Expert Report on the Permitted Purpose Test: New or Improved Function, Performance, Reliability, or Quality in the Illinois R&D Tax Credit

I. Executive Summary and Definitional Mandate (The Permitted Purpose Test)

1.1. Simple Definitional Mandate

The Illinois Research and Development (R&D) Tax Credit requires qualifying research activities to pursue a fundamental technical objective. This objective must focus on creating a new or measurably improved business component in terms of its function, performance, reliability, or quality.1

1.2. The Illinois Statutory Context (35 ILCS 5/201(k))

The Illinois R&D Tax Credit (Credit Code 5340) operates under the authority of the Illinois Income Tax Act, specifically 35 ILCS 5/201(k).1 This mechanism provides a non-refundable credit to taxpayers, calculated as 6.5% of the qualifying research expenses (QREs) incurred in Illinois that exceed a base amount.3 The statutory framework of Illinois relies heavily on federal tax law for its core definitions and criteria.

Illinois law explicitly references Section 41 of the Internal Revenue Code (IRC § 41) to define what constitutes “Qualified Research”.1 This incorporation mandates that any activity qualifying for the state credit must first satisfy the stringent four-part test established under federal law, including the critical Permitted Purpose criterion—the pursuit of a new or improved function, performance, reliability, or quality. Furthermore, the statute outlines that the credit is applied to the excess of current-year QREs over the average QREs incurred during the three immediately preceding tax periods (the base period).1

The longevity of the incentive is secured by recent legislative action. While prior provisions indicated an earlier expiration, the credit has been officially extended through tax years ending on or before December 31, 2031.4 This extension provides a consistent runway for businesses to plan long-term innovation strategies that meet the Permitted Purpose standard.

The explicit adoption of IRC § 41 imposes a significant compliance constraint rooted in the principle of Federal Precedence. Since the Illinois Income Tax Act relies entirely on the federal definition of “qualified research,” any audit or change in federal Treasury interpretation regarding the Permitted Purpose test immediately impacts Illinois claims. If a taxpayer’s research activity is deemed non-qualifying by the Internal Revenue Service (IRS), it is inherently non-qualifying for the Illinois credit as well. In the absence of detailed, unique Illinois Administrative Code rulings on complex technical matters, the Illinois Department of Revenue (IDOR) auditors default to federal standards, often relying on established IRS Audit Technique Guides (ATGs) when challenging whether a project successfully achieved a “new or improved function.” Consequently, taxpayers must ensure their documentation related to the Permitted Purpose not only meets IDOR’s procedural requirements but also adheres to the highest federal evidentiary standards, as federal compliance serves as the indispensable foundation for state qualification.

II. The Core Requirement: Defining the Permitted Purpose Test

The Permitted Purpose test, mandated by IRC § 41(d)(3) and adopted by Illinois, functions as the qualitative filter for R&D activities. It ensures that expenditures are directed toward genuine technical innovation rather than routine business optimization or aesthetic development.

2.1. The Business Component and Scope of Research

The Permitted Purpose test is applied separately with respect to each “business component” developed or improved by the taxpayer.9 A business component is broadly defined as any product, process, computer software, technique, formula, or invention which is intended to be (i) held for sale, lease, or license, or (ii) used by the taxpayer in the ordinary course of their trade or business.9 This definition is expansive and covers the development of new goods, manufacturing methods, and specialized computer software.

A critical nuance for industrial taxpayers is the Special Rule for Production Processes. Under IRC § 41(d)(2)(C), any plant process, machinery, or technique used for the commercial production of a business component is treated as a separate business component.9 This provision is particularly relevant for Illinois, which possesses a robust manufacturing sector.10 Manufacturers frequently invest substantial resources into improving their internal processes to achieve higher efficiency, even if the final product sold to the customer remains functionally unchanged. Because the process itself qualifies as a separate business component, activities aimed at improved performance or reliability of the manufacturing line are eligible for the R&D credit, provided they meet the other three prongs of the four-part test.6 This understanding broadens the scope significantly beyond product development, enabling claims for engineering and technical operations aimed at successfully resolving technical uncertainty related to internal operational performance or process reliability.

2.2. Detailed Analysis of the Four Qualified Purposes (IRC § 41(d)(3))

Research must be directed toward one of the four measurable objectives to satisfy the Permitted Purpose requirement 9:

Function (New Capability or Intended Use)

The pursuit of a new or improved function involves creating a capability that the business component did not previously possess, or substantially expanding the range of applications or intended uses. For research to qualify under this category, the activities must aim to overcome technical challenges associated with creating this new capability. For instance, developing a novel sensor system that performs a task previously requiring multiple independent components, or creating a new algorithm that executes a specialized task formerly requiring human intervention, thereby establishing a new function for the overall system, would meet this standard.

Performance (Speed, Output, or Efficiency)

Improvements in performance must be quantifiable increases in key operational parameters. Examples include achieving a faster speed of operation, demonstrating increased capacity or throughput, realizing a higher yield of output, or improving the efficiency of resource consumption (e.g., energy or raw material). Documentation in this area is paramount, as the taxpayer must demonstrate measurable baseline data compared against post-experimentation results. This evidence is necessary to establish that the improved performance was attained directly through the systematic technical activity conducted during the experimentation process.

Reliability (Durability and Failure Reduction)

Improvements in reliability relate to enhancing the consistency or durability of a business component, which often translates into extending its useful operating life or statistically reducing the rate of failure, defect, or malfunction under expected operating conditions.12 Research into material science, stress tolerances, or new bonding agents aimed at enabling a component to withstand harsh environmental conditions or heavy use for a longer duration than the existing component would satisfy this purpose. The activity must be intended to discover information that eliminates uncertainty regarding how to enhance the component’s durability.

Quality (Consistency and Precision)

The pursuit of improved quality is focused on technical metrics, such as enhancing consistency, precision, or adherence to tight technical standards (e.g., achieving tighter dimensional tolerances or purer chemical output).12 It is vital to distinguish this technical requirement from purely subjective or aesthetic goals. If the research involves changing or refining manufacturing inputs, parameters, or methodologies to achieve better technical consistency or precision in production, it qualifies. However, if the improvement relates primarily to the product’s appearance or subjective feel, it is excluded.

2.3. The Mandatory Exclusion: Non-Functional Research

The Permitted Purpose test includes a critical limitation to maintain the scientific rigor of the credit. Research activities related to style, taste, cosmetic, or seasonal design factors are statutorily ineligible and shall in no event be treated as conducted for a qualified purpose.9

This Statutory Mandate is adopted directly by Illinois through its reference to IRC § 41(d)(3)(B). The IDOR must enforce this exclusion, automatically rejecting claims where the primary objective was purely marketing-driven, aesthetic, or related to subjective factors. Treasury Regulations confirm that the process of experimentation must be for a qualified purpose that is fundamentally functional in nature.15 Therefore, even if significant technical effort was expended to achieve a specific aesthetic goal (such as finding a paint that resists fading under certain light conditions), if the primary improvement remains cosmetic and non-functional, the associated expenditures will be disqualified.

III. IDOR Guidance and the Application of Exclusionary Rules

The Illinois Department of Revenue (IDOR) applies the Permitted Purpose test and the federal statutory exclusions through its administrative guidance, primarily found within the instructions for Schedule 1299 (the forms used to claim various Illinois tax credits).1

3.1. IDOR Administrative Application (Schedule 1299 Instructions)

The instructions for Schedule 1299-I (used by individuals) and Schedule 1299-D (used by corporations) serve as the authoritative guidance on 35 ILCS 5/201(k).1 These documents explicitly restate the requirement that “Qualified research” must be research or experimental activities that create or improve a function, performance, reliability, or quality.1

Crucially, the IDOR enforces a strict Illinois Sourcing Mandate, requiring that qualifying expenses must be attributable to research activities conducted entirely within the State of Illinois.1 This is a fundamental administrative requirement unique to the state credit, and activities that otherwise meet the Permitted Purpose test but occur outside the state are ineligible, regardless of the nexus to an Illinois-based business component.

3.2. Detailed Analysis of Non-Qualifying Activities (IDOR Exclusions)

The IDOR instructions provide a list of non-qualifying activities that mirror the federal IRC § 41(d)(4) exclusions.1 These exclusions clarify the limitations of the Permitted Purpose test by defining activities that are considered routine, market-driven, or otherwise non-innovative for tax purposes.

The list of activities for which the credit may not be taken includes:

1. Research conducted after the beginning of commercial production: Once the business component is functionally ready for commercial sale or use, subsequent research is classified as routine quality control, troubleshooting, or maintenance, and therefore ceases to meet the Permitted Purpose test.1
2. Research adapting an existing product or process to a particular customer’s need: This activity fails the requirement that the resulting improvement must be applicable to the taxpayer’s overall business component. Customization work, even if technically challenging, does not constitute the development of a new or improved business component generally held for sale, lease, license, or use by the taxpayer.1
3. Duplication of an existing product or process: Research aimed at reproducing an existing component (whether from examination, plans, or publicly available specifications) explicitly fails the “new or improved” element of the Permitted Purpose test.1
4. Surveys or studies: These activities are generally excluded because they typically lack the technical rigor required by the Process of Experimentation criterion and are not activities directly aimed at achieving a measurable technical improvement in function.1
5. Research relating to certain internal-use computer software: Software developed primarily for the taxpayer’s internal use (such as general administrative or support functions) is subject to heightened federal scrutiny, requiring a demonstration of high innovation. To qualify, this software must achieve a truly new or improved function that is not merely routine or related to general management.1
6. Research in the social sciences, arts, or humanities: This research fails the Technological in Nature test, which is a necessary co-requisite to the Permitted Purpose.1
7. Research funded by another person (or government entity): The taxpayer must retain the economic risk associated with the research activities; if the research is funded by a third party, the taxpayer is ineligible for the credit.1

This extensive list of exclusions in the IDOR instructions represents a critical audit tool for the Department. These categories act as an initial high-risk screen for R&D claims. If a taxpayer’s activities fall squarely into one of these buckets—for instance, adaptation for a specific customer or simple duplication—the claim fails immediately, irrespective of any novel function achieved for that single external party. Compliance professionals must, therefore, confirm avoidance of all listed exclusions before proceeding to document the four-part test elements, including the Permitted Purpose.

3.3. Hierarchy of IDOR Legal Interpretations

Taxpayers requiring specific clarity on whether a unique, complex activity meets the definition of “new or improved function” under Illinois law have access to formal guidance mechanisms offered by the IDOR.

• Private Letter Rulings (PLRs): A PLR is issued by the IDOR in response to a specific taxpayer’s inquiry concerning the application of a tax statute or rule to a particular fact situation. A PLR is legally binding on the Department, but only as to the taxpayer who requested the ruling and only to the extent the facts recited are complete and correct.16 PLRs are the most authoritative source for determining complex eligibility issues regarding the Permitted Purpose test in a specific context.
• General Information Letters (GILs): GILs are designed to provide general information or direct taxpayers to relevant regulations and are not a statement of department policy. They are explicitly not binding on the Department.16

IV. Contextualizing the Permitted Purpose: The Mandatory Four-Part Test

The Permitted Purpose test—achieving a new or improved function, performance, reliability, or quality—is only one quarter of the total qualification requirements. The Illinois R&D credit, by adopting IRC § 41(d), mandates that four conditions must be met concurrently for research expenses to qualify.18 The specific purpose defined (the ‘What’) dictates the nature of the activities required for the other three elements (the ‘How’ and ‘Why’).

4.1. The Necessary Process of Experimentation (The ‘How’)

The second test requires that the research activities include a systematic Process of Experimentation. This means that substantially all of the activities must involve the systematic evaluation of alternatives to achieve the desired technical result.6 This process typically involves modeling, simulation, or systematic trial-and-error methodologies.6

The Permitted Purpose is inextricably linked to this process. If the research goal is, for instance, improved Reliability, the Process of Experimentation must involve rigorously testing, analyzing, and potentially discarding various design alternatives (e.g., materials or structural methods) until the desired technical reliability metric is conclusively met. The systematic trial-and-error methodology is the empirical proof required during an audit that the technical improvement was achieved through genuine R&D, and not through routine engineering or adaptation.

4.2. Elimination of Uncertainty (The ‘Why’)

The third test demands that the taxpayer must intend to discover information that would Eliminate Uncertainty concerning the capability, methodology, or optimal design of the new or improved business component.6 This criterion establishes the motive for the research.

If a taxpayer claims a new Function was achieved, they must demonstrate that a technical uncertainty existed at the outset regarding the feasibility of achieving that function or the optimal technical method of developing or implementing it. If the means and method to achieve the desired Permitted Purpose were known or readily apparent to a skilled professional in the field, the activity is classified as routine engineering or production preparation, and not qualified research. Therefore, the elimination of technical uncertainty provides the justification for pursuing the specific Permitted Purpose.

4.3. Technological in Nature (The ‘Foundation’)

The final test requires that the process of experimentation used to resolve the uncertainty must rely on principles of the Technological in Nature sciences: physical or biological sciences, engineering, or computer science.22

This test ensures that the functional improvement (the Permitted Purpose) is rooted in hard science or technical engineering disciplines. This criterion formally disqualifies research projects in soft sciences, social sciences, arts, or humanities.1 The reliance on established technical principles must be evident in the systematic experimentation performed.

The structure of the four-part test necessitates adherence to the Substantially All Rule. Federal law requires that “substantially all” (generally interpreted as 80% or more) of the research activities within a project must constitute elements of a process of experimentation undertaken for a qualified purpose.12 Since Illinois adheres to the federal definition, this stringent ratio applies directly to Illinois projects. This has significant ramifications for audit defense, as taxpayers must demonstrate that employees (whose wages constitute Qualified Research Expenses) involved in achieving the “new or improved function” dedicate the overwhelming majority of their time on that project to systematic testing, data analysis, and technical uncertainty resolution, rather than routine administrative or manufacturing tasks. Failure to establish this high threshold for qualified activities (specifically related to wages for qualified services 24) can lead to the disqualification of the entire QRE base for that project.

V. Illustrative Example: Technical Process Improvement and Credit Calculation

The Illinois R&D credit provides tangible financial support for activities that satisfy the Permitted Purpose test, particularly in manufacturing and process engineering.

5.1. Case Study: Improving Manufacturing Performance

Scenario: Illinois Metals Inc. (IMI), a manufacturer of high-tolerance aluminum components in Aurora 25, undertakes a project to address escalating production bottlenecks. IMI’s goal is to increase the rate of metal shaping and finishing during the fabrication process by 15%. This objective is a Permitted Purpose: improved Performance of a production process, which is treated as a separate business component.9

Uncertainty and Experimentation: The technical uncertainty lay in identifying the optimal machine tool material, cutting speed, and coolant delivery pressure that would allow for faster processing without introducing micro-fractures, which would compromise the alloy’s structural Quality. IMI’s engineers did not rely on standard industry manuals; they systematically designed and executed 40 unique test runs, adjusting the tool materials and parameters according to a predetermined factorial design matrix (Process of Experimentation).6 They measured the resultant stress, finish quality, and throughput speed for each run, utilizing engineering principles (Technological in Nature) to analyze the outcomes.

Result and Qualification: The research successfully identified a new proprietary machining protocol that achieved a 14.5% improvement in throughput speed while maintaining quality specifications. Because the component being improved was the “plant process” itself 9, and the improvement (Performance) was technical, measurable, and resolved an initial technical uncertainty, the wages, supplies, and contract research expenses associated with the 40 test runs qualify as Illinois QREs.

5.2. Credit Calculation Example (6.5% Incremental)

The Illinois credit is calculated as 6.5% of the increase in current-year Illinois QREs over the Base Period Average (BPA).4 The structure of this calculation necessitates strategic planning, as the credit heavily favors taxpayers who continuously increase their investment in activities designed to achieve “new or improved function, performance, reliability, or quality.”

The use of an incremental calculation structure requires careful consideration of investment timing. The base period is the average of the QREs over the three immediately preceding tax years.1 This structure means that a sudden, massive outlay of QREs in one year—even if driven by a successful Permitted Purpose project—will significantly inflate the Base Period Average (BPA) for the next three years. This inflation may reduce or eliminate the incremental excess QREs eligible for the credit during those subsequent years. Taxpayers planning large, capital-intensive projects aimed at achieving a new Function or Performance metric should therefore optimize the timing and recognition of QREs to stabilize or maximize the incremental excess, thereby ensuring the financial benefit of the Permitted Purpose activity is fully realized across the applicable credit years.

The table below illustrates the application of the Illinois incremental credit using a hypothetical timeline:

Table: Application of the Illinois Incremental R&D Credit (35 ILCS 5/201(k))

VI. Documentation Requirements and Audit Defense

6.1. Establishing the Permitted Purpose via Contemporaneous Records

The successful defense of an Illinois R&D credit claim rests heavily on the ability of the taxpayer to establish a clear, documented link between the QREs and the technical activities aimed at achieving a new or improved functional element. The documentation must be collected contemporaneously with the research activities.18

Key documentation requirements include:

1. Project Plan and Objectives: Records must explicitly define the technical objective (e.g., target reliability improvement or new function) and clearly articulate the initial technical uncertainty that necessitated the research, thus proving that the Permitted Purpose was the intent of the activity.6
2. Personnel Records: Detailed payroll records and time tracking must link the wages for qualified services (direct research, direct supervision, or direct support) to the specific Permitted Purpose activities undertaken in Illinois.1
3. Testing Logs and Analysis: Detailed records of the systematic experimentation utilized are essential. This includes logs that record test parameters, data collected, analysis performed, and conclusions drawn, demonstrating how design alternatives were evaluated and why certain alternatives failed to achieve the desired Function, Performance, Reliability, or Quality metrics.6

6.2. Conclusion on Compliance

Compliance with the Illinois R&D Tax Credit (35 ILCS 5/201(k)) demands absolute fidelity to the federal Permitted Purpose test established under IRC § 41(d)(3). The determination of eligibility is not satisfied merely by demonstrating technical effort or investment; rather, it requires conclusive proof that the activity was systematically and technically directed at achieving a measurable improvement in the function, performance, reliability, or quality of a business component. This proof must simultaneously demonstrate that the activity overcame technical uncertainty, employed a process of experimentation, and avoided the specific aesthetic and routine exclusions mandated by both federal and state guidance. The reliance of the IDOR on federal statutes and regulations means that rigorous, contemporaneous documentation aligned with IRS standards is the most effective strategy for audit defense in Illinois.

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