Qualified Research Expenses (QREs)

Qualified Research Expenses (QREs) are the specific in-state costs of wages, supplies, and contract services that drive technical innovation and qualify for a seven percent tax credit against Ohio’s Commercial Activity Tax. This incentive provides a critical financial mechanism for enterprises to offset the risks associated with developing new products, processes, or software within the state’s borders.

The Ohio Research and Development Investment Tax Credit represents a cornerstone of the state’s economic strategy to transition from a traditional manufacturing base to a high-tech, innovation-driven economy. Codified primarily in Section 5751.51 of the Ohio Revised Code (ORC), this credit operates by incentivizing incremental investment in research and development (R&D). Unlike standard tax deductions that merely reduce taxable income, this credit provides a dollar-for-dollar reduction in the Commercial Activity Tax (CAT) liability, making it a powerful tool for liquidity management among scaling technology and manufacturing firms. The definition of what constitutes a “Qualified Research Expense” is the fulcrum upon which the entire credit turns. To ensure administrative consistency and federal alignment, Ohio law largely “piggybacks” on the federal definitions found in Section 41 of the Internal Revenue Code (IRC), yet it imposes a strict jurisdictional requirement that these expenses must be incurred within Ohio. This dual-layered requirement—meeting federal technical standards while satisfying state geographic mandates—creates a complex compliance landscape that requires rigorous documentation and strategic tax planning.

The Statutory Foundation: Integrating Federal and State Law

The legislative intent behind ORC 5751.51 was to simplify the state-level tax incentive process by adopting established federal standards. Section 5751.51(A) explicitly states that “qualified research expenses” has the same meaning as provided in Section 41 of the Internal Revenue Code. This incorporation means that for an expense to be qualified in Ohio, it must first be qualified for the federal Credit for Increasing Research Activities.

The Evolution of the Ohio R&D Credit

Historically, the R&D credit was a component of the Ohio Corporation Franchise Tax, governed by ORC 5733.351. When the state underwent massive tax reform in 2005, phasing out the franchise tax in favor of the Commercial Activity Tax (CAT), the credit was reimagined and transitioned into the CAT framework. This transition marked a shift from an income-based tax system to a gross receipts tax system, which altered how businesses perceive the value of tax credits. In a gross receipts system like the CAT, the tax is applied to the privilege of doing business in Ohio, measured by receipts without deductions for expenses like cost of goods sold. Consequently, a nonrefundable credit like the R&D credit becomes the primary mechanism for a business to reduce its effective tax rate relative to its operational efficiency and innovation spend.

Statutory Element	Reference	Application to Taxpayer
Definition of QRE	IRC Section 41	Federal standards for wages, supplies, and contracts.
Credit Rate	ORC 5751.51(B)(1)	7% of excess expenses over the base amount.
Base Period	ORC 5751.51(B)(1)(b)	Rolling average of the 3 preceding calendar years.
Carryforward	ORC 5751.51(B)(2)	7-year window to use excess credits.
Record Retention	ORC 5751.51(D)	4 years post-filing or due date.

The “Incurred in This State” Mandate

While Ohio adopts the federal definition of QREs, it narrows the scope through a strict jurisdictional lens. Under ORC 5751.51(B)(1), the credit is only available for expenses “incurred in this state”. This creates a significant distinction from the federal credit, which allows for research conducted anywhere in the United States, its possessions, or Puerto Rico. For an Ohio business, this means that even if a research project qualifies for the federal credit, the costs associated with work performed by employees in a remote office outside Ohio or by out-of-state contractors must be painstakingly removed from the Ohio calculation.

Deconstructing the Four-Part Test: The Gateway to Qualification

Since Ohio’s definition of QREs is tied to IRC Section 41, the underlying activity must satisfy the “Four-Part Test” to be considered “Qualified Research”. This test is applied at the level of the “business component,” which can be a product, process, software, technique, formula, or invention held for sale or used in the taxpayer’s trade or business.

The Section 174 Test (Permissibility)

The first hurdle is that the expenditures must be eligible to be treated as expenses under IRC Section 174. This means the costs must be research and development costs “in the experimental or laboratory sense,” incurred in connection with the taxpayer’s trade or business. It excludes costs for routine quality control, ordinary testing, or inspection of materials for quality.

The Technological Information Test

The research must be undertaken for the purpose of discovering information that is “technological in nature”. This requirement is satisfied if the process of experimentation relies fundamentally on principles of physical science, biological science, engineering, or computer science. It prohibits “soft science” research, such as market surveys, social sciences, or management studies.

The Business Component Test

The taxpayer must intend for the information discovered to be useful in the development of a new or improved “business component”. The improvement must relate to the “permitted purpose” of increasing functionality, performance, reliability, or quality. Improvements that are purely aesthetic do not qualify for the credit.

The Process of Experimentation Test

This is often the most difficult part of the test to document for state audits. At least 80% of the research activities must constitute elements of a process of experimentation. This involves identifying a technical uncertainty (a question of capability, method, or design), evaluating one or more alternatives to achieve the result, and using a systematic trial-and-error approach, such as modeling, simulation, or physical testing, to eliminate that uncertainty.

QRA Requirement	Primary Objective	Standard for Substantiation
Section 174 Eligibility	Connect to trade/business	General Ledger records of R&D spend.
Technological Nature	Rooted in hard science	Credentials of researchers; technical white papers.
Permitted Purpose	Improve function/quality	Design specifications; performance metrics.
Experimentation	Resolve technical uncertainty	Iterative test logs; prototype revision history.

Categorizing Qualified Research Expenses

Once an activity is deemed a QRA, the taxpayer must aggregate the specific expenses directly linked to it. Ohio allows four primary categories of QREs, matching federal guidelines.

Wage Expenses for Qualified Services

Wages are typically the largest component of an R&D claim. These are defined as amounts paid to an employee for “qualified services,” which include actually conducting the research, directly supervising the research, or providing direct support.

The “Substantially All” rule is a vital administrative tool here: if an employee spends at least 80% of their time performing qualified services, 100% of their wages may be included as QREs. In an Ohio context, these wages must be paid for services performed in Ohio. This requires companies to track not only what the employee does, but where they are physically sitused when they do it.

Supplies Used in Research

Supplies include tangible property that is consumed during the research process or used in the development of a prototype. However, this category specifically excludes land, improvements to land, and depreciable property. For example, the chemicals used in a laboratory test or the raw materials destroyed during a stress test of a new engine component are qualified supplies.

Contract Research Expenses

Many companies outsource specialized technical tasks to universities or independent research firms. Ohio allows taxpayers to include 65% of the amounts paid to third parties for qualified research performed on the taxpayer’s behalf. For this to be an Ohio QRE, the contractor must perform the work within Ohio. Furthermore, the taxpayer must maintain the “substantial rights” to the research and bear the “financial risk” of the project—meaning they must pay for the work even if it fails to yield a result.

Computer Rental and Lease Costs

This category is increasingly relevant in the era of cloud computing. It includes amounts paid for the right to use computers in the conduct of qualified research. Generally, this applies to cloud-based server costs or time-sharing on a mainframe, provided the computer is not located on the taxpayer’s premises and is not operated by the taxpayer.

Local Revenue Office Guidance: The Ohio Department of Taxation’s Perspective

The Ohio Department of Taxation (ODT) acts as the primary regulator for the R&D credit. Unlike some other state incentives, the R&D Investment Tax Credit does not require a pre-approval certificate from the Department of Development; it is “self-claimed” on the CAT return. However, this ease of filing comes with the significant risk of post-filing audit.

Audit Procedures and Documentation Requirements

The Tax Commissioner has broad authority to audit a taxpayer’s QREs. Administrative guidance from the ODT emphasizes that taxpayers must maintain a “nexus” between the expense and the qualified activity. In several Final Determinations, the Commissioner has ruled that simply providing a general ledger is insufficient; the taxpayer must provide documentation that specifically links employee time and material costs to a project that meets the Four-Part Test.

One of the most significant pieces of guidance involves the 2023 legislative update via House Bill 33. This bill codified the Commissioner’s ability to use “representative sampling” during an audit. Under this rule, an auditor can select a sample of projects from a representative period to determine the overall credit’s validity. The law mandates that the Commissioner make a “good faith effort” to reach an agreement with the taxpayer on the sample, but if no agreement is reached, the Commissioner may proceed with their own selection. This highlights the need for companies to have high-quality documentation for all projects, as any single project could be chosen as the representative benchmark for the entire claim.

Record Retention Mandates

The Ohio Revised Code is strict regarding recordkeeping. Taxpayers are required to retain all records used to calculate the credit—including those from the three-year base period—for at least four years from the date the return was filed or the due date, whichever is later.

Required Record Type	Purpose in Audit	Ohio-Specific Requirement
Federal Form 6765	Verification of federal claim	Must be submitted for current and 3 prior years.
Project Narratives	Substantiate 4-Part Test	Must explain why the research happened in Ohio.
Employee Time Logs	Support wage allocation	Must confirm work was done in an Ohio facility.
Contract Agreements	Verify 65% eligibility	Must show the contractor’s location is in Ohio.

Calculating the Credit: The Incremental Mechanics

The Ohio R&D credit is strictly incremental, meaning it only rewards research spending that exceeds a historical baseline. This baseline is known as the “Base Amount”.

The Three-Year Base Period

The Base Amount is calculated as the average annual Ohio QREs for the three preceding calendar years. This creates a “rolling” average that adjusts as the company grows.

$$Base Amount = \frac{\text{Ohio QRE}_{Year -1} + \text{Ohio QRE}_{Year -2} + \text{Ohio QRE}_{Year -3}}{3}$$

If a company is new or has no prior research history, the average is $0, meaning the 7% credit applies to the entire current year spend.

The Final Calculation Formula

Once the current year Ohio QREs and the Base Amount are determined, the credit is calculated as follows:

$$Credit = 0.07 \times (\text{Current Ohio QREs} – Base Amount)$$

Any credit that exceeds the CAT liability for the year cannot be refunded but may be carried forward for up to seven years to offset future CAT liability.

Comprehensive Example: The “AeroTech Ohio” Simulation

To understand how these rules apply in a real-world business context, consider AeroTech Ohio, a fictitious aerospace engineering firm based in Dayton.

Year 1: Establishing the Baseline

In its first three years of operation, AeroTech invested modestly in Ohio-based R&D.

Historical Year	Ohio QREs	Activity Type
2021	$1,200,000	Prototype wing design.
2022	$1,500,000	New composite material testing.
2023	$1,800,000	Software for flight stabilization.

Total Historical QREs: $4,500,000

Base Amount for 2024: $4,500,000 / 3 = $1,500,000.

Year 4: The 2024 Credit Claim

In 2024, AeroTech expanded its operations, hiring ten new engineers in Dayton and contracting with an Ohio university for wind tunnel testing.

• Ohio Wages: $2,000,000
• Ohio Supplies: $300,000
• Ohio Contract Research: $200,000 (qualified at 65% = $130,000)
• Total 2024 Ohio QREs: $2,430,000

The Math:

1. Current Year QREs ($2,430,000) minus Base Amount ($1,500,000) = $930,000 (Excess QREs).

2. 7% of Excess QREs ($930,000 * 0.07) = $65,100 (Tax Credit).

Integration with CAT Liability

AeroTech has $15,000,000 in Ohio taxable gross receipts in 2024.

1. Exclusion Amount: Under the new 2024 CAT rules, the first $3,000,000 of receipts is excluded from the tax.

2. Taxable Base: $15,000,000 – $3,000,000 = $12,000,000.

3. CAT Rate: The tax rate is 0.26% (0.0026).

4. Gross Tax Liability: $12,000,000 * 0.0026 = $31,200.

5. Application of Credit: The $65,100 R&D credit is applied. It wipes out the $31,200 liability entirely.

6. Carryforward: AeroTech has $33,900 ($65,100 – $31,200) remaining to carry forward to 2025.

Strategic Context: The Changing Commercial Activity Tax Landscape

The R&D credit’s value is fundamentally tied to the taxpayer’s CAT status. Recent legislative changes have significantly altered the threshold for who pays the CAT, which in turn impacts who can utilize the R&D credit.

The Exclusion Threshold “Cliff”

Historically, any business with over $150,000 in Ohio taxable gross receipts was subject to the CAT. However, beginning in 2024, this threshold rose to $3 million, and it will rise further to $6 million in 2025.

For many smaller R&D-performing startups, this change is a double-edged sword. While it eliminates their CAT liability entirely—a significant saving—it also renders their R&D credits unusable in the short term, as the credit is nonrefundable. These companies must meticulously track their QREs and carryforwards, hoping to exceed the $6 million revenue mark before their seven-year credit window expires.

Tax Year	Exclusion Threshold	Tax Treatment for Receipts Over Threshold
2023	$1,000,000	0.26% rate applies.
2024	$3,000,000	0.26% rate applies.
2025+	$6,000,000	0.26% rate applies.

Impact of the Elimination of the Annual Minimum Tax (AMT)

Before 2024, all CAT taxpayers were required to pay an Annual Minimum Tax (AMT) regardless of their credit position. The R&D credit could not be used to offset the AMT. With the elimination of the AMT in 2024, a company that has sufficient R&D credits can now effectively reduce its Ohio CAT liability to zero if its gross receipts exceed the exclusion amount. This represents a massive boost in the “liquidity value” of the credit for companies that remain in the tax base.

Advanced Insights: The “State-Federal Nexus” and Audit Volatility

A sophisticated understanding of the Ohio R&D credit requires looking past the simple 7% calculation into the burgeoning conflicts between taxpayers and the ODT.

The Problem of “Aggressive Piggybacking”

Legally, Ohio adopts the federal definition. However, in practice, the Ohio Department of Taxation has increasingly begun to perform its own “mini-IRS” audits. Practitioner reports suggest that ODT auditors are now challenging the technical nature of research projects independently, even in cases where the federal government has not audited the taxpayer.

This creates a “documentation gap.” A company may feel secure because they have not been audited by the IRS, but Ohio’s four-year statute of limitations and its new representative sampling authority mean that the state could reach back and disallow a credit based on a technical interpretation of “experimentation” that is more stringent than the taxpayer’s internal standards.

The Role of Pass-Through Entities (PTEs)

In Ohio, most businesses are organized as pass-through entities (LLCs, S-Corps, or Partnerships). For CAT purposes, the entity itself pays the tax and claims the credit. However, there is a historical overlap with the individual income tax. If a business was previously subject to the Corporation Franchise Tax and had unused credits, those credits could sometimes flow through to the owners. For modern CAT filings, the “Separate Entity” rule applies: in a consolidated group, each member must calculate their credit based solely on the QREs they incurred in Ohio. This prevents a company from “shifting” Michigan research costs into an Ohio entity just to boost a credit claim.

Statistics: The Economic Footprint of Innovation in Ohio

The R&D Investment Tax Credit is more than just a line on a tax form; it is a multi-million-dollar expenditure for the state of Ohio.

Revenue Foregone and Tax Expenditure Reports

Ohio’s Tax Expenditure Report identifies the R&D credit as a significant “business and economic development” break. These breaks collectively account for approximately 64% of all revenue foregone by the state in the current biennium.

Fiscal Period	Estimated Revenue Foregone (Business Breaks)	Total Tax Expenditures in Ohio
FY 2022-2023	$11.1 Billion	$18.7 Billion
FY 2024-2025	$12.5 Billion (Est.)	$25.4 Billion
FY 2026-2027	$16.4 Billion (Proj.)	$25.8 Billion

The rising value of these expenditures indicates that Ohio’s business sector is increasingly utilizing tax incentives to fuel growth, particularly in manufacturing and high-tech services. Manufacturing machinery and equipment exemptions alone constitute one of the largest single tax breaks in the state, often working in tandem with the R&D credit to support “Factory of the Future” initiatives.

Industry-Specific Eligibility

The ODT’s guidance highlights that while manufacturing remains the largest claimant group, the credit is expanding into other sectors.

• Textiles and Apparel: Modernization of weaving techniques and development of performance fabrics.
• Poultry and Agriculture: Innovation in food safety processes and automated packaging.
• Software Development: Developing new algorithms for data analytics or internal-use software for specialized design.
• Food Science: Formulating better nutritional profiles or improving shelf-life stability.

The “Shrinking-Back” Rule and Internal Use Software

For complex enterprises, determining the “business component” is a critical exercise. Federal regulations—and by extension, Ohio law—employ the “shrinking-back” rule. If a whole product fails to meet the Four-Part Test, the taxpayer must “shrink back” to the next discrete sub-component (e.g., a specific new engine valve rather than the whole car) to see if that component qualifies.

Similarly, “Internal Use Software” (IUS) faces a higher bar for qualification. Software used primarily for administrative, financial, or human resource functions must meet a “high-threshold innovation test”. It must be “unique or novel,” involve “significant economic risk,” and not be commercially available. Ohio businesses developing proprietary software for internal logistics or customer management must be prepared to prove that this software represents a significant technical leap rather than just a routine application of existing technology.

Compliance Case Study: “Columbus BioTech Group”

Consider a consolidated CAT group, Columbus BioTech, which consists of three members:

1. Parent Co: Located in Ohio, performs administrative support.

2. Lab 1: Located in Columbus, OH, performing direct research.

3. Lab 2: Located in Boston, MA, performing direct research.

The Audit Scenario:

The ODT initiates an audit of the group’s 2024 R&D claim. The group claimed $5,000,000 in QREs.

Auditor Finding 1: Sourcing

The group included $2,000,000 in wages for scientists working at Lab 2 in Boston. The ODT disallows these because the expenses were not “incurred in this state”. The fact that the Parent Co is in Ohio and paid the checks is irrelevant; the activity must be in Ohio.

Auditor Finding 2: Direct Support

The group included 100% of the wages for the Parent Co’s HR manager. The ODT challenges this. While HR is “support,” the auditor argues it is “indirect” support rather than “direct” support (like a lab tech cleaning equipment). The wages for HR are disallowed.

Auditor Finding 3: Sampling

The auditor selects the group’s “Project Alpha” (a new vaccine) as a representative sample for the remaining $3,000,000 in Ohio QREs. If the group cannot provide the experimental logs for Project Alpha, the ODT may extrapolate a 100% failure rate for that project onto the rest of the claim, potentially leading to a massive tax assessment.

Future Outlook: Legislative and Technical Trends

The future of the Ohio R&D tax credit is being shaped by two major forces: further CAT simplification and the federal Section 174 amortization crisis.

The Section 174 Amortization Conflict

Starting in 2022, federal law (Tax Cuts and Jobs Act) required businesses to amortize R&D expenses over five years rather than deducting them immediately. While this is an income tax rule, it has created confusion in the R&D credit space. Currently, the Tax Relief for American Families and Workers Act of 2024 (pending in the US Senate) seeks to retroactively restore immediate expensing. Since Ohio “piggybacks” on the federal definition of QREs, any federal change that alters what is considered a “Section 174 expense” will immediately impact Ohio’s CAT CS calculation.

Automation and Remote Work

As more Ohio firms employ remote technical talent, the ODT is likely to issue further guidance on “remote R&D.” Current rules require the expense to be “incurred in this state,” which strongly suggests the employee must be physically present in Ohio. Companies with remote teams must be vigilant in “slicing” their payroll to exclude days worked by employees from out-of-state homes, even if those employees are assigned to an Ohio-based “home office”.

Final Thoughts: Integrating Insight into Action

The Ohio R&D Investment Tax Credit remains one of the most effective tools for corporate tax mitigation in the state, providing a robust 7% return on incremental innovation investment. However, its effectiveness is contingent upon a nuanced understanding of the intersection between IRC Section 41 and ORC Section 5751.51.

To succeed in claiming and defending the credit, Ohio business leaders must:

1. Prioritize Jurisdictional Sourcing: Treat the “incurred in this state” requirement as the primary filter for all R&D spend. Implement tracking systems that can segregate Ohio-based employee time and contractor performance with surgical precision.

2. Document the “Process”: Move beyond accounting-based “cost centers” and adopt project-based “technical narratives.” Ensure that for every dollar claimed, there is a corresponding record of a technical uncertainty and the steps taken to resolve it.

3. Anticipate the CAT Thresholds: With the $3 million and $6 million exclusion amounts coming into effect, model the carryforward value of R&D credits. For companies hovering near these thresholds, the credit is a long-term play for future tax years.

4. Embrace the Negotiated Audit: Given the new “representative sampling” rules, build a relationship of transparency with the ODT. Use the “good faith effort” provision to negotiate fair sample sizes that accurately reflect the diversity of the company’s research portfolio.

By aligning technical operations with these statutory and administrative mandates, Ohio enterprises can ensure that their pursuit of innovation is supported by a stable and predictable tax environment, securing the financial resources necessary to compete on a national and global stage.