In-House Research Expenses

In-house research expenses within the Ohio tax code represent the sum of qualified wages, research supplies, and computer leasing costs incurred directly by a taxpayer for experimentation conducted physically within the state. These expenditures serve as the primary basis for a nonrefundable seven percent credit against the Commercial Activity Tax, calculated on the incremental growth of research investments over a three-year rolling average.

The legal and administrative structure of the Ohio Research and Development (R&D) Investment Tax Credit is anchored in a complex intersection of state statutes and federal tax definitions. Authorized under Section 5751.51 of the Ohio Revised Code (R.C.), the credit is designed to incentivize corporations and consolidated groups to deepen their technological footprint within the state. While the Ohio General Assembly intentionally “piggybacked” the credit onto the federal definitions provided in Section 41 of the Internal Revenue Code (IRC), the application of law by the Ohio Department of Taxation (ODT) has evolved into a highly specialized discipline. Taxpayers must navigate not only the federal “four-part test” for qualified research but also a stringent geographic mandate that requires every dollar of claimed in-house expense to be “incurred in this state”. This requirement creates a significant evidentiary burden, as the state frequently re-evaluates federal eligibility during audits, demanding contemporaneous documentation that links specific Ohio-based activities to qualified experimental outcomes. As the Commercial Activity Tax (CAT) undergoes transformative changes in 2024 and 2025—specifically the drastic increase in the exclusion threshold to $3 million and $6 million, respectively—the strategic value and administrative necessity of tracking in-house research expenses have taken on new dimensions for both established manufacturers and emerging technology firms.

Statutory Foundations and the Federal Internal Revenue Code Linkage

The Ohio R&D credit is not a standalone definition of research but rather a jurisdictional application of federal standards. R.C. 5751.51(A) explicitly dictates that “qualified research expenses” possess the same meaning as defined in Section 41 of the Internal Revenue Code. This statutory bridge ensures that the state credit remains aligned with national standards for innovation while allowing the state to focus its limited revenue resources on activities occurring within its own borders.

The Structural Components of In-House Research Expenses

Under IRC Section 41, which Ohio adopts, in-house research expenses (IHRE) are distinguished from contract research expenses by the direct nature of the expenditure. While contract research is generally limited to 65% of the amount paid to external parties, in-house expenses are typically includable at 100% of the qualified amount, provided they fall into three specific categories: qualified wages, qualified supplies, and qualified computer leasing costs.

The distinction between in-house and contract research is vital because in-house expenses represent the internal “innovation capacity” of a firm. The Ohio Department of Taxation scrutinizes these costs to ensure they are not merely general and administrative (G&A) expenses rebranded as R&D. For example, while 100% of an Ohio engineer’s qualified wages can be claimed, the ODT often requires proof that the engineer’s time was spent on activities that meet the “Process of Experimentation” test, rather than routine quality control or maintenance.

The Evolution from Franchise Tax to Commercial Activity Tax

The current R&D credit is a successor to earlier incentives provided under the now-phased-out Ohio Corporation Franchise Tax. Section 5733.351 of the R.C. originally provided an R&D credit for tax years 2002 through 2008. When Ohio transitioned to the CAT—a gross receipts tax—the credit was preserved and converted to ensure continuity for the state’s industrial base. This historical transition is relevant for modern taxpayers because unused credits from the Franchise Tax era were allowed to be carried forward into the CAT era, provided the total carryforward period did not exceed seven years. The mechanism for the credit remains a nonrefundable offset, meaning it can reduce a taxpayer’s CAT liability to zero but cannot result in a cash refund from the state treasury.

Detailed Analysis of Qualified In-House Expense Categories

The meaning of in-house research expenses is best understood through the specific types of costs that the ODT permits. Each category carries its own set of evidentiary requirements and common pitfalls during state audits.

Qualified Wages and the “Qualified Services” Requirement

Wages constitute the largest portion of most R&D claims, often representing nearly 70% of total qualified research expenditures. In the context of the Ohio credit, “wages” generally refers to taxable compensation as defined under IRC Section 3401(a), which includes Box 1 of the W-2 form. However, not every dollar paid to a researcher qualifies. The wages must be specifically for “qualified services,” which are categorized into three tiers of activity.

Direct Conduct: This involves the actual performance of the experimental work. Examples include a software developer in Cleveland coding a novel encryption algorithm or a mechanical engineer in Dayton testing a new alloy’s heat resistance.

Direct Supervision: This applies to the immediate managers who oversee the researchers. To qualify, the supervisor must be “first-line” management. Higher-level executives, such as a CEO or CFO, typically do not qualify unless they are directly involved in the technical decision-making and experimentation process.

Direct Support: This covers auxiliary services that are essential to the research, such as a lab technician cleaning specialized equipment or a machinist creating a custom part for a one-off prototype.

A critical administrative rule used by both the IRS and the ODT is the “Substantially All” or “80% Rule.” If an employee spends at least 80% of their professional time engaged in qualified services, 100% of their wages may be treated as a qualified in-house research expense. If the time spent is between 0% and 80%, the taxpayer may only claim the proportionate share of that employee’s wages. The ODT strictly enforces this through the requirement of contemporaneous time tracking or employee surveys conducted at the end of each pay cycle or year.

Qualified Supplies: Consumables vs. Capital Assets

Supplies in the R&D context must be tangible property that is consumed during the research process or used to create prototypes. The state revenue office guidance emphasizes that these must not be depreciable assets. If a piece of equipment has a useful life and is subject to depreciation under the tax code, it is excluded from the R&D credit base, as it is viewed as a capital investment rather than a research expense.

Commonly qualified supplies in Ohio industries include:

• Chemicals used in laboratory testing.
• Materials used to construct “pilot models” or prototypes that are not intended for final sale.
• Extraordinary utility costs, such as the massive amounts of electricity required to run a particle accelerator or a high-intensity testing chamber, provided the taxpayer can distinguish these from standard G&A utilities.

The “Shrinking-Back” rule is often applied to supplies. If a taxpayer creates a large, complex machine that contains both innovative and routine components, the ODT may require the taxpayer to “shrink back” the supply costs to only those specific parts of the machine that were part of the experimental process.

Computer Rental and Leasing in the Cloud Era

The third category of in-house research expenses—computer leasing—has seen a resurgence in relevance due to the transition to cloud-based development environments. Under IRC Section 41(b)(2)(A)(iii), payments made to another person for the right to use computers in the conduct of qualified research are includable. Historically, this was used for mainframe time-sharing. Today, this is the primary mechanism for claiming costs related to Amazon Web Services (AWS) or Microsoft Azure.

To qualify as an in-house expense in Ohio, the cloud computing costs must be:

• Used specifically for a development, staging, or testing environment related to a qualified Ohio research project.
• Not used for general hosting of a commercial product or for administrative IT functions.
• Supported by documentation that identifies the Ohio-based personnel who utilized the computing resources.

The Geographic Mandate: “Incurred in This State”

Perhaps the most rigorous aspect of the Ohio R&D tax credit is the jurisdictional requirement found in R.C. 5751.51(B)(1). The statute allows the credit only for expenses “incurred in this state by the taxpayer”. This creates a sharp divergence from the federal credit, which applies to research conducted anywhere in the United States or its territories.

Interpreting the Nexus of the Expense

The Ohio Department of Taxation interprets “incurred in this state” through the physical location of the activity. For in-house research expenses, this is relatively straightforward for supplies—they must be used at an Ohio facility. However, for wages, the rise of remote and hybrid work has complicated the analysis. If a company is headquartered in Columbus but employs a specialized software architect living and working in Michigan, the architect’s wages may qualify for the federal credit but are strictly excluded from the Ohio credit.

In the landmark Cristal USA determination, the Tax Commissioner emphasized that the burden of proof rests entirely on the taxpayer to demonstrate the Ohio nexus. Even if a company has a massive presence in Ohio, if the specific personnel or materials used in a research project cannot be tied to an Ohio location through contemporaneous records (such as employee W-2s and facility logs), the credit will be denied.

Audit Trends and Final Determinations

The ODT has adopted an increasingly aggressive stance regarding the “in-state” requirement. Recent final determinations indicate that the state will not simply accept a company’s federal 6765 form as evidence of Ohio spend. Instead, the state may conduct a “field audit” where they inspect the facility where the research supposedly took place and interview the engineers involved.

The 2023 amendments to R.C. 5751.51 and R.C. 5726.56 have formalized the Tax Commissioner’s right to audit a “representative sample” of research projects. This means that if a large manufacturer claims 100 different R&D projects, the state can audit 10 of them. If the state finds that 3 of those 10 do not meet the “in Ohio” or “qualified research” standards, they can apply a 30% reduction to the entire credit claim.

The Four-Part Test: Federal Standards in the Ohio Context

While Ohio adds a geographic layer, it still relies on the four-part test codified in IRC Section 41(d) to determine if the activity itself is “qualified” research. For an in-house expense to be eligible, the activity it supports must pass every one of these tests.

The Section 174 Test (Permitted Purpose)

The expenditure must be eligible for treatment as a research or experimental expenditure under Section 174 of the IRC. This means the costs must be “incurred in connection with the taxpayer’s trade or business” and represent R&D costs in the “experimental or laboratory sense”.

Recent federal changes under the Tax Cuts and Jobs Act (TCJA) have required these costs to be capitalized and amortized over five years. While this impacts the timing of deductions, it does not change the eligibility for the Ohio credit. A cost that is capitalized under Section 174 is still a “qualified research expense” for the purposes of calculating the 7% Ohio credit.

The Technological Information Test

The research must be undertaken for the purpose of discovering information which is “technological in nature”. This requires that the process of experimentation rely fundamentally on the principles of:

• Physical sciences.
• Biological sciences.
• Engineering.
• Computer science.

Ohio strictly excludes research in the social sciences, arts, or humanities. Market research, efficiency surveys, and management studies are also explicitly excluded.

The Business Component Test

The taxpayer must intend to use the discovered information to develop a “new or improved business component”. A business component can be a:

• Product.
• Process.
• Computer software.
• Technique.
• Formula.
• Invention.

In Ohio’s manufacturing-heavy economy, this test is often applied to the “Process” component. A factory that develops a new, more efficient way to cast steel is conducting research on a “process,” even if the steel product itself remains unchanged.

The Process of Experimentation Test

This is arguably the most difficult test to pass during an ODT audit. The taxpayer must demonstrate that “substantially all” (80% or more) of the research activities constitute elements of a process of experimentation. A process of experimentation involves:

Identifying a technical uncertainty regarding the capability, method, or appropriate design of the component.

Identifying one or more alternatives intended to eliminate that uncertainty.

Conducting a systematic evaluation of those alternatives through modeling, simulation, or trial-and-error.

The ODT often denies credits for “routine” engineering. If a company is simply applying existing knowledge to a new project without facing true “technical uncertainty,” the activity is not considered qualified research.

Administrative Guidance: Revenue Office Rules and Filing

The Ohio Department of Taxation provides a clear roadmap for claiming the R&D credit, primarily through Rule 5703-29-22 of the Ohio Administrative Code (OAC).

Computation on a Calendar Year Basis

Regardless of the taxpayer’s fiscal year, the credit for qualified research expenses must be computed based on expenses incurred during the calendar year. This is a unique requirement for the CAT. If a company has a June 30 fiscal year-end, it must still “carve out” its QREs for January 1 through December 31 to calculate the Ohio credit.

Filing the CAT CS Schedule

The credit is not claimed through a separate application or pre-approval process. Instead, it is claimed directly on the CAT return. Taxpayers must complete and submit the CAT CS (Credit Schedule) along with their return.

The CAT CS requires the following data points:

• Qualified research expenses for the current calendar year.
• Qualified research expenses for the three preceding calendar years.
• The addresses of the facilities in Ohio where the research was conducted.

If a taxpayer is part of a “Consolidated Elected” or “Combined” taxpayer group, each member of the group must separately calculate its own credit on a separate schedule. The group then aggregates these credits to offset the total group liability.

Carryforward Rules and Limitations

The Ohio R&D credit is nonrefundable. If the credit amount exceeds the CAT liability for the year, the excess cannot be refunded but may be carried forward for up to seven years.

$$Carryforward\_Remaining = Credit\_Earned – CAT\_Liability\_Current$$

The law mandates a specific “Order of Credits” in R.C. 5751.98. The R&D credit is generally claimed after certain other credits, such as the Jobs Creation Credit, but before others. Taxpayers must use any carryforward amounts from previous years before using the credit generated in the current year.

The Impact of 2024 and 2025 CAT Legislative Changes

The 135th General Assembly enacted sweeping changes to the Commercial Activity Tax that have drastically altered the landscape for R&D tax planning. These changes focus on the exclusion amount—the level of gross receipts at which a company starts paying the tax.

The $3 Million and $6 Million Exclusion Thresholds

Historically, the CAT featured a $1 million exclusion. Recent legislation has significantly increased these amounts:

For 2025 and beyond, a business with less than $6 million in Ohio taxable gross receipts will have no CAT liability and is not even required to file a return. This has two profound effects on the R&D credit:

Immediate Benefit: For small and medium-sized enterprises (SMEs) with Ohio sales below $6 million, the R&D credit is currently unusable. Since there is no tax to offset, the nonrefundable credit provides no immediate cash-flow benefit.

Base Period Distortion: Even if a company does not pay CAT in 2025, they must continue to track their in-house research expenses. If the company’s sales grow to $10 million in 2028, their 2025 QREs will form part of the three-year base average used to calculate their 2028 credit. Failure to document 2025 expenses today could prevent them from accurately claiming a credit in the future.

Strategic Relevance for Large Enterprises

For companies with gross receipts significantly above $6 million, the R&D credit remains as valuable as ever. The tax rate on receipts above the exclusion remains at 0.26%. For a company with $100 million in Ohio sales, the CAT liability is approximately $244,400 (($100M – $6M) * 0.0026). In this scenario, a robust R&D credit claim can still eliminate the entire tax liability.

Internal Use Software (IUS) and Modern Tech Expenses

As Ohio attracts more technology firms and data centers (such as Intel’s new $20 billion facility), the ODT’s guidance on software development has become a focal point of discussion. Software developed for “internal use” is subject to a higher standard than software developed for sale, lease, or license.

The High Threshold of Innovation (HTI) Test

In-house research expenses for software that is intended for “general and administrative” functions (e.g., internal HR systems, accounting software, or project management tools) are only qualified if they pass the three-part HTI test:

Innovation: The software must be significantly different from other existing software and provide substantial cost or time savings.

Significant Economic Risk: The taxpayer must commit substantial resources with no certainty that the software can be successfully developed.

Commercial Availability: The software cannot be something that is already available for purchase or license in the open market.

Importantly, software that is developed to be “dual-use”—meaning it supports both internal functions and interaction with customers (e.g., an online banking portal)—may be exempt from the HTI test. Software used in a manufacturing process or as part of a hardware-software package is also generally exempt from the higher HTI standard.

Cloud Infrastructure as a “Computer Lease”

As noted previously, the ODT has begun to accept cloud infrastructure costs as in-house research expenses. This is a critical development for startups. Instead of buying $500,000 in servers (which are depreciable and thus excluded from R&D), a startup can pay $500,000 to AWS for a development environment. Because this is a “lease” of a computer, the entire amount can be treated as an in-house research expense, assuming it meets the other four-part test criteria.

Comprehensive Example: The “Buckeye Innovation” Scenario

To synthesize the law, guidance, and calculations, consider a multi-year scenario for a hypothetical Ohio company, “Buckeye Innovation Corp,” which designs specialized medical devices in Cleveland.

Data Collection and Year-by-Year Analysis

The company must first aggregate its Ohio-based in-house research expenses for the current year and the three-year base period.

Step 1: Calculate the 2024 Base Amount

The base amount is the average of the previous three years of Ohio QREs.

$$Base\_Average = \frac{1,400,000 + 1,520,000 + 1,780,000}{3} = \frac{4,700,000}{3} \approx **$1,566,667**$$

Step 2: Calculate the 2024 Incremental Excess

The credit applies only to the “excess” spend in the current year.

$$Excess = 2,150,000 (2024\ QRE) – 1,566,667 (Base) = **$583,333**$$

Step 3: Determine the 2024 Credit Amount

The statutory rate is seven percent.

$$Credit = 583,333 \times 0.07 = **$40,833.31**$$

Step 4: Contextualize Against the 2024 CAT Liability

Assume Buckeye Innovation Corp has $25,000,000 in Ohio Taxable Gross Receipts in 2024.

Exclusion: The first $3,000,000 is excluded for 2024.

Taxable Receipts: $25,000,000 – $3,000,000 = $22,000,000.

Gross CAT Liability: $22,000,000 * 0.0026 = $57,200.

Application of Credit: The $40,833.31 credit is applied against the $57,200 liability.

Final CAT Payment: $57,200 – $40,833.31 = $16,366.69.

Audit Substantiation Requirements for the Example

If the ODT audits this $40,833 credit, the company must be prepared to provide:

• W-2s for the Ohio Engineers: Proving they are Ohio residents or were working physically in Cleveland.
• Contemporaneous Documentation: Project notes and Jira tickets showing that the $250,000 in supplies were used for medical device prototypes (non-depreciable) and not for final inventory sold to hospitals.
• Technical Narratives: Explaining why the 2024 projects involved “Technical Uncertainty.” If the company was just making a minor aesthetic change to an existing device, the ODT would likely exclude those hours and wages from the numerator, potentially reducing the credit to zero.

Intersection with Section 174: Amortization and Cash Flow

For tax years beginning after December 31, 2021, IRC Section 174 requires all R&D expenses—including those that don’t qualify for the credit—to be capitalized and amortized. This creates a complex dynamic for Ohio taxpayers.

The Broader Scope of Section 174

Section 174 covers more costs than Section 41. It includes things like:

• Rent and utilities for R&D facilities.
• Travel expenses for R&D personnel.
• Patent attorney fees and filing costs.

While these costs must now be amortized over five years for federal income tax purposes, they do not qualify for the 7% Ohio R&D credit, which remains restricted to the “In-House” (Wages, Supplies, Computer) and “Contract” (65%) categories.

Strategic Implications

The mandatory amortization of R&D expenses has effectively increased the tax burden on innovative companies by removing the immediate deduction. In this environment, the 7% Ohio R&D credit becomes even more critical as a mechanism to recoup some of that lost cash flow. Companies must ensure they are capturing every possible dollar of Ohio IHRE to offset the increased federal and potentially state tax liabilities resulting from capitalization.

Specific Exclusions: What Does NOT Count as an IHRE?

To maintain a defensible claim, taxpayers must be aware of the activities and costs explicitly excluded by the Ohio Department of Taxation and IRC Section 41.

Foreign Research: Any research conducted outside the 50 states and U.S. territories is excluded from the federal credit. More specifically, for Ohio, any research conducted outside of Ohio is excluded from the state credit.

Post-Commercial Production: Research conducted after a product has entered the market is generally viewed as routine quality control or maintenance.

Funded Research: If a customer or a government grant pays for the research, the taxpayer cannot claim the credit for those expenses. To claim the credit, the taxpayer must bear the “financial risk” of the research outcome.

Reverse Engineering: Reproducing an existing product through a physical examination or from blueprints is not “qualified” research.

Social Sciences: Research in sociology, psychology, or the arts is never eligible, no matter how “innovative” the methodology.

Final Thoughts and Strategic Recommendations

The meaning of in-house research expenses in the context of the Ohio R&D tax credit is defined by a rigorous focus on physical nexus and experimental uncertainty. While the 7% credit rate is competitive and its permanent status provides stability for long-term planning, the administrative burden of claiming the credit has never been higher.

Final Strategic Takeaways:

• Documentation is Paramount: The ODT’s transition to a sampling-based audit model means that a single undocumented project can negatively impact the entire credit claim. Companies should implement project-based time tracking for all Ohio R&D personnel.
• Mind the Exclusion: Businesses with Ohio gross receipts near the $3 million (2024) or $6 million (2025) mark must evaluate whether the administrative cost of tracking R&D expenses exceeds the tax benefit of the credit, given they may have no CAT liability to offset.
• Leverage Modern IHRE Categories: The acceptance of cloud computing costs as a “computer lease” IHRE provides a significant opportunity for software-heavy companies to qualify for the credit without heavy capital expenditures.
• Geographic Precision: Taxpayers must rigorously audit their own remote-work policies. Wages for employees living outside of Ohio must be stripped from the state claim to avoid audit flags.

As Ohio continues to pivot toward a high-tech manufacturing and technology hub, the Research and Development Investment Tax Credit remains a cornerstone of the state’s economic policy. For the professional tax advisor or corporate tax department, the key to unlocking this value lies in a nuanced understanding of how federal definitions are interpreted and narrowed by the Ohio Department of Taxation’s jurisdictional requirements.