Expert Report on In-House Research Expenses (IHRE) and the Illinois R&D Tax Credit

I. Executive Summary and Statutory Foundation

In-House Research Expenses (IHRE) are expenditures paid or incurred directly by a taxpayer for the conduct of qualified research, including wages, supplies, and computer usage. These expenses form the foundational cost components utilized in calculating the nonrefundable 6.5% Illinois Research and Development Tax Credit, provided the underlying activities are conducted entirely within the state.

A. Detailed Definition and Purpose of IHRE

Qualified Research Expenses (QREs) are defined under the federal Internal Revenue Code (IRC) Section 41, which Illinois adopts.1 QREs are generally the sum of in-house research expenses, contract research expenses, and basic research payments paid or incurred by the business.1 IHRE specifically addresses costs incurred internally by the taxpayer, distinguishing them from payments made to external contractors. These expenses are designed to capture the direct costs of innovation within the state’s economy.

The Illinois Research and Development (R&D) Tax Credit (Credit Code 5340) is authorized under the Illinois Income Tax Act, 35 ILCS 5/201(k).2 The credit is explicitly designed to incentivize businesses, particularly those in manufacturing, pharmaceuticals, and technology, to invest in qualified research activities within Illinois.2

B. Statutory Framework and Credit Structure

The eligibility criteria for the Illinois R&D credit mirror federal standards established under IRC § 41, but with a critical caveat: the activities and expenses must be definitively Illinois-sourced.2 Businesses must demonstrate technical uncertainty in developing or improving products, processes, or software within the state to qualify for the underlying research activities.2

The credit structure is incremental, calculated at a rate of 6.5% of the qualifying expenses for increasing research activities (QREs) that exceed a statutory base amount.2 Taxpayers claim the credit by filing Schedule 1299-D (for corporations and fiduciaries) or Schedule 1299-A/C (for flow-through entities).2

The credit is nonrefundable, meaning it can only offset Illinois income tax liabilities; it cannot result in a cash refund to the taxpayer.1 Importantly, any unused credit can be carried forward for five years, or until fully utilized.1 This carryforward provision is essential for startups and companies in early development stages that may generate large QREs but lack current taxable income. The R&D credit has been extended repeatedly, with current legislation extending availability for tax years ending prior to January 1, 2032.6 This legislative history confirms the state’s continued commitment to the program but requires tax planning professionals to remain vigilant regarding potential future expiration dates, as the credit is not a permanent feature of the state tax code like its federal counterpart.

II. The Anatomy of In-House Research Expenses (IHRE) in Illinois

The Illinois definition of IHRE adopts the foundational components outlined in IRC § 41(b)(2). These costs are generally paid or incurred by the taxpayer directly for R&D activities and do not include payments made to third-party contractors.7

A. Detailed Components of IHRE

1. Qualified Wages for Services

Wages represent the most significant component of IHRE for most taxpayers. This category includes salaries paid to employees who perform, supervise, or directly support qualified research activities.2

• Performance: Activities constituting the actual conduct of the research (e.g., an engineer writing code for a new product function).
• Direct Supervision: Activities of immediate supervisors who manage the personnel directly performing research (e.g., a laboratory manager overseeing experiments).
• Direct Support: Activities that are not inherently research but are required for the performance of research (e.g., maintaining equipment used exclusively in R&D or preparing supplies for testing).2

For inclusion in IHRE, wages generally constitute gross salaries.2 While other tax credits in Illinois may broaden the definition of “labor expenditure” to include taxes and benefits 3, standard R&D credit analysis typically focuses on the taxable W-2 wages related to the qualified services performed.

2. Qualified Supplies

Qualified supplies refer to tangible property, materials, and prototypes consumed or expended during the systematic conduct of qualified research.2 This consumption requirement is strictly enforced.

A critical exclusion within this category is any item subject to depreciation. Equipment, machinery, and land used in the research process are capital expenditures and are not eligible to be claimed as supply IHRE.8 Taxpayers must ensure that supplies are entirely consumed or rendered worthless during the research or experimental process, such as chemicals used in a reaction or prototype components destroyed during stress testing.2 A review of federal guidance, which Illinois follows, indicates that auditors often flag claims where supply QREs form an unusually high proportion of total QREs, as this may signal the improper inclusion of capital or ineligible expenses.8

3. Computer Rental or Lease Costs

The costs associated with leased computer equipment or payments for cloud services used directly to conduct qualified research are includible in IHRE.2 This component recognizes the essential role of computational resources, data processing, and cloud infrastructure in modern R&D, particularly in software development and engineering design.

B. Excluded Activities as Guidance from IDOR

The Illinois Department of Revenue (IDOR), through its instructions for Schedule 1299-I, explicitly excludes several categories of research activity from generating qualified expenses, mirroring federal limitations.3 Taxpayers must ensure their IHRE is not tied to any of the following prohibited activities 3:

• Research conducted after the beginning of commercial production.
• Research adapting an existing product or process to a particular customer’s specific needs.
• Duplication of an existing product or process.
• Surveys or studies.
• Research relating to certain internal-use computer software (subject to specific federal tests).
• Research in the social sciences, arts, or humanities.
• Research funded by another person or a government entity.
• Research conducted outside Illinois (the most crucial sourcing requirement for the state credit).

III. Illinois Department of Revenue (IDOR) Regulatory Guidance and Sourcing Rules

The most significant compliance hurdle for multi-state businesses claiming the Illinois R&D credit is the strict requirement that all QREs must be attributable to research activities physically conducted within Illinois.2 IDOR eligibility standards require Illinois-sourced activities and expenses, ensuring the credit incentivizes in-state economic activity.2

A. Critical Sourcing and Documentation for IHRE Wages

For IHRE, the sourcing rules are most challenging for qualified wages. In multi-state operations, wages must be meticulously apportioned based on where the employee’s qualified services were performed.

IDOR places a high burden on taxpayers to justify wage claims. The lack of detailed documentation regarding wage expenses is consistently cited as a primary problem during audits.5 Companies must maintain robust records detailing precisely how much time each employee spent on activities directly related to qualified research.5 This detailed time tracking—often down to specific projects and hours—is required to defend the allocation of employee salaries to Illinois R&D efforts.2

The expectation is that companies establish internal cost centers dedicated to capturing the basis for the Illinois credit, thereby avoiding the commingling of qualified, in-state expenses with non-qualified or out-of-state costs.5

This rigorous time-tracking is not merely administrative; it is central to the state’s enforcement of the Illinois-sourcing requirement. For employees who split time between an Illinois facility and an office in a neighboring state, contemporaneous time sheets or project allocation systems must be in place to demonstrate which hours were spent physically performing research within Illinois boundaries. Without this defensible allocation based on time and effort, the wage component of IHRE for mobile or multi-state employees is highly susceptible to disallowance during IDOR examination.

B. Sourcing of Supplies and Computer Rentals

The sourcing rules also apply to non-labor IHRE components. Qualified supplies must be consumed during experimentation that occurs at an Illinois facility.2 Similarly, computer rental and cloud service costs must be allocated only to the proportion of time or resources utilized by the R&D team physically executing the qualified research project within Illinois.2 Comprehensive documentation is required to tie these supply and technology costs directly to the specific Illinois-based R&D activities.

IV. Calculating the Illinois R&D Tax Credit (Credit Code 5340)

A. Mandatory Calculation Method

Illinois mandates a single, incremental calculation methodology, often referred to as the Regular Method, to determine the allowable credit.2 The state explicitly does not permit taxpayers to utilize the federal Alternative Simplified Credit (ASC) method or the fixed-base percentage method, simplifying the available compliance options while removing certain calculation flexibilities.2

The credit calculation is straightforward: it is 6.5% of the current year’s QREs that exceed a predetermined base amount.2

B. Determining the Base Amount (The Three-Year Lookback)

The base amount represents the historical average of a taxpayer’s research spending, serving as a benchmark against the current year’s investment.

The statutory base period is defined as the three taxable years immediately preceding the current tax year for which the credit determination is being made.2 The base amount is computed as the average of the Illinois-sourced QREs incurred during this three-year lookback.2

For new taxpayers or those who incurred no qualifying expenses during the base period years, the qualifying expenditures for that year are zero, resulting in a base amount of zero.2 This rule significantly benefits startups and new businesses beginning R&D operations in Illinois, allowing them to claim the 6.5% credit on their total current-year QREs until they establish a three-year history.2

For corporate reorganizations, if a taxpayer succeeds to the tax items of a predecessor corporation under IITA Section 405(a), the predecessor corporation’s base period qualifying expenditures are automatically deemed to be those of the successor taxpayer (86 Ill. Admin. Code 100.2160).9 This continuity rule prevents companies from restructuring solely to erase their historical QRE base.

C. Step-by-Step Calculation Mechanics

The calculation follows three primary steps:

1. Determine Current Year Illinois QREs: Sum all Illinois-sourced IHRE (Wages, Supplies, Computer Costs) and Contract Research Expenses for the current tax year.2
2. Calculate Excess QREs: Subtract the calculated Base Amount (3-year average QREs) from the Current Year QREs.2
3. Apply Credit Rate: Multiply the resulting Excess QREs by 6.5% to determine the final credit amount.2

V. Compliance and Reporting Requirements (Schedules 1299-D and 1299-I)

Compliance with the Illinois R&D credit involves specific state reporting forms tailored to different entity types.

A. Primary Reporting Forms and Flow-Through Rules

Taxpayers claiming the credit must complete the necessary schedule and attach it to their income tax return.10

• C Corporations and Fiduciaries: Use Schedule 1299-D, Income Tax Credits for Corporations and Fiduciaries.5
• Pass-Through Entities (S Corporations and Partnerships/LLCs): The credit is calculated at the entity level, but generally passes through to the owners.2 The entity completes Schedule 1299-A or 1299-C, and then distributes the credit to partners or shareholders based on their distributive share of the entity’s income (or by written agreement starting in 2023) using Schedule K-1-P.1

Unitary business groups filing a combined return must calculate the credit based on the group’s total Illinois QREs and file only one Schedule 1299-D for the entire combined group.2

B. The Role of Schedule 1299-I

The linchpin of the Illinois R&D credit calculation is the Research and Development Worksheet contained within Schedule 1299-I, Income Tax Credits Information and Worksheets.10 This worksheet serves as the mandatory mechanism for substantiating the base period calculation and deriving the final incremental QREs, which are then transferred to the appropriate Schedule 1299-A, C, or D.10 Failure to follow the detailed instructions for completing Schedule 1299-I and attaching all required documentation will lead to delays in processing or the potential disallowance of the credit.10

VI. Detailed Example: Applying In-House Research Expenses to the Illinois Credit

This example illustrates the practical application of IHRE components and the mandatory incremental calculation for an established Illinois manufacturer.

A. Case Study Setup: “Illini Innovations LLC” (Tax Year 4)

Illini Innovations LLC (a pass-through entity) is a Chicago-based manufacturing company that designs and develops proprietary components for industrial equipment. The company’s engineering and prototyping activities meet the four-part test for qualified research activities, and all services, supplies, and computer usage are performed/consumed within its Illinois facility. The current analysis focuses on determining the credit earned in Year 4 based on the preceding three-year base period.

The IHRE components (Wages, Supplies, Computer Rental) are tracked alongside Contract Research Expenses to arrive at the total Qualified Research Expenses (QREs).

Table 1: Illini Innovations LLC Illinois Qualified Research Expenses (QREs)

The data confirms that In-House Research Expenses consistently account for a substantial portion of the company’s total QREs, representing the direct labor and material costs incurred by the manufacturer.2

B. Step-by-Step Credit Calculation for Year 4

The calculation determines the 6.5% credit on the excess QREs above the three-year average base amount.2

Table 2: Mandatory Illinois R&D Credit Calculation (Illini Innovations LLC)

The resulting $52,542 is the nonrefundable credit earned in Year 4. Since Illini Innovations is an LLC, this credit is calculated at the entity level and then distributed to the individual partners via Schedule K-1-P.1 Each partner may then utilize their allocated share of the credit to offset their individual Illinois income tax liability (Form IL-1040) using Schedule 1299-C.5

VII. Conclusion and Strategic Compliance Recommendations

The Illinois R&D Tax Credit provides a significant financial incentive, but its utilization demands meticulous adherence to state-specific sourcing and documentation standards. IHRE is the backbone of QREs, yet it is also the segment most exposed to audit scrutiny due to the wage component.

The defining characteristic of compliance is the mandate for hyper-localization. Taxpayers cannot simply rely on federal documentation, but must prove unequivocally that the services, materials, and computer usage reflected in the IHRE were physically consumed or performed in Illinois.2 This necessitates setting up internal cost centers and maintaining contemporaneous time allocation records for R&D employees, going beyond standard payroll data to accurately capture time spent performing qualified activities within state lines.5

Because Illinois restricts taxpayers to the incremental calculation method and disallows the use of the Alternative Simplified Credit (ASC), strategic financial planning must focus exclusively on ensuring sustained growth in Illinois-sourced QREs (primarily IHRE) year-over-year.2 Only the expenditure exceeding the rolling three-year average base will generate the credit. Furthermore, given that the credit is nonrefundable, businesses must project future Illinois income tax liability to ensure the credit, which carries forward for only five years, can be fully utilized before its expiration.2

To achieve audit readiness and maximize the credit, taxpayers should treat the requirements of Schedule 1299-I as a compliance blueprint. Specific evidence must be gathered, including detailed time-tracking logs for all R&D personnel, invoices and usage logs proving the consumption of qualified supplies, and allocation records linking leased computer costs to Illinois R&D projects.12 Failure to adhere to these stringent documentation requirements may result in delayed processing of returns or the total disallowance of the claimed credit by the IDOR.10

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