Expert Analysis of the Exclusion for Research in Social Sciences, Arts, or Humanities under the Illinois R&D Tax Credit (35 ILCS 5/201(k))

Executive Summary: Defining the Exclusion

The Illinois Research and Development (R&D) Tax Credit explicitly prohibits the inclusion of expenditures related to research in the social sciences, arts, or humanities within qualifying research expenses (QREs).1 This mandated exclusion, adopted directly from federal statute, ensures that the credit incentivizes only technological experimentation rather than non-technical studies concerning economics, consumer behavior, or managerial methodology.2

This report provides an authoritative analysis of this exclusion, detailing its statutory basis within the Illinois Income Tax Act (IITA), the corresponding guidance issued by the Illinois Department of Revenue (IDOR), and the compliance requirements necessary to segregate non-qualifying costs during audit scrutiny.

Section I: Statutory Foundation of the Illinois R&D Tax Credit

1.1 Scope and Duration of the Illinois Research and Development Tax Credit (Credit Code 5340)

The Illinois R&D Tax Credit, designated as Credit Code 5340, is a nonrefundable incentive designed to encourage businesses to increase qualified research activities conducted within the state.4 The statutory authority for this credit is found under 35 ILCS 5/201(k).1 This provision allows taxpayers to claim a credit for tax years ending on or after December 31, 2004.1

The duration of the credit has been a focus of state legislative action. While initially set to expire, the credit was most recently extended by Public Act 103-0595, ensuring its applicability until tax years ending on or before December 31, 2031.1 This extended period of availability signals the state’s continued commitment to fostering innovation, requiring taxpayers to adopt robust, long-term compliance strategies for eligible activities.

1.2 Credit Mechanics and Calculation Methodology

The Illinois R&D credit is calculated as 6.5% of the taxpayer’s qualifying expenses for increasing research activities in Illinois.4 Critically, this is an incremental calculation, meaning the credit is applied only to the amount by which the qualifying expenses incurred for the current tax year exceed the qualifying expenses incurred during the base period.1

The “base period” is defined as the average of the three tax periods immediately preceding the current year.1 The nonrefundable credit can be carried forward for up to five years to offset future Illinois income tax liability.4 Because the credit uses a historical base period, the accurate classification of QREs—and particularly the rigorous exclusion of non-qualifying costs such as social science research—is paramount. Misclassification in the current year risks audit disallowance, while misclassification in the base period could artificially increase the average base amount, consequently reducing the incremental credit available in the current period.

1.3 Mandatory Federal Linkage: Adoption of IRC Section 41 Definitions

The structure of the Illinois R&D tax credit is fundamentally tethered to federal law. Illinois statute defines “Qualifying expenses” as those expenditures qualifying under Internal Revenue Code (IRC) Section 41 that are attributable to research conducted in Illinois.1 This critical linkage mandates that Illinois taxpayers must adhere to all federal requirements and exclusions defining “qualified research,” which are codified in IRC §41(d).7

Qualified research, under both state and federal law, is defined as research or experimental activities that are technical in nature, intended to be useful in the development of a new or improved business component, and substantially all of which constitute elements of a process of experimentation.1

1.4 Explicit Statutory Exclusions in Illinois

Illinois guidance, such as the instructions for Schedule 1299-I and 1299-C, explicitly enumerates several types of activities that are disqualified from receiving the credit, mirroring the exclusions in IRC §41(d)(4).1 These exclusions include, but are not limited to:

• Research conducted after the beginning of commercial production.1
• Research adapting an existing product or process to a particular customer’s need.1
• Duplication of an existing product or process.1
• Research conducted outside Illinois.1
• Research funded by another person or government entity.1
• Research in the social sciences, arts, or humanities.1

Furthermore, Illinois guidance specifically includes the exclusion for “surveys or studies,” a point often related to, but distinct from, the social sciences exclusion, and highly relevant for activities involving market research.1

Section II: Deconstructing the “Social Sciences, Arts, or Humanities” Exclusion

2.1 Statutory Basis and Definitional Scope (IRC §41(d)(4)(G))

The exclusion for research in the social sciences, arts, or humanities is mandated by federal statute under IRC §41(d)(4)(G).10 Because the Illinois credit relies entirely on the federal definition of qualified research, this exclusion is binding on all Illinois claims.1

The most significant interpretation of this exclusion is found in federal Treasury Regulation §1.41-4(c)(10), which clarifies the scope of the prohibited activities. This regulation explicitly includes specific disciplines within the definition of “social sciences,” encompassing economics, business management, and behavioral sciences.2

This expanded definition carries profound implications for non-traditional R&D claimants, particularly those in the service, finance, or technology sectors focused on organizational efficiency, consumer engagement, or pricing models. When a company claims R&D expenses for developing software or processes related to these fields, the internal analysis must rigorously differentiate the technological experimentation from the underlying social science principles being applied. For example, developing a new internal staffing model based on organizational behavior studies is likely excluded under “business management,” unless the project’s expenditure relates only to the novel, uncertain computer science required to construct and test the computational model.

2.2 The Dual Risk: Differentiating the Social Science Exclusion from Related Activities

Illinois compliance is made more rigorous by the presence of a second, overlapping exclusion: “surveys or studies”.1 This explicit state-level inclusion provides IDOR auditors with two separate and distinct avenues to deny claims related to market validation, user research, or feasibility testing.

Activities such as market research, routine data collection, routine testing, or quality control are routinely excluded from QREs.12 For a project aiming to optimize pricing (economics, a social science), any associated expenses for conducting customer feedback sessions or market surveys would not only fall under the social science umbrella but also be separately disallowed as “surveys or studies.” This regulatory redundancy strengthens the barrier against claiming costs associated with gathering social science data or applying established business practices.15

Successful compliance requires taxpayers to meticulously segregate costs associated with the non-technological gathering and analysis of social science data (the excluded survey/study component) from the costs related to developing the technological tool or system used to facilitate the research (the potentially qualified R&D component).

2.3 Focus on the Process, Not the Outcome

A fundamental principle governing the exclusion is that the qualification is determined by the process of the research activity, rather than the intended end result or beneficiary.3 The research must be undertaken for the purpose of discovering information that is technological in nature and intended to eliminate technical uncertainty through a process of experimentation.7

For instance, if a company undertakes chemical research to develop a new, non-toxic pigment formulation for artists’ paints, the research is qualified because it involves technological experimentation (chemistry and materials science). The fact that the ultimate benefit is to the arts community does not disqualify the activity. Conversely, research conducted by an art historian examining the biographical details or painting techniques of Van Gogh is explicitly excluded, as it is research in the humanities.3

This distinction is crucial: activities are excluded only if the uncertainty being addressed relates to the behavioral, economic, or managerial domain, rather than the engineering, physical, or computer science domain.

Section III: IDOR Guidance, Compliance, and Audit Defense

3.1 Administrative Code and Regulatory Alignment

The Illinois Department of Revenue (IDOR) enforces the R&D credit through the Illinois Income Tax Act (35 ILCS 5/201(k)) and the Illinois Administrative Code, specifically 86 Ill. Adm. Code 100.2160.5 IDOR’s guidance materials, such as the instructions accompanying Schedule 1299-C (for individuals) and related schedules for corporate taxpayers, explicitly state that research in the social sciences, arts, or humanities is ineligible for the credit.1

By adopting federal IRC §41 requirements, IDOR inherently relies on the extensive federal interpretation (including Treasury Regulations) for defining the scope of these exclusions. This means that if an activity is denied at the federal level due to the social science exclusion, it will invariably be denied for the Illinois credit.

3.2 The Fundamental Audit Test: Technological Uncertainty and the Process of Experimentation

During an audit of the R&D tax credit claim, IDOR personnel are concerned with verifying the documentation that supports the line-by-line items reported on the tax returns.17 When reviewing hybrid projects that touch upon behavioral or economic outcomes (e.g., software intended to influence customer choices), the auditor will apply the “process of experimentation” test rigorously to determine if the activity truly qualifies as technical research.18

Qualified research must demonstrate that the taxpayer was attempting to eliminate technical uncertainty concerning the development or improvement of a business component.3 This requires demonstrating that the research was technological in nature.7

If a taxpayer develops a complex financial modeling algorithm (a project concerning economics), the eligibility hinges on whether the uncertainty was technical (e.g., developing a novel mathematical function or coding architecture to process data efficiently) or economic (e.g., whether the resulting model will accurately predict market movement). Activities that merely apply established computational techniques to solve a social science problem are highly susceptible to disallowance under the social sciences exclusion. The documentation must clearly show that the primary function of the expenditure was to overcome engineering hurdles, utilizing principles of the physical or biological sciences, engineering, or computer science.3

3.3 Audit Documentation and Segregation of Costs

The Illinois Administrative Code Title 86, Section 100.9530 governs income tax record-keeping guidance.17 Due to the high risk of commingling qualified technical costs with excluded social science costs in hybrid projects, detailed contemporaneous documentation is not merely advisable but essential for audit defense.

Taxpayers must maintain records that meticulously segregate costs. This includes separating wages, supplies, and contract expenses related to non-technological studies from those related to qualified technological research.4 If documentation is unclear or fails to delineate the specific function performed, an IDOR auditor may elect to disqualify the entire project, arguing that the social science exclusion permeates all claimed expenditures.

For instance, time tracking records must functionally differentiate hours spent by employees. If an employee divides time between writing proprietary code to improve a technical process (a QRE) and conducting surveys to analyze user preference (excluded as a survey/study), only the former can be counted toward QREs. The inability to justify the exclusion of non-qualifying activities demonstrates insufficient diligence and significantly elevates the audit risk profile of the entire claim.

Section IV: Practical Nuance and Distinction in Application

4.1 The Challenge of Hybrid Projects in FinTech and MarTech

The rise of industries focused on optimizing business outcomes through data—such as Financial Technology (FinTech) and Marketing Technology (MarTech)—presents frequent challenges regarding the social sciences exclusion. These projects often blend technological development with behavioral or economic research.

4.1.1 Qualified Technological Components

Expenditures qualify when they relate to the technical activities necessary to overcome uncertainty. Examples include developing novel algorithms, building custom cloud-based applications, or engineering high-throughput data pipelines.8 The focus remains on the process of development that required technical experimentation in computer science or engineering.8

4.1.2 Excluded Social Science Components

Excluded expenditures are those related to the managerial or behavioral aspects. This includes the salaries of personnel dedicated to:

1. Formulating or testing new economic or psychological hypotheses.15
2. Conducting consumer attitude surveys or focus groups (excluded as “surveys or studies”).1
3. Improving internal business management functions that do not rely on resolving technological uncertainty.14

If a FinTech company develops an internal-use software system for optimized pricing, that software must pass the highly rigorous three-part test for internal-use software (High Threshold of Innovation, Significant Economic Risk, and Not Commercially Available) and ensure that the research costs do not pertain to the excluded business management or economic functions the software supports.20

4.2 Application of the Exclusion in Arts and Humanities

The exclusion relating to the arts and humanities similarly targets non-technological research. This typically includes activities involving historical analysis, literary review, aesthetic criticism, or organizational structure development.12

However, when a project involves scientific or engineering principles to improve a product used in the arts, the technological expenditure is qualified. For instance, the costs associated with the physical development of an improved polymer for use in sculpture or a new chemical etching process for graphic arts would qualify as R&D, as the research process involves materials science or chemistry.3 The key differentiator remains whether the uncertainty addressed is technical (how to make the material work) or aesthetic/historical (what is the meaning of the material).

4.3 Practical Exclusion Examples

The following table summarizes common activities susceptible to challenge under the social sciences and related exclusions:

Table 1: Qualification Status of Research Activities

Section V: Case Study, Credit Calculation, and Compliance Strategy

5.1 Case Study: The Corporate Workflow Optimization System (CWOS)

A major Illinois-based logistics corporation, LogiCorp, decided to develop a proprietary Corporate Workflow Optimization System (CWOS) to improve employee efficiency and resource deployment across its warehouses. The project involved two major tracks:

1. Technological Track (QREs): Developing a custom, real-time machine learning (ML) algorithm to dynamically schedule autonomous delivery vehicles, requiring extensive experimentation in algorithm design and testing due to novel computing demands.
2. Managerial Track (Excluded): Researching and defining the optimal organizational structure and managerial reporting lines based on behavioral science principles and internal staff performance studies. This also involved conducting internal time-motion surveys.

LogiCorp incurred total expenditures of $\$1,500,000$ in the current tax year (Year 4).

5.2 Segregation of Expenditures: Applying the Exclusion

Based on functional time tracking and supply consumption:

• Excluded Expenses: Costs related to the Managerial Track (including wages for management consultants, behavioral analysts, and costs associated with the internal time-motion surveys/studies). Total Excluded Costs: $\$500,000$.
• Qualified Expenses (QREs): Costs related to the Technological Track (wages for software developers, engineers, and computer testing resources for the ML algorithm). Total QREs: $\$1,000,000$.

The $\$500,000$ related to managerial techniques and behavioral studies must be subtracted from the total research costs, as these fall under the excluded fields of “business management,” “behavioral sciences,” and “surveys or studies”.2

5.3 Illinois Credit Calculation Demonstration

To calculate the Illinois R&D credit, the incremental QREs must be determined by comparing the current year’s QREs against the three-year base period average. The Illinois credit rate is 6.5%.6

Table 2: Illinois R&D Credit Calculation (LogiCorp Example)

The disciplined exclusion of the $\$500,000$ in non-qualifying social science and business management research was essential for securing the $\$13,000$ credit derived from the qualified technological activities. Had LogiCorp failed to exclude these costs in the current year and claimed them, an IDOR audit would likely have disallowed not just the $\$500,000$ in question, but potentially challenged the entire $\$1,500,000$ project if the segregation was not defensible.

5.4 Recommendations for Proactive Documentation and Audit Defense

To successfully navigate IDOR audits regarding the social sciences exclusion, taxpayers must shift their focus from the business component’s goal to the technological process required to achieve it.

1. Functional Time Tracking: Wages for qualified services, which are typically the largest component of QREs, must be tracked based on function. Time allocation records must clearly delineate hours spent by employees on technological development, testing, and supervision (qualifying activities) versus time spent on market analysis, behavioral studies, or managerial research (excluded activities).4
2. Project Definition and Scoping: All project documentation, including research meeting minutes, technical memos, and project summaries, should focus exclusively on the specific technological uncertainties addressed by the engineering team. Any references to the economic or behavioral payoff should be secondary to the discussion of the physical, engineering, or computer science challenges overcome.3
3. Positive Justification for Exclusion: Taxpayers should maintain internal memoranda that not only justify the inclusion of qualified costs but also proactively document why certain expenditures, specifically related to surveys, studies, or business management, were excluded from the QRE base. This demonstrates clear adherence to both the explicit state exclusion (surveys/studies) and the implicit federal exclusion (social sciences) adopted by Illinois.1

Conclusion: Maintaining Compliance in a Hybrid R&D Environment

The Illinois R&D Tax Credit, codified under 35 ILCS 5/201(k), rigorously enforces the exclusion of research conducted in the social sciences, arts, or humanities, mirroring the federal mandate of IRC §41(d)(4)(G). This prohibition extends to activities categorized as economics, business management, behavioral sciences, and explicit surveys or studies.

For modern businesses operating in fields like software development, where technological processes frequently overlap with behavioral or economic goals, the risk of audit disallowance is significant if compliance strategies are inadequate. The determination of eligibility hinges entirely on whether the expenditure addresses a technological uncertainty through a process of experimentation, rather than applying established technology to solve a non-technical problem.

Successful compliance strategies must prioritize the segregation of costs at the lowest practical level of granularity. By documenting the functional activities of personnel and ensuring that QREs are tied exclusively to the technological development process—and not the associated managerial, economic, or behavioral testing—taxpayers can defend their claim effectively against IDOR scrutiny and maximize the nonrefundable 6.5% incremental credit available through 2031.1

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