Contracted Research Expenses (65%)

Contracted research expenses represent 65% of the qualifying payments made to third-party entities for research services performed on a taxpayer’s behalf within the State of Ohio. These expenditures are integrated into a 7% incremental credit calculation designed to incentivize technological innovation and industrial modernization across the state’s commercial landscape.

The Ohio Research and Development (R&D) Investment Tax Credit stands as a pillar of the state’s economic development strategy, specifically engineered to reward businesses that expand their scientific and technological footprint within Ohio. Central to this incentive is the treatment of “contract research expenses,” a classification that acknowledges that many modern firms do not possess the internal infrastructure to perform all facets of highly specialized research. By allowing a credit for 65% of payments made to outside firms, the Ohio Revised Code (R.C.) effectively permits a “pass-through” of research activities, provided they are conducted with a geographical nexus to Ohio and satisfy the rigid qualitative requirements of the Internal Revenue Code (IRC). This 65% statutory threshold acts as a “haircut,” intended by the legislature to isolate the portion of a contractor’s fee that relates to the actual performance of research, while stripping away the contractor’s internal overhead, administrative profit, and non-research related business expenses. Consequently, the taxpayer receives a tax benefit for the research being conducted “on their dime” and “at their risk,” even if their own employees are not the ones in the laboratory.

The Statutory Architecture: Ohio Revised Code and Federal Conformity

The legal foundation of the Ohio R&D credit is established primarily in R.C. 5751.51 for taxpayers subject to the Commercial Activity Tax (CAT) and R.C. 5726.56 for those subject to the Financial Institutions Tax (FIT). A critical feature of these statutes is their explicit adoption of federal standards. Both sections state that “qualified research expenses” shall have the same meaning as in Section 41 of the Internal Revenue Code. This legislative design ensures that the Ohio credit “piggybacks” off the federal research credit, theoretically simplifying the compliance burden for taxpayers by allowing them to use the same underlying data for both their federal and state filings.

Under federal law, which Ohio incorporates by reference, IRC § 41(b)(1) defines qualified research expenses (QREs) as the sum of in-house research expenses and contract research expenses paid or incurred by the taxpayer during the taxable year in carrying on any trade or business. While in-house expenses—such as the wages of employees directly engaged in research or the cost of supplies consumed in the process—are generally eligible at 100% of their value, contract research expenses are limited by IRC § 41(b)(3) to 65% of the amount paid.

Statute	Target Taxpayer	Primary Credit Rate	Key Expense Limitation
R.C. 5751.51	Commercial Activity Tax (CAT) Filers	7% of Incremental Excess	65% for Third-Party Contracts
R.C. 5726.56	Financial Institutions (FIT)	7% of Incremental Excess	65% for Third-Party Contracts
IRC § 41	Federal Income Tax Filers	20% (Regular) or 14% (ASC)	65% for Third-Party Contracts

The historical evolution of this credit reflects a transition in Ohio’s tax policy. Originally applied against the Corporate Franchise Tax under R.C. 5733.351, the credit was transitioned to the CAT in 2008 as part of a broader shift toward a gross receipts tax model. This transition was intended to maintain the state’s competitiveness in attracting high-tech manufacturing and software development firms. Despite these structural changes in the state’s tax regime, the core definition of contract research expenses remained anchored to the federal 65% standard, ensuring a level of continuity for R&D-intensive businesses.

Qualifying Criteria for the 65% Contract Research Expense

To validly claim 65% of a contractor’s payment as a QRE in Ohio, the expenditure must meet several rigorous qualitative tests defined by Treasury Regulation § 1.41-2(e). These tests are designed to ensure that the taxpayer is indeed the party responsible for the research and that the activity itself constitutes genuine scientific or technological inquiry.

The “On Behalf Of” and Pre-Performance Agreement Mandates

An expense is only eligible if it is paid or incurred pursuant to an agreement that is entered into prior to the performance of the qualified research. This requirement is strictly enforced by the Ohio Department of Taxation during audits to prevent “retroactive engineering” of tax credits, where taxpayers attempt to reclassify general consulting or maintenance fees as research expenses after a project has already concluded. The agreement must explicitly provide that the research is being performed on behalf of the taxpayer.

The concept of “on behalf of” is deeply intertwined with the ownership of the resulting intellectual property. While the contractor may retain some rights to use the research or maintain ownership of the “background” IP (technologies they owned before the contract), the taxpayer must generally retain “substantial rights” to the “foreground” IP (the results of the research). If the contract is structured such that the contractor retains all rights to the invention and merely sells a license to the taxpayer, the payments may fail to qualify as contract research expenses and instead be viewed as the purchase of an intangible asset or a finished product.

The Economic Risk (At-Risk) Requirement

The most critical hurdle for contract research is the “at-risk” rule. Under Treas. Reg. § 1.41-2(e)(2), the taxpayer must be required to bear the expense even if the research is not successful. This distinguishes a research contract from a product procurement contract. In a typical research engagement, the taxpayer pays for the contractor’s time and effort to solve a technological problem, with no guarantee of a successful outcome.

If a contract is structured such that payment is contingent upon the contractor achieving a specific result (a “success-based” fee) or successfully developing a working prototype, the contractor is the one bearing the economic risk of the research failure. In such an instance, the contractor, not the taxpayer, is entitled to claim the R&D credit (though usually as in-house wages rather than contract expenses). Ohio taxpayers must therefore ensure their service agreements are not “contingent” or “guaranteed” if they intend to include those costs in their 65% QRE calculation.

Contract Type	Economic Risk Holder	Eligibility for 65% Credit
Time and Materials	Taxpayer	Highly Likely
Fixed Fee (Non-Contingent)	Taxpayer	Likely
Success-Based / Contingent	Contractor	Ineligible for Taxpayer
Product Purchase (Standard)	Manufacturer	Ineligible for Taxpayer

The Four-Part Test: Application to Outsourced Activities

Even if a contract is properly structured for risk and rights, the work performed by the contractor must pass the “Four-Part Test” established by IRC § 41(d)(1). The Ohio Department of Taxation applies these tests to each “business component” of the taxpayer—meaning each individual product, process, or software project for which the contractor was hired.

The Section 174 Test (Permissibility)

The contractor’s activities must relate to expenditures that could be treated as expenses under Section 174 of the IRC. This requires that the research be intended to discover information that would eliminate uncertainty concerning the development or improvement of a business component. Uncertainty exists if the information available to the contractor at the start of the project does not establish the capability or method for developing the component, or the appropriate design of the component.

The Technological Information Test

The research must be undertaken for the purpose of discovering information that is “technological in nature”. This means the research must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science. For example, hiring a contractor to perform architectural design that relies on structural engineering principles qualifies, whereas hiring a contractor for market research or aesthetic design does not.

The Business Component Test

The application of the research must be intended to be useful in the development of a new or improved “business component” of the taxpayer. A business component can be a product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in its trade or business. If a manufacturer hires a contractor to develop a more efficient assembly line process (a process business component), 65% of those costs are eligible.

The Process of Experimentation Test

Substantially all (interpreted as 80% or more) of the activities of the contractor must constitute elements of a “process of experimentation”. This requires a systematic evaluation of one or more alternatives to achieve a result where the capability, method, or design is uncertain. The contractor must engage in a process of identifying the uncertainty, formulating a hypothesis, and evaluating alternatives through modeling, simulation, or systematic trial-and-error.

Local State Revenue Office Guidance: The Ohio Department of Taxation

The Ohio Department of Taxation (ODT) provides the administrative bridge between the state law and the federal definitions. Taxpayers must look to Administrative Code rules and the Department’s Information Releases to understand the specific filing and documentation requirements that govern the 65% contract research claim.

Administrative Code 5703-29-22: Filing and Timing

Under O.A.C. 5703-29-22, the nonrefundable credit for qualified research expenses is available to apply against the CAT liability. A critical local requirement is that regardless of a taxpayer’s federal tax year, the credit must be computed based on expenses incurred during the calendar year (January 1 through December 31).

For quarterly filers, the credit must first be claimed on the fourth-quarter return, which is due in February of the year following the calendar year for which the credit is claimed. Annual filers must claim the credit on their annual return due in May. Failure to claim the credit on the appropriate return can lead to a denial of the credit, as seen in several Final Determinations issued by the Tax Commissioner where taxpayers attempted to claim the credit on an original first or second-quarter return rather than reconciling it on the year-end return.

The Geographic Nexus: “Incurred in This State”

Perhaps the most significant “local” rule is the requirement that the qualified research expenses be “incurred in this state”. While the federal credit allows for research performed anywhere within the United States, the Ohio credit is strictly limited to work performed physically within Ohio’s borders.

For contract research, this means that even if a taxpayer is an Ohio corporation, they cannot claim the 65% credit for payments made to a contractor located in another state, such as Michigan or California, unless it can be proven that the contractor’s employees were physically present in Ohio while performing the research. Conversely, a company based in New York could claim the Ohio R&D credit if it pays a Cincinnati-based laboratory to conduct qualified research on its behalf. The Department of Taxation requires proof of the contractor’s performance location, often in the form of site addresses or employee location logs.

Form CAT-CS and Documentation Standards

The Department mandates the use of Form CAT-CS (Credit Schedule) to track and report the R&D credit. This form requires a breakdown of the current year’s expenses and the three preceding years’ expenses to calculate the incremental base. Key documentation required to be retained for four years after the filing date includes:

• A complete calculation of the tax credit.
• The address of the facility where the research was conducted.
• A copy of Federal Form 6765 for the current and prior three tax periods.
• Service contracts, invoices, and proof of payment for all 65% contract claims.

Audit Trends and the “Vorys” Perspective

Recent years have seen a marked shift in the audit posture of the Ohio Department of Taxation. According to industry analyses, the Department has moved away from merely verifying the Ohio nexus of expenses toward a more aggressive re-evaluation of the “qualified” nature of the research.

The Impact of House Bill 33 (2023)

The 2023 biennial budget bill (Am. Sub. HB 33) introduced several amendments to R.C. 5751.51 that solidified the Department’s authority. Notably, the law now explicitly empowers the Tax Commissioner to audit a “sample” of the taxpayer’s research expenses over a representative period. While the Commissioner is directed to make a “good faith effort” to reach an agreement with the taxpayer on the sample size, they are not precluded from proceeding if an agreement is not reached.

Furthermore, the legislation clarified the “member-by-member” calculation for consolidated or combined groups. In a group filing, each person in the group must separately calculate their own credit based on the QREs they individually incurred. This prevents a group with a high overall revenue from diluting the R&D intensity of a single, highly innovative subsidiary.

The Disparity Between Federal and State Reviews

A point of frequent frustration for taxpayers is the Department’s tendency to disallow 65% contract expenses even if those expenses were included in a federal return that was not challenged by the IRS. The Department maintains that it is not bound by federal inaction and has the right to conduct its own independent review of the “Four-Part Test”. This has led to high-profile denials in cases like Cristal USA v. McClain, where the Tax Commissioner emphasized that “meeting the federal definition, alone, is not sufficient to qualify for Ohio’s credit”. Taxpayers are therefore advised to maintain much more robust technical documentation for their Ohio claims than they might for a federal “Alternative Simplified Credit” (ASC) claim.

Calculation Methodology: The 7% Incremental Model

The Ohio R&D credit is not a flat percentage of all spending; it is an incremental credit that rewards growth in R&D investment. The credit is calculated as 7% of the amount by which the current year’s Ohio QREs exceed the average annual Ohio QREs for the three preceding calendar years.

The Base Period Calculation

For a claim in 2024, the “base amount” would be the average of Ohio QREs from 2021, 2022, and 2023. If a company has no prior QRE history in Ohio, the base amount is zero, allowing them to take a credit on the full 7% of their current year’s spending.

The Mathematical Formula

The credit is derived as follows:

1. Identify Ohio QREs (QRE_OH): Sum of 100% of Ohio-based wages/supplies and 65% of Ohio-based contract payments.
2. Calculate Base Amount (Base_avg): (QRE_n-1 + QRE_n-2 + QRE_n-3) / 3.
3. Determine Excess: Excess = QRE_current – Base_avg.
4. Final Credit: Credit = Excess × 0.07.

Industrial Application Examples

The 65% contract research rule applies differently across sectors, depending on how research is typically outsourced.

Software and SaaS

Software companies often hire third-party contractors for “algorithm optimization,” “beta testing,” or “back-end architectural development”. If an Ohio software firm pays a Columbus-based individual developer $50,000 for specialized coding to solve a stability issue in a new AI platform, the firm can include $32,500 ($50,000 × 0.65) in its QREs. However, routine debugging or cosmetic UI changes would be excluded under the “process of experimentation” test.

Manufacturing and Engineering

In the manufacturing sector, contractors are frequently hired for “prototyping,” “material testing,” or “tooling design”. A manufacturer developing a new heat-resistant alloy might hire an Ohio engineering firm to perform “destructive testing” on various metal mixtures. Because the outcome (the failure point of each mixture) is uncertain and relies on metallurgical science, 65% of the fees paid for those tests would qualify.

Agriculture and Food Science

The food industry often utilizes outside laboratories to test ingredient mixtures for “shelf life stability” or “aroma consistency”. Under the Section 174 test, if a snack company hires an Ohio lab to experiment with natural preservatives to replace synthetic ones, and the appropriate preservative formulation is uncertain at the start, 65% of the lab’s fees are eligible QREs.

Comprehensive Multi-Phase Project Example

To demonstrate the full complexity of the Ohio credit, consider “Midwest MedTech,” an Ohio-based medical device manufacturer developing a new surgical laser system.

Phase 1: Internal Design (In-House)

Midwest MedTech uses its own Ohio staff to create the initial schematics.

• Wages: $200,000
• Supplies (Materials): $50,000
• Total Phase 1 QRE: $250,000 (100% of internal costs).

Phase 2: Specialized Component Development (Contracted)

Midwest MedTech hires “LensTech,” a Cleveland-based optics firm, to design a custom sapphire lens capable of handling the laser’s heat.

• Agreement: $100,000 fixed-fee, time-and-materials. Midwest MedTech owns all designs. LensTech bears no risk of failure.
• Location: LensTech performs all work in Cleveland, OH.
• QRE Calculation: $100,000 × 0.65 = $65,000.

Phase 3: Software Integration (Contracted – Out of State)

Midwest MedTech hires a California software firm to write the user interface code.

• Contract Amount: $80,000.
• Location: Work performed in Silicon Valley.
• QRE Calculation: $0 (Fails the “incurred in this state” requirement).

Phase 4: Safety Validation (Contracted – University)

Midwest MedTech pays the Ohio State University (OSU) to perform safety validation tests through a research consortium.

• Contract Amount: $40,000.
• QRE Calculation: $40,000 × 0.75 = $30,000 (Note: Consortium payments qualify for 75% rather than 65% under federal/Ohio rules).

Summary of 2024 Ohio QREs

Activity	Expense Type	Amount	Multiplier	Ohio QRE
Internal Design	Wages/Supplies	$250,000	1.00	$250,000
Lens Development	Contract (In-State)	$100,000	0.65	$65,000
Software UI	Contract (Out-of-State)	$80,000	0.00	$0
Safety Testing	Contract (University/Consortium)	$40,000	0.75	$30,000
Total 2024 QRE				$345,000

Determining the Credit Value

Midwest MedTech had the following historical Ohio QREs:

• 2021: $280,000
• 2022: $310,000
• 2023: $310,000
• Base Amount (3-Year Average): (280k + 310k + 310k) / 3 = $300,000.

The Calculation:

1. Excess: $345,000 – $300,000 = $45,000.
2. Credit (7%): $45,000 × 0.07 = $3,150.

The company will claim this $3,150 nonrefundable credit on its 2024 4th Quarter CAT return using Form CAT-CS.

Interaction with the R&D Sales Tax Exemption

It is important to distinguish the R&D Investment Tax Credit (the 7% CAT credit) from the Research and Development Sales Tax Exemption. While the 65% contract research rule provides a credit against CAT for service payments, the Sales Tax Exemption provides a dollar-for-dollar exemption from the 5.75%+ state sales tax on the purchase of machinery and equipment used primarily for research.

The sales tax exemption applies to equipment used in both “direct” and “pure” research. To utilize this, a taxpayer or their vendor must complete an Ohio Department of Taxation Sales and Use Tax Blanket Exemption Certificate. While a contractor’s own equipment purchases are generally their own responsibility, if a taxpayer purchases equipment for a contractor to use exclusively in an Ohio-based research project, that equipment may qualify for the exemption, further lowering the effective cost of the research.

Strategic Documentation: Avoiding Denial in Audit

Given the ODT’s “strictly construed” interpretation of tax reduction statutes, taxpayers should adopt a “defense-first” documentation strategy for their 65% contract claims.

Proving the “At-Risk” Rule

Taxpayers should avoid “Lump Sum” contracts that trigger payment only upon “Acceptance of Final Deliverable.” Instead, contracts should be structured to pay for milestones or hourly effort, showing that even if the contractor’s hypothesis is proven wrong, the taxpayer is still contractually obligated to pay for the scientific labor performed.

Substantiating the Ohio Performance Location

Since “incurred in this state” is a jurisdictional requirement, a mere invoice from an Ohio address may not be sufficient if the contractor has multiple offices. Taxpayers should request a “Statement of Work Location” from their contractors, certifying that the services were performed at a specific Ohio site. This is particularly critical for individual 1099-NEC contractors who may travel or work remotely.

The Role of “Internal Use Software” (IUS)

For software development contracts, Ohio follows federal “shrink-back” rules but with additional scrutiny on whether the software is for “internal use” (e.g., an internal HR portal) or “commercial use” (e.g., a SaaS product sold to customers). Internal Use Software (IUS) must meet a “Higher Hurdle” test, requiring it to be innovative, involve significant economic risk, and not be commercially available. When hiring a contractor for software research, the taxpayer must be able to demonstrate which side of this line the project falls on to justify the 65% claim.

Final Thoughts: Navigating the Future of the Ohio R&D Credit

The Ohio Research and Development Investment Tax Credit, with its integration of the 65% contract research rule, provides a powerful yet nuanced incentive for businesses to deepen their technological roots in the state. As the legislative environment evolves—most notably with the 2024 and 2025 rollbacks to the CAT exclusion threshold, which will exempt businesses with less than $3 million and $6 million in gross receipts respectively—the R&D credit will become increasingly focused on the state’s larger and mid-sized innovative engines.

For these firms, the 65% rule remains the primary mechanism for subsidizing collaboration with the state’s vibrant network of private laboratories, engineering firms, and research universities. However, the path to a successful claim is paved with rigorous documentation. By understanding the interplay between federal qualitative tests and state-specific jurisdictional rules, and by meticulously tracking the “at-risk” nature and physical location of all third-party research, Ohio taxpayers can maximize their credit and successfully defend it against the increasing scrutiny of the Department of Taxation. The 6% to 7% incremental benefit serves not only as a tax reduction but as a strategic reinvestment in the state’s intellectual capital.