Maximizing the Illinois R&D Tax Credit: A Deep Dive into the “Cost of Supplies” Qualification

I. Executive Summary: The Meaning of Cost of Supplies

The Cost of Supplies represents tangible materials that are consumed or used up during the physical conduct of qualified research activities within Illinois. These expenses are essential “in-house research expenses” and form one of the three core pillars (alongside wages and computer rentals) of Illinois Qualified Research Expenditures (QREs).

The ability to claim the cost of supplies is dictated entirely by federal law, specifically Internal Revenue Code (IRC) Section 41, which Illinois adopts through the Illinois Income Tax Act (35 ILCS 5/201(k)).1 The credit is nonrefundable and equals 6.5% of the increase in qualified expenditures above a three-year historical base period.1 For tax purposes, supplies must satisfy the rigorous “Consumed Test,” meaning the material must be physically destroyed, consumed, or rendered worthless during the experimentation process and must not be an item subject to depreciation or capitalization.3 For compliance with the Illinois Department of Revenue (IDOR), these specific costs must be precisely documented and sourced to the state, being reported on Schedule 1299-I, Line 2: Illinois cost of supplies.5 Accurate tracking and strict application of the federal consumption rules are critical for maximizing the credit and ensuring compliance with both federal and state tax authorities.

II. The Statutory and Regulatory Foundation of Qualified Supplies

2.1 Federal Framework: IRC Section 41 Alignment

The definition and qualification criteria for the Cost of Supplies are derived directly from federal statutes, establishing a crucial nexus between state and federal tax codes. IRC Section 41 governs the Credit for Increasing Research Activities, defining the Qualified Research Expenses (QREs) necessary for calculating the credit.7

Components of Qualified Research Expenses

QREs are fundamentally divided into two major categories: in-house research expenses (IHRE) and contract research expenses.7 Cost of Supplies falls squarely under the IHRE category. Specifically, IRC Section 41(b)(2) defines IHREs to include three core types of expenditures: (i) any wages paid or incurred to an employee for qualified services; (ii) any amount paid or incurred for supplies used in the conduct of qualified research; and (iii) under prescribed regulations, any amount paid or incurred for the right to use computers in the conduct of qualified research.7

The statutory citation for supplies is explicit: IRC § 41(b)(2)(A)(ii) mandates the inclusion of costs associated with tangible property consumed in the research effort.7 Furthermore, for any expense to qualify, it must be paid or incurred by the taxpayer during the taxable year “in carrying on any trade or business of the taxpayer”.7 Treasury Regulation 1.41-2(b)(1) confirms that this “trade or business” requirement parallels the standard established for general business deductions under IRC Section 162.10 This requirement ensures that the credit is claimed only for research activities conducted within an active, existing business enterprise, rather than purely prospective ventures.

2.2 Illinois Adoption and the Incremental Calculation

The State of Illinois leverages the detailed federal structure to administer its own incentive. The Illinois R&D Tax Credit, codified under 35 ILCS 5/201(k), permits a nonrefundable credit against state income tax liability.1

The Credit Calculation Mechanism

The Illinois credit calculation adheres closely to the federal model but features unique parameters. The credit rate is 6.5% of the taxpayer’s qualifying expenditures.1 Crucially, this percentage is applied to the amount of current-year QREs that exceed the sum of the average expenses incurred during the three taxable years immediately preceding the current year (the base period).2 This structure confirms that the Illinois R&D credit is an incremental credit—it rewards increases in research spending.1

The credit is nonrefundable but can be carried forward for five years, allowing businesses to utilize the benefit even if they lack sufficient state income tax liability in the immediate year of earning the credit.1

Strategic Value of Incremental Classification

Because the calculation is incremental—relying on the current year’s QREs relative to a four-year window (current year plus three base years)—the classification of supplies has a profound strategic impact beyond the current tax year. The proper inclusion or exclusion of supply costs affects the total QREs for four years simultaneously.2 If a company fails to accurately include all eligible supply costs in the current year, it reduces the immediate tax benefit. Conversely, if a company retrospectively finds that supplies were incorrectly excluded from prior base years, an amended return could raise the base amount, thereby reducing the available incremental credit in the current period.

Maintaining consistent, meticulous historical records of supply costs is therefore essential for mitigating risk. This consistency is required across all base period years, including those years where the taxpayer may not have formally qualified for or claimed the credit.11 By maximizing the accurate inclusion of supplies, taxpayers not only secure immediate tax reduction but also bolster the nonrefundable credit carryforward, extending the financial utility of the incentive over the five-year carryforward period.1

III. The Technical Definition: The “Consumed Test” for Supplies

The most critical challenge in substantiating the Cost of Supplies expense is passing the “Consumed Test,” which establishes a bright line between qualifying, expensed materials and capitalized, non-qualifying assets.

3.1 Defining “Supplies”: Tangible Property and Exclusion from Depreciation

To be eligible for inclusion as a QRE supply expense, the material must first meet two basic requirements: it must be tangible property, and it must not be of a character subject to depreciation.3

The Non-Depreciable Standard

The most fundamental distinction is that qualifying supplies cannot be costs recoverable through depreciation or capitalization under IRC Sections 167 or 168.3 Items that are considered long-term capital assets, such as equipment, machinery, buildings, or land used for research, are explicitly excluded from the supplies category.3 The rationale behind this exclusion is that depreciable assets have a useful life extending beyond the immediate research phase, requiring their costs to be recovered over time rather than immediately expensed as a QRE supply cost.3

3.2 The Consumed or Scrapped Standard

For materials that are tangible and non-depreciable, the final hurdle is demonstrating that they were used or consumed directly in the research process.

The Application of the Consumed Test

Qualified supplies must be consumed, used up, or subjected to wear and tear during the experimental phase.4 This standard encompasses:

1. Raw Materials: Materials used to develop, fabricate, or build prototypes and first articles.3
2. Chemicals and Reagents: Substances consumed or exhausted during testing, formulation trials, or chemical reactions.4
3. Materials Scrapped: Components or materials that fail, are destroyed, or are discarded during stress testing or trial production runs.4

The qualification of the supply cost is irrespective of whether the research was successful or failed.4 For example, a company developing a new medical device may purchase specialized circuitry and materials. If these parts are used up or destroyed during the rigorous testing of the prototypes, their costs are generally includable in the R&D credit calculation.4

Prototypes and Pilot Models

Materials integrated into prototypes or pilot models are generally considered supplies. However, this is conditioned on the ultimate disposition of the prototype. If the materials are used to build a model that is subsequently tested to destruction, or if the resulting product is merely a test batch that is scrapped and never moved into commercial inventory, the materials qualify.12 Conversely, if a prototype or pilot machine is subsequently repurposed and utilized in commercial production for a multi-year period, its cost would likely be deemed a capital asset subject to depreciation, thus disqualifying the incorporated materials as QRE supplies.3

3.3 Statutory and Regulatory Exclusions

IRC Section 41 and its corresponding regulations list several categories of expenditures that, even if related to R&D activities, cannot be claimed as QRE supplies:

• General and Administrative (G&A) Costs: Expenditures that are indirectly related to R&D, such as general office supplies (e.g., paper, pens), researchers’ telephone expenses, travel, meals, or entertainment, do not qualify.3 Similarly, professional dues, royalties, or license fees are excluded because they are not tangible materials consumed in the physical conduct of research.14
• Post-Commercial Production Research: Research activities and, consequently, supplies consumed after the beginning of commercial production of a business component are excluded from the definition of qualified research.9
• Funded Research: Supplies used for research that is funded by a third party, where the taxpayer does not retain the economic risk or proprietary rights, are explicitly excluded from QREs.9
• Depreciable Assets: As noted, equipment, land, and buildings used for research purposes are capitalized and cannot be treated as supplies.3 Rental or lease costs of computers are treated as a separate category of IHRE, not general supplies.5

The Necessity of Strict Documentation for Exclusion

The detailed exclusion list, particularly the overlap between routine business expenses and G&A, necessitates extremely strict documentation standards for audit defense. When auditors review supply expenses, they often look for general consumables or indirect costs that have been improperly categorized as QREs. Taxpayers must be able to demonstrate a direct, causal linkage between the claimed supply material and the specific experimentation effort aimed at resolving technological uncertainty.14

To satisfy this stringent requirement, businesses should implement robust internal cost accounting systems that track supplies at the project level, completely segregating them from routine Materials, Repairs, and Operations (MRO) inventory and general administrative expense accounts. Without definitive proof of physical consumption in the research process, supply costs, especially those related to prototype components, are highly susceptible to disallowance.

IV. Illinois Department of Revenue (IDOR) Guidance and Compliance

While the foundational definition of supplies is federal, the procedural path for claiming the credit—including documentation and state sourcing—is dictated by the Illinois Department of Revenue (IDOR).

4.1 Required Documentation: The Schedule 1299-I Mandate

The IDOR’s guidance confirms reliance on federal standards by requiring taxpayers to calculate qualified expenditures on specific state-level forms. The primary compliance gateway for R&D expenditures is Schedule 1299-I, the “Research and Development Credit Worksheet”.5

The Cost of Supplies component is specifically entered on Line 2: Illinois cost of supplies of this Schedule 1299-I worksheet.5 The Schedule 1299-I instructions, in turn, feed the final credit amount into the relevant credit schedule, such as Schedule 1299-C (for individuals) or Schedule 1299-D (for corporations).6

The state tax forms do not introduce any novel or specialized definitions for “Cost of Supplies” that deviate from IRC § 41.16 Instead, the forms simply create a standardized mechanism for allocating and reporting the federally defined QREs to Illinois. This formalizes the requirement for a consistent application of the federal Consumed Test at the state level.

4.2 Sourcing Requirements: The “In Illinois” Mandate

The Illinois statute mandates that the QREs must be “attributable to research in Illinois” to qualify for the 6.5% credit.2 This sourcing requirement is straightforward but requires precise record-keeping for the tangible materials comprising the Cost of Supplies.

For supplies, the sourcing rule means the materials must be physically used up, consumed, or scrapped during qualified research activities that take place within the geographical boundaries of the State of Illinois.1 For multi-state taxpayers with R&D operations in different locations, this presents an accounting necessity to differentiate costs based on physical location of consumption.

Apportionment and Inventory Tracking

The requirement for state sourcing imposes an administrative burden on multi-state companies. If a company purchases a bulk quantity of raw material that is later divided and shipped to R&D facilities in Illinois and other states, only the quantity of materials verifiably consumed within the Illinois facility can be reported on Schedule 1299-I, Line 2. The critical element is proving the material’s location at the time it was consumed during the experimentation process.

This necessitates sophisticated internal inventory management and cost tracking. Taxpayers must reconcile their total federal QRE supply costs against their Illinois-apportioned QRE supply costs. Supporting documentation, such as internal inventory usage logs, material requisitions linked to specific Illinois R&D projects, and shipping or transfer manifests, must confirm the materials’ physical deployment and subsequent consumption within the state.

Table 1: Components of Illinois Qualified Research Expenses (QREs) on Schedule 1299-I

The following table summarizes how the core QRE elements, particularly the Cost of Supplies, are categorized for Illinois compliance:

Table Title

V. Practical Application and Case Example: Applying the Consumed Test

5.1 Industry Focus and Typical Qualifying Expenses

The supply component is most financially impactful for industries engaged in physical research and development, such as advanced manufacturing, pharmaceuticals, materials engineering, and technology hardware.13

For example, in manufacturing, qualified supplies often include materials utilized for iterative product improvements or process development. These materials encompass raw materials used for prototypes, materials dedicated to test batches (small or large scale), specialized custom tooling or molds consumed during the development process, and materials that are scrapped during process optimization trials.13 In life sciences, the costs of consumables such as specialized chemicals, reagents, lab media, and disposable testing components that are exhausted during laboratory research are generally eligible.4

5.2 Illustrative Example: Qualitatively Distinguishing Costs

Proper classification depends entirely on the material’s fate—consumption in the research effort versus inclusion in a depreciable asset or G&A pool.

Table 2: Qualifying vs. Non-Qualifying R&D Supplies (The Consumed Test)

Table Title

5.3 Case Study: Precision Materials Corp. (An Illinois-Based Manufacturing Firm)

Precision Materials Corp. (PMC), based entirely in Illinois, is developing a new, lightweight composite for the automotive industry. PMC analyzes its expenditures to determine its qualified Cost of Supplies for Schedule 1299-I, Line 2.

In this scenario, PMC can include $100,000 in its total Illinois QRE calculation. This amount, combined with qualifying wages, computer lease costs, and contract research expenses, will be used to determine the incremental increase over the historical base, upon which the 6.5% Illinois credit will be calculated.2

VI. Economic Context and Strategic Compliance

6.1 Broader Economic Commitment

The Illinois R&D tax credit is a significant component of the state’s broader economic strategy to stimulate investment in high-technology, manufacturing, and pharmaceutical sectors.1 The credit was extended to tax years ending on or before December 31, 2031.1 By offering a 6.5% credit against income tax liability, the state reinforces its commitment to fostering innovation and economic growth.17

These incentives have demonstrable effects. Related economic analyses of clean energy tax credits in Illinois show substantial support for the economy, generating over $1.4 billion in annual economic value added and supporting more than 10,500 jobs annually.19 The 6.5% rate offers a significant financial inducement, directly reducing the tax bill rather than just reducing taxable income, thereby providing substantial financial benefits to eligible businesses.17 The structure ensures that only those companies that consistently increase their level of R&D investment benefit fully, thereby rewarding sustained innovative effort.2

6.2 Best Practices for Documentation and Audit Defense

Successfully claiming the Cost of Supplies requires a commitment to documentary discipline that exceeds standard financial reporting. Robust documentation is the cornerstone of audit defense, particularly given the audit scrutiny applied to the Consumed Test and the state sourcing requirement.

1. Project-Level Tracking: Expenses must be meticulously tracked and tied directly to specific internal qualified research projects. This documentation must include narratives confirming that the project sought to eliminate technological uncertainty through a process of experimentation, validating the fundamental necessity of the supply consumption.
2. Verification of Consumption and Disposal: Taxpayers must maintain detailed inventory usage logs, requisition forms, and internal scrap or destruction reports. These records must definitively prove that the materials were consumed, destroyed, or rendered permanently unusable in the experimental phase. This is necessary to substantiate that the materials failed the test for capitalization.4
3. State Sourcing Proof: For multi-state companies, records must verify the physical location of consumption. This involves linking supply costs to the specific Illinois R&D facility where the materials were physically used, ensuring compliance with the “attributable to research in Illinois” sourcing rule.2
4. Historical Consistency: The methodology used to define and calculate the Cost of Supplies for the current year must be applied consistently to the three-year base period.11 Any changes in classification methodology risk an auditor adjusting the base period average, which could result in a detrimental recalculation of the incremental credit amount.

VII. Conclusion

The “Cost of Supplies” is a critical, high-value component of the Illinois R&D Tax Credit, determined by the rigorous standards of IRC Section 41. Successful qualification is predicated on satisfying the “Consumed Test,” which dictates that supplies must be tangible, non-depreciable materials that are physically consumed or used up during the conduct of qualified research.

Compliance with the Illinois Department of Revenue necessitates precise cost segregation and adherence to the formal state reporting structure, specifically Schedule 1299-I, Line 2. The state’s 6.5% incremental credit mechanism rewards not only innovation but also the corporate diligence required to establish and maintain transparent, consistent records across a four-year measurement window. Taxpayers who implement sophisticated internal accounting systems that prove physical consumption and verified in-state sourcing will be best positioned to maximize this valuable nonrefundable credit and withstand subsequent audit scrutiny.

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