Exclusion: Research Outside Illinois in the Context of the Illinois R&D Tax Credit

The Illinois Research and Development (R&D) Tax Credit is strictly limited to costs incurred for research activities physically performed within the State of Illinois.

All Qualified Research Expenses (QREs) attributable to activities conducted outside Illinois must be excluded from both the current year calculation and the historical base calculation.

1.2 Detailed Thesis: The Non-Negotiable Requirement for Illinois-Sourced Activity

The Illinois R&D Tax Credit, codified under 35 ILCS 5/201(k), serves as a targeted financial incentive, providing a 6.5% credit on qualifying expenditures exceeding a determined base amount.1 This state-level incentive is administered through the Illinois Department of Revenue (IDOR) and is designed specifically to foster innovation within Illinois borders.1 Although the underlying definitions of qualified research activities (QRAs) and Qualified Research Expenses (QREs) largely align with the federal standards set forth in Internal Revenue Code (IRC) § 41 2, the foundational principle of the state credit is the geographic nexus: eligibility requires activities and expenses to be sourced exclusively to Illinois.

This geographical restriction mandates the full exclusion of any research activities performed outside the state. For multistate taxpayers, this requirement creates a crucial compliance challenge, as it necessitates the establishment of two distinct and non-interchangeable pools of QREs for compliance purposes. The federal QRE determination relies on the technical and functional merits of the activity, allowing nationwide expenses to contribute toward the credit base. Conversely, the Illinois credit imposes an overriding constraint: physical location. Consequently, the total QRE calculated for federal purposes will almost always exceed the QRE calculated for Illinois purposes. Tax professionals must therefore conduct a separate, location-specific sourcing exercise to establish the authoritative Illinois-Only QRE pool, as reliance on federal documentation alone is insufficient for state compliance.

2. Statutory and Legislative Framework for Exclusion

The mandate to exclude out-of-state research is firmly rooted in Illinois statute and is central to the operation of the state’s R&D tax incentive.

2.1 Legislative Authority: 35 ILCS 5/201(k)

The Illinois statute explicitly provides a nonrefundable credit equal to 6.5% of the increase in qualified research expenses over a determined base amount.1 The statutory phrase “performed in Illinois” explicitly limits the benefit to in-state activities.1 This definitive language in 35 ILCS 5/201(k) is the legal basis for the exclusion requirement. The credit is currently authorized for tax years ending on or before December 31, 2031, providing an established, long-term incentive for businesses operating within the state.1 This longevity underscores the necessity for taxpayers to establish auditable, geographically focused sourcing protocols to sustain future claims.

2.2 Alignment and Deviation from Federal IRC § 41

The Illinois R&D tax credit is structured to harmonize with federal standards, adopting the federal definitions for qualifying research and QRE categories, which include wages, supplies, and contract research.1 This alignment allows taxpayers to utilize existing federal technical documentation, saving administrative effort related to establishing new qualification criteria for the nature of their R&D projects.

However, the critical divergence lies in the geographic limitation. While the federal credit applies to activities performed anywhere in the U.S., the Illinois credit applies only to activities physically performed within state lines. This rule mandates the systematic exclusion of all out-of-state QREs, irrespective of their federal qualification status.

2.3 Mandatory Incremental Method as a Sourcing Enforcement Tool

Illinois administers the R&D credit using a specific incremental method, where the credit is 6.5% of QREs exceeding the average QREs of the three immediately preceding taxable years.1 This methodology is mandatory. The state does not permit the use of the federal Alternative Simplified Credit (ASC) or the Fixed-Base Percentage options.1

This restriction on calculation methods ensures that the geographical sourcing rule (“performed in Illinois”) applies uniformly and strictly to both the current year QRE determination and the historical base calculation.3 If Illinois permitted the use of federal methods, such as those relying on gross receipts, the geographical control over the QRE base calculation might be diluted or complicated by income apportionment rules. By mandating the incremental method based purely on QRE history, the state guarantees that the importance of consistent, Illinois-only sourcing is reinforced across a multi-year window, requiring uniform documentation standards for both current and historical data capture.

3. The Definition and Application of Exclusion: IDOR Guidance on Allocating QREs

The physical location requirement imposed by the IDOR necessitates distinct, auditable sourcing methodologies for the three primary categories of QREs.

3.1 Establishing the Geographic Nexus: The Burden of Proof

Taxpayers claiming the Illinois R&D credit carry a high burden of proof. The taxpayer must affirmatively demonstrate that the activities clearly satisfy the criteria under 35 ILCS 5/201(k).4 IDOR rulings have emphasized that reliance on testimonial evidence alone regarding the nature and location of R&D expenditures is insufficient; the Department requires contemporaneous records verifying that the research and development was physically “performed in Illinois”.4 Therefore, compliance hinges entirely on the quality of documentation demonstrating physical location, effectively making the exclusion process an exercise in verifiable geographic data capture.

3.2 Sourcing Wages: The Time and Effort Test

Wages, often the largest QRE category, require meticulous allocation for employees who operate across state lines. Qualified wages are determined based on the actual time and effort spent by research employees performing, supervising, or supporting qualified research physically within Illinois.1

The exclusion protocol dictates that if an employee’s qualified services are split between an Illinois headquarters and an out-of-state facility, only the documented percentage of time physically spent in Illinois is includible in the QRE calculation. All time and associated payroll allocated to work performed outside Illinois must be excluded. It is crucial that sourcing is not based on the employee’s tax home or payroll jurisdiction, but rather on the direct linkage of time tracking to specific R&D project codes and the physical location where the effort occurred.

3.3 Sourcing Supplies and Contract Research

Sourcing Supplies

Qualified supplies, defined as materials and prototypes consumed in research 1, are sourced to the location where the materials are physically consumed or tested during the qualified research process. The location where the supplies were purchased or where payment originated is irrelevant to the sourcing decision. For example, materials purchased in Chicago but shipped for use and consumption in an Indiana research laboratory must be fully excluded from the Illinois QRE pool.

Sourcing Contract Research

Contract research expenses, which are includible at 65% of the payment cost 1, are sourced based on the location where the third-party contractor physically performs the research activity. If an Illinois company contracts with a research firm whose facilities and personnel are located in Texas, the resulting contract payments must be fully excluded from the Illinois QRE calculation, regardless of the Illinois company’s intent or the benefit derived.

3.4 Historical Data Reconstruction and Compliance Risk

A critical challenge arises in determining the historical base amount. The credit calculation requires averaging the QREs incurred in the three immediately preceding taxable years.3 If a multistate company did not claim the Illinois R&D credit in those base years, they likely did not maintain the granular, state-specific time and effort tracking necessary to accurately separate Illinois-only QREs from the broader federal QREs retrospectively.

This situation frequently necessitates a costly and resource-intensive historical reconstruction effort, which introduces inherent complexity and potential inaccuracy, compounding the risk associated with the high burden of proof required by the Department.4 This complexity establishes that the “Exclusion of Research Outside Illinois” rule forces taxpayers to maintain Illinois-specific QRE documentation not just for the current year, but also for the three look-back years, requiring a minimum of four years of consistently tracked, auditable geographic data.

Table 2 provides a summary of IDOR’s QRE sourcing guidelines in a multistate environment, highlighting the necessary exclusion process.

Table 2: IDOR QRE Sourcing Guidelines for Multistate Operations (The Exclusion Process)

4. IDOR Compliance: Calculating the Illinois Research Credit

The calculation of the Illinois R&D credit is wholly dependent on the taxpayer’s success in filtering out all excluded (non-Illinois) QREs from both the current and base periods.

4.1 The Calculation Mechanism and Limitations

The Illinois credit is calculated as 6.5% of the Current Year Illinois QREs that exceed the Illinois Base Amount.1 The credit is nonrefundable, meaning it applies only against the taxpayer’s Illinois income tax liability (IITA Section 201(a) and (b)), and cannot generate a cash refund. However, any unused credit may be carried forward for five subsequent tax years, providing flexibility for utilization in future periods.1

4.2 Determining Current Year Illinois QREs (The Numerator)

To determine the current year QRE pool for Illinois (CYIQRE), the taxpayer must first determine its total QREs using federal IRC § 41 standards. Following this initial determination, the taxpayer must systematically apply the exclusion protocols detailed in Section 3, filtering all QREs sourced outside Illinois (wages by time/effort, supplies by consumption, contracts by performance location). The resulting sum represents the creditable Current Year Illinois Qualified Research Expenses (CYIQRE).

4.3 Calculating the Illinois-Sourced Base Amount (The Denominator)

The exclusion requirement is equally critical when calculating the historical base amount. The base amount is defined as the average of QREs incurred in the three immediately preceding taxable years.2 Crucially, the QREs used in this base calculation must also be restricted only to those activities demonstrated to have been performed in Illinois.1

This requirement can be leveraged strategically by taxpayers. If a company strategically moved a significant portion of its R&D activity out of Illinois several years prior, the subsequent base calculation will reflect only the dramatically reduced level of in-state activity. This circumstance can lead to a minimal historical base amount, thereby substantially increasing the incremental credit calculation for the current year, even if overall nationwide R&D activity remained constant. This dynamic provides a clear tax benefit for companies that have stabilized or slightly increased their Illinois R&D after a period of contraction or relocation, essentially allowing the exclusion rule to facilitate a reduction of the base amount. For new businesses or those without any Illinois QREs in the prior three years, the base calculation defaults to $0, maximizing the initial incremental benefit.1

5. IDOR Reporting, Forms, and Multistate Complexities

Formal compliance requires navigating specific IDOR forms and addressing the intricacies of combined filing for multistate organizations.

5.1 Mandatory Forms and Worksheets

The detailed guidance and specific methodologies required for sourcing and excluding non-Illinois QREs are formalized within the IDOR’s administrative schedules. The Research and Development Worksheet in Schedule 1299-I is the foundational document. Taxpayers must consult the instructions and complete this worksheet first to accurately determine the amount of credit earned, as the specific definition and methodology for sourcing are embedded within its structure.5 Once the creditable amount is finalized, it is carried over and formally claimed on Schedule 1299-D using Credit Code 5340.5

5.2 Unitary Business Groups and Combined Reporting

Multistate unitary groups that file a combined return in Illinois face unique sourcing issues. Unitary groups aggregate the QREs of all members, but the credit computation must still adhere strictly to the “performed in Illinois” requirement.6 Only QREs that were physically performed in Illinois by any member of the group are includible in the combined QRE pool.1

The methodology used for R&D credit sourcing (based on the physical location of qualified payroll, supplies, and contract research) is functionally separate from the state’s income apportionment formula. Illinois uses a single sales factor (SSF) for apportioning unitary business income.7 The R&D credit calculation is not a function of this SSF; rather, it is tied to the physical location of the research activity, which is typically a proxy for the standard payroll/property factors used in apportionment. This separation means that taxpayers must strategically model these two factors independently. Maximizing the R&D credit requires demonstrating maximal physical presence in Illinois, which may run counter to strategies focused purely on minimizing the overall SSF apportionment percentage.8 Furthermore, when calculating the credit for the unitary group, any intercompany transactions (such as charges for R&D services between two members) must be eliminated to prevent distortion of the credit calculation, mirroring the requirements for income apportionment factors.8

6. Case Study: Multistate Exclusion and Sourcing Example

The following example illustrates the direct financial impact of applying the “Exclusion: Research Outside Illinois” rule to a multistate taxpayer’s calculation.

6.1 Scenario Setup: XYZ Tech, A Multistate R&D Entity (Tax Year 2024)

XYZ Tech, a firm engaged in R&D, operates with its primary headquarters and core research personnel in Illinois (HQ) and utilizes a dedicated testing facility in Ohio (OH).

Current Year QRE Data (Federal Total):

• Wages (R&D personnel): $1,500,000
• Supplies (Materials consumed): $300,000
• Contract Research (Testing analysis): $400,000
• Total Federal QREs: $2,200,000

Historical Illinois QRE Data (Preceding 3 Years, already Illinois-Sourced):

• 2023 Illinois QREs: $850,000
• 2022 Illinois QREs: $750,000
• 2021 Illinois QREs: $640,000

6.2 Step-by-Step Sourcing Analysis (Applying the Exclusion)

1. Sourcing Wages (Time & Effort): Labor tracking documentation confirms R&D employees spent 30% of their qualified time physically working in Ohio.

• Exclusion: $1,500,000 $\times$ 30% = $450,000.
• Inclusion (Illinois QRE): $1,500,000 – $450,000 = $1,050,000.

1. Sourcing Supplies (Consumption Location): $100,000 worth of raw materials were physically consumed during testing conducted in the Ohio facility.

• Exclusion: $100,000.
• Inclusion (Illinois QRE): $300,000 – $100,000 = $200,000.

1. Sourcing Contract Research (Performance Location): The third-party contractor performed all specialized testing and analysis at its independent lab in Michigan.

• Exclusion: $400,000 (Full Exclusion).
• Inclusion (Illinois QRE): $0.

6.3 Final Credit Calculation Summary

• Total Current Year Illinois QRE (CYIQRE): $1,050,000 (Wages) + $200,000 (Supplies) + $0 (Contract Research) = $1,250,000 (A).
• Historical Base Calculation (Illinois-Only):

• Base QREs Sum: $850,000 + $750,000 + $640,000 = $2,240,000.
• Illinois Base Amount (Average): $2,240,000 / 3 = $746,667 (B).

Table 3: Calculation Example: Exclusion and Illinois Credit Determination (Tax Year 2024)

The example demonstrates that although the company incurred $2,200,000 in federally qualified expenses, $950,000, or 43%, had to be excluded because the research was physically performed outside of Illinois, resulting in a calculated state credit of $32,717.

7. Strategic Recommendations and Conclusion

7.1 Maximizing the Credit Through Proactive Sourcing and Documentation

Given the high audit standard imposed by IDOR, which requires taxpayers to demonstrate clear compliance with 35 ILCS 5/201(k) using substantive evidence beyond mere testimony 4, compliance must be built on robust, systematic documentation that proactively addresses the exclusion rule.

To mitigate compliance risk and maximize the allowable credit, entities must implement integrated tracking systems. This involves leveraging labor tracking software that accurately links R&D project codes with geographical markers, such as GPS or designated facility codes, for all employees contributing to the credit. Furthermore, businesses should establish an annual sourcing protocol to rigorously verify that the historical QRE base (the denominator) was consistently calculated using Illinois-only sourced data, ensuring no contamination from excluded expenses carried over from prior years. Finally, contracts with external R&D partners should explicitly detail the physical location where the services are performed, providing primary, auditable evidence for either inclusion or exclusion.

7.2 Conclusion: The Requirement of Physical Presence

The Illinois R&D tax credit offers a valuable 6.5% nonrefundable incentive for in-state innovation.1 However, the core compliance and planning challenge for multistate taxpayers lies in the mandate for Exclusion: Research Outside Illinois. This statutory constraint requires the meticulous application of geographical sourcing rules to all QRE categories—wages, supplies, and contract research.

This rule dictates the formation of a distinct, auditable, Illinois-only QRE pool that must be consistently tracked across the current year and the three-year base period, as detailed in IDOR’s Schedules 1299-I and 1299-D.5 Failure to apply a granular geographical exclusion to both current and historical QREs risks jeopardizing the credit claim entirely. Taxpayers must adopt sophisticated data capture methodologies that decouple the R&D credit calculation from standard state income apportionment rules, focusing strictly on the physical location of the qualified research activity to ensure accuracy and defense against audit disallowance.

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