Internal Revenue Code (IRC) Section 41

Internal Revenue Code Section 41 defines the federal research credit that New Mexico uses to identify qualifying technical innovation and expenditures. New Mexico integrates this federal definition into a dual-tiered state credit system that provides significant tax offsets for technology-based businesses creating jobs within the state.

The intersection of federal tax law and state-level incentives creates a sophisticated fiscal environment for technology companies operating within New Mexico. While the federal Credit for Increasing Research Activities—Internal Revenue Code (IRC) Section 41—focuses primarily on rewarding incremental growth in research spending at a national level, the New Mexico Technology Jobs and Research and Development Tax Credit Act leverage these federal definitions to achieve localized economic objectives. By adopting the rigorous Four-Part Test established under IRC § 41(d), New Mexico ensures that state tax expenditures are directed toward genuine scientific and technological advancement, rather than routine business activities. This alignment allows taxpayers to utilize a single set of documentation to support both federal and state claims, although the state-specific application involves unique nuances regarding facility locations, payroll growth benchmarks, and specific tax types against which the credits may be applied. The state’s guidance, primarily found in New Mexico Taxation and Revenue Department (TRD) publication FYI-106 and the Administrative Code, provides the procedural roadmap for translating these complex federal requirements into state-level tax savings.

The Federal Prism: Understanding IRC Section 41 and the Four-Part Test

Internal Revenue Code Section 41, technically titled the “Credit for Increasing Research Activities,” is widely regarded by the United States Tax Court as one of the most complex provisions in the code. Its primary function is to incentivize private-sector investment in innovation by providing a non-refundable tax credit for qualified research expenses (QREs). To grasp the New Mexico credit, one must first master the federal definitions that serve as its bedrock.

The Section 174 Requirement: Permitted Purpose

The first hurdle for any research activity to be considered “qualified” under Section 41 is that the associated expenditures must qualify as research and experimental expenditures under Section 174. This implies that the costs must be incurred in connection with the taxpayer’s trade or business and represent research and development costs in the experimental or laboratory sense. The focus here is on the nature of the activity: it must be intended to develop or improve a business component’s functionality, performance, reliability, or quality. A business component is defined broadly to include any product, process, computer software, technique, formula, or invention that the taxpayer intends to hold for sale, lease, or license, or use in its own trade or business.

This requirement serves as a gatekeeper, filtering out expenditures that are merely administrative or aesthetic. For example, if a company is researching a new method of crushing grapes to increase the efficiency of juice extraction, the $2,000 spent on labor and materials for laboratory testing would likely meet this threshold. However, if the company were merely testing a new label design for the wine bottles, the cost would fail this test because it relates to “style, taste, cosmetic or seasonal design factors” rather than functional improvement.

The Technological in Nature Test

The second part of the test requires that the research fundamentally rely on the principles of the “hard sciences”. This includes the physical sciences, biological sciences, engineering, or computer science. The process of experimentation must use these principles to discover information that is technological in nature.

The exclusion of “soft sciences” is a critical distinction. Research in the social sciences, arts, humanities, or business management does not qualify. For instance, a study to determine whether a new office layout increases employee morale is a management study based on social science, not a technological inquiry based on engineering or computer science, and thus fails the test.

The Elimination of Uncertainty Test

Under Section 41, a taxpayer must demonstrate that the research was undertaken for the purpose of discovering information that would eliminate uncertainty regarding the development or improvement of a business component. Uncertainty exists if the information available to the taxpayer at the beginning of the research activity does not establish the capability or method for developing or improving the component, or the appropriate design of that component.

It is important to note that the taxpayer does not have to be the first person in the world to attempt the research; the uncertainty must simply exist for the taxpayer at the project’s inception. If a company knows exactly how to build a product but chooses to research a more expensive way to do it for non-functional reasons, there is no technological uncertainty to be resolved, and the credit is unavailable.

The Process of Experimentation Test

The final and perhaps most rigorous part of the test is the requirement that substantially all of the activities constitute elements of a process of experimentation. The IRS defines “substantially all” as at least 80 percent of the research activities, measured on a cost or other reasonable basis. A process of experimentation involves evaluating one or more alternatives to achieve a result where the capability, method, or design is uncertain.

This process typically follows a systematic trial-and-error cycle:

• Identifying the technological uncertainty.
• Formulating one or more alternatives intended to eliminate that uncertainty.
• Conducting a systematic process to evaluate those alternatives, such as modeling, simulation, or systematic testing.

The “shrink-back” rule is an essential concept here. If the requirements are not met at the level of the entire product, the test is applied to the most significant subset of elements of the product, essentially “shrinking back” until a qualifying component is found.

Statutorily Excluded Activities

Even if an activity passes the four-part test, it may still be disqualified by specific exclusions under Section 41(d)(4). These exclusions prevent the credit from being used for activities that are considered routine or occur after the innovation phase:

Excluded Activity	Description and Impact
Research After Commercial Production	Includes preproduction planning, tooling up, trial production runs, and troubleshooting production equipment.
Adaptation	Adapting an existing business component to a specific customer’s requirement or need.
Duplication	Reproducing an existing component from physical examination, blueprints, or specifications.
Surveys and Studies	Efficiency surveys, management studies, consumer surveys, market research, and routine data collection.
Foreign Research	Any research conducted outside the United States, Puerto Rico, or U.S. possessions.
Funded Research	Research to the extent it is funded by any grant, contract, or other person or governmental entity.

The New Mexico Framework: NMSA 1978 § 7-9F

The New Mexico “Technology Jobs and Research and Development Tax Credit Act” (NMSA 1978 §§ 7-9F-1 to 7-9F-13) serves as the state’s primary vehicle for incentivizing technological growth. The stated purpose of the act is to provide a favorable tax climate for technology-based businesses and to promote increased employment and higher wages in those fields.

Statutory Definition of Qualified Research in New Mexico

New Mexico law (NMSA 7-9F-3) adopts the core principles of IRC Section 41 but applies them with a specific geographic and facility-based focus. Under the state act, “qualified research” means research that is undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component, and where substantially all activities involve a process of experimentation.

However, the state law adds a critical requirement: the research must be conducted at a “qualified facility” in New Mexico. A qualified facility is defined as a factory, mill, plant, refinery, warehouse, building, or complex of buildings located within the state, including the land and equipment used in connection with its operation. Notably, a facility operated for the United States government or its agencies is specifically excluded.

The Dual-Credit Structure

New Mexico offers two distinct types of credits under this act, each targeting different aspects of a business’s tax liability and growth profile.

1. The Basic Credit: Equal to 5 percent of qualified expenditures (or 10 percent in rural areas). This credit is applied against the state’s portion of gross receipts tax (GRT), compensating tax, or withholding tax.
2. The Additional Credit: Provides an additional 5 percent of qualified expenditures (or 10 percent in rural areas). This credit is applied against the taxpayer’s personal or corporate income tax liability.

Qualified Expenditures Defined

A “qualified expenditure” in New Mexico is defined as an expenditure or an allocated portion of an expenditure made in connection with qualified research at a qualified facility. These expenditures are more varied than federal QREs and include:

• Wages: Payments to employees performing, supervising, or supporting qualified research at the facility.
• Supplies and Materials: Test materials, technical books, manuals, and consumables used in research.
• Contract Services: Payments to New Mexico-based consultants and contractors for research-tied services.
• Equipment and Software: Machinery, equipment, and computer software/upgrades used directly in research at the facility.
• Facility Operating Expenses: Allowable expenses for maintaining the facility, including depletable land and rent for land or improvements.

There is a $5 million annual cap on the amount of qualified expenditures a taxpayer can claim for these credits in a single tax year.

Deep Dive: The Basic Technology Jobs and R&D Tax Credit

The Basic Credit is the most widely utilized component of the New Mexico program, providing immediate relief for the transaction-based taxes that businesses face daily.

Rates and Rural Bonuses

The standard rate for the Basic Credit is 5 percent of the amount of qualified expenditures made by the taxpayer. To promote innovation in less developed regions, New Mexico doubles this rate to 10 percent for expenditures made in “rural areas”.

A “rural area” is defined as any location in New Mexico outside of:

• Bernalillo County.
• Doña Ana County.
• Santa Fe County.
• Counties with a population of 200,000 or more.

Facilities located in economically distressed areas designated by the TRD may also qualify for the rural bonus.

Application Against CRS Taxes

The Basic Credit can be applied against a taxpayer’s liability under the Combined Report System (CRS), which includes the state’s portion of:

• Gross Receipts Tax: The tax on the privilege of doing business in New Mexico. Note that the credit excludes local option gross receipts taxes.
• Compensating Tax: The tax on property or services used in New Mexico on which GRT was not paid.
• Withholding Tax: The tax withheld from employee wages.

The amount of approved Basic Credit claimed for any reporting period cannot exceed the total sum of the taxpayer’s GRT, compensating, and withholding taxes due for that period. If the approved credit is greater than the tax due, the excess may be carried forward for up to three years.

Application Process: Form RPD-41385

To receive the credit, a taxpayer must first apply for approval from the TRD by filing Form RPD-41385, Application for Technology Jobs and Research and Development Tax Credit. The application must be submitted within one year of the end of the calendar year in which the qualified expenditures were made.

The TRD requires specific documentation with the application:

• A summary and description of the qualified expenditures.
• Proof that the activities meet the federal definition of qualified research.
• Identification of the qualified facility in New Mexico where the research took place.

Once approved, the taxpayer receives a certificate or approval letter and can then claim the credit on their CRS-1 form using Form RPD-41386.

Deep Dive: The Additional Technology Jobs and R&D Tax Credit

The Additional Credit is designed to reward businesses that not only conduct research but also significantly grow their New Mexico-based workforce.

The Payroll Growth Benchmark

To be eligible for the Additional Credit, a taxpayer must meet a specific “payroll growth” requirement. The taxpayer must increase their annual payroll expense by at least $75,000 for every $1 million in qualified expenditures claimed in the same tax year.

• Annual Payroll Expense: The total wages paid to employees in New Mexico during the taxable year for which the credit is claimed.
• Base Payroll Expense: The total wages paid in New Mexico during the year prior to the claim year, adjusted for inflation.

“Wages” for this purpose are defined as the remuneration for services performed by an employee in New Mexico for an employer, as reported in Box 1 of Form W-2. Interestingly, the Administrative Code (NMAC 3.13.5) clarifies that wages paid to administrative personnel at the facility—not just those directly involved in research—can be included in the payroll calculation to meet this eligibility benchmark.

Rates and Application

Like the Basic Credit, the Additional Credit is 5 percent of qualified expenditures (10 percent in rural areas). However, this credit is applied against:

• Personal Income Tax: For individuals, partners, or members of pass-through entities.
• Corporate Income Tax: For C-corporations.

The Additional Credit cannot exceed the taxpayer’s income tax or corporate income tax liability for the reporting period. Any unused portion can be carried forward for up to three years. Married individuals filing separately must split the credit, each claiming only one-half.

Application Process: Form RPD-41385

The application for the Additional Credit is also made via Form RPD-41385. This application must be submitted within one year of the end of the tax year in which the qualified expenditures were made. Taxpayers must attach a payroll expense summary that clearly shows both the annual and base payroll expenses to prove they have met the $75,000/$1,000,000 growth benchmark.

Small Business Provisions and Refundability

New Mexico provides critical support for “Qualified Research and Development Small Businesses” through unique refundability provisions, acknowledging that many startups have high research costs but little to no initial income tax liability.

Defining the R&D Small Business

To qualify as a small business under this act (NMSA 7-9F-3(J)), a taxpayer must meet three criteria:

1. Employment: No more than 50 employees for which the taxpayer was liable for unemployment insurance coverage in the taxable year.
2. Expenditure Cap: Total qualified expenditures of no more than $5 million in the taxable year.
3. Ownership: No more than 50 percent of the business’s voting securities or equity is owned directly or indirectly by another business entity.

Additionally, the small business must demonstrate that their qualified research expenditures for the 12-month period ending with the month for which the credit is sought are at least 20 percent of their total expenditures for that same period.

Refundability of the Additional Credit

For these qualified small businesses, the Additional Credit becomes partially or fully refundable if it exceeds their income tax liability. The refund amount is based on the taxpayer’s total qualified expenditures for the year:

Total Qualified Expenditures	Portion of Excess Additional Credit Refunded
Less than $3,000,000	100% (The entire excess is refunded)
$3,000,000 to $3,999,999	66.6% (Two-thirds of the excess is refunded)
$4,000,000 to $5,000,000	33.3% (One-third of the excess is refunded)

To claim this refund, small businesses must use Form RPD-41298, R&D Small Business Tax Credit Claim Form and attach it to their CRS-1 return.

State Revenue Office Guidance: FYI-106 and Regulatory Compliance

The New Mexico Taxation and Revenue Department provides definitive guidance through its “For Your Information” (FYI) publications and the New Mexico Administrative Code (NMAC).

FYI-106: The Taxpayer’s Guide

FYI-106: Claiming Business-Related Tax Credits for Individuals and Businesses is the foundational document for understanding compliance. It summarizes all credits, provides statutory references, and explains the mechanics of carry-forwards and refundability.

Key compliance notes from the TRD:

• Exclusivity: A taxpayer cannot “double-dip.” Claiming the Technology Jobs and R&D Credit for a specific reporting period makes that taxpayer ineligible to claim the Investment Credit or the separate R&D Small Business Tax Credit against that same period.
• Rounding: All calculations on New Mexico tax forms should be rounded up to the next dollar.
• Electronic Filing: The TRD strongly encourages the use of its electronic filing system, the Taxpayer Access Point (TAP), for both applications and claims.

Reporting and Recapture Requirements

The New Mexico R&D credit is not a “one-and-done” filing. Taxpayers must comply with ongoing reporting requirements to avoid having their credits recaptured by the state.

1. Annual Reports: Any taxpayer claiming either the Basic or Additional credit must submit annual reports to the TRD by June 30 of the year following the claim and for each of the two subsequent years. These reports must include detailed information on business activities and New Mexico operations.
2. Recapture Conditions: The state can recapture (take back) the credit if the taxpayer:
   • Fails to submit the required annual reports.
   • Ceases operations in New Mexico for 180 consecutive days within any two-year period within seven years of the first claim.

If recapture is triggered, any approved but unclaimed credits are extinguished, and the taxpayer must pay back any credits already taken against taxes within 30 days.

Audit Guidelines

The TRD conducts post-approval audits to ensure the integrity of the program. Taxpayers are required to maintain all relevant records for at least four years. Audit focus areas typically include:

• Payroll Verification: Ensuring that employees for whom wages were claimed were actually physically present and working at the qualified facility in New Mexico.
• Scientific Validity: Reviewing project descriptions to ensure they satisfy the IRC Section 41 four-part test, particularly the “Process of Experimentation” and “Technological in Nature” requirements.
• Expenditure Accuracy: Verifying that supply and equipment costs were used directly in the research process and were not capitalized or depreciated elsewhere in a way that violates state law.

Economic Impact and Statistics: The LFC July 2025 Report

The New Mexico Legislative Finance Committee (LFC) periodically assesses the fiscal and economic impact of state tax expenditures. The report titled “Tax Expenditure Assessment – Tech Jobs & R&D Credit – July 2025” provides a detailed look at the program’s recent performance.

Fiscal Expenditure and Claims

The credit has seen significant growth in usage, reflecting a robust technology sector in the state:

Fiscal Year	Total Expenditure	Number of Claims
FY24	$11.2 Million	390
3-Year Avg (FY22-24)	$7.2 Million	320
10-Year Avg	$5.8 Million	(Data varies)

The $11.2 million expenditure in FY24 represents a 125 percent increase over the previous year, highlighting an “especially marked” trend in program utilization.

Economic ROI and Revenue Return

The LFC evaluates the “cost” to the state against the “growth” stimulated in the economy:

• Economic ROI (92%): For every $1 the state spends on the credit, the New Mexico economy (GDP) grows by 92 cents.
• Return in Revenue (-81%): For every $1 spent, the state forgoes 81 cents of tax revenue and recaptures 19 cents through other economic activities.
• Cost Per Job ($35,000): The state essentially “pays” $35,000 in tax incentives for every new job created by the program.

Broad Economic Benefits

The LFC report estimates the following net annual impacts attributable to the Technology Jobs and R&D Credit:

• State GDP Impact: $20.9 million.
• State Personal Income Increase: $33 million, driven by higher wage earnings and increased business profits.
• Job Creation: An average of 165 new jobs per year.

The report concludes that the credit is likely meeting its purpose of providing a favorable tax climate for export-based technology industries and promoting higher-wage employment.

Practical Example: Integrated Federal and State Credit Analysis

To understand how these laws apply in a real-world business context, consider the case of SolarVortex Inc., a startup developing high-efficiency solar tracking software.

Business Profile

• Location: Roswell, New Mexico (Rural Area).
• Entity Type: C-Corporation.
• Employees: 10 full-time engineers.
• 2023 Payroll: $800,000.
• 2024 Payroll: $1,050,000 (Increase of $250,000).

2024 Research Activity

SolarVortex engineers conducted a systematic process of modeling and testing various algorithm alternatives to resolve uncertainties about how their software handles sudden cloud cover—a technological uncertainty rooted in computer science and physics.

2024 Qualified Expenditures

• Wages (Research Staff): $600,000.
• Supplies (Testing Prototypes): $50,000.
• NM-Based Contract Research: $150,000.
• Total NM Qualified Expenditures: $800,000.

Step 1: Federal IRC Section 41 Calculation

Using the Alternative Simplified Credit (ASC) method (assuming 2024 QREs exceed 50% of the 3-year average), SolarVortex calculates a federal credit. While federal calculations are complex, this state-level analysis focuses on the QRE pool of $800,000.

Step 2: New Mexico Basic Credit

• Rate: 10% (5% basic + 5% rural bonus).
• Calculation: $800,000 \times 10\% = \$80,000.
• Application: SolarVortex applies this $80,000 against its state Gross Receipts Tax and Withholding Tax due for 2024. If their total tax due is only $60,000, they pay $0 and carry forward the remaining $20,000 for up to three years.

Step 3: New Mexico Additional Credit

SolarVortex must first meet the payroll growth benchmark ($75k per $1M QRE).

• Required Growth: ($800,000 / $1,000,000) \times $75,000 = $60,000.
• Actual Growth: $250,000.
• Result: They qualify for the Additional Credit.
• Rate: 10% (Rural area).
• Calculation: $800,000 \times 10\% = \$80,000.
• Application: Applied against Corporate Income Tax.

Step 4: Small Business Refund

SolarVortex has fewer than 50 employees and $800k in QRE, qualifying them as an R&D Small Business.

• Suppose their Corporate Income Tax is only $5,000.
• They use $5,000 of the credit to reduce tax to $0.
• The excess is $75,000.
• Since their QRE is < $3 Million, the entire $75,000 is refunded to them in cash.

Summary of Benefits

Benefit Type	Amount
Basic Credit (Offsets CRS Taxes)	$80,000
Additional Credit (Refunded)	$80,000
Total State Support	$160,000

This example demonstrates how a rural tech startup can effectively “stack” these credits to receive a benefit equal to 20% of their research spending, significantly easing the capital constraints common in the technology sector.

Future Outlook: Legislative Trends and Quantum Research

New Mexico continues to refine its tax landscape to maintain its competitive edge. Senate Bill 212 (SB 212), discussed in the 2025 legislative session, highlights the state’s interest in niche technology sectors like quantum research.

Quantum Testing and Evaluation Credit

SB 212 establishes a specific gross receipts tax credit for national laboratories in New Mexico involved in federally funded quantum research and device fabrication. This credit aims to match federal funds received, with a $15 million annual cap and a total aggregate cap of $60 million through 2035. While distinct from the general Technology Jobs and R&D Credit, it signals a legislative priority toward matching federal investment with state-level tax relief to ensure New Mexico remains a hub for high-end scientific testing and evaluation.

Potential Design Adjustments

The LFC has suggested that the Technology Jobs and R&D Credit could be more effective if it differentiated more based on demographics or specific economic activity, rather than purely geographic (rural) bonuses. However, with no expiration date currently set for the act, it remains a stable and predictable part of the New Mexico business climate.

Final Thoughts

The synergy between Internal Revenue Code Section 41 and New Mexico’s Technology Jobs and Research and Development Tax Credit Act creates a powerful engine for innovation within the state. By adopting federal standards, New Mexico provides a rigorous yet accessible framework that allows technology companies to leverage their national R&D documentation for localized state benefits. The dual-credit structure—offering offsets for transactional taxes through the Basic Credit and rewarding workforce growth through the Additional Credit—provides comprehensive support throughout a company’s lifecycle.

The program’s particular focus on rural development and small business refundability makes New Mexico an exceptionally attractive destination for startups and established tech firms alike. As demonstrated by the 92% economic ROI and the significant cash-flow benefits available to small businesses, the credit is more than just a tax break; it is a strategic investment in the state’s future as a technological leader. For businesses to succeed in claiming these incentives, they must look beyond the federal definitions and master the state-specific guidance provided in FYI-106 and the Administrative Code. By integrating rigorous scientific documentation with careful payroll tracking and timely administrative filings, New Mexico innovators can significantly reduce their tax burden and accelerate the development of next-generation technologies.