Contract Research Expenses Incurred in this State

Contract Research Expenses Incurred in this State denotes sixty-five percent of payments made to external entities for qualified research activities physically conducted within Utah’s borders. This statutory term limits eligibility to expenditures that satisfy federal research definitions while maintaining a strictly defined geographic nexus to the state.

The Utah Research and Development (R&D) tax credit represents a critical instrument in the state’s economic policy, designed to foster a robust ecosystem of innovation by incentivizing both incremental growth in research investment and the maintenance of significant research operations. The legislative architecture of this credit is primarily established in the Utah Code under Section 59-7-612 for corporate entities and Section 59-10-1012 for individual taxpayers, including those who receive pass-through income from partnerships or S-corporations. The statutory framework is characterized by its reliance on the federal Internal Revenue Code (IRC) Section 41, yet it introduces unique state-level constraints, specifically the incurred in this state requirement, which serves as a geographic filter for all qualifying expenditures.

The Statutory Definition and the Three-Component Credit Structure

The Utah R&D credit is not a monolithic incentive but rather a tripartite structure that rewards different aspects of research activity. According to Section 59-7-612, a taxpayer may claim three distinct nonrefundable tax credits for research activities conducted within the state. The first component is an incremental credit equal to five percent of the taxpayer’s qualified research expenses (QREs) for the current taxable year that exceed a calculated base amount. The second component is a five percent credit for payments made to qualified organizations for basic research, specifically for amounts that exceed a base amount defined in accordance with IRC Section 41(e). The third component, often referred to as the volume credit, allows a credit equal to seven and a half percent of the taxpayer’s total qualified research expenses for the current taxable year, regardless of any historical spending levels.

This three-component system is a unique feature of the Utah tax code. While the incremental and basic research credits can be carried forward for a period of up to fourteen years if they exceed the taxpayer’s current liability, the seven and a half percent volume credit must be used in the year it is generated or it is forfeited. This distinction forces taxpayers to engage in strategic tax planning, prioritizing the non-carryforward volume credit while preserving the incremental credits for future periods. The definition of qualified research expenses used for all three components is explicitly linked to IRC Section 41(b), but it is restricted to only include in-house research expenses incurred in Utah and contract research expenses incurred in Utah.

Deconstructing Contract Research Expenses

To interpret contract research expenses incurred in this state, one must look at the interplay between federal definitions and state-specific geographic limitations. Under federal law, IRC Section 41(b)(3) defines contract research expenses as the applicable percentage of any amount paid or incurred by the taxpayer to any person, other than an employee, for qualified research. The Utah Code adopts this definition but modifies it by adding the in-state mandate.

The Percentage Limitations on Contractor Payments

Both federal and Utah laws recognize that payments to contractors inherently include overhead, administrative costs, and profit margins that do not represent direct research efforts. Consequently, only a portion of these payments is considered a qualified research expense. The standard inclusion rate for contract research is sixty-five percent of the actual amount paid to the third party. This statutory haircut ensures that the credit is focused on the underlying research activity rather than the contractor’s business markup. However, the law provides for higher inclusion rates in specific circumstances:

Contractor Type	Inclusion Percentage	Statutory Basis
Standard Third-Party Contractor	65%	IRC § 41(b)(3)(A)
Qualified Research Consortia	75%	IRC § 41(b)(3)(C)
Energy Research (Federal context)	100%	IRC § 41(b)(3)(D)

In the Utah context, these percentages apply to the gross payment, provided the underlying work is performed within the state. For example, if a Utah corporation pays a local engineering firm $100,000 to perform qualified stress testing on a new prototype, the contract research expense for the purpose of the credit is $65,000.

The Scope of Qualified Research

For a contractor’s work to generate a qualifying expense, the activity must meet the federal four-part test as defined in IRC Section 41(d). Utah law incorporates this definition without modification, except for the geographic requirement. The activity must:

1. Be Technological in Nature: The research must fundamentally rely on the principles of physical or biological science, engineering, or computer science.

2. Have a Permitted Purpose: The objective must be to develop a new or improved business component, such as a product, process, software, or technique, with the aim of improving functionality, performance, reliability, or quality.

3. Eliminate Uncertainty: The research must be intended to discover information that would eliminate technical uncertainty regarding the capability, method, or appropriateness of the design of the business component.

4. Involve a Process of Experimentation: Substantially all of the activities must constitute a process of evaluating alternatives through modeling, simulation, or systematic trial and error.

The administrative guidance provided by the Utah State Tax Commission underscores that routine data collection, market research, and aesthetic modifications are specifically excluded from this definition. For contract research, the taxpayer must demonstrate that the contractor was hired specifically to engage in these experimental activities rather than merely providing a standard commercial service.

The Incurred in This State Requirement

The phrase incurred in this state is the most restrictive and significant deviation from the federal credit. While the federal credit applies to all research performed within the United States, the Utah credit is strictly limited to research performed within the geographic boundaries of Utah. The Utah State Tax Commission interprets incurred in this state as an activity-based requirement, meaning the physical location where the research is performed determines the eligibility of the expense, regardless of where the contractor or the taxpayer is legally headquartered.

Activity-Based Nexus vs. Payment Sourcing

For in-house expenses, the location of the employee is generally straightforward. However, for contract research, the taxpayer must be able to prove that the contractor’s personnel were physically present in Utah while performing the qualified services. If a Utah-based technology firm hires a software development contractor located in California, the payments to that contractor are completely ineligible for the Utah R&D credit, even if the software will be used exclusively in Utah and the contract was signed in Salt Lake City. Conversely, a non-Utah company that maintains a research facility in Utah can claim the credit for payments made to Utah-based contractors for work done at that facility.

The administrative rules regarding the sourcing of income, such as R865-6F-32 (Financial Institutions) and R865-6F-8 (Allocation and Apportionment), provide a useful analog for understanding how the state views the location of an activity. Rule R865-6F-32 defines the location of employees and activities as the place where the personnel are regularly connected or working out of. In the realm of contract research, this implies that the contractor’s base of operations for the specific project must be in Utah. If a contractor has research teams in both Utah and Arizona, the taxpayer must bifurcate the payments and only claim the portion of the fee attributable to the Utah-based team.

Implications of Remote Work

The rise of remote and distributed workforces has complicated the incurred in this state analysis. For a contractor to be considered in this state, the individual researcher must be performing the work while physically located within Utah. Utah Administrative Rule R865-6F-6 defines an in-home office and sets parameters for determining when an employee’s residence constitutes a place of business. For contract research purposes, if a 1099 contractor is a Utah resident and performs the research from their home office in Logan, the payment qualifies. If that same contractor moves their home office to Nevada while continuing to work for the Utah taxpayer, the expenses cease to be incurred in this state at the moment they cross the state line.

Detailed Analysis of Local Revenue Office Guidance

The Utah State Tax Commission provides guidance primarily through its administrative rules, form instructions (such as the TC-20 and TC-40 instructions), and published appeals decisions. These documents clarify the practical application of the statutes to complex real-world scenarios.

Administrative Rule R865-6F-32 and Apportionment Principles

While R865-6F-32 is formally titled Taxation of Financial Institutions, it is often cited in research contexts because it provides the state’s most detailed definitions for what constitutes active solicitation, investigation, negotiation, and administration by employees and agents. The rule establishes that an activity is located at the place of business where the person performing the activity is regularly connected, irrespective of where the services might ultimately be delivered. This reinforces the principle that for the R&D credit, the location of the research effort is paramount, not the location of the research result.

Furthermore, Rule R865-6F-8, which deals with the allocation and apportionment of income under UDITPA, establishes that business income is sourced to Utah based on the location of the business activity. For many years, Utah utilized a cost of performance method for sourcing service income, which looked at where the majority of the work was performed. While the state has recently moved toward a market-based sourcing model for general income (focusing on the location of the benefit), the R&D tax credit statute remains explicitly tied to the location of the expenditure and the activity.

Findings from Utah State Tax Commission Appeals

Two specific appeals provide significant clarity on the Commission’s interpretation of qualified research expenses.

In Appeal No. 12-0799, a taxpayer attempted to claim the R&D credit for the purchase of a vehicle used to collect mineral samples for research conducted in Utah. The Commission denied the credit, citing several critical legal interpretations:

Depreciable Assets are Not Supplies: IRC Section 41(b)(2)(C) defines supplies as any tangible property other than land and property of a character subject to the allowance for depreciation. Since the vehicle was depreciable, it could not be a QRE. By extension, payments to a contractor that are used to purchase depreciable equipment for the taxpayer do not qualify as contract research expenses.

Budgeting is Not Incurring: The taxpayer argued that budgeting for the expense should allow for the credit in that year. The Commission clarified that the credit is limited to expenses for the current taxable year that are actually paid or incurred. This is vital for contract research; prepayments for research to be conducted in a future year are generally treated as being incurred in the future year when the research is actually performed.

In Appeal No. 10-3022, the Commission addressed a claim based on the value of uncompensated research time. The Commission ruled that:

Actual Expenditure is Required: The research credit is limited to expenses paid or incurred. Uncompensated work by a business owner or partner does not constitute a QRE because no economic liability was created. For contract research, this means a legitimate third-party contractual obligation with a monetary consideration must exist.

Interaction with Nexus Standards (P.L. 86-272)

The Utah State Tax Commission provides guidance on how in-state activities by contractors can create nexus, potentially subjecting a foreign corporation to Utah franchise tax. Under P.L. 86-272 and Rule R865-6F-6, a corporation is generally not subject to state income tax if its only activity in the state is the solicitation of orders for tangible personal property. However, engaging a contractor to perform research and development within Utah is considered an activity that goes beyond mere solicitation. Therefore, a foreign corporation claiming the Utah R&D credit for contract research must be aware that the very activity qualifying them for the credit also establishes their nexus with the state and their obligation to file Utah tax returns.

Mechanics of Calculating the Credit for Contract Research

The calculation of the Utah R&D credit involves a complex integration of current year expenditures and historical data, with contract research expenses serving as a major variable.

Step-by-Step Computational Process

To determine the credit amount, a taxpayer must first aggregate all QREs that were incurred within the state of Utah during the taxable year.

1. Identify In-House Wages: Salaries for employees performing, supervising, or supporting research in Utah.

2. Identify In-House Supplies: Materials consumed or used in Utah-based research.

3. Calculate Contract Research QREs: Take 65% of payments to unrelated Utah contractors and 75% of payments to qualified Utah-based research consortia.

4. Determine Total Utah QREs: Sum the results of steps 1 through 3.

The credit is then calculated using the three statutory components:

Incremental Credit = 5% × (Total Utah QREs – Base Amount)

Basic Research Credit = 5% × (Excess Basic Research Payments)

Volume Credit = 7.5% × Total Utah QREs

The Base Amount and the Startup Election

The base amount is calculated as the product of the taxpayer’s fixed-base percentage and their average annual Utah gross receipts for the preceding four taxable years.

Utah Gross Receipts: This includes only receipts attributable to Utah sources under the state’s apportionment rules.

The 50% Floor: Consistent with federal law, the base amount cannot be less than 50% of the current year’s QREs.

Startup Election: Utah law allows a unique flexibility for newer companies. A taxpayer may irrevocably elect to be treated as a start-up company as provided in IRC Section 41(c)(3)(B), even if they do not meet the federal requirements for that status. This election allows the company to use a 3% fixed-base percentage for the first five years, which then phases into an actual percentage over the subsequent five years.

Documentation and Substantiation of Contract Research

The Utah State Tax Commission does not require taxpayers to submit separate R&D credit forms with their tax returns; however, the burden of proof is high. Taxpayers must maintain contemporaneous records that clearly distinguish Utah activities from those conducted elsewhere.

Essential Documentation for Contractors

To substantiate contract research expenses, a taxpayer should maintain a dedicated file for each contractor that includes:

The Formal Agreement: A contract executed prior to the start of the research that outlines the scope of work.

Substantial Rights Clause: The contract must state that the taxpayer retains substantial rights to the research results, even if those rights are not exclusive.

Financial Risk Allocation: The agreement must show that the taxpayer bears the financial risk. Payments should be based on effort or time-and-materials, rather than being contingent upon the successful completion of a product.

Detailed Invoices: Invoices must describe the activities performed and identify the personnel involved.

Location Verification: Documentation such as the contractor’s Utah business license, office address, or project status reports that place the researchers within the state of Utah.

1099-NEC Records: For individual contractors, these tax forms provide evidence of the payment and the contractor’s residence.

The USTC may perform audits to verify that the 65% haircut was applied correctly and that none of the contractor’s work was performed outside of Utah. If a contractor’s invoice is vague, the auditor may disallow the entire expense.

Historical Context and Legislative Evolution

The Utah R&D tax credit has evolved through various legislative sessions, reflecting the state’s efforts to balance fiscal responsibility with economic stimulus.

Legislative Trajectory of Credit Rates

The volume-based credit has seen the most significant rate changes. In 2007, Senate Bill 223 introduced substantial modifications to the credit structure, including the elimination of the sunset date and an increase in the credit percentages. During the 2010 and 2011 taxable years, the volume credit was set at a high of 9.2%. However, following a review of the program’s cost and effectiveness, House Bill 365 in the 2012 General Session reduced the volume credit to its current rate of 7.5%.

The Revenue and Taxation Interim Committee Study

A recurring provision in both the corporate and individual statutes (Sections 59-7-612(7) and 59-10-1012(6)) is the requirement for a periodic study by the Revenue and Taxation Interim Committee. This committee is tasked with reviewing:

1. The total cost of the tax credits to the state budget.

2. The purpose and effectiveness of the credits in driving innovation.

3. Whether the credits provide a tangible benefit to the state of Utah.

This legislative oversight mechanism ensures that the in-state requirement remains a central pillar of the credit. If research spending were allowed to leak out of the state, the credit would fail to satisfy the benefit to the state criteria that the committee monitors.

Recent Legislative Activity

The 2018 General Session saw the introduction of House Bill 202, which proposed reducing the 5% incremental rates to 2.5%. While such measures highlight the ongoing debate regarding the optimal level of tax incentives, the three-component structure has remained a stable fixture of Utah’s business tax landscape. Furthermore, the 2022 General Session (HB 262) introduced new requirements for the State Tax Commission to provide, and taxpayers to complete, specific forms for tracking the carryforward of research credits as they expire or are repealed.

Comprehensive Example: Multi-Contractor Utah R&D Credit Calculation

To illustrate the application of Contract Research Expenses Incurred in this State, consider the case of Utah Aerospace Solutions, a mid-sized corporation based in Ogden, Utah. In the 2024 tax year, the company develops a new lightweight composite material for aircraft wings.

Research and Development Data for 2024

Expenditure Item	Description	Location	Total Amount Paid
In-House Salaries	Salaries for composite engineers	Ogden, UT	$800,000
Lab Supplies	Chemicals and fibers used in testing	Utah Lab	$150,000
Contractor X	Specialized stress analysis firm	Salt Lake City, UT	$200,000
Contractor Y	Software modeling firm	Denver, CO	$100,000
Utah State University	Basic research on material durability	Logan, UT	$80,000
Contractor Z	Individual 1099 consultant (UT resident)	Home office, UT	$50,000

Financial Context for Base Amount Calculation

Average Utah Gross Receipts (2020–2023): $10,000,000.

Fixed-Base Percentage: 5%.

Taxpayer Status: Established firm (not using startup election).

Step 1: Segregate and Filter Utah QREs

1. In-House Salaries: $800,000. These are fully qualifying in-state wages.

2. Lab Supplies: $150,000. These are fully qualifying in-state supplies.

3. Contractor X (Utah): $200,000 × 65% = $130,000. These qualify as contract research expenses incurred in this state.

4. Contractor Y (Colorado): $0. These are disqualified because the research was not conducted in Utah.

5. Utah State University: This is treated as a Basic Research Payment for the incremental calculation but counts as a QRE for the volume credit. Amount: $80,000.

6. Contractor Z (Utah Resident): $50,000 × 65% = $32,500. This qualifies as an in-state contract research expense.

Total Utah QRE Pool (excluding Basic Research for incremental purposes): $800,000 + $150,000 + $130,000 + $32,500 = $1,112,500

Step 2: Calculate the Base Amount

Initial Base Calculation: 5% (Fixed-Base %) × $10,000,000 (Avg Receipts) = $500,000.

50% Statutory Floor: 50% × $1,112,500 = $556,250.

Adjusted Base Amount: $556,250 (The base cannot be lower than the floor).

Step 3: Compute the Credit Components

1. Incremental Credit (5%):

Excess QREs: $1,112,500 – $556,250 = $556,250.

Credit: $556,250 × 5% = $27,812.50.

2. Basic Research Credit (5%):

Assuming the base for basic research is $20,000.

Excess Payments: $80,000 – $20,000 = $60,000.

Credit: $60,000 × 5% = $3,000.00.

3. Volume Credit (7.5%):

Total Utah QREs (including USU): $1,112,500 + $80,000 = $1,192,500.

Credit: $1,192,500 × 7.5% = $89,437.50.

Step 4: Final Credit Application

Total Generated Credit: $27,812.50 + $3,000.00 + $89,437.50 = $120,250.00.

Reporting: The company enters $120,250 on Form TC-20, Schedule B using Code 12.

Carryforward Potential: $30,812.50 (Incremental + Basic) is carryforward-eligible for 14 years. $89,437.50 (Volume) must be used against 2024 tax liability or lost.

Comparison with Federal Treatment

While the Utah credit is derivative of the federal credit, the differences in Contract Research Expenses Incurred in this State create a significant administrative burden for multi-state companies.

Feature	Federal IRC § 41 Credit	Utah R&D Credit
Geographic Scope	All 50 States & Territories	Utah Only
Standard Contractor Rate	65%	65%
Alternative Incremental Credit	Allowed (ASC or Regular)	Prohibited
Base Amount Floor	50% of QREs	50% of Utah QREs
Gross Receipts Sourcing	Federal Gross Receipts	Utah-Apportioned Receipts
Startup Election	Strict Requirements	Taxpayer Option (Irrevocable)

For a company with operations in both Utah and Arizona, a single contract with a national research firm may require three separate accounting treatments: one for the federal return (all U.S. work at 65%), one for the Utah return (only Utah work at 65%), and one for the Arizona return (only Arizona work according to their specific statutes).

Final Thoughts

The definition and application of Contract Research Expenses Incurred in this State will continue to be a focal point for Utah’s tax policy. As the state’s economy becomes increasingly service-oriented and tech-driven, the pressure to expand the definition of in-state to include remote or virtual participation may grow. However, current Tax Commission guidance remains firmly rooted in the physical location of the researcher.

The mandatory review by the Revenue and Taxation Interim Committee serves as a guardrail, ensuring that the credit remains a targeted incentive that provides a measurable return on investment for the state’s taxpayers. For businesses, the incurred in this state provision creates a powerful secondary incentive to not just conduct research, but to specifically hire Utah-based contractors and collaborate with Utah-based universities. This locally focused multiplier effect is the intended outcome of the statute’s geographic restriction.

In conclusion, Contract Research Expenses Incurred in this State is a precise legal term that bridges federal research standards with Utah’s regional economic goals. By understanding the 65% inclusion rate, the activity-based nexus, and the rigorous documentation requirements, Utah taxpayers can effectively utilize this incentive to fuel their innovative ventures while remaining in full compliance with state revenue office guidance. The hybrid nature of the credit—rewarding both growth and volume—makes it one of the most sophisticated and valuable state-level research incentives in the United States, provided that the geographic boundaries of the research are strictly respected and documented.