Excess Qualified Research Expenses

Excess Qualified Research Expenses represent the positive numerical difference between a taxpayer’s current-year qualified research expenditures in Ohio and the average of those expenditures over the three preceding taxable years. This incremental value serves as the statutory base for calculating Ohio’s seven percent nonrefundable credit against the Commercial Activity Tax or the Financial Institutions Tax.

The concept of “Excess Qualified Research Expenses” (EQRE) is the cornerstone of Ohio’s strategy to incentivize high-tech industrial growth and corporate innovation within its borders. Unlike a standard deduction that merely reduces taxable income by a portion of total spending, the Ohio Research and Development (R&D) Investment Tax Credit is designed as an incremental benefit. This specific architecture ensures that the state’s fiscal resources are targeted toward businesses that are actively expanding their research footprint in Ohio rather than those simply maintaining a static level of investment. To appreciate the nuance of EQRE, one must look at it as a multi-layered construct involving federal definitions, state-specific geographic boundaries, and a rolling historical average that creates a high bar for qualification.

The detailed analysis of EQRE begins with the recognition that Ohio “piggybacks” on the Internal Revenue Code (IRC) Section 41 for its primary definitions of what constitutes a “qualified” expense. However, the application of these federal standards within the Ohio Commercial Activity Tax (CAT) and Financial Institutions Tax (FIT) regimes introduces a suite of administrative complexities, particularly following the significant legislative reforms enacted through House Bill 33 in 2023. These changes have moved the state toward a more granular, “member-by-member” calculation for corporate groups, emphasizing individual entity accountability and rigorous record-keeping. As Ohio continues to attract massive technological investments, such as the semiconductor manufacturing facilities in central Ohio, the interpretation of EQRE by the Department of Taxation has become a focal point of corporate tax planning and state-level audits.

Statutory Foundations and Legal Framework

The legal authority for the Ohio R&D credit is bifurcated based on the taxpayer’s primary tax liability. For most commercial entities, the credit is governed by Ohio Revised Code (ORC) Section 5751.51, which applies to the Commercial Activity Tax. For financial institutions, the parallel provision is found in ORC Section 5726.56, which provides a credit against the Financial Institutions Tax. Historically, the credit was a staple of the now-repealed Corporation Franchise Tax (CFT) under Section 5733.351, and many of the current rules regarding carryforwards and the definition of “Excess” were carried over from that era to maintain continuity in the state’s economic development policy.

Under ORC Section 5751.51(A), “qualified research expenses” are explicitly defined as having the same meaning as in Section 41 of the Internal Revenue Code. This incorporation by reference is critical because it brings decades of federal case law and IRS regulations into the Ohio tax environment. The “Excess” portion of the term is operationalized in Section 5751.51(B)(1), which states that the credit equals seven percent of the excess of qualified research expenses incurred in Ohio during the calendar year over the taxpayer’s average annual qualified research expenses incurred in Ohio for the three preceding years. This three-year rolling average is often referred to as the “base amount” or “base period,” and it serves as the benchmark for growth.

The statutory language is precise in its geographic limitation: the expenses must be “incurred in this state”. This creates a nexus requirement that is often more restrictive than the federal credit, which considers research performed anywhere within the United States. Consequently, a taxpayer might have a large federal R&D credit but a much smaller Ohio credit if a significant portion of their research team is located in another state or if they utilize out-of-state contractors.

Summary of Governing Statutes

The transition from the CFT to the CAT in 2005 marked a fundamental change in Ohio’s tax structure—shifting from an income-based tax to a gross-receipts tax—but the legislature intentionally preserved the R&D credit. This preservation reflects a long-standing consensus that high-wage R&D jobs provide a disproportionate benefit to the state’s economy, even if the corporate entities themselves pay a lower effective tax rate due to the credit.

Defining Qualified Research Expenses (QRE) in the Ohio Context

To determine the “Excess,” a taxpayer must first master the “Qualified” portion of the equation. Since Ohio adopts the IRC Section 41 definition, a project must meet the four-part test to be considered qualified research. The activity must be intended to discover information that would eliminate a technical uncertainty, the discovery must be through a process of experimentation, the research must be technological in nature (relying on physical, biological, or computer sciences), and it must relate to a new or improved business component.

Once an activity is deemed “qualified research,” the expenses associated with it fall into four primary categories under the federal and state frameworks: wages, supplies, contract research, and computer leasing or rental. For the Ohio credit, each of these must be isolated to show their “situsing” or location within Ohio borders.

Internal Use Software and Modern Technological Challenges

A significant area of debate in the current technological landscape involves “Internal Use Software” (IUS). While software developed for sale or license is treated under the standard four-part test, software developed solely for a company’s internal administrative functions faces a more stringent “three-part innovation test” at the federal level, which Ohio also follows. This requires the software to be innovative, to involve significant economic risk, and not to be commercially available. As more Ohio manufacturers transition to “Smart Factory” environments or developed proprietary logistics software to manage global supply chains, the distinction between “routine IT” and “qualified research” for IUS has become a frequent point of contention in state audits.

Ohio-Specific Expense Categories

Wages are generally the largest component of any EQRE claim. In Ohio, these are defined by the employee’s W-2 Box 1 wages, but they must be apportioned based on the percentage of time the individual spent on qualifying activities within the state. Supplies include materials used for prototypes or experimental batches, provided they are not capitalized and depreciated. Contract research is particularly notable because only 65% of the cost is included in the QRE base, and the burden of proof is on the taxpayer to show that the contractor actually performed the work in Ohio.

The Mathematical Derivation of EQRE

The determination of EQRE is a rigorous mathematical process that involves establishing a baseline and measuring incremental growth. The formula is strictly mandated by ORC Section 5751.51(B) and interpreted through Ohio Administrative Code Rule 5703-29-22.

Step 1: Current Year Ohio QRE Identification

The taxpayer must identify all qualifying expenditures incurred within Ohio during the calendar year for which the credit is being claimed. For the Commercial Activity Tax, this is always a calendar year basis (January 1 to December 31), regardless of the taxpayer’s fiscal year for federal income tax purposes. This often requires a “bridge” calculation for companies with non-calendar fiscal years to ensure their R&D spend is properly aligned with the Ohio tax period.

QRE_Current = Wages_OH + Supplies_OH + (0.65 × Contract_OH) + Computer_OH

Step 2: Establishing the Base Amount (Three-Year Average)

The base amount is the arithmetic mean of the Ohio QREs for the three taxable years immediately preceding the current year. If a taxpayer was not in existence for all three prior years, or did not conduct R&D in Ohio during those years, the expenses for those missing years are treated as $0. This creates a significant advantage for startups or companies relocating to Ohio, as their initial year of research will have a base amount of $0, allowing 100% of their first-year QRE to be classified as “Excess”.

Base Amount = (QRE_(n-1) + QRE_(n-2) + QRE_(n-3)) / 3

Step 3: Isolating the Excess

The EQRE is the positive difference between the current year and the base amount. If the current year’s spending is lower than the base amount—due to a scaling back of operations or a shift in research focus to another state—the EQRE is treated as zero, and no credit is generated for that year.

EQRE = max(0, QRE_Current – Base Amount)

Step 4: Applying the Credit Rate

The final credit is calculated by multiplying the EQRE by seven percent. This credit is nonrefundable but can be carried forward for seven ensuing years if it exceeds the current year’s tax liability.

Tax Credit = 0.07 × EQRE

Comprehensive Example: The Rolling Base Period

To illustrate the interplay between a growing research budget and the rolling base period, consider the following data for a hypothetical Ohio biotech firm, “Buckeye Bio-Labs,” from 2020 through 2024.

Buckeye Bio-Labs R&D Expenditure and Credit Generation

In 2023, even though Buckeye Bio-Labs spent slightly less than it did in 2022, its expenses still exceeded the three-year average of $1,233,333, resulting in an EQRE of $166,667. However, because 2023’s spend was lower than 2022’s, the base amount for 2024 actually increased more slowly, allowing for a much larger EQRE of $633,333 when research spending spiked to $2,000,000. This illustrates how the rolling average rewards consistent upward investment.

Administrative Guidance and Local Revenue Office Standards

The Ohio Department of Taxation (ODT) has provided detailed guidance on the application of the R&D credit through Information Releases and the Ohio Administrative Code. A pivotal document in this history is Information Release CAT 2007-03, which explained the credit’s implementation following the creation of the CAT. This guidance, which has been updated multiple times to reflect rule changes in OAC 5703-29-22, establishes the “ground rules” for both taxpayers and ODT auditors.

The Order of Credits (ORC §5751.98)

Ohio law requires that tax credits be claimed in a specific order. The R&D credit is classified as a nonrefundable credit and sits in the middle of the credit hierarchy. This is important for taxpayers with multiple incentives, as they must exhaust earlier credits before applying the R&D credit to their liability.

1. Jobs Creation Tax Credit (Refundable portion).
2. Jobs Retention Tax Credit (Nonrefundable portion).
3. Credit for Qualified Research Expenses (Nonrefundable).
4. Credit for Research and Development Loan Payments (Nonrefundable).
5. Credit for Unused Franchise Tax Net Operating Losses.

Mandatory Compliance Procedures

Under OAC 5703-29-22, a taxpayer claiming the R&D credit must follow strict procedural steps. Failure to adhere to these can result in an immediate denial of the credit during a desk review or audit.

• Tracking Schedule: The taxpayer must complete a schedule (such as the CAT CS or FIT CS form) that tracks the credit’s origin and any carryforward amounts. This schedule must include the primary reporting entity’s name, address, and CAT account number, as well as the federal identification number for any member of a group that is claiming the credit.
• Member-by-Member Detail: For consolidated elected or combined taxpayer groups, a separate schedule is required for each entity claiming the credit. The ODT requires this to verify that the expenses were incurred by the specific entity and to prevent the unauthorized transfer of credits between group members.
• Documentation Retention: Taxpayers must retain all records used to calculate the credit—including the data for the three-year base period—for four years after the return was filed or due, whichever is later.

The Evolution of the Member-by-Member Rule (HB 33)

Perhaps the most significant legislative change to the EQRE calculation in recent history was the passage of House Bill 33 (135th General Assembly) in 2023. This bill fundamentally changed how corporate groups calculate their R&D credits.

Prior to HB 33, there was some ambiguity regarding whether a consolidated group could calculate its credit in the aggregate. HB 33 clarified and mandated that each person in a financial institution group (ORC §5726.56) or a CAT group (ORC §5751.51) must separately calculate the credit using the qualified research expenses incurred by that specific person.

Furthermore, a taxpayer may only claim the credit with respect to persons who were included in the group as of December 31 of the taxable year in which the expenses were incurred. For a carryforward credit, the group may only claim it if the entity that originally generated the credit remains in the group as of the last day of the tax period for which the return is being filed.

This “member-by-member” rule was designed to increase transparency and simplify the audit process for the ODT, but it has introduced new strategic challenges for businesses. If a high-growth research subsidiary is sold or reorganized, the group may lose the ability to utilize that subsidiary’s “Excess” or its historical “Base Amount,” potentially leading to a higher tax liability for the remaining members.

Group Membership and Credit Eligibility

This requirement for year-end membership prevents “credit shopping” and ensures that the tax benefit remains tied to the entity that actually performed the innovation within Ohio.

The Audit Environment and the “Piggyback” Controversy

While the Ohio statutes explicitly state that QRE has the same meaning as in IRC Section 41, the actual experience of Ohio taxpayers during audits has been one of increasing divergence. Legal practitioners have noted that the ODT has adopted an “aggressive audit policy” in recent years, often conducting independent technical reviews of research projects even after they have been accepted by the IRS.

The Conflict over Technical Uncertainty

Under the federal “Four-Part Test,” research must involve a process of experimentation intended to eliminate technical uncertainty. ODT auditors have increasingly challenged whether a project truly involves “uncertainty” in the scientific sense or if it is merely “routine engineering”. This puts Ohio businesses in a difficult position, as they may have to defend the technological merit of their work to state tax auditors who may not have the same specialized scientific training as federal agents.

Audit Sampling (ORC §5751.51(E))

The law authorizes the Tax Commissioner to audit a “sample” of the taxpayer’s expenses over a representative period. The ODT must make a “good faith effort” to reach an agreement with the taxpayer on the selection of this sample. If an agreement is not reached, the ODT can proceed with its own representative sample, which is then used to extrapolate the findings across the entire multi-year claim period. This highlights the importance of keeping detailed “project files” and “time logs” for every individual included in the QRE base, as an error found in a single sample project can lead to a proportional reduction of the entire 7% credit across all years being audited.

Macroeconomic Context: The Role of the CAT and FIT

To understand the practical impact of the R&D credit, one must consider the broader revenue landscape of the Ohio Commercial Activity Tax. In fiscal year 2024, CAT collections reached approximately $2.39 billion. The R&D credit represents a significant “expenditure” in the state budget—a term used by the Department of Taxation to describe the revenue forgone due to tax breaks.

CAT Restructuring and the R&D Credit (2024-2025)

The Ohio biennial budget for FY 2024-2025 (HB 33) introduced massive changes to the CAT that directly affect how businesses prioritize the R&D credit.

• Elimination of the Annual Minimum Tax (AMT): Before 2024, all businesses paid an AMT ranging from $150 to $2,600 regardless of their credit status. The AMT was non-reducible by credits. This was eliminated in 2024.
• Increased Exclusion Thresholds: The exclusion amount—the gross receipts a business can have before paying the 0.26% tax—increased to $3 million in 2024 and will increase to $6 million in 2025.

For many small and mid-sized Ohio innovators, these changes mean they will no longer owe any CAT liability. However, they should still continue to calculate and “bank” their EQRE credits. Because the credit has a seven-year carryforward, a company that spends heavily on R&D today while its receipts are under $6 million can use those credits once its growth pushes its receipts above the threshold in future years.

Statistics on Ohio Tax Expenditures

The Ohio Tax Expenditure Report estimates the financial benefit provided to recipients of various tax breaks. According to Policy Matters Ohio, business and economic development tax breaks accounted for 59% of the estimated $18.7 billion in forgone revenues over the 2022-2023 biennium. While the R&D credit is just one part of this, its strategic value is amplified by the fact that it is a “permanent” credit, unlike many other incentives that require constant legislative renewal.

Interaction with Other Incentives: JobsOhio and R&D Loans

The EQRE calculation does not exist in a vacuum. Many Ohio businesses pair the R&D Investment Tax Credit with other state programs to maximize their return on investment.

The Research and Development Investment Loan

Ohio offers low-interest financing through the Department of Development for R&D projects that create high-wage jobs. Under ORC Section 5751.52, a separate credit is available for the repayment of these loans. While the R&D Investment Tax Credit (7% of EQRE) is calculated based on expenditures, the Loan Payment Credit is calculated based on the principal and interest payments made on the state loan.

A savvy taxpayer can utilize both: they can use the state loan to fund their R&D lab, and then use the 7% credit on their EQRE to offset the tax liability generated by their increased production, while using the Loan Payment Credit as a secondary offset.

Detailed Scenario: Corporate Acquisition and the Base Amount

One of the most complex areas of EQRE calculation involves corporate acquisitions. When an Ohio company is acquired, the “Base Amount” of the target must be handled carefully to determine the “Excess” for the new combined group.

Consider “Ohio Tech A” (the acquirer) and “Ohio Tech B” (the target).

In 2024, the two entities operate as a single consolidated group. To calculate the 2024 credit, the group must look at the combined history to establish the “Base Amount.” The average combined spend for 2021-2023 was (7M + 7.7M + 8.5M)/3 = $7,733,333. The EQRE for the combined group in 2024 is 12,000,000 – 7,733,333 = 4,266,667. The resulting credit is 298,667.

Under the HB 33 member-by-member rule, this calculation becomes even more granular. If “Ohio Tech B” remains a separate legal subsidiary, it must calculate its own EQRE against its own $2,233,333 average, while “Ohio Tech A” calculates its EQRE against its own $5,500,000 average. If one entity’s research spending declines while the other’s increases, the total group credit may be lower than if it were calculated in the aggregate—a critical insight for post-merger integration planning.

Special Considerations for Pass-Through Entities (PTEs)

In Ohio, the Commercial Activity Tax is an entity-level tax. Unlike the personal income tax, where credits typically “flow through” to the individual owners, the CAT R&D credit is used at the business level to reduce the CAT liability.

However, there is a nuance for owners of S-corporations and LLCs who are subject to the Ohio Individual Income Tax. Ohio offers a “Small Business Income Deduction” (SBID) which allows owners to deduct 100% of the first $250,000 of business income from their personal tax filing. While the R&D credit does not directly reduce the personal income tax of these owners, the expenses that generate the credit (wages, supplies) are still deductible business expenses for income tax purposes.

Furthermore, some recent budget changes allow PTEs to elect to be taxed at the entity level for income tax purposes (as a “SALT cap workaround”). Under these circumstances, if the R&D credit were available against the income tax, it would be handled differently, but as of 2025, the R&D credit remains primarily a CAT and FIT incentive.

Situsing of Expenses: The “In This State” Requirement

The most common error in calculating EQRE is the failure to properly situs expenses. Ohio Administrative Code and Information Releases emphasize that the “privilege of doing business” in Ohio is measured by activities within the state. This applies equally to the R&D credit.

Wages

Wages are sitused based on where the service is performed. If an Ohio-based company has a research lab in Cleveland and another in Detroit, only the wages paid to employees working in the Cleveland lab count toward the Ohio QRE. If a manager in Cleveland supervises researchers in both locations, only the portion of their salary attributable to the supervision of the Cleveland researchers (the Ohio-based activity) is eligible.

Supplies

Supplies are sitused where they are “used or consumed” in the research process. If a company buys specialized titanium in Pennsylvania but uses it to build an experimental aircraft engine in Cincinnati, the cost is an Ohio QRE.

Contract Research

Contract research is sitused based on where the contractor performs the work. This is a common pitfall. If an Ohio manufacturer hires an engineering firm based in Chicago to perform stress tests, the expense is not an Ohio QRE, even if the results are sent to Ohio and the check is written from an Ohio bank. To qualify, the contractor must conduct the testing or experimentation within the borders of Ohio.

Future Outlook: Legislative and Economic Trends

As Ohio moves into 2025 and 2026, the interpretation of EQRE will likely be influenced by two major forces: the full implementation of the CAT threshold changes and the ongoing fallout from federal R&D capitalization rules.

The Impact of Federal Section 174

The federal Tax Cuts and Jobs Act (TCJA) of 2017 introduced a requirement that domestic R&D expenses (Section 174) be capitalized and amortized over five years rather than immediately expensed. While there has been significant legislative effort in Congress to restore immediate expensing, the uncertainty has created a ripple effect in state tax planning.

For Ohio purposes, it is vital to distinguish between the Section 174 capitalization rules and the Section 41 R&D credit rules. The Ohio credit is still based on the incurred expenses (QRE) for the year, regardless of how they are treated for federal income tax capitalization purposes. This makes the Ohio credit an even more valuable “current year” cash-flow tool for companies struggling with higher federal tax bills due to capitalization.

The Rise of Regional Innovation Hubs

Ohio’s “Innovation Districts” in Cincinnati, Cleveland, and Columbus are designed to foster clusters of research-intensive companies. As these districts mature, the ODT may face increasing numbers of complex R&D claims involving university partnerships and public-private consortia. The “65% rule” for contract research and the specific definitions of “Qualified Research Consortia” (which can allow for a 75% inclusion rate in some federal contexts adopted by Ohio) will become increasingly relevant.

Final Thoughts: Strategic Recommendations for Taxpayers

The “Excess Qualified Research Expenses” calculation is more than a line item on a tax return; it is a multi-year narrative of a company’s commitment to Ohio-based innovation. To effectively capture and defend this credit, taxpayers must move beyond retroactive “look-back” studies and integrate R&D tracking into their daily operations.

First, the member-by-member calculation mandated by HB 33 requires that companies with complex structures maintain distinct R&D accounts for every legal entity. Relying on a high-level corporate “allocation” of R&D expenses is no longer sufficient and will likely be rejected during an audit.

Second, the geographic situsing of research must be documented with the same precision as a payroll audit. With the rise of hybrid and remote work, maintaining a “contemporaneous record” of where research employees are physically located when they perform their work is essential to satisfying the “in this state” requirement.

Finally, as the ODT continues its trend of independent technical review, Ohio businesses must ensure that their “project files” do not just contain financial data, but also technical documentation—such as test plans, prototype photos, and emails discussing technical failures and iterations—that explicitly demonstrate a “process of experimentation”. By mastering both the quantitative “Excess” and the qualitative “Qualified” aspects of the formula, Ohio businesses can ensure that their innovation efforts are fully supported by the state’s strategic tax framework.