Direct Research

Direct Research in Ohio tax law refers to investigative activities conducted to design, create, or formulate new or improved products, processes, or equipment within state borders. It functions as a core qualifying pillar for both the Commercial Activity Tax (CAT) Investment Credit and the state’s specialized sales tax exemption for research machinery.

The conceptualization of direct research within the Ohio regulatory landscape represents a sophisticated intersection of federal tax methodology and state-specific economic development strategy. Since the inception of the Ohio Research and Development Investment Tax Credit, originally authorized under the corporate franchise tax regime in Section 5733.351 of the Ohio Revised Code and later transitioned to the Commercial Activity Tax under Section 5751.51, the state has maintained a policy of mirroring the rigorous technical standards of Internal Revenue Code Section 41. However, Ohio’s administrative guidance introduces a critical distinction between “direct research” and “pure research,” particularly within the context of the Research and Development Sales Tax Exemption. While federal law focuses broadly on the “increasing research activities” through qualified services and expenses, Ohio tax authorities utilize the term direct research to categorize results-oriented, applied inquiry aimed at commercializable improvements. This distinction is vital for taxpayers, as it dictates the scope of eligible machinery and equipment purchases that can be exempted from state and county sales taxes. Furthermore, the application of this law is governed by the doctrine of “strict construction,” meaning that any ambiguity regarding whether an activity constitutes direct research or a non-qualifying production activity is typically resolved in favor of the Department of Taxation. Consequently, a granular understanding of how direct research activities map to both the federal Four-Part Test and Ohio’s jurisdictional requirements is the foundation of a defensible and optimized tax strategy.

The Statutory Architecture of the Ohio Research and Development Investment Credit

The Ohio Research and Development Investment Tax Credit is a nonrefundable fiscal incentive currently codified under Section 5751.51 of the Ohio Revised Code. Its primary function is to offset the Commercial Activity Tax, a gross receipts tax imposed on the privilege of doing business in Ohio. The credit is calculated as seven percent of the excess of qualified research expenses incurred in Ohio during the calendar year over the taxpayer’s average annual qualified research expenses incurred in Ohio during the three preceding years.

Legislative Evolution and the Transition to CAT

The credit’s origin reflects Ohio’s broader shift from an income-based corporate tax system to a receipts-based system. Historically, the credit was applied against the Corporate Franchise Tax under ORC 5733.351. With the enactment of the Commercial Activity Tax in 2005, the credit was transitioned to ensure that corporations subject to the new tax regime could continue to leverage their R&D investments. For financial institutions, a nearly identical credit exists under Section 5726.56 of the Revised Code, ensuring that the incentive remains accessible across different entity structures.

Federal Incorporation and Jurisdictional Limitation

The most critical aspect of the Ohio statute is its explicit adoption of federal definitions. ORC 5751.51(A) states that “qualified research expenses” has the same meaning as in Section 41 of the Internal Revenue Code. This creates a “test within a test,” where a taxpayer must satisfy every federal requirement to be considered for the Ohio credit. However, Section 5751.51(B)(1) introduces a strict “in-state” requirement that serves as the primary point of contention in state audits.

Statutory Provision	Component Description	Regulatory Significance
ORC 5751.51(A)	Definition of QREs	Incorporates IRC Section 41 in its entirety.
ORC 5751.51(B)(1)	Credit Rate and Base	7% of Ohio QREs exceeding the 3-year Ohio average.
ORC 5751.51(B)(2)	Carryforward Period	Unused credits may be carried forward for 7 years.
ORC 5751.51(D)	Record Retention	Mandates 4-year retention of substantiation records.
ORC 5751.51(E)	Audit Authority	Authorizes the Tax Commissioner to audit a representative sample.

Conceptualizing Direct Research: The Bifurcated Definition

In the Ohio tax ecosystem, the term “direct research” appears most prominently in guidance related to the Research and Development Sales Tax Exemption, which provides a total exemption from state and county sales and use taxes for machinery and equipment used primarily for R&D. The Department of Taxation utilizes a specific taxonomy to define the innovation lifecycle, separating it into “direct” and “pure” research.

Direct Research as Applied Innovation

Direct research refers to research conducted specifically to design, create, or formulate new or better products, equipment, or processes. This is the industrial application of the scientific method where the primary objective is a commercializable business component. It includes activities such as:

• The design and fabrication of prototypes for new consumer electronics.
• The development of unique manufacturing process improvements that reduce scrap or increase precision.
• The creation of specialized software algorithms to solve specific functional challenges in an online platform.

Pure Research as Fundamental Inquiry

Pure research refers to scientific or technological inquiry and experimentation in the physical sciences that may not have an immediate or direct application to a specific product or process. This typically involves lab-based discovery aimed at expanding the frontiers of scientific knowledge, such as physics experimentation or basic chemical synthesis. Ohio law ensures that both stages of research—the fundamental discovery and the applied design—qualify for the sales tax exemption on associated equipment.

Mechanical Application of IRC Section 41 in Ohio Jurisprudence

To claim the R&D Investment Tax Credit against the CAT, a taxpayer’s “direct research” activities must satisfy the federal Four-Part Test. This test is applied at the level of the “business component,” which includes any product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in their trade or business.

The Section 174 Test: Requirement of Uncertainty

The first part of the test requires that the expenditures associated with the activity be eligible for treatment as research or experimental expenditures under IRC Section 174. This means the expenditures must be incurred in connection with the taxpayer’s trade or business and represent research and development costs in the “experimental or laboratory sense”. Crucially, there must be a technical “uncertainty” at the outset of the project. Uncertainty exists if the information available to the taxpayer does not establish either the capability or the method for developing or improving the business component, or the appropriate design of the business component.

The Technological Information Test

The research must be undertaken for the purpose of discovering information that is “technological in nature”. This requirement is met if the process of experimentation fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. Notably, Ohio and federal law clarify that the taxpayer does not need to expand the general “common knowledge” of a field; it is sufficient that the taxpayer seeks to expand their own technological knowledge through existing scientific principles.

The Business Component Test (Qualified Purpose)

The activity must be intended to be useful in the development of a new or improved business component. A qualified purpose must relate to a new or improved function, performance, reliability, or quality. Activities intended to improve style, taste, cosmetic, or seasonal design factors are explicitly excluded from being considered qualified research.

The Process of Experimentation Test

The final and most scrutinized requirement is that “substantially all”—defined as 80% or more—of the research activities for each business component must constitute elements of a process of experimentation. A process of experimentation involves the systematic evaluation of one or more alternatives to achieve a result where the capability, method, or design is uncertain. This evaluative process typically employs trial-and-error, modeling, simulation, or other scientific methods to test a hypothesis and refine or discard it based on experimental results.

Analysis of Qualified Research Expenses (QREs) within Ohio Borders

Qualified Research Expenses for Ohio purposes are the sum of “in-house research expenses” and “contract research expenses”. For these expenses to count toward the Ohio credit, they must be “incurred in this state”.

In-House Research Expenses: Wages and Supplies

The most significant category of QREs is typically employee wages. To qualify, wages must be paid for “qualified services” performed by an employee. Federal and Ohio law divide qualified services into three sub-categories:

1. Engaging in Qualified Research: The actual performance of the research activities, such as an engineer running tests or a developer writing code for a new algorithm.
2. Direct Supervision: The immediate supervision of qualified research activities. This includes first-line management but excludes executive-level oversight that is only indirectly related to the technical progress of a project.
3. Direct Support: Services that support the researchers or their direct supervisors. Standard examples include a machinist creating a prototype part, a laboratory worker cleaning research equipment, or a secretary compiling research data into a technical report.

Under the “Substantially All” rule for wages, if 80% or more of an employee’s annual services consist of qualified research, supervision, or support, then 100% of that employee’s wages are treated as QREs.

Contract Research Expenses

Ohio allows taxpayers to include 65% of amounts paid or incurred to outside research firms or contractors for qualified research performed on the taxpayer’s behalf. To be qualifying, the research must be “unfunded,” meaning the taxpayer must bear the financial risk of the research’s failure and must retain substantial rights to the research results.

Expense Type	Qualification Criteria	Ohio-Specific Requirement
Wages	Performance of “qualified services.”	Services must be performed in Ohio.
Supplies	Consumed during the research process.	Must be used in an Ohio facility.
Contract Research	65% of fees to third parties.	Research must be conducted in Ohio.
Computer Lease	Paid for rights to use computers for R&D.	Computers must be located in Ohio.

State Revenue Office Guidance: Parsing Administrative Rule 5703-29-22

The Ohio Department of Taxation provides detailed operational guidance through Administrative Code Rule 5703-29-22. This rule outlines the specific procedures for claiming credits against the Commercial Activity Tax and serves as the primary manual for compliance.

Reporting Frequency and Deadlines

Regardless of whether a taxpayer files CAT returns on a quarterly or annual basis, the R&D credit must be calculated based on the calendar year in which the expenses were incurred.

• Quarterly Taxpayers: Must claim the credit on the fourth quarter return, which is due by February 10th of the year following the research activities.
• Annual Taxpayers: Must claim the credit on their annual return, which is due by May 10th of the year following the research activities.

Failure to claim the credit on the original annual or fourth-quarter return may complicate the ability to obtain a refund, as demonstrated in several Tax Commissioner Final Determinations where refund claims were denied for being “improperly claimed” on interim quarterly returns.

The Role of Form CAT-CS

To claim the R&D credit, taxpayers must complete and submit the Commercial Activity Tax Credit Schedule (CAT-CS). This form is used to:

1. Report the current calendar year’s Ohio QREs.
2. Report Ohio QREs for each of the three preceding years.
3. Calculate the 7% credit on the incremental excess.
4. Track the carryforward of any unused nonrefundable credits from prior years.

Taxpayers who are members of a “combined” or “consolidated elected” group must calculate the credit on a person-by-person basis, using the specific QREs incurred by each entity within the group.

The Research and Development Sales Tax Exemption: Direct Research in Equipment

A parallel benefit for Ohio researchers is the Research and Development Sales Tax Exemption, which is separate from the CAT-based investment credit. This exemption allows businesses to purchase machinery and equipment without paying state or county sales and use taxes, provided the equipment is used “primarily” (more than 50% of the time) for research and development.

The Primary Use Test

Ohio law requires that the “primary use” of the property be for research. If a machine is used 60% of the time for designing a new prototype (direct research) and 40% of the time for routine manufacturing, it is 100% exempt from sales tax. Conversely, if its use for R&D is only 30%, the entire purchase price is taxable.

Eligible and Ineligible Machinery

Local state revenue office guidance clarifies that the exemption covers equipment used in both direct and pure research.

• Eligible Items: Prototype fabrication equipment, lab testing rigs, computers used primarily for CAD or R&D simulation, and specialized environmental control systems necessary for research.
• Ineligible Items: Property used for administrative or personnel functions, routine quality control testing after commercial production has begun, and equipment for storing raw materials or finished products.

To claim the exemption, a taxpayer does not need to apply to the state for a specific number. Instead, they provide a “Sales and Use Tax Blanket Exemption Certificate” (Form STEC-B) to the vendor at the time of purchase.

The Burden of Proof: “Strict Construction” and Audit Defense

The Ohio Department of Taxation (ODT) adheres to a policy of “strict construction” for all tax reduction statutes. This doctrine mandates that the taxpayer bears the burden of demonstrating a “clear entitlement” to the credit. If a taxpayer cannot definitively prove that an activity meets both the federal technical standards and the Ohio jurisdictional standards, the credit will be denied.

Insights from Final Determinations

Reviewing Final Determinations from the Tax Commissioner provides critical insight into common audit pitfalls. In several cases, taxpayers were denied credits because:

• They relied solely on federal Form 6765 without providing a breakdown of which specific expenses occurred at Ohio facilities.
• They failed to maintain contemporaneous project-based records, such as time logs or laboratory notebooks.
• They claimed the credit for “routine” activities, such as troubleshooting production errors or conducting quality control on products that had already entered commercial production.

The Tax Commissioner has the explicit authority to audit a “representative sample” of the taxpayer’s QREs. If an error is found in the sample, it can be extrapolated across the entire claim, leading to significant assessments.

Recordkeeping Standards

Taxpayers are required to retain all records used to calculate the credit—including expenses from the three prior “base” years—for at least four years after the return is filed. Documentation should include:

• Employee time records linked to specific R&D projects.
• Project descriptions explaining the technical uncertainties and the process of experimentation.
• Invoices for supplies used specifically in the R&D process.
• Contractual agreements proving the unfunded nature of third-party research.

Federal Conformity and the 2025 Legislative Landscape

The relationship between Section 174 (Research and Experimental Expenditures) and Section 41 (R&D Tax Credit) has undergone massive shifts due to federal tax policy changes, which directly impact Ohio’s credit calculations.

Section 174 Amortization and OBBBA 2025

Starting in 2022, the Tax Cuts and Jobs Act required companies to capitalize and amortize R&D costs over five years (domestic) or fifteen years (foreign). Because the first requirement of the R&D credit is that expenses must be Section 174 expenditures, this amortization requirement significantly changed the financial landscape for Ohio taxpayers.

However, the “One Big Beautiful Bill Act of 2025” (OBBBA) restored the immediate deductibility of U.S.-based R&D expenditures. This restoration is available retroactively for tax years 2022, 2023, and 2024 for eligible small businesses. Ohio taxpayers who previously capitalized these costs may now have the opportunity to amend their federal and state returns to claim immediate deductions and potentially adjust their CAT credit claims to ensure conformity with the restored federal standards.

Enhanced IRS Disclosures (Form 6765, Section G)

The IRS has proposed significant changes to Form 6765, adding a new Section G that requires QREs to be reported at the “business component” level. While this is a federal requirement, the Ohio Department of Taxation frequently requests a copy of Form 6765 during audits. Consequently, Ohio businesses must be prepared to provide a much higher level of granular detail than was required in the past, including quantitative information on wages by direct research, supervision, and support for each specific project.

Practical Implementation: A Comprehensive Multi-Phase Case Study

To illustrate the application of direct research within the Ohio tax framework, we examine “Cuyahoga Advanced Materials” (CAM), a mid-sized Ohio manufacturer specializing in high-performance polymer resins for the aerospace industry.

Phase 1: Identifying the Business Component and Uncertainty

In 2024, CAM identified a market need for a fire-retardant resin that maintains structural integrity at temperatures exceeding 1,000 degrees Celsius. Initial research indicated that existing polymer chains would fail at this threshold.

• The Uncertainty: CAM did not know the appropriate molecular design (method) or the specific chemical additive ratio (design) required to achieve the temperature goal.
• Direct Research Activity: CAM’s research scientists began designing new polymer formulations. This is classified as direct research because it is conducted to design a new product.

Phase 2: The Process of Experimentation

The team developed ten different chemical variations. Each variation was subjected to thermal stress testing in a laboratory located in Cleveland, Ohio.

• The Process: The team used trial-and-error to evaluate each alternative, discarding eight and refining two based on the test data.
• Qualified Services:

• The lead chemist spent 90% of her time performing the tests (Direct Performance).
• The lab manager spent 20% of his time providing technical guidance on the testing protocol (Direct Supervision).
• A junior technician spent 100% of his time cleaning the testing equipment and documenting the results (Direct Support).

Phase 3: Calculating the Credit

CAM’s total 2024 Ohio QREs, including wages and laboratory supplies consumed in the tests, amounted to $1,200,000. Their average annual Ohio QREs for 2021, 2022, and 2023 were $800,000.

• The Calculation: $1,200,000 – $800,000 = $400,000 (Excess).
• The Credit: $400,000 x 0.07 = $28,000.
• The Filing: CAM claims this $28,000 credit on their 2024 fourth-quarter CAT return, filed by February 10, 2025, using Form CAT-CS.

Phase 4: Leveraging the Sales Tax Exemption

To conduct the high-temperature tests, CAM purchased a $200,000 specialized furnace.

• The Usage: The furnace is used 100% of the time for the fire-retardant resin project.
• The Benefit: CAM provides the furnace vendor with a blanket exemption certificate (STEC-B). This saves CAM approximately $15,000 in upfront sales tax, assuming a 7.5% local rate.

Strategic Outlook and Policy Implications

The Ohio research tax landscape is designed to incentivize the high-value “direct research” phase of innovation—where products and processes are fundamentally designed and improved. However, the state’s reliance on the Commercial Activity Tax (CAT) as the primary offset mechanism creates a unique environment compared to most states that offer credits against income tax.

Future Outlook

As the CAT exclusion threshold continues to rise—from $150,000 in 2023 to $6 million in 2025—the R&D Investment Tax Credit will become increasingly concentrated among larger taxpayers or those with significant growth trajectories. Smaller firms that no longer have a CAT liability may find the R&D Sales Tax Exemption to be their primary research-related tax benefit.

Furthermore, the integration with JobsOhio programs, such as the Research and Development Investment Loan Fund, suggests a trend toward “bundled” incentives. These programs provide low-interest loans coupled with an additional CAT credit equal to the principal and interest repaid, capped at $150,000 annually. This highlights Ohio’s intent to support not just the activities of direct research, but also the capital investment required to build and maintain the facilities where that research takes place.

In conclusion, “direct research” in Ohio serves as the bridge between theoretical science and commercial manufacturing. For a taxpayer to successfully navigate this environment, they must be bilingual in both federal Section 41 technical standards and Ohio-specific jurisdictional and administrative rules. By maintaining rigorous project-level documentation, ensuring all research activities are sitused to Ohio, and properly utilizing both the CAT credit and the sales tax exemption, businesses can maximize the state’s incentives for innovation and significantly reduce the net cost of their R&D operations.