Direct Conduct of Research

Direct conduct of research encompasses the technical performance of qualified research activities by employees, such as scientists and engineers, who are actively engaged in the process of experimentation to resolve technological uncertainties. In the context of the Ohio R&D tax credit, this term specifically identifies the “hands-on” scientific or engineering work performed within the state that qualifies for a seven percent nonrefundable credit against the Commercial Activity Tax.

The conceptual architecture of the Ohio Research and Development Investment Tax Credit is fundamentally built upon the integration of federal standards with specific state-level jurisdictional requirements. While the federal government provides the foundational definition of what constitutes research, the Ohio Department of Taxation (ODT) serves as the primary arbiter of how those definitions are applied within the unique landscape of the state’s tax system. To understand the “direct conduct of research,” one must first recognize its position as the primary tier within the hierarchy of “qualified services” as defined under Internal Revenue Code (IRC) §41 and subsequently adopted by the Ohio Revised Code (R.C.). This tier is distinct from “direct supervision” and “direct support,” and it demands a higher level of technical substantiation because it represents the actual scientific or engineering labor that drives innovation.

Statutory Construction and the Adoption of Federal Standards

The Ohio Research and Development Investment Tax Credit is codified primarily under R.C. 5751.51 for the Commercial Activity Tax (CAT) and R.C. 5726.56 for the Financial Institutions Tax (FIT). These statutes provide the legal mechanism through which a taxpayer may claim a nonrefundable credit equal to seven percent of the amount by which their qualified research expenses (QREs) incurred in Ohio exceed a historical base amount. The critical phrase within these sections is the definition of “qualified research expenses,” which the law dictates “has the same meaning as in section 41 of the Internal Revenue Code”.

By adopting IRC §41, Ohio effectively imports decades of federal tax jurisprudence, Treasury Regulations, and administrative guidance into its own tax code. However, the Ohio Department of Taxation has made it clear through various final determinations and administrative rules that meeting the federal definition is merely the first step; the taxpayer must also comply with state-specific jurisdictional and procedural mandates to successfully claim the credit. This creates a dual-layered burden of proof where a taxpayer must demonstrate both the technical validity of the research under federal standards and the geographical validity of the expenses under Ohio law.

The Mechanism of Qualified Services

Under IRC §41(b)(2)(B), “qualified services” are divided into three specific categories: engaging in qualified research, the direct supervision of qualified research, and the direct support of qualified research. The phrase “engaging in qualified research” is synonymous with the “direct conduct of research”. This category identifies the individuals who are actually performing the systematic trial and error, modeling, or laboratory work required to resolve a technical challenge.

The distinction between these categories is vital for accurate credit calculation. While all three categories are eligible for the credit, “direct conduct” is often the largest component of a claim and receives the most scrutiny during an ODT audit. The Department requires that wages be apportioned based on the actual percentage of time an employee spends on these activities, necessitating robust contemporaneous documentation.

The Four-Part Test: The Technical Standard for Direct Conduct

To qualify as “direct conduct,” the activity must satisfy the “four-part test” established by the federal government and applied by the Ohio Tax Commissioner. This test is designed to separate true technological research from routine product development, cosmetic changes, or business process improvements.

The Permitted Purpose Test

The first prong requires that the research be undertaken for a “permitted purpose,” which involves the creation of a new or improved “business component”. A business component is defined as any product, process, computer software, technique, formula, or invention that is held for sale, lease, or use in the taxpayer’s trade or business. The direct conduct of research must aim to improve the functionality, performance, reliability, or quality of this component.

In a manufacturing context, this might involve an engineer in Ohio designing a more efficient turbine blade. In a software context, it could involve a developer in Columbus creating a new algorithm for high-speed data processing. The ODT emphasizes that activities aimed at aesthetic or cosmetic improvements do not meet this test; the focus must be on technical performance.

The Technological in Nature Test

The second prong mandates that the process of experimentation must “fundamentally rely on principles of the physical or biological sciences, engineering, or computer science”. This requirement excludes research based on social sciences, economics, or business management. Direct conduct personnel must be using these hard sciences to achieve their results. For example, a chemist at a facility in Akron using molecular modeling to develop a new polymer is engaged in technological research, whereas a market researcher in the same building conducting surveys on consumer preferences is not.

The Elimination of Uncertainty Test

The third prong focuses on the “intent” of the researcher. The taxpayer must intend to discover information that would eliminate uncertainty regarding the “capability” or “method” for developing the component, or the “appropriate design” of that component. Uncertainty exists if the information available to the taxpayer at the beginning of the research does not establish how to achieve the desired result.

Direct conduct personnel are the individuals tasked with resolving these uncertainties. Their work begins when the path forward is unclear and ends when the technical design is established. If the result is already known and the work is merely a standard application of existing knowledge, it does not constitute the direct conduct of qualified research.

The Process of Experimentation Test

The final prong requires that “substantially all” (interpreted as 80 percent or more) of the activities constitute elements of a “process of experimentation”. This process involves the systematic evaluation of alternatives, such as through modeling, simulation, or trial and error.

For an employee to be engaged in “direct conduct,” they must be the one performing these evaluations. The federal courts and the ODT have clarified that the “substantially all” test applies to the activities of the personnel, not the physical elements of the product. A direct conduct researcher’s daily routine should be characterized by testing hypotheses and adjusting designs based on experimental data.

Local State Revenue Office Guidance: The Ohio Department of Taxation

The Ohio Department of Taxation provides specific guidance on the application of the R&D credit through Administrative Rules and Information Releases. The primary rule is OAC 5703-29-22, which details the “Explanation of the commercial activity tax credits”. This rule, alongside Information Release CAT 2007-03, serves as the definitive manual for Ohio taxpayers.

Administrative Rule OAC 5703-29-22

This rule establishes the procedural framework for claiming the credit against the CAT. It emphasizes that while the credit is nonrefundable, it may be carried forward for up to seven years.

The Department’s guidance on “direct conduct” mirrors the federal definitions but adds a layer of administrative strictness regarding the “situs” of the expenses. For a researcher’s wages to be eligible, they must be paid for “qualified services performed by such employee” in Ohio. If an employee performs research in both Ohio and another state, only the portion of their time physically spent in Ohio on qualified activities can be used to generate the credit.

Information Release CAT 2007-03 and Revisions

The Information Release, originally issued in 2007 and revised as recently as 2022, provides a broader explanation of the credit’s interaction with other CAT credits. It confirms that the credit for qualified research expenses is available to offset the CAT liability starting from the period beginning July 1, 2008. It also clarifies the order in which credits must be claimed under R.C. 5751.98, placing the nonrefundable R&D credit early in the hierarchy to maximize its utility for the taxpayer.

The 2022 revision is particularly important as it reflects changes in the Ohio Administrative Code and clarifies the Department’s position on audit requirements. It explicitly states that the Tax Commissioner may audit a “representative sample” of a taxpayer’s expenses to verify the amount of the credit claimed. This gives the ODT broad authority to demand the same level of granular documentation that the IRS requires for federal claims.

Application of the Law: Jurisdictional and Geographic Constraints

The most significant divergence between the federal R&D tax credit and the Ohio version is the “jurisdictional and geographical distinction” found in R.C. 5751.51(B)(1). While the federal credit applies to research conducted anywhere in the United States, the Ohio credit is strictly limited to expenses “incurred in this state”.

The “Incurred in This State” Mandate

This requirement applies to all three categories of qualified expenses: wages, supplies, and contract research.

• Wages: For direct conduct personnel, the taxpayer must demonstrate that the employee was physically present in Ohio while performing the qualified research. This often requires the use of state-specific time logs or geolocation data for remote or multi-state workers.
• Supplies: Tangible property (other than land or depreciable property) used in the research must be “consumed” in Ohio. This includes materials for prototypes and chemicals used in lab trials.
• Contract Research: Payments to third parties are qualifying only if the research services are performed in Ohio. Under both federal and Ohio law, only 65 percent of contract research payments are eligible for inclusion in the credit calculation.

The ODT’s strict construction of “incurred in this state” has led to significant disputes. In the Cristal USA Final Determination, the Department denied credits because the taxpayer could not confirm that the research activities actually occurred at their Ohio plants, despite the taxpayer having manufacturing operations in the state. This case highlights that the mere presence of a facility in Ohio is insufficient; there must be a direct evidentiary link between the “direct conduct” labor and an Ohio location.

Interaction with the 80 Percent Rule

The “substantially all” rule (or 80 percent rule) further complicates the application of the law. If at least 80 percent of an employee’s services in a year are “qualified services,” then 100 percent of their wages may be treated as QREs. However, for the Ohio credit, this rule must be applied specifically to the time spent in Ohio. An employee who spends 50 percent of their total time on R&D, but only 10 percent of that time is in Ohio, would only generate Ohio QREs based on that 10 percent. Conversely, if an Ohio-based researcher spends 85 percent of their time on qualified direct conduct activities in a lab in Cleveland, 100 percent of their Ohio wages would qualify for the Ohio credit.

Audit Scrutiny and the Evolving Standards of Documentation

A critical aspect of the “direct conduct” meaning is the evidentiary standard required to defend it under audit. The Ohio Department of Taxation emphasizes that “taxpayers seeking to claim a QRE credit must do so in the manner laid out in R.C. 5751.51” and must “affirmatively demonstrate” their entitlement to the credit.

The Shift Toward Project-Level Detail

Historically, many taxpayers used a “Departmental Approach” to document R&D, relying on high-level job descriptions and manager interviews to estimate the time spent on research. However, following trends at the federal level—most notably the Park-Ohio Holdings Corp. v. United States litigation—the standard is shifting toward a “Project Approach”.

The Park-Ohio case, though a federal dispute, has profound implications for Ohio taxpayers because of the state’s reliance on IRC §41. The IRS (and now, increasingly, the ODT) is demanding line-by-line, person-by-person explanations of the research activities performed for every business component. For a claim to be considered valid, the taxpayer must identify:

• Every business component for which a credit is claimed.
• All research activities performed for each component.
• The specific individuals (direct conduct personnel) who performed those activities.
• The specific technological uncertainty each individual sought to resolve.

This level of detail is necessary because the ODT performs “paper-only” audits that rely entirely on the provided documentation. If the taxpayer cannot provide contemporaneous records (e.g., time logs, technical reports, source code commit histories) linking an employee’s wages directly to a qualified project, the credit is likely to be disallowed.

Record Retention Requirements

Ohio law (R.C. 5751.51(F) and FIT R.C. 5726.56(F)) mandates that taxpayers retain records to substantiate their credit for four years after the return is filed or its due date, whichever is later. This includes not just the records for the current year, but also for the three preceding “base” years used to calculate the credit. Failure to produce these records during an audit can lead to a retroactive assessment of tax and interest.

Calculation Methodology and Economic Impact

The Ohio R&D credit is calculated using an incremental formula that rewards businesses for increasing their research investment within the state.

The Calculation Formula

The credit is equal to seven percent of the “excess” QREs. The calculation follows this mathematical structure:

Credit = 0.07 × (Current Year Ohio QREs – Base Amount)

The “Base Amount” is defined as the average annual qualified research expenses incurred in Ohio by the taxpayer for the three preceding taxable years. If the taxpayer has not previously conducted research in Ohio, the base amount is zero.

This incremental model incentivizes growth. For a company to maximize its credit, it must continually increase its spending on direct conduct personnel and related expenses in Ohio. The credit is nonrefundable, meaning it can only offset a taxpayer’s CAT liability. However, the seven-year carryforward period provides a significant window for businesses to utilize the benefit as they scale.

Impact of CAT Threshold Changes

Starting in 2024, Ohio significantly increased the exclusion threshold for the Commercial Activity Tax. The exclusion rose from $1 million to $3 million in 2024, and will rise further to $6 million in 2025. This change effectively eliminates the CAT for many small and medium-sized businesses. For companies falling below these thresholds, the R&D credit becomes less relevant in the immediate term, as they have no tax liability to offset. However, larger high-growth companies that exceed these thresholds—particularly in the technology and manufacturing sectors—continue to find the R&D credit to be a critical component of their tax strategy.

Case Analysis: Cristal USA Inc. v. McClain

The Final Determination in Cristal USA Inc. (now INEOS Pigments) offers one of the most comprehensive looks at how the ODT applies the concepts of direct conduct and the “in Ohio” rule.

Procedural Background

Cristal USA, a producer of titanium dioxide, filed amended CAT returns claiming R&D credits for its 2012 tax year. The company argued that “plant trial activities” performed at its facilities in Ashtabula, Ohio, constituted qualified research under IRC §41 and thus were eligible for the Ohio credit.

The Tax Commissioner’s Reasoning

The Tax Commissioner upheld the denial of the credits on three primary grounds:

• Filing Methodology: The taxpayer failed to claim the credit in a manner consistent with R.C. 5751.051 and OAC 5703-29-09. The credit was claimed on an amended return in a way that the Department deemed procedurally improper for offsetting assessed tax.
• Evidence of In-State Performance: Despite the presence of Ohio manufacturing plants, the taxpayer could not provide specific records (time logs or project summaries) proving that the research was performed by personnel physically located in those plants during the trials.
• Independence of State Review: The Commissioner explicitly rejected the argument that receiving federal R&D credits automatically entitles a taxpayer to Ohio’s credit. The determination noted that “the IRS does not audit every taxpayer” and that the ODT has the independent authority to review the facts under state law.

Implications for Direct Conduct

This case underscores that “direct conduct” is not merely a technical status but a documented, geographic event. To the ODT, a plant trial is not qualified research simply because it results in a better product; it is qualified research only if the taxpayer can provide a “granular breakdown” of the individuals involved, the technical hurdles they faced, and proof that the labor occurred in Ohio.

Detailed Example: Precision Manufacturing in Dayton, Ohio

To illustrate the integrated application of these concepts, consider the case of “AeroForge Inc.,” a hypothetical precision aerospace components manufacturer located in Dayton, Ohio.

The Innovation Project

AeroForge intends to develop a new additive manufacturing (3D printing) process for titanium engine mounts. The project aims to reduce component weight by 15 percent while maintaining structural integrity. The technical challenges include:

• Uncertainty regarding the optimal cooling rates for the titanium alloy to prevent micro-fractures.
• Uncertainty regarding the structural design of the “honeycomb” interior of the mount.

Direct Conduct Personnel and Activities

Documentation Strategy

To satisfy the ODT’s requirements, AeroForge must maintain a comprehensive project file:

• Technical Specifications: A document outlining the weight reduction goal and the metallurgical uncertainties.
• Source Code: Commit logs for the firmware modifications made by the software developer.
• Lab Notes: The Material Scientist’s records of micro-fracture analysis across different cooling rates.
• Ohio Time Logs: For the Software Developer, logs proving that the R&D coding was performed during the three days a week they spent in the Dayton office, as opposed to their home in Kentucky.

Financial Calculation

For the 2024 calendar year, AeroForge identifies the following Ohio QREs:

• Qualified Wages: $800,000 (apportioned based on time in Ohio and time on research).
• Qualified Supplies: $200,000 (titanium powder and testing reagents consumed in Dayton).
• Total 2024 Ohio QREs: $1,000,000.

Base Period Analysis:

• 2023 Ohio QREs: $700,000.
• 2022 Ohio QREs: $600,000.
• 2021 Ohio QREs: $500,000.
• Average Base: $600,000.

Credit Computation:

Credit = 0.07 × ($1,000,000 – $600,000) = $28,000

AeroForge claims this $28,000 credit on its fourth-quarter 2024 CAT return. Because AeroForge’s taxable gross receipts in 2024 were $10 million, and the exclusion was $3 million, their CAT liability before the credit was:

($10,000,000 – $3,000,000) × 0.0026 = $18,200

Since the $28,000 credit exceeds the $18,200 liability, AeroForge pays $0 in CAT for the period and carries forward the remaining $9,800 to the 2025 tax year.

Future Outlook: Legislative Changes and Compliance Trends

The landscape for the direct conduct of research in Ohio is subject to ongoing shifts in both legislative policy and judicial interpretation.

Federal Amortization of R&D Expenses (Section 174)

A major development impacting the R&D environment is the change to IRC §174 under the Tax Cuts and Jobs Act (TCJA). Starting in 2022, businesses were no longer permitted to immediately deduct R&D expenses but were instead required to amortize them over five years for domestic research and fifteen years for foreign research. While this change primarily affects federal income tax, it has influenced how companies track their “direct conduct” expenses, often leading to more rigorous accounting systems that can benefit state-level R&D credit claims by providing better data on labor and supplies.

The Role of JobsOhio

Ohio also integrates its tax credit framework with other incentive programs. Businesses investing in R&D may also qualify for the “Research and Development Investment Loan” through JobsOhio. This program offers low-interest financing and a separate CAT credit for loan repayments, typically capped at $150,000 per year. For companies engaged in the direct conduct of research, pairing these incentives can significantly reduce the cost of capital for high-wage R&D jobs.

Increasing Judicial Oversight

Recent decisions by the Ohio Supreme Court, such as those involving NASCAR Holdings and the CAUV valuation case, indicate a trend where the court is willing to scrutinize and overrule the determinations of the Tax Commissioner and the Board of Tax Appeals (BTA). This “national and ongoing trend of courts to scrutinize agency determinations” means that taxpayers who have been denied R&D credits may find a more receptive audience in the judicial system if they can present a legally sound, well-documented case that the Department abused its discretion or applied a “distinction that allows no other conclusion” regarding the nature of the research.

Key Takeaways for Direct Conduct

Understanding the direct conduct of research in the Ohio context requires a comprehensive grasp of both technical and administrative details.

• Technical Definition: Direct conduct is the Tier 1 category of qualified services, involving the “hands-on” engineering or scientific work of an employee to resolve technological uncertainty.
• Four-Part Test Mastery: Every project must be technological in nature, have a permitted purpose, involve uncertainty, and utilize a process of experimentation.
• Geographic Nexus: Ohio law strictly limits the credit to expenses “incurred in this state,” meaning all research labor, supplies, and contract work must physically occur within Ohio.
• Documentation as Defense: The shift toward the “Project Approach” means that taxpayers must maintain person-by-person, activity-level documentation to survive an ODT audit.
• Credit Utilization: The seven percent nonrefundable credit is calculated on an incremental basis over a three-year average and can be carried forward for seven years to offset CAT or FIT liability.

For the professional tax advisor or corporate leader, the “direct conduct” of research represents the highest point of both risk and reward within the Ohio tax code. It is the engine of innovation that the state seeks to incentivize, but it is also the area where the burden of substantiation is most demanding. By aligning internal project tracking with the standards of IRC §41 and the jurisdictional mandates of R.C. 5751.51, Ohio businesses can secure their credits and continue to drive technological advancement within the state.