Qualified Services

Qualified services represent the labor-based activities—specifically the direct performance, supervision, or support of technical experimentation—that constitute eligible wage expenses for the Ohio Research and Development tax credit. To qualify under Ohio Revised Code Section 5751.51, these services must satisfy the federal four-part test and be physically performed within the state of Ohio.

The implementation of the Ohio Research and Development (R&D) Investment Tax Credit requires a sophisticated understanding of how state-level tax statutes interact with federal definitions. The credit is fundamentally an incremental incentive, rewarding taxpayers for increasing their investment in technical innovation over a historical baseline. Central to this incentive is the concept of “Qualified Research Expenses” (QREs), which Ohio defines by direct reference to Section 41 of the Internal Revenue Code (IRC). Within the QRE framework, “qualified services” form the core component of in-house research expenses, as the wages paid for these services typically represent the largest portion of a taxpayer’s claim. The Ohio Department of Taxation enforces a strict jurisdictional boundary, requiring that these services be “incurred in this state” to offset Commercial Activity Tax (CAT) or Financial Institutions Tax (FIT) liabilities. This report examines the statutory definitions, administrative guidance, and practical applications of qualified services in Ohio, providing a comprehensive guide for professional tax practitioners.

Statutory Evolution and the Transition to the Commercial Activity Tax

The legislative history of the Ohio R&D credit reflects the state’s transition from a traditional corporate income tax to a gross receipts-based tax system. Historically, the credit was authorized under Section 5733.351 of the Ohio Revised Code as a nonrefundable credit against the Corporation Franchise Tax. As Ohio phased out the franchise tax for most non-financial corporations, the credit was transitioned to the Commercial Activity Tax framework under ORC 5751.51, effective for tax periods beginning on or after January 1, 2008.

This transition was not merely a change in the tax against which the credit could be applied; it also represented a shift in the reporting and auditing mechanisms. Under the franchise tax, the credit was calculated based on the taxpayer’s federal taxable year. However, for CAT purposes, the credit must be computed based on expenses incurred during the calendar year, regardless of the taxpayer’s federal fiscal year-end. This distinction is critical for compliance, as misaligning the timing of qualified services can lead to the permanent loss of credit carryforwards or the assessment of penalties during an audit. For financial institutions, a parallel credit exists under ORC 5726.56, which maintains the same reliance on the IRC Section 41 definition of qualified research expenses while applying it to the Financial Institutions Tax.

The following table outlines the statutory hierarchy and the primary tax liabilities affected by the R&D investment tax credit.

Ohio R&D Tax Credit Statutory Framework

Statutory Provision	Tax Type	Primary Beneficiaries	Effectiveness
ORC 5751.51	Commercial Activity Tax (CAT)	General Business, Manufacturers, Software Dev	Permanent (Post-2008)
ORC 5726.56	Financial Institutions Tax (FIT)	Banks, Insurance Affiliates, Financial Firms	Permanent (Post-2013)
ORC 5733.351	Corporation Franchise Tax	Historically all; now limited to specific entities	Repealed for most (Pre-2008)
OAC 5703-29-22	Administrative Guidance	All CAT Taxpayers	Regulatory Overlay

The state’s commitment to these incentives is further evidenced by the Research and Development Sales Tax Exemption, which provides a complementary benefit by exempting the purchase of machinery and equipment used primarily for research from state and county sales and use taxes. This exemption applies to both “direct research”—aimed at creating new products—and “pure research”—scientific inquiry in the physical sciences—further broading the definition of what constitutes an R&D environment in Ohio.

The Three-Pronged Definition of Qualified Services

Because Ohio incorporates IRC Section 41 by reference, the definition of “qualified services” is identical to the federal standard found in IRC 41(b)(2)(B). This section identifies three distinct roles that an employee may perform to have their wages included in the QRE calculation.

Engaging in Qualified Research

The first prong of the definition encompasses the actual conduct of the research. This is the “boots-on-the-ground” technical work performed by scientists, engineers, and software developers who are attempting to solve a technical problem or eliminate a technological uncertainty. To meet this definition, the individual must be actively involved in the “Four-Part Test” activities, such as developing a new product formulation, writing novel source code, or testing a manufacturing prototype. The services must be technical in nature and rely on the hard sciences; services that focus on aesthetics, market research, or social sciences do not qualify.

Direct Supervision of Qualified Research

Direct supervision applies to the immediate managers of the individuals engaging in the research. A supervisor’s services qualify if they are managing the technical direction of the project, reviewing the results of experimentation, or making decisions on which technical alternatives to pursue. It is important to distinguish between “direct supervision” and “general management.” If a manager is merely approving timecards or overseeing the department’s budget, their services are considered general and administrative (G&A) and are excluded from the credit. Only when the supervision is “direct”—meaning the manager is technically involved in the research process—do the wages become eligible.

Direct Support of Qualified Research

Direct support includes activities that are auxiliary to the research but essential for its execution. Examples of direct support include a machinist who fabricates a one-of-a-kind prototype based on an engineer’s designs, a lab assistant who cleans and calibrates specialized testing equipment, or a clerk who compiles and organizes the technical data from an experiment. Similar to supervision, there is a clear boundary between “direct” and “indirect” support. Indirect support, such as the work performed by HR, accounting, or maintenance staff who keep the facility running but do not participate in the research projects, is ineligible.

The following table contrasts qualified services with ineligible activities to clarify the boundaries of the credit.

Analysis of Service Eligibility by Role

Service Type	Eligible Activity Examples	Ineligible Activity Examples
Engaging	Coding algorithms, testing material stress, chemical synthesis	Market testing, routine QC, aesthetic design
Supervision	Reviewing technical blueprints, directing lab trials	Budgeting, performance reviews, payroll approval
Support	Building prototypes, data entry of trial results	General janitorial work, HR recruiting, legal review

The nuance of these definitions is often the focal point of Department of Taxation audits. Taxpayers are frequently asked to provide job descriptions and “nexus” documentation that links specific employees to specific business components.

Wages and the Substantially All Rule

In the context of the Ohio R&D tax credit, the “meaning” of qualified services is monetized through the payment of wages. Ohio adheres to the federal definition of wages found in IRC 3401(a), which includes all remuneration for services performed by an employee. For most corporate taxpayers, this corresponds to the “Social Security wages” or “Medicare wages” reported on the employee’s Form W-2. It encompasses base salary, performance bonuses, and the spread on non-qualified stock options exercised during the year.

A pivotal administrative rule in the application of qualified services is the “Substantially All” rule, often referred to as the 80% rule. Under IRC 41(b)(2)(B), if an employee spends 80% or more of their total work time performing qualified services, then 100% of their wages may be treated as qualified research expenses. This rule provides a significant benefit to companies with dedicated research teams, as it eliminates the need to bifurcate the non-R&D portions of their work, such as attending general staff meetings or undergoing routine training.

Conversely, if an employee’s time spent on qualified services falls below the 80% threshold, only the actual percentage of their wages attributable to those services can be claimed. For instance, if an engineer spends 40% of their time on a new product development project and 60% on routine manufacturing support for existing products, the taxpayer can only claim 40% of that engineer’s wages as a QRE. This requires the taxpayer to maintain a more granular level of documentation, such as project-based time tracking.

The mathematical relationship between service time and eligible wages is expressed in the following equation:

$$W_{Qualified} = \begin{cases} W_{Total} & \text{if } \frac{T_{R\&D}}{T_{Total}} \ge 0.80 \\ W_{Total} \times \frac{T_{R\&D}}{T_{Total}} & \text{if } \frac{T_{R\&D}}{T_{Total}} < 0.80 \end{cases}$$

Where $W_{Qualified}$ represents the wage amount eligible for the 7% credit, $W_{Total}$ is the total Box 1 W-2 wages, $T_{R\&D}$ is the time spent on qualified services, and $T_{Total}$ is the total work time for the year.

The administrative ease of the 80% rule is a double-edged sword; if an auditor determines that a “100% researcher” actually spent 25% of their time on excluded activities like sales support, the entire wage claim for that individual may be reduced to 75%, causing a significant drop in the total credit.

Geographic Nexus: The Incurred in This State Requirement

While Ohio aligns with federal definitions for the nature of the services, it departs from federal law regarding the location of those services. ORC 5751.51(B)(1) specifies that the credit is only available for qualified research expenses “incurred in this state”. This geographic mandate is the most common cause of credit adjustments during state audits.

For services to be “incurred in this state,” the employee must be physically present in Ohio when they perform the work. This creates complex compliance issues for multi-state organizations. If an Ohio-based company has a research lab in Akron but its software development team is located in California, only the wages of the Akron-based researchers qualify for the Ohio credit. Furthermore, if an Ohio employee performs research while traveling out of state or working remotely from a residence in another state, those hours must technically be excluded from the Ohio QRE calculation, even if they remain eligible for the federal credit.

In the landmark administrative case of Cristal USA Inc. v. McClain (Final Determination, December 2020), the Tax Commissioner addressed a petition for reassessment where the taxpayer attempted to claim credits based on global research activities. The Department of Taxation ruled that merely having a facility in Ohio is insufficient; the taxpayer must “affirmatively demonstrate” that the specific activities giving rise to the expenses were performed within Ohio’s borders. The ruling emphasized that because tax reduction statutes are “strictly construed against the taxpayer,” any ambiguity regarding the location of the services results in the denial of the credit.

Jurisdictional Comparisons of QRE Incurrence

Jurisdiction	Expense Boundary	Ohio Tax Credit Impact
Inside Ohio	Within state borders	100% of QRE eligible for 7% credit
Outside Ohio (U.S.)	Other 49 states/Territories	0% Ohio credit; 20% Federal credit
Outside U.S.	Foreign countries	0% Ohio credit; 0% Federal credit

This geographic filter serves a critical economic purpose: it ensures that the tax revenue foregone by the state through the credit is directly tied to the creation and retention of high-wage technical jobs within the Ohio workforce.

Local State Revenue Office Guidance and Administrative Procedures

The Ohio Department of Taxation provides a framework for claiming the credit that emphasizes simplicity but carries high audit risks. Unlike other state incentives, such as the Jobs Creation Tax Credit or the Jobs Retention Tax Credit, the R&D Investment Tax Credit does not require an application to the Ohio Department of Development or the Tax Credit Authority. Instead, it is a self-claimed credit that a taxpayer reports on their Commercial Activity Tax return.

Calculating the Incremental Benefit

The Ohio credit is not 7% of total QREs; it is 7% of the excess of current-year Ohio QREs over the average annual Ohio QREs for the three preceding taxable years. This structure means that a company with flat or declining R&D spending will not receive a credit, even if they spend millions on qualified services. Conversely, a startup or a company expanding its Ohio operations will see a high credit-to-expense ratio because their three-year average “base” is low.

Filing Mechanics and Carryforwards

To claim the credit, a taxpayer must file the “CAT CS” credit schedule with their return. The schedule requires the taxpayer to list the QREs for the current year and the three prior years to calculate the 7% incremental benefit. Because the CAT is a gross receipts tax, the credit can only be used to offset the tax liability on receipts that exceed the annual exclusion amount ($3 million for 2024 and $6 million for 2025). Any unused credit can be carried forward for up to seven years.

For combined or consolidated elected taxpayer groups, each member of the group must calculate their own credit separately based on their own Ohio-incurred QREs. Only the member that actually incurred the expenses and performed the qualified services can generate the credit, though the resulting credit can typically be used to offset the group’s total CAT liability.

The Role of Information Release CAT 2007-03

The primary administrative guidance for the credit is found in Information Release CAT 2007-03, “Commercial Activity Tax Credits, Explained”. This release, most recently updated in May 2022, provides the “ordering rules” for claiming multiple credits. The R&D credit is generally claimed after the Jobs Creation and Jobs Retention credits but before the R&D Loan Repayment credit in the order required by ORC 5751.98. The release also clarifies that a taxpayer cannot “double-dip” by claiming the same expense as a credit against both the CAT and another tax, such as the individual income tax or the insurance premiums tax.

Documentation and the Impact of the Park-Ohio Litigation

The “meaning” of qualified services is ultimately defined by the documentation a taxpayer can produce during an audit. ORC 5751.51(D) mandates that a taxpayer must retain records to substantiate their claim for four years after the return is filed. The Department of Taxation has the statutory authority to audit a “sample” of the taxpayer’s expenses over a representative period.

Required Substantiation Materials

The local revenue office expects a clear “paper trail” that connects the financial cost of the services to the technical nature of the research. This typically includes:

• Financial Records: Payroll registers, W-2 forms, and general ledger reports identifying wage payments.
• Project Records: Technical reports, blueprints, white papers, and design documents that prove the project met the Four-Part Test.
• Personnel Records: Contemporaneous time logs, project-specific calendars, or internal emails that demonstrate the percentage of time each employee spent on qualified services.
• Nexus Records: Facility address lists, utility bills, or lease agreements that prove the research was conducted at an Ohio location.

The Implications of Park-Ohio v. United States

Taxpayers and practitioners are closely monitoring Park-Ohio Holdings Corp. v. United States, a case currently in the U.S. District Court for the Northern District of Ohio. Although it is a federal case, it centers on the IRS’s 2021 guidance which significantly increased the disclosure requirements for R&D refund claims. The IRS now requires a line-by-line, person-by-person explanation of the R&D work behind every claim.

Because Ohio law relies so heavily on federal definitions, any judicial decision in Park-Ohio that strikes down or reinforces these “granular” documentation requirements will likely dictate how the Ohio Department of Taxation handles state-level audits. If the IRS prevails, Ohio taxpayers can expect state auditors to demand even more detailed evidence of “who did what, when, and where” within their Ohio facilities.

Contract Research: The 65% Rule and the Performance Requirement

In addition to in-house services performed by employees, qualified services can be performed by third-party contractors. Under IRC 41(b)(3), “contract research expenses” are defined as 65% of any amount paid to a non-employee for qualified research. Ohio adopts this 65% limitation, recognizing that the contractor’s fee includes overhead and profit that do not constitute pure research costs.

For contract research to generate an Ohio credit, the services must be performed in Ohio. This creates a high hurdle for companies that outsource their R&D. If an Ohio manufacturer hires a specialized lab in North Carolina to test a new material, the 65% payment is a valid QRE for the federal credit, but it is an “out-of-state” expense that must be excluded from the Ohio CAT return. Conversely, if they hire a local lab in Cleveland or a research team at the University of Toledo, the expense is eligible.

Furthermore, the contract research must be conducted “on behalf of” the taxpayer, meaning the taxpayer must retain “substantial rights” to the research results and must bear the “economic risk” of the research. If a company only pays for the research if it is successful, they are not bearing the economic risk; in that case, the contractor is the one performing the research for their own account, and the company is simply purchasing a finished product.

Eligibility Conditions for Contracted Qualified Services

Condition	Requirement	Ohio Impact
Performance Location	Must be within Ohio borders	Non-Ohio work is ineligible
Expense Limitation	Only 65% of the fee is a QRE	Standardized federal/state limit
Economic Risk	Taxpayer pays regardless of success	Mandatory for QRE classification
Substantial Rights	Taxpayer must own or have right to use results	Prevents “double-dipping” by contractors

Internal Use Software and the High Threshold of Innovation

A specialized and highly scrutinized subset of qualified services involves the development of internal use software (IUS). This refers to software that a company develops for its own internal administrative functions, such as human resources, accounting, or inventory management, rather than for sale or lease to customers.

Under federal and Ohio law, IUS must meet a “high threshold of innovation” in addition to the standard Four-Part Test. The services must be:

1. Innovative: The software must result in a reduction in cost or improvement in speed that is substantial and economically significant.
2. Significant Economic Risk: The taxpayer must commit substantial resources, and there must be substantial uncertainty that the investment will be recovered.
3. Not Commercially Available: The software must not be available for purchase or lease in the market in a form that can be used for the taxpayer’s purposes without significant modification.

For Ohio’s thriving tech and financial services sectors, IUS qualified services are a major source of credit generation. However, the Ohio Department of Taxation frequently challenges these claims by arguing that the software development was “routine” or that it did not meet the “high threshold” of being economically significant.

Case Study: Advanced Manufacturing of Automotive Components in Dayton

To provide a practical application of these rules, consider “Apex Auto Parts,” a Tier-1 automotive supplier with a primary manufacturing and R&D facility in Dayton, Ohio. In 2024, Apex begins a project to develop a new lightweight alloy for engine pistons that can withstand 20% higher temperatures than current industry standards.

Step 1: Identification of Qualified Services and Employees

Apex identifies a cross-functional team of 10 employees involved in the project.

Role	Total W-2 Wages	% Time on Piston Project	Qualified Services Category	Ohio QRE
Lead Metallurgist	$180,000	90%	Engaging / Supervision	$180,000 (80% Rule)
Design Engineer	$130,000	100%	Engaging (CAD/Sim)	$130,000
Lab Technician	$70,000	60%	Direct Support (Trials)	$42,000
Plant Manager	$200,000	10%	General Supervision	$0 (Excluded)
Project Clerk	$50,000	100%	Direct Support (Data)	$50,000

• Lead Metallurgist: Because they spend 90% of their time on the project, the “Substantially All” rule allows Apex to claim 100% of their wages ($180,000).
• Plant Manager: While they oversee the facility, their involvement in the technical aspects of the piston project is only 10%. This is considered general management, and their wages are excluded.
• Project Clerk: Their entire job is to enter the temperature and stress data from the lab trials into the engineering database. This is “direct support”.

Step 2: Contract Research in Ohio

Apex hires the University of Dayton’s engineering department to perform specialized thermal imaging on the piston prototypes at a cost of $50,000. Because the university is in Ohio and Apex bears the risk of the testing, they can claim 65% of the fee ($32,500) as an Ohio QRE.

Step 3: Calculation of the 7% Credit

Apex aggregates all its Ohio-incurred QREs (wages, supplies, and contract research) for 2024 and compares them to the 3-year average.

• 2024 Ohio QREs: $600,000
• Average QREs (2021-2023): $400,000
• Incremental Excess: $200,000
• Ohio R&D Credit: $200,000 \times 0.07 = \mathbf{\$14,000}

Apex will claim this $14,000 credit on their 2024 CAT return. If their CAT liability is only $10,000, they will use the credit to pay the tax in full and carry forward the remaining $4,000 to 2025.

Interaction with JobsOhio and Other State Incentives

The “meaning” of qualified services in Ohio is enhanced by the ability to pair the R&D tax credit with other state programs. One notable example is the Research and Development Investment Loan, administered by JobsOhio. This program offers low-interest financing for R&D projects that create high-wage jobs in the state.

Crucially, taxpayers who receive a JobsOhio R&D loan may also be eligible for a separate tax credit under ORC 5751.52 (Credit for Research and Development Loan Payments). This credit is equal to the principal and interest payments made on the loan during the year. A taxpayer can claim both the 7% QRE credit for their qualified services and the loan repayment credit for their debt service, provided they meet the separate requirements for each. This “stacking” of incentives significantly reduces the effective cost of conducting research in Ohio.

Comparative Table of Ohio R&D Incentives

Feature	R&D Investment Tax Credit (ORC 5751.51)	R&D Loan Repayment Credit (ORC 5751.52)	R&D Sales Tax Exemption
Incentive Type	7% Incremental Credit	Credit for Loan Payments	Sales Tax Waiver
Basis	Wages, Supplies, Contract Research	Principal & Interest on State Loans	Machinery & Equipment
Approval	Self-claimed on return	Requires state loan agreement	Self-claimed with certificate
Benefit Period	Current Year + 7yr Carryforward	Duration of the loan	Point of Purchase

This multi-layered approach to R&D support reflects Ohio’s broader economic strategy of attracting high-tech manufacturing and bioscience industries by lowering both operational and capital costs.

The Future of Qualified Services: Legislative and Economic Outlook

As we look toward 2025 and beyond, several factors will influence the application of the Ohio R&D tax credit. The state legislature’s recent decision to significantly increase the CAT exclusion amount ($3 million in 2024 and $6 million in 2025) means that thousands of small businesses will no longer be subject to the CAT. While this simplifies their tax filings, it also means they will no longer be able to utilize the R&D tax credit to offset state tax liability, as they will have no CAT liability to offset. For these companies, the federal R&D credit and the Ohio Sales Tax Exemption will become the primary R&D incentives.

For larger taxpayers, however, the credit remains a vital tool. The potential outcome of the Park-Ohio case and the restoration of full federal R&D expensing in 2025 (as suggested by recent federal legislative proposals) will likely lead to a resurgence in R&D activity. Furthermore, as artificial intelligence and advanced robotics become central to Ohio’s manufacturing base, the definition of “qualified services” will continue to evolve to include increasingly complex software and hardware integration tasks.

The Ohio Department of Taxation is expected to maintain its rigorous audit standards, particularly regarding the “in this state” requirement. Taxpayers should view the credit not just as a financial calculation but as a documentation challenge. Those who can clearly articulate the technical uncertainty their Ohio employees solved and provide the contemporaneous records to prove it will be best positioned to defend their claims and maximize their after-tax returns on innovation.

Synthesis and Final Thoughts

The definition of “qualified services” within the Ohio R&D tax credit framework is a hybrid concept that blends federal technical standards with a rigid state-level geographic nexus. By adopting IRC Section 41, Ohio provides a familiar baseline for taxpayers, allowing them to leverage their federal R&D studies for state purposes. However, the requirement that services be “incurred in this state” introduces a critical jurisdictional filter that necessitates Ohio-specific record-keeping and time-tracking.

The 7% incremental credit against the Commercial Activity Tax rewards growth and investment in Ohio’s technical workforce. Through the “Substantially All” rule, companies can efficiently capture the full value of their dedicated researchers, while the “direct supervision” and “direct support” prongs allow for the inclusion of the broader team essential to technical experimentation. As administrative guidance and judicial precedents like the Park-Ohio case emphasize higher standards for granular documentation, the burden of proof for “meaningful” qualified services has never been higher.

Ultimately, the Ohio R&D tax credit remains a cornerstone of the state’s pro-innovation tax policy. By providing a clear, nonrefundable offset against the CAT, and by allowing for the carryforward of unused benefits, Ohio ensures that companies that take the technical and financial risk of innovation within its borders are appropriately rewarded. For professional tax peers, the mandate is clear: successful credit claims require a marriage of technical insight and administrative discipline, ensuring that every dollar of qualified services is backed by a robust, Ohio-centric evidentiary record.