, as well as those who directly supervise or support such personnel.11
• Supplies and raw materials consumed during the design, fabrication, or testing phases of a project, provided they are not subject to depreciation or capitalization under other code sections.5
• Contract research expenses, where the taxpayer pays a third party to conduct research on their behalf while retaining the economic risk and the rights to the resulting intellectual property.11
• Patent costs, including attorney fees and other legal expenses incurred in making or perfecting a patent application.4

Software Development as a Mandatory Section 174 Expense

A significant nuance introduced by the TCJA and later clarified by the Nebraska Department of Revenue involves the treatment of software development. Beginning in 2022, the IRC mandates that any cost paid or incurred in connection with the development of software must be treated as a Section 174 expense.4 This remains true regardless of whether the software is intended for sale, lease, or internal use.4 For Nebraska taxpayers, this means that activities once considered routine maintenance or general IT development may now fall under the mandatory capitalization and amortization rules at the federal level, directly affecting the starting point for their Nebraska tax calculations.6

The Nebraska Advantage Research and Development Act: Statutory Framework

The Nebraska Advantage Research and Development Act was enacted in 2005 to foster a competitive environment for innovation within the state.2 The Act provides a refundable tax credit for business firms that make expenditures in research and experimental activities in Nebraska.1 Because the credit is refundable, businesses can receive a direct payment from the state if the credit exceeds their income tax liability, or they can use it to obtain a refund of sales and use taxes paid.2

Eligibility and the Federal Linkage

Under Neb. Rev. Stat. § 77-5803, the state research credit is directly proportional to the federal credit allowed under IRC Section 41.1 While Section 174 provides the definition of the activity, Section 41 provides the calculation mechanism for the credit.11 Therefore, to be eligible for the Nebraska credit, a business must first determine its federal research credit amount attributable to Nebraska-sourced activities.14

The Nebraska Department of Revenue requires that the research satisfy the federal “Four-Part Test” to qualify as an eligible activity 2:

1. Technological in Nature: The research must rely on the principles of physical or biological sciences, engineering, or computer science.2
2. Permitted Purpose: The activity must relate to a new or improved function, performance, reliability, or quality of a business component.11
3. Elimination of Uncertainty: The taxpayer must intend to discover information that would eliminate uncertainty concerning the capability, method, or design of a product or process.11
4. Process of Experimentation: The taxpayer must evaluate alternatives through a systematic process, such as testing, modeling, or trial and error.11

Standard vs. Enhanced Credits

Nebraska offers two tiers of R&D tax credits based on the location where the research is conducted. This tiered structure is intended to encourage collaboration between the private sector and the state’s academic institutions.1

• Standard Research Tax Credit (15%): Any business firm making qualified expenditures in the state is allowed a credit equal to 15 percent of the federal credit allowed under Section 41.1
• Enhanced Research Tax Credit (35%): If the research and experimental activities are conducted on the campus of a college or university in Nebraska, or at a Nebraska facility owned by such an institution, the credit amount increases to 35 percent of the federal credit.1

The enhanced credit is a significant differentiator for Nebraska. Revenue Ruling 29-10-2 clarifies that “on-campus” research only includes the portion of the federal credit derived from activities actually performed at a university facility.3 A firm that performs $90\%$ of its research at its own private lab and $10\%$ at a university facility can only claim the 35% rate on the $10\%$ portion; the remainder is capped at the 15% rate.3

Duration and Continuity of the Credit

The standard 15 percent credit is allowed for the first tax year it is claimed and may be claimed for the following 20 tax years, provided the business continues to earn the federal credit.3 The enhanced 35 percent credit is more time-limited; it is allowed for the first year claimed and for the following four tax years, as long as the campus-based expenditures continue.3 If a business has unused credits, they may be carried forward for up to 20 years.14

Local Revenue Office Guidance: Administrative Mandates and Rulings

The Nebraska Department of Revenue (DOR) issues specific guidance through Revenue Rulings and FAQ documents to ensure compliance with the Research and Development Act. Two primary areas of administrative focus are the mandatory use of the E-Verify system and the precise definition of qualifying campus locations.

Revenue Ruling 29-13-3: The E-Verify Requirement

Nebraska’s incentive programs are strictly conditioned on the legal work eligibility of the taxpayer’s workforce. Revenue Ruling 29-13-3 mandates that any business claiming the R&D credit must utilize the federal E-Verify system to confirm the work eligibility status of all new employees hired in Nebraska during the tax year for which the credit is claimed.3

The DOR enforces this rule with zero tolerance. If a business fails to electronically verify even one new hire during the relevant tax year, the entire R&D tax credit is disallowed for that year.3 Key nuances of this ruling include:

• Timing: Verification must occur within three business days of the hire date, consistent with the federal Memorandum of Understanding.3
• No Retroactive Fix: Taxpayers cannot cure a failure by verifying employees at a later date after discovering an omission.3
• Acquisitions: If a taxpayer acquires an existing Nebraska business, they do not need to verify the existing employees of that business, but all employees hired after the acquisition must be verified.3
• Transfers: Employees hired outside Nebraska and transferred to a Nebraska location are not considered “newly hired” for the purposes of this mandate, provided they were continuously employed by the taxpayer.3

Revenue Ruling 29-10-2: Defining Campus-Based Research

This ruling provides the technical framework for the 35 percent enhanced credit. It clarifies that a “college or university” is defined as an institution of higher learning offering courses that result in a bachelor’s, vocational, associate, technical, or professional degree.3

The DOR emphasizes that the “on-campus” status is determined by the physical location of the research activity, not the location of the taxpayer’s headquarters or the university’s main office.3 For the purposes of this credit, a business must maintain records that specifically isolate on-campus expenditures. If a business conducts research both on and off campus, it must use a consistent method—either actual expenditures or apportionment—to divide the federal credit between the two rates.3

The Impact of Federal Amortization and Nebraska’s Decoupling (LB 1023)

The tax landscape for R&D underwent a major disruption with the TCJA’s modification of Section 174. Starting in 2022, the immediate deduction of R&E costs was replaced with a mandatory amortization schedule: five years for domestic costs and fifteen years for foreign costs.4

The Amortization Burden

Because of the mid-year convention, a company that incurs $1,000,000$ in domestic R&D expenses in 2022 is only permitted a federal deduction of approximately $10\%$ (or $100,000$) in that first year.4 This creates a massive spike in taxable income, as companies must pay taxes on the $900,000$ that they actually spent but cannot yet deduct.4 For many Nebraska startups and mid-sized manufacturing firms, this resulted in an unexpected and significant cash-flow strain.4

Decoupling through Legislative Bill 1023 (2024)

Recognizing the competitive disadvantage this federal rule placed on local businesses, the Nebraska Legislature passed LB 1023, which was signed into law on April 23, 2024.8 This legislation allows Nebraska to “decouple” from the federal amortization requirement.

For tax years beginning on or after January 1, 2025, Nebraska taxpayers may elect to treat Section 174 R&E expenditures as immediate expenses for state tax purposes.8 The law provides that these expenditures “shall be allowed as a deduction, notwithstanding any changes to the Internal Revenue Code related to the amortization of R&E expenditures”.9

Key Provisions of LB 1023:

• Full Expensing: Taxpayers can deduct $100\%$ of their qualified research and experimental expenditures in the year they are paid or incurred.8
• Irrevocable Election: If a taxpayer chooses not to fully expense the costs in the year incurred, they may instead elect to amortize the expenditures over an irrevocable five-year term for Nebraska purposes.8
• Qualified Property: LB 1023 also allows for a $60\%$ immediate deduction for qualified business assets and improvement property under IRC Section 168, further incentivizing capital investment alongside R&D.8

This decoupling represents a significant policy shift, making Nebraska one of the more favorable states for R&D by allowing the acceleration of deductions that remain restricted at the federal level.9

Multi-State Apportionment and Calculation Methodologies

For firms doing business both within and outside of Nebraska, the amount of the research credit must be accurately apportioned to reflect only those activities conducted within the state.1 The Nebraska DOR provides two primary methods for this calculation on Form 3800N Worksheet RD.21

Method I: Property and Payroll Factor Apportionment

This method is often used by established corporations that already calculate apportionment factors for their general state income tax returns. It averages the business’s property and payroll factors for its Nebraska locations relative to its total operations.21

$$\text{Nebraska Factor} = \frac{\left( \frac{\text{Nebraska Property}}{\text{Total Property}} + \frac{\text{Nebraska Payroll}}{\text{Total Payroll}} \right)}{2}$$

The taxpayer then multiplies their total federal research credit by this factor to determine the portion eligible for the Nebraska 15% (or 35%) credit rate.21

Method II: Actual Expenditures Apportionment

This method is generally more precise and is preferred by businesses that can directly track their Qualified Research Expenses (QREs) by location. The credit is determined by dividing the amount expended in research and experimental activities in Nebraska by the total amount expended in such activities globally, and then multiplying that ratio by the federal credit.1

$$\text{Nebraska Credit} = \left( \frac{\text{Qualified Nebraska R\&D Expenses}}{\text{Total Federal R\&D Expenses}} \right) \times \text{Federal Credit} \times 15\% \text{ (or } 35\%)$$

Revenue Ruling 29-10-2 notes that the same method must be used to calculate both the regular and enhanced portions of the credit to ensure that expenditures are not counted twice or incorrectly categorized.3

Example Scenario: Prairie Innovation Systems, LLC

To understand how these rules apply in practice, consider Prairie Innovation Systems, LLC, a hypothetical Nebraska-based biotechnology firm.

Company Profile (Tax Year 2024)

• Total R&D Expenditures (IRC 174): $\$5,000,000$ (all domestic).
• Total Federal Research Credit (IRC 41): $\$450,000$ (as calculated on IRS Form 6765).
• Location of Research:

• $\$3,000,000$ conducted at their proprietary lab in Omaha, NE.
• $\$1,000,000$ conducted at a specialized lab at the University of Nebraska Medical Center (UNMC).
• $\$1,000,000$ conducted at a contractor’s lab in California.

Step 1: Federal Section 174 Treatment

Because it is the 2024 tax year, the company must capitalize and amortize the $\$5,000,000$ at the federal level over five years. Using the mid-year convention, the federal deduction for 2024 is:

$$\$5,000,000 \times \left( \frac{1}{5} \times 0.5 \right) = \$500,000$$

The remaining $\$4,500,000$ is carried on the balance sheet for future amortization.4

Step 2: Nebraska Apportionment (Method II)

Prairie Innovation identifies that $\$4,000,000$ of their $\$ 5,000,000$ total spend occurred in Nebraska.

• Off-Campus Nebraska Ratio: $\frac{\$3,000,000}{\$5,000,000} = 60\%$
• On-Campus Nebraska Ratio: $\frac{\$1,000,000}{\$5,000,000} = 20\%$

Step 3: Credit Calculation

• Standard Credit (15%): $15\% \times (\$450,000 \times 60\%) = \$40,500$
• Enhanced Credit (35%): $35\% \times (\$450,000 \times 20\%) = \$31,500$
• Total Nebraska R&D Credit: $\$40,500 + \$31,500 = \$72,000$.16

Step 4: Refund Election

The company has a Nebraska income tax liability of $\$25,000$. They use $\$25,000$ of the credit to offset this liability. Because the credit is refundable, they receive the remaining $\$47,000$ as a direct cash payment from the state.2

Step 5: Compliance Check

Prairie Innovation must ensure they E-Verified all 12 new employees hired in Omaha during the year. If they failed to E-Verify even one, they would lose the entire $\$72,000$ credit.3

Statistics and Economic Performance of the R&D Act

Nebraska’s investment in R&D through this tax credit is significant. Between the program’s inception in 2006 and the end of 2020, over 460 companies participated in the program, earning a total of $\$72.3$ million in credits.19

Participation Trends and Fiscal Impact

The program has historically been a driver for high-tech and agricultural innovation. According to a 2017 audit by the Legislative Audit Office, the R&D credit was found to be highly competitive, with Nebraska being rated as one of the most favorable tax climates for new R&D companies among its neighboring states (Iowa, Kansas, Missouri, and Colorado).19

In 2020 alone, over $\$10$ million in program credits were used, exceeding the Legislature’s annual estimate of $\$5$ million.19 This growth reflects the increasing importance of software development and technological innovation in Nebraska’s core industries, such as agriculture and manufacturing.16

Sector-Specific Distribution

The 2017 and 2024 reports highlight the diversity of industries benefiting from the Section 174-linked credit:

• High-Tech Sector: Representing $24\%$ of participants, these firms were awarded $\$14.8$ million in credits through 2020. The most prominent sub-sector was Computer Systems Design.19
• Renewable Energy: While a smaller portion of the total, $19$ companies in the renewable energy sector received $\$4.2$ million in credits, primarily focused on agricultural inputs for energy production.19
• Agribusiness: Nebraska’s agriculture sector leverages the credit heavily for crop innovation and equipment R&D, with the refundability feature providing essential cash flow for seasonal operations.16

Reporting Requirements and Filing Procedures

To claim the Nebraska R&D credit, taxpayers must navigate a series of state-specific forms that are filed alongside their federal return. Unlike some other state incentives, the R&D credit does not require a prior application; it is claimed directly on the tax return for the year the expenses are incurred.3

Essential Forms and Worksheets

1. Form 3800N: This is the master form for all Nebraska incentive credits. It identifies the program (using the code “RD”) and distinguishes between refundable and nonrefundable amounts.27
2. Form 3800N Worksheet RD: This worksheet is where the actual state credit is calculated. It requires inputs from Federal Form 6765 and provides sections for the Method I or Method II apportionment.3
3. Schedule K-1N: For partnerships, S-Corps, and LLCs, the credit earned at the entity level is distributed to partners or shareholders via this schedule. However, it is important to note that credits distributed to owners are generally nonrefundable at the individual level and can only be used to offset Nebraska income tax.16

Audit and Documentation Standards

The Nebraska Department of Revenue expects taxpayers to maintain documentation that mirrors federal requirements. This includes:

• Project Logs: Detailed records of the activities performed, linked to the “Four-Part Test”.11
• Payroll Records: Documentation of the time spent by specific employees on qualifying research projects.15
• E-Verify Logs: Verification reports from the federal system for every employee hired during the tax year.3
• Campus Collaboration Agreements: For those claiming the 35% credit, contracts or agreements with the Nebraska college or university detailing the research conducted at their facilities.3

Taxpayers must retain these records for at least three years after filing the return, or three years after the last credit carryforward is used.27

Future Regulatory Shifts: Foreign Adversaries and Sunset Provisions

As Nebraska looks toward the next decade of innovation, two regulatory factors loom large: the 2033 program sunset and the new restrictions on foreign adversarial companies.

The 2033 Expiration Date

The Nebraska Advantage Research and Development Act is currently slated to sunset for tax years beginning after December 31, 2033.2 While the program has been extended in the past, businesses planning long-term, multi-decade research projects must consider the possibility of this expiration.

The Foreign Adversarial Company Rule (2025)

A significant new restriction becomes effective on October 1, 2025. Under Neb. Rev. Stat. § 77-3,114, any company defined as a “foreign adversarial company” (FAC) is ineligible to receive benefits from Nebraska tax incentive programs, including the R&D credit.25

This rule is particularly stringent because it applies retroactively to carried-forward credits. The DOR has indicated that if a business or one of its owners is identified as an FAC, the department will decline to honor existing incentive contracts, even if the business previously fulfilled its investment and employment obligations.31 Designated foreign adversaries currently include China (including Hong Kong and Macau), Cuba, Iran, North Korea, Russia, and the Maduro regime in Venezuela.28 Businesses with international ownership or partners must carefully review these new compliance requirements to avoid the sudden loss of earned credits.

Conclusion: Navigating the Intersection of Section 174 and Nebraska Law

The alignment of Nebraska’s tax incentives with IRC Section 174 represents a sophisticated approach to state-level economic development. By utilizing federal definitions, Nebraska simplifies the qualifying process for innovative firms while maintaining high standards for the technical merit of the research conducted. However, the federal shift to mandatory amortization under the TCJA created a significant hurdle that Nebraska has successfully mitigated through the passage of LB 1023.

For the modern Nebraska business, success in claiming the R&D credit requires more than just technical innovation; it requires rigorous administrative discipline. The mandatory use of E-Verify, the precision required in multi-state apportionment, and the vigilance needed to comply with new foreign adversary restrictions all point to an environment where tax compliance is a primary business function. As the state moves toward the 2025 decoupling and the eventual 2033 sunset, the Research and Development Act remains one of the state’s most powerful tools for fostering an economy built on high-tech manufacturing, advanced agriculture, and academic collaboration. By understanding the nuanced interplay between federal code and state guidance, Nebraska firms can maximize their return on innovation and secure a competitive edge in the regional and national markets.

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