Analysis of the Massachusetts Research and Development Tax Credit: The 65% Contractor Expense Limitation, Small Business Impact, and Pathways for Policy Reform

1. Executive Summary

The Massachusetts research and development tax credit is a cornerstone of the Commonwealth’s strategy to foster a high-growth, innovation-led economy. Governed primarily by Massachusetts General Laws (M.G.L.) c. 63, § 38M, the credit provides a significant financial incentive for corporations to invest in scientific discovery and technological advancement within the state. Since its inception in 1991, the credit has been closely modeled after the federal research credit established under Internal Revenue Code (IRC) § 41, creating a framework where the definition of “qualified research” and “qualified research expenses” (QREs) largely aligns with federal standards.^{1, 2, 3}

However, as the global competition for innovation intensifies and the structural nature of research shifts toward collaborative and outsourced models, specific provisions within the Massachusetts statute—most notably the 65% limitation on contract research expenses—have become points of significant economic and policy friction.

The “haircut” applied to contractor expenses represents a historical administrative proxy that assumes a portion of third-party payments covers non-qualified overhead and profit margins. For the modern startup ecosystem in Massachusetts, particularly in the life sciences and software sectors, this limitation creates a disparate impact. Small businesses and early-stage ventures often lack the capital to maintain massive in-house research facilities and must instead rely on specialized Contract Research Organizations (CROs) to perform critical experimentation.^{4, 5, 6} When these entities are forced to exclude 35% of their primary research costs from credit eligibility, the effective value of the incentive is diminished, creating what some industry advocates describe as an “outsourcing tax” on the state’s most agile innovators.

2. The Statutory Architecture of M.G.L. c. 63 § 38M

The Massachusetts R&D tax credit is available to business corporations subject to the corporate excise tax under Chapter 63.^{7, 8} The statute allows a credit against the excise due, calculated as a percentage of the excess of qualified research expenses for the taxable year over a defined base amount, plus a percentage of basic research payments.^{2, 9, 10} The primary objective of the 1991 legislation was to encourage incremental increases in research spending, ensuring that the tax benefit is tied to expanded innovation rather than merely subsidizing existing activity.^{2, 3}

Calculation Methodologies: Traditional vs. Alternative Simplified

Taxpayers in Massachusetts generally have two options for calculating their research credit, reflecting the evolution of federal law and the state’s commitment to providing flexible incentive structures.

Table 1: Comparison of Research Credit Calculation Methods

The Regular Research Credit (RRC) method relies on a complex “fixed-base ratio” that compares a firm’s research intensity during a historical period (typically 1984–1988) to its more recent gross receipts.^{2, 11} For many modern startups, this calculation is both administratively burdensome and practically impossible due to a lack of historical data. To address this, Massachusetts introduced the Alternative Simplified Method (ASM) for tax years beginning on or after January 1, 2015.^{3, 7} The ASM focuses solely on research expenditures over the preceding three years, eliminating the need for historical gross receipts data and making the credit more accessible to newer firms.^{7, 12, 13}

Utilization Caps and Carryforward Provisions

The utilization of the R&D credit in Massachusetts is restricted by several statutory layers designed to ensure a minimum level of tax contribution from corporations. The credit cannot reduce a taxpayer’s liability below the statutory minimum excise, which is currently $456.^{6, 8, 13} Furthermore, the credit is limited to 100% of the first $25,000 of excise due, plus 75% of the excise in excess of $25,000.^{2, 8, 9, 10}

Unused credits are not lost but are subject to different carryforward rules depending on why they were not used. Credits that exceed the taxpayer’s liability for the year may generally be carried forward for 15 years.^{6, 8, 9, 13} However, credits that are disallowed specifically because of the 75% utilization cap may be carried forward indefinitely.^{2, 8, 10} This distinction is critical for large corporations with massive R&D operations, as it prevents the permanent loss of earned incentives due to annual tax liability limits.

3. The Mechanics of the 65% Contractor “Haircut”

The central tension for many Massachusetts innovators lies in the definition of “qualified research expenses” as applied to external service providers. Under M.G.L. c. 63 § 38M, Massachusetts adopts the federal definition of QREs found in IRC § 41(b), which distinguishes between in-house research expenses and contract research expenses.^{3, 14, 15}

The 65% Inclusion Rule and Its Origins

According to IRC § 41(b)(3), “contract research expenses” are defined as 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.^{4, 15, 16} This 35% reduction—commonly known as the “haircut”—is a non-negotiable statutory limitation.⁴ It applies regardless of the contract’s structure, the actual profit margin of the contractor, or the specific breakdown of costs provided on an invoice.^{4, 16}

The policy rationale behind this exclusion is primarily administrative. When a company conducts research in-house, it can claim 100% of the wages paid to employees directly involved in research, but it cannot claim general administrative overhead, utilities, or rent.^{4, 17, 18} However, a contractor’s fee to a third party naturally includes these overhead costs plus a profit margin.⁴ The 65% inclusion rate was established by the Treasury Department and adopted by Congress as a standardized proxy to strip out these non-qualifying costs without requiring the IRS or state tax authorities to perform complex, project-by-project audits of a contractor’s internal cost structure.⁴

Categorization of Inclusion Rates

While 65% is the standard rate for third-party contractors, the tax code provides for different inclusion levels based on the nature of the research entity.

Table 2: Inclusion Rates by Expenditure Type

In Massachusetts, the 15% credit for basic research payments under M.G.L. c. 63 § 38M(a)(1) is particularly notable, as it offers a higher incentive rate for university-based research compared to the standard 10% rate for qualified research expenses.^{2, 10, 13, 22} This creates a tiered incentive structure that prioritizes fundamental academic collaboration over standard commercial contracting.

Contractual Compliance and Risk

To include even the 65% of contract payments in the R&D credit calculation, the taxpayer must satisfy rigorous contractual and economic requirements. These are often categorized into three “pillars” of compliance derived from federal Treasury Regulation § 1.41-2(e).

First, the agreement must be entered into prior to the performance of the research.¹⁶ Retroactive agreements are generally disallowed, as the credit is intended to incentivize prospective investment. Second, the research must be performed “on behalf of” the taxpayer.^{16, 19} This means the taxpayer must retain “substantial rights” to the research results.¹⁹ If the contractor retains all intellectual property rights and only sells the taxpayer a finished product, the payment is viewed as a purchase of an asset rather than a contract for research.^{4, 19}

Third, the taxpayer must bear the “financial risk” of the research.^{16, 17, 19} If the contract specifies that the taxpayer only pays if the research is successful, the contractor is the one bearing the risk of failure, and thus the contractor—not the taxpayer—is entitled to the credit.^{16, 17, 19} For the taxpayer to claim the 65% expense, they must be obligated to pay the contractor regardless of whether the research yields the desired outcome.^{16, 17}

4. Economic Impact on the Small Business and Startup Ecosystem

The 65% contractor haircut creates a significant structural disadvantage for small businesses and startups, which are often the primary drivers of innovation in Massachusetts. Unlike established “incumbent” firms that possess the capital to build and staff internal laboratories, many early-stage ventures operate on a “virtual” or “distributed” model.^{6, 23, 24}

The Capital-Intensive Barrier

For a startup in the biotechnology or medical device sector, the cost of building a wet lab in Cambridge or Boston is prohibitive. These firms typically outsource early-stage experimentation, clinical trial management, and prototyping to specialized CROs and manufacturing partners.^{6, 23, 25} Under the current tax regime, these startups are essentially penalized for their lack of scale. A large firm conducting the same research in-house can claim 100% of its research wages, while the startup can only claim 65% of its contractor costs for the exact same scientific activity.^{4, 18}

This disparity is mathematically significant. In Massachusetts, the 10% credit rate applied to 65% of an expense results in an “effective” credit of only 6.5% of the total spend.^{4, 18, 26}

Effective Credit Rate = Statutory Rate (10%) × Inclusion Rate (65%) = 6.5%

For a startup spending $1,000,000 on critical clinical testing via a Massachusetts-based contractor, the haircut results in $35,000 in lost credit value compared to an in-house wage model ($100,000 credit for in-house vs. $65,000 for contract).^{4, 13, 26}

The “Valley of Death” and Non-Refundability

A further complication for Massachusetts small businesses is the non-refundable nature of the general R&D tax credit.^{10, 13} Most startups operate at a loss for years before achieving commercialization and profitability. For these pre-revenue firms, a non-refundable credit that only offsets corporate excise tax (beyond the $456 minimum) provides no immediate cash flow benefit.^{6, 13, 26}

While the federal government allows “qualified small businesses” (those with less than $5 million in gross receipts) to apply up to $500,000 of their R&D credits against the employer portion of Social Security payroll taxes, Massachusetts does not have a general state-level payroll tax offset.^{17, 20, 26} This forces Massachusetts startups to carry forward credits for up to 15 years, during which time the “time value of money” significantly erodes the incentive’s actual utility.^{6, 10, 13}

The CRO Sector and Leakage

The 65% haircut also has second-order effects on the Massachusetts service sector. Because the credit is only available for research conducted at a research facility located in Massachusetts, the tax code encourages firms to hire local contractors.^{3, 11, 14} However, if the 35% penalty is too high, companies may find that the combined benefit of the Massachusetts R&D credit is not enough to offset the lower labor or overhead costs of contractors in other states or countries.^{14, 19} This can lead to “innovation leakage,” where the high-value research services are offshored, and the Commonwealth loses not just the tax revenue, but the high-skilled jobs associated with the CRO sector.^{14, 27}

5. Comparative Analysis: How Massachusetts Competes with Innovation Hubs

To evaluate the impact of the Massachusetts R&D credit, it is necessary to compare its design features with other states that actively compete for the same talent and capital.^{28, 29}

California: High Rates but Rigid Structure

California offers a 15% credit for incremental research, which is higher than the Massachusetts 10% rate.^{28, 30} Like Massachusetts, California applies the 65% contractor haircut.^{31, 32} However, California has historically been more rigid, refusing to conform to the federal Alternative Simplified Credit (ASC) method for nearly two decades.^{28, 33} It was only with the passage of Senate Bill 711 in late 2025 that California finally adopted an ASC version, but at significantly lower rates (1.3% or 3%) compared to the federal 14%.^{30, 33, 34} California’s credits are non-refundable and do not allow payroll tax offsets, but they can be carried forward indefinitely, a feature Massachusetts only offers for credits disallowed by the 75% rule.^{28, 32}

New York: The Refundability Leader

New York represents the most significant competitive threat to Massachusetts regarding startup incentives.^{29, 35} Through programs like the Excelsior Jobs Program and the Life Sciences Research and Development Tax Credit, New York offers fully refundable R&D credits.^{29, 35} For a pre-revenue startup, a 6% refundable credit in New York is often more valuable than a 10% non-refundable credit in Massachusetts.²⁹ New York does not limit the amount by which credits can reduce tax liability, providing a “clearer” benefit than the Massachusetts 75% rule.²⁹

New Jersey: Flexibility through Credit Transfers

New Jersey provides a 10% credit for QREs and basic research payments, similar to Massachusetts.^{36, 37, 38} A unique feature of the New Jersey ecosystem is the Tax Certificate Transfer Program, which allows small and mid-sized biotechnology and technology firms to sell their unused R&D tax credits and net operating losses (NOLs) to profitable companies for cash.³⁷ This program provides immediate non-dilutive capital to startups, effectively bypassing the limitations of non-refundability.³⁷

Connecticut: Targeted Vouchers and Pass-Through Access

Connecticut has recently been aggressive in reforming its R&D incentives to support small businesses.^{12, 39} In 2024 and 2025, legislative pushes aimed to expand the credit to pass-through entities like LLCs and partnerships, which were previously ineligible.^{12, 39} Connecticut’s proposed small business tax credit voucher program would allow companies with less than $70 million in gross income to claim a 6% credit, with the ability to exchange unused portions for a cash refund at 65% of their value (and up to 90% for biotechnology firms).^{29, 39}

6. The Life Sciences Exception: A Model for Reform?

Massachusetts has already recognized the limitations of the general R&D credit for startups in one specific sector: Life Sciences. Through the Massachusetts Life Sciences Center (MLSC) Tax Incentive Program, certified life sciences companies can access a suite of enhanced benefits.^{6, 23}

Refundability and Job Creation

Under M.G.L. c. 23I and the related tax provisions in Chapter 63, certified life sciences companies can apply for a refund of up to 90% of their unused R&D credits.^{6, 29} This program is discretionary and requires companies to meet specific job creation and capital investment targets.^{6, 23}

Table 3: Comparison of General vs. Life Sciences Incentives

The MLSC program serves as a “proof of concept” for sector-wide reform. By providing cash refunds, the state has successfully anchored the biotechnology industry in Massachusetts despite high costs of living and doing business.^{23, 25, 42} However, this “life sciences exception” creates an unlevel playing field for other innovative sectors—such as clean energy, robotics, and artificial intelligence—that face the same 65% contractor haircut and non-refundability challenges but do not qualify for MLSC certification.^{23, 25}

7. Legislative Solutions and Policy Proposals (2023–2026)

The period between 2023 and 2026 has seen a flurry of legislative activity in Massachusetts aimed at modernizing the R&D tax framework to address the concerns of small businesses and the impacts of federal tax changes.^{12, 43, 44, 45}

The “Super Research and Development Tax Credit” (Senate Bill 2080)

Introduced by Senator Bruce Tarr in early 2025, Senate Bill 2080 (and its predecessor SD184) proposes the creation of a “Super Research and Development Tax Credit”.^{44, 46} This credit would be available as an additional incentive for companies that increase their research spending beyond a historical baseline.^{44, 46}

The “Super Credit” would be equal to the excess of a company’s current QREs over a “super credit base amount,” defined as the average research spending from the previous five years, increased by 50%.^{44, 46}

Super Credit Base = (Average QREs_5-year) × 1.50

While this bill does not directly eliminate the 65% contractor haircut, its 100% credit rate for “super-incremental” spending would provide a massive boost to companies that are aggressively scaling their Massachusetts-based research, effectively “pricing out” the penalty of the contractor haircut through higher overall subsidy rates.^{44, 46} The credit would be limited to 50% of the taxpayer’s liability and could be carried forward for five years.^{44, 46}

Expanding the Sales Tax Exemption to LLCs (House Bill 3168)

Small businesses are often organized as limited liability companies (LLCs) or partnerships for tax flexibility. However, the Massachusetts sales tax exemption for R&D equipment—a vital incentive that covers 100% of the cost of machinery and supplies—has historically been restricted to “manufacturing corporations” and “research and development corporations”.^{22, 40, 41}

House Bill 3168, presented by Representative Jay Livingstone, seeks to extend this exemption to LLCs, partnerships, and other non-corporate entities primarily engaged in R&D.^{40, 41} This legislative update is designed to support a wider range of business structures, ensuring that a startup’s choice of legal entity does not disqualify it from critical tax savings on lab equipment and prototypes.⁴⁰ The bill would require the Department of Revenue to issue specific guidance for these entities to apply for the exemption, likely involving an annual statement confirming their primary research focus.⁴⁰

The OBBBA and the Conflict over Conformity (HB 4975)

Perhaps the most significant challenge facing Massachusetts businesses in 2026 is the state’s response to the federal “One Big Beautiful Bill Act” (OBBBA) of 2025.^{45, 47} The OBBBA restored full and immediate expensing for domestic R&D costs under a new IRC Section 174A, reversing the widely disliked five-year amortization requirement that had been in place since 2022.^{5, 20, 43, 47}

While the OBBBA provides much-needed federal relief, Massachusetts Governor Maura Healey introduced House Bill 4975 in early 2026 to temporarily delay Massachusetts’ conformity to these federal changes.⁴⁵ If enacted, HB 4975 would force businesses to continue amortizing their R&D costs for Massachusetts tax purposes through 2025, even though they can fully deduct those same costs on their federal returns.⁴⁵

For a small business, this “decoupling” from federal law is a major financial blow. It results in higher Massachusetts taxable income, increased estimated tax payments, and significant administrative complexity as firms must maintain two separate sets of books for R&D costs.⁴⁵ The administration’s rationale for the delay is “budget stability and revenue forecasting,” but industry groups argue that this short-term revenue gain for the state comes at the expense of the very startups the Commonwealth is trying to cultivate.⁴⁵

8. Deep Insight: The Economic Justification for Reform

The debate over R&D tax policy is not merely about tax rates; it is about the “social return” on innovation. Research spending creates “spillovers”—benefits that the investing firm cannot fully capture.⁴⁸ When a Massachusetts biotech company discovers a new drug or a software firm develops a new encryption protocol, the knowledge spreads, leading to new startups, improved health outcomes, and increased productivity across the economy.⁴⁸

Social Returns and Marginal Effective Tax Rates

Economists typically estimate that the social return to R&D is two to four times higher than the private return.⁴⁸ This “positive externality” provides the economic justification for government intervention via tax subsidies. Without corporate tax benefits, the Marginal Effective Tax Rate (METR) on new investment is estimated at 27.2%.⁴⁸ With the addition of expensing and the R&D credit, the METR falls to minus 30.3%—effectively a subsidy that encourages firms to undertake projects that would otherwise be unprofitable on a purely private basis.⁴⁸

Table 4: Impact of Tax Benefits on Marginal Effective Tax Rate (METR)

The 65% contractor haircut directly undermines this objective. By increasing the user cost of capital for firms that outsource research, the haircut reduces the likelihood that socially beneficial research will be conducted in Massachusetts.^{14, 48}

The Entrepreneurship Quality-Quantity Tradeoff

A striking insight from recent MIT studies is that state-level R&D credits do more than just increase the number of new firms; they increase the quality of those firms.^{24, 49} While general “investment tax credits” (which focus on capital equipment) can sometimes reinforce the power of large, established businesses and create barriers to entry for new firms, the R&D credit facilitates the “science-driven” entrepreneurship that leads to high-growth outcomes.²⁴

Areas introducing R&D tax credits experience a 20% rise in “high-quality” new-firm formation over a 10-year period.^{24, 49} However, this study also found that “investment tax credits” were associated with a 12% drop in high-quality firm growth, as they favored incumbents.²⁴ This suggests that Massachusetts’ policy of focusing on the R&D credit rather than broad-based capital subsidies is correct, but only if the credit is accessible to the startups that generate that high-quality growth.

9. Strategic Policy Recommendations for Massachusetts

To address the unsatisfied requirements of the small business community and maintain the Commonwealth’s lead in the “knowledge economy,” the following policy solutions should be evaluated by the 194th General Court and the Department of Revenue.

1. Modernizing the Contractor Inclusion Rate

The current 65% inclusion rate is a relic of the early 1980s. In the modern research environment, the overhead and profit components of CRO fees are often much lower than 35%.^{4, 18, 19} Furthermore, many CROs are themselves R&D-intensive companies.

Massachusetts should consider increasing the inclusion rate to 75% or 80%, specifically for “domestic” contract research conducted at facilities within Massachusetts.^{14, 19} This would align with the 75% rate already offered for university-based research and would provide a powerful incentive for firms to keep their contract work within the state’s research ecosystem.^{14, 15, 18}

2. Implementing a Sector-Neutral Payroll Tax Offset

The Life Sciences Tax Incentive Program proves that refundability works, but its discretionary nature and sector-specific focus exclude a significant portion of the innovation economy.^{6, 23, 25}

Massachusetts should adopt a statutory payroll tax offset for “qualified small businesses” across all industries.^{17, 20, 26} By allowing startups with less than $5 million in gross receipts to use their R&D credits to offset the employer’s share of state-level payroll taxes (such as unemployment insurance or the Paid Family and Medical Leave excise), the Commonwealth would provide immediate, non-discretionary liquidity to the companies that need it most.^{20, 26}

3. Streamlining Documentation for Small Claims

The recent move by the IRS toward business-component-level reporting (Form 6765, Section G) will impose a disproportionate administrative burden on small firms.^{20, 47} Massachusetts should consider a “Safe Harbor” provision for small business R&D claims under a certain threshold (e.g., $100,000 in credits).^{5, 47, 48} This would allow startups to claim the credit with simplified documentation requirements, reducing the need for expensive CPA-verified reports and audit defense specialists during their most vulnerable growth stages.^{4, 12, 47}

4. Fully Conforming to OBBBA Section 174A

To maintain tax competitiveness with states that follow rolling conformity, Massachusetts should reject the proposed two-year delay in OBBBA conformity found in HB 4975.⁴⁵ Allowing full and immediate expensing of R&D costs for state tax purposes would align the Commonwealth with federal priorities and prevent the “phantom income” tax hikes that threaten to drain the cash reserves of early-stage software and biotech firms.^{45, 47}

10. Administrative and Technical Nuances in Audit Defense

For professional practitioners, the impact of the 65% rule is often felt most acutely during the “data validation” and “audit” phases of a credit claim.^{10, 42}

The Behavioral Control Test

Proving that a contractor is “other than an employee” is a critical defense mechanism against penalties.⁴ The IRS and MA DOR focus on three areas of control: behavioral, financial, and the relationship of the parties.⁴ To secure a claim for the 65% contractor expense, firms must document that they did not exercise “behavioral control” over the contractor—meaning the contractor determined the how of the research, while the taxpayer only determined the what.⁴

Substantiating the “Knowledge Gap”

Even if a contractor is properly classified, the 65% payment is only includible if the activity satisfies the “Process of Experimentation” (POE) test.^{4, 20, 50} Audit preparation must include records demonstrating how the company established that no existing products or processes offered a suitable solution—essentially proving the “knowledge gap” that the research was intended to bridge.^{4, 20} If the contractor was merely performing “routine adaptation” or “standard engineering,” the 65% payment will be disallowed entirely, regardless of the contractual terms.^{4, 20}

11. Conclusion: The Path Forward for the Commonwealth

The Massachusetts R&D tax credit is a vital but increasingly strained instrument of economic policy. While the 65% contractor haircut was intended as a simplified administrative proxy, it now acts as a barrier to the decentralized, collaborative research models that define the 21st century. The structural disadvantage this creates for small businesses—compounded by non-refundability and the looming threat of conformity delays—risks cooling the very entrepreneurial “take-off point” that fuels the state’s long-term prosperity.

By modernizing the contractor inclusion rate, expanding access to refundability through payroll tax offsets, and fully aligning with federal full-expensing rules, Massachusetts can ensure that its tax code remains a catalyst for, rather than a drag on, scientific discovery. The evidence suggests that for every dollar the Commonwealth “loses” in tax revenue through these reforms, the social and economic returns in the form of high-quality firm formation, high-skilled job growth, and technological breakthrough will be several times greater. The path forward requires a transition from a tiered, discretionary incentive model to a more inclusive, neutral, and liquidity-focused framework that recognizes innovation in all its forms.

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