In-house Research Expenses Incurred in this State

In-house research expenses incurred in this state comprise the wages, supplies, and computer rental costs paid for qualified research activities physically conducted within the boundaries of Utah. These expenditures represent the core components used to determine a taxpayer’s eligibility for the state’s tiered research and development tax credits under Utah Code Sections 59-7-612 and 59-10-1012.

The statutory architecture governing the Utah Research and Development (R&D) tax credit is designed as a powerful economic engine, meticulously calibrated to incentivize the relocation and expansion of high-technology industries within the “Silicon Slopes” corridor and the broader state geography. While the credit relies heavily on federal definitions established in Section 41 of the Internal Revenue Code (IRC), the Utah State Tax Commission and the state legislature have imposed a strict geographical nexus that distinguishes the state-level incentive from its federal counterpart. This analysis explores the granular requirements of “in-house research expenses,” the administrative guidance provided by the Utah State Tax Commission, and the judicial precedents that define the boundaries of what constitutes research “incurred in this state.”

Legislative Intent and the Statutory Framework

The Utah legislature established the research tax credit to foster a climate of innovation, recognizing that investment in the discovery of new information and the development of new business components yields long-term dividends in the form of high-wage employment and corporate growth. The legal authority for these credits is split between corporate taxpayers under Chapter 7 and individual or pass-through entity taxpayers under Chapter 10 of Title 59. Despite this bifurcation, the operative language regarding research expenses remains remarkably consistent, pointing back to the federal standard while layering on the requirement for physical presence within Utah.

Utah Code Section 59-7-612(4)(d) and Section 59-10-1012(3)(d) define “qualified research expenses” as having the same meaning as provided in IRC Section 41(b), but with the critical caveat that the term includes only in-house research expenses and contract research expenses “incurred in this state”. This intentional deviation from the federal “within the United States” standard creates a substantial administrative burden on the taxpayer to segregate expenses that occur within Utah’s borders from those occurring elsewhere, even if those out-of-state activities would otherwise qualify for the federal credit.

The evolution of these statutes reflects a transition from a purely incremental credit to a hybrid model that rewards both the total volume of research and the growth of that research over time. Significant amendments, such as those passed in 2007, 2011, and 2016, have refined the credit rates and carryforward periods to balance fiscal responsibility with competitive incentive structures.

The Three-Part Credit Hierarchy

To understand the context of in-house research expenses, one must first master the three distinct credit components authorized by Utah law. A taxpayer does not simply claim “a credit” but rather calculates three separate figures that are then aggregated on the tax return.

Credit Component	Statutory Rate	Calculation Basis	Carryforward Provisions
Incremental Research Credit	5%	Qualified research expenses (QREs) that exceed a calculated base amount.	14 Years
Basic Research Payment Credit	5%	Payments to qualified organizations for basic research exceeding a base amount.	14 Years
Current Year (Volume) Credit	7.5%	The total sum of qualified research expenses incurred during the taxable year.	No Carryforward

The inclusion of the 7.5% volume credit represents a significant departure from many state regimes that only reward incremental growth. This component is particularly valuable for established Utah firms that maintain large, stable R&D budgets but may not see significant year-over-year increases. However, the statutory prohibition against carrying this 7.5% credit forward means that taxpayers must have sufficient tax liability in the current year to realize the benefit; otherwise, the credit is permanently lost.

The Sourcing Mandate: “Incurred in this State”

The foundational requirement that in-house research expenses be “incurred in this state” applies to the three sub-categories of in-house expenses: wages, supplies, and computer rental/lease costs. For a multi-state corporation, this necessitates a rigorous internal accounting system capable of tracking the physical location of employees, the consumption of materials, and the use of computational resources.

Utah revenue office guidance, as expressed through various Commission decisions and administrative rules, emphasizes that “incurred in this state” is fundamentally a question of where the activity is performed, not necessarily where the payroll is processed or where the corporate headquarters is located. This interpretation aligns with the UDITPA (Uniform Division of Income for Tax Purposes Act) principles adopted by Utah, which seek to assign income and expenses to the location where the underlying economic activity takes place.

Qualified Research Wages: Technical and Geographical Standards

Wages typically constitute the vast majority of a taxpayer’s in-house research expenses. Under IRC Section 41(b)(2)(D), adopted by Utah, wages include all remuneration for services performed by an employee for their employer, which would generally be subject to federal income tax withholding.

The Functional Categories of Qualified Services

To qualify for the Utah credit, wages must be paid for “qualified services,” which are categorized into three distinct functional roles. The analysis of these roles must be performed at the individual employee level, and documentation must clearly demonstrate that the work was performed within Utah.

1. Direct Performance: This includes the actual research activities, such as an engineer in a Salt Lake City lab conducting experiments, a software developer in Lehi writing code to solve a technical uncertainty, or a scientist in Logan testing a new biological compound.
2. Direct Supervision: This encompasses the immediate management of those directly performing the research. A manager who reviews technical designs, assigns specific experimental tasks, or supervises lab personnel is providing qualified services. However, high-level administrative supervision (e.g., a CEO reviewing a project’s budget) is generally excluded.
3. Direct Support: This involves activities that assist the research process but do not constitute the research itself. Examples include a technician cleaning specialized lab equipment, a secretary typing a technical report on the results of an experiment, or a machinist in a Utah facility fabricating a prototype part designed by the R&D team.

The “Substantially All” Rule and the 80% Threshold

Utah adopts the federal “substantially all” rule, which provides a significant administrative simplification for taxpayers. If at least 80% of an employee’s services during the year consist of qualified services, then 100% of that employee’s wages may be included in the Utah research expense calculation. If an employee’s time falls below the 80% threshold, the taxpayer must prorate the wages based on the actual percentage of time spent on qualified activities.

The application of this rule in Utah is strictly limited to the time spent on research within the state. An employee who spends 50% of their time on R&D in Utah and 50% of their time on sales would have only 50% of their wages qualified. Conversely, an employee who spends 90% of their time on R&D, but only 50% of that time is spent in a Utah office while the other 40% is spent in a California office, would likely face an audit challenge if they attempted to claim the full 90% of wages for the Utah credit.

Remote Work and the Changing Landscape of Wage Sourcing

One of the most complex areas of recent Revenue Office guidance concerns the sourcing of wages for employees who work remotely. The Utah State Tax Commission has issued rulings, such as Appeal #22-2043 and Appeal #21-1302, which address when an out-of-state remote worker’s wages are considered Utah-source income. The Commission has determined that if an employer physically located in Utah assigns accounts or customers to an out-of-state employee, and that employee’s wages are sourced to Utah for withholding purposes on the Form W-2, those wages are subject to Utah income tax.

The implication for the R&D credit is subtle but critical. While the Commission might source the wages to Utah for taxation purposes, the R&D statute specifically requires the research to be conducted in this state. There is a prevailing legal argument that “conducting” research implies physical presence. Therefore, a remote worker living in Nevada but working for a Utah company might have their wages taxed by Utah, yet those same wages might be excluded from the Utah R&D credit because the physical “conduct” of the research occurred in Nevada. Taxpayers should exercise caution and maintain detailed records of the physical location of R&D staff to avoid disallowance during an audit.

The Consumption Rule: Supplies in the Research Process

In-house research expenses also include amounts paid for “supplies” used in the conduct of qualified research in Utah. The definition of supplies is restrictive: it includes any tangible property other than land or improvements to land and property of a character subject to the allowance for depreciation.

The Exclusion of Depreciable Assets

A common error in Utah R&D claims is the inclusion of capitalized equipment. If an item is depreciable under federal tax law, it is statutorily excluded from the definition of “supplies” for the R&D credit. This means that while a specialized microscope used in a Utah biotech lab is essential for research, its purchase price cannot be claimed as an in-house research expense because it is a capital asset.

However, the materials consumed by that equipment or the parts used to build a prototype using that equipment may qualify. The “consumption rule” requires that the supply be used up or significantly transformed during the research process in Utah.

Category	Examples of Qualified Supplies	Examples of Excluded Items
Manufacturing	Raw metal for prototype casting, chemicals for testing, resins.	CNC machines, furnaces, testing chambers.
Software	Specialized development kit components, temporary servers.	Standard laptops, office furniture, monitors.
Biotechnology	Reagents, disposable pipettes, media for cell cultures.	Centrifuges, sequencers, refrigeration units.

Sourcing of Supplies

Supplies must be “used in the conduct of qualified research” in Utah. The Commission generally looks to the delivery location and the site of consumption. If a company purchases materials in Utah but ships them to a research facility in Colorado, those expenses do not qualify for the Utah credit. Conversely, if materials are purchased from an out-of-state vendor but are used in a lab in Provo, they are considered “incurred in this state”.

Computational Infrastructure: Computer Rentals and Cloud Computing

The third category of in-house research expenses involves amounts paid or incurred to another person for the right to use computers in the conduct of qualified research. In its historical context, this was designed for “time-sharing” arrangements where companies rented time on massive mainframes. In the modern Utah economy, this provision has been repurposed to cover cloud computing expenses, such as those paid to Amazon Web Services (AWS), Microsoft Azure, or Google Cloud.

Cloud Hosting and the Process of Experimentation

For Utah’s burgeoning software sector, cloud hosting fees represent a significant R&D cost. However, not all cloud expenses are qualified. Taxpayers must distinguish between environments used for development and those used for commercial production.

• Qualified Usage: Fees paid for “instances” or “compute time” used to run simulations, conduct unit testing, or host a beta-test environment where developers are actively iterating on code to eliminate technical uncertainty.
• Excluded Usage: Fees for hosting a software-as-a-service (SaaS) platform for paying customers, general corporate data storage, or “maintenance” environments where no active R&D is occurring.

The Utah State Tax Commission requires that these expenses be directly tied to experimentation. Documentation such as “tagging” reports from cloud providers, which segregate costs by environment (e.g., “Dev/Test” vs. “Production”), is essential to substantiate these claims.

The Four-Part Test: Judicial and Administrative Interpretations

Even if an expense is incurred in Utah, it only qualifies if the underlying activity meets the “four-part test” established in IRC Section 41(d) and adopted by Utah Code § 59-7-612(4)(c) and § 59-10-1012(3)(c). The Utah State Tax Commission has demonstrated through its rulings that it will strictly apply these tests, placing a heavy burden of proof on the taxpayer.

1. The Section 174 Test

The expenditure must first qualify as a research and experimental cost under IRC Section 174. This means the activities must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing the product or the appropriate design of the product.

2. The Technological in Nature Test

The research must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science. Utah auditors frequently challenge claims that rely on social sciences, market research, or aesthetic design. For software development, this requires demonstrating that the work involved overcoming technical hurdles in computer science, rather than simply using existing tools to create a functional interface.

3. The Business Component Test

The research must be intended to result in a new or improved business component, which is defined as any product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used by the taxpayer in its trade or business.

4. The Process of Experimentation Test

This is often the most difficult test to satisfy in a Utah audit. Substantially all of the activities must constitute a process of experimentation, which involves the identification of uncertainty, the development of one or more hypotheses, and the systematic evaluation of alternatives through modeling, simulation, or trial-and-error.

In Appeal No. 16-1707, the Commission sustained an assessment against a construction management firm, concluding that the taxpayers failed to prove their activities met this test. The Commission noted that the taxpayers did not provide documentation of a systematic trial-and-error process and instead relied on broad assertions that their projects involved “innovation”. This highlights the need for contemporaneous project records, such as test logs, version control histories, and technical meeting minutes.

Calculation Mechanics: The Utah Base Amount and Startup Election

The calculation of the Utah R&D credit is an “incremental” exercise for two of its three components. The taxpayer must determine a “base amount” and only the expenses exceeding this amount qualify for the 5% credit.

The Fixed-Base Percentage and Gross Receipts

The base amount is the product of the “fixed-base percentage” and the average annual Utah gross receipts for the four taxable years preceding the credit year.

Crucially, for Utah purposes, “gross receipts” include only those attributable to sources within the state, as determined under the UDITPA allocation and apportionment provisions. This ensures that the base amount is compared on an apples-to-apples basis with the Utah-only QREs.

The Utah Startup Election

The federal definition of a “startup” is rigid, requiring a company to have had no gross receipts and QREs prior to a certain window in the 1980s or 1990s. However, Utah Code Section 59-7-612(4)(a)(iii) and Section 59-10-1012(3)(a)(iii) allow a taxpayer to elect to be treated as a startup company regardless of whether they meet the federal criteria.

Status	Fixed-Base Percentage (Initial Years)	Benefit of Election
Established	Calculated based on 1984-1988 data (capped at 16%).	Stability for mature firms with consistent R&D.
Startup Election	Fixed at 3% for the first five years.	Highly beneficial for companies new to Utah or with low historical R&D.

This election is irrevocable. It is a strategic tool used by companies that have recently relocated their research headquarters to Utah, as it prevents their global historical gross receipts from artificially inflating the Utah base amount and neutralizing the credit.

Administrative Procedures and Revenue Office Guidance

The Utah State Tax Commission provides guidance through administrative rules and formal publications. Rule R865-6F-27 establishes the “ordering” of credits, stating that nonrefundable credits without carryforward (like the 7.5% volume credit) must be applied before nonrefundable credits with carryforward (like the 5% incremental credit).

Documentation and Recordkeeping Responsibilities

The Commission does not require a specific form to claim the R&D credit, but it mandates that all related documents be kept with the taxpayer’s records. In the event of an audit, the Commission will demand:

• W-2s and Payroll Registers: To verify Utah withholding and sourcing of wages.
• Time Tracking Data: To substantiate the percentage of time spent on qualified activities.
• Project Lists and Descriptions: To identify the “business components” being developed.
• General Ledger Detail: To identify supply costs and cloud hosting fees.
• Experimental Evidence: To prove the “process of experimentation,” such as design revisions or test failure reports.

The Appeals Process and Private Letter Rulings

If a taxpayer disagrees with an audit assessment regarding their research expenses, they may file a petition for redetermination within 30 days. For taxpayers seeking certainty before filing, a Private Letter Ruling (PLR) can be requested under Administrative Code R861-1A-34. A PLR provides a binding interpretation of how the R&D law applies to a specific set of facts, such as whether a particular type of Utah-based software development activity meets the technological in nature test.

Comprehensive Numerical Example: Nexus Dynamics

To illustrate the application of these principles, consider “Nexus Dynamics,” a hypothetical mid-sized robotics firm located in Salt Lake City, Utah. Nexus is developing a new autonomous navigation system for warehouse drones.

Step 1: Identify In-house Research Expenses (Current Year)

Nexus identifies the following costs incurred physically within Utah during the 2024 tax year:

1. Qualified Wages:

• Engineer A: Spends 100% of time in the Salt Lake lab on drone AI. Annual salary: $150,000. Under the “substantially all” rule, 100% of wages are qualified.
• Manager B: Spends 50% of time supervising Engineer A in Salt Lake and 50% on general corporate management. Annual salary: $200,000. Prorated qualified wages: $100,000 (50%).
• Support Tech C: Spends 90% of time in the Salt Lake machine shop building prototype frames for tests. Annual salary: $60,000. 100% of wages are qualified under the 80% rule.
• Remote Developer D: Lives in California, works 100% on the drone AI for the Utah division. Salary: $180,000. Although Utah taxes these wages, they are excluded from the R&D credit because the research is not conducted in Utah.

2. Qualified Supplies:

• Raw aluminum and carbon fiber consumed in building 20 prototype drones in Salt Lake: $40,000.
• Sensors and microchips used for iterative testing: $25,000.
• Excluded: A $50,000 3D printer used for prototypes (excluded as depreciable property).

3. Computer Rental (Cloud):

• Fees paid to AWS for high-performance compute instances used for AI training simulations: $30,000.
• Excluded: Fees for hosting the company’s website and customer portal: $10,000.

Total 2024 Utah QREs: $150,000 + $100,000 + $60,000 + $40,000 + $25,000 + $30,000 = $405,000.

Step 2: Determine the Base Amount

Nexus elects to be treated as a startup company under the Utah startup election.

• Fixed-Base Percentage: 3%.
• Average Utah Gross Receipts (Prior 4 Years): $5,000,000.
• Calculated Base Amount: 3% × $5,000,000 = $150,000.
• Check Minimum Base Floor: 50% × $405,000 = $202,500.
• Final Base Amount: $202,500 (The greater of the calculated base or the 50% floor).

Step 3: Calculate the Three Credit Components

1. Incremental Credit (5%):
   5% × ($405,000 – $202,500) = $10,125.
2. Basic Research Credit:
   Nexus made no payments to universities in 2024. Credit = $0.
3. Current Year (Volume) Credit (7.5%):
   7.5% × $405,000 = $30,375.

Total Aggregated Credit Amount: $10,125 + $30,375 = $40,500.

Step 4: Apply the Credit and Carryforward

Nexus has a Utah corporate franchise tax liability of $35,000.

• Following the ordering rules of R865-6F-27, Nexus applies the $30,375 volume credit first.
• Remaining tax liability: $35,000 – $30,375 = $4,625.
• Nexus applies $4,625 of the incremental credit to reduce its tax liability to zero.
• Unused Carryforward: $10,125 – $4,625 = $5,500.
• This $5,500 may be carried forward for up to 14 years.

Final Thoughts

In-house research expenses incurred in this state serve as the bedrock of Utah’s fiscal strategy to attract and retain high-growth technology firms. By requiring that wages be paid for services physically performed in Utah, that supplies be consumed in Utah labs, and that computational resources be utilized by Utah-based teams, the state ensures that the economic benefits of its tax incentives are realized by its own residents and local economies.

The intersection of federal technical definitions and state geographical mandates creates a unique compliance environment. Taxpayers must navigate the nuances of the “substantially all” rule, the exclusion of depreciable property from supply costs, and the complex sourcing of cloud computing fees. Furthermore, the recent administrative focus on remote work sourcing emphasizes the need for physical-presence tracking that goes beyond simple payroll documentation.

As Utah’s economy continues to evolve, particularly in fields like artificial intelligence, aerospace, and biotechnology, the application of the “four-part test” will remain a central point of contention in audits. Companies that proactively establish contemporaneous, project-level documentation and strategically leverage the Utah Startup Election will be best positioned to maximize their credits. The 7.5% volume credit remains a powerful tool for immediate tax reduction, while the 14-year carryforward on incremental growth provides long-term stability. Ultimately, the successful claim of in-house research expenses in Utah is not merely a mathematical exercise, but a narrative one—requiring a clear, documented story of technological uncertainty, experimentation, and physical innovation within the borders of the Beehive State.