The Process of Experimentation: A Technical Guide to Maximizing and Defending the Illinois R&D Tax Credit

The Process of Experimentation (PoE) is the foundational technical criterion requiring qualified research activities to involve systematic testing and trial-and-error to overcome specific technical uncertainties.

For the Illinois Research and Development (R&D) Tax Credit, robust compliance demands meticulous application of this federal standard (IRC § 41) to Illinois-sourced expenditures, ensuring all hypotheses, trials, and refinements are rigorously documented for audit defense by the Illinois Department of Revenue (IDOR).

The Interplay of Federal and State Law

The Illinois R&D Tax Credit is a significant nonrefundable incentive codified under 35 ILCS 5/201(k).1 It is designed to encourage investment in qualified research activities performed within the state. The credit equals 6.5% of qualifying research expenditures (QREs) that exceed a three-year historical average base amount.1 Critically, eligibility for the state credit is predicated entirely upon meeting the definition of “qualified research” established under Internal Revenue Code (IRC) Section 41.1

Illinois law specifically adopts the federal framework but imposes a crucial jurisdictional constraint: all QREs must be attributable to research physically conducted in Illinois.1 This creates a dual compliance burden for Illinois taxpayers, who must satisfy both the technical rigor of the four-part federal test—specifically the Process of Experimentation—and the administrative documentation requirements set forth by the IDOR regarding the sourcing and calculation of expenses.

The Legal Foundation: Defining the Process of Experimentation (PoE)

To qualify for the Illinois R&D Tax Credit, a business activity must first meet the criteria set out in the four-part test of IRC § 41. The Process of Experimentation serves as the validation step, proving that the methodology used to achieve the desired outcome was truly research-based and not routine development.

The Federal Mandate: The Four-Part Test of IRC § 41

For expenditures to be considered Qualified Research Expenditures (QREs) under Illinois statute, all four following elements must be satisfied 4:

1. Permitted Purpose: The activity must aim to develop or improve a business component—such as a product, process, software, technique, formula, or invention—specifically regarding its functionality, quality, reliability, or performance.4
2. Technological in Nature: The research process must fundamentally rely upon the principles of hard sciences. This includes disciplines such as engineering, physics, chemistry, and the life, biological, or computer sciences.4
3. Elimination of Uncertainty: The taxpayer must demonstrate that, at the outset of the project, there was an unresolved technical risk. The activities undertaken must have been intended to discover information necessary to eliminate technical uncertainty concerning the capability of the component, its optimal design, or the appropriate methodology for its development.6
4. Process of Experimentation (PoE): Substantially all of the activities of the research unit must constitute elements of a process of experimentation. This requires systematic testing, analysis, and refinement, moving away from known capabilities to reach a resolution to the identified technical uncertainty.5

Table 1: The Four-Part Test for Qualified Research (IRC § 41)

Detailed Analysis of the Process of Experimentation

The Process of Experimentation is the most challenging element of the four-part test to substantiate in an audit setting because it demands proof of methodical research structure.

The Critical Threshold: The “Substantially All” Rule

IRC § 41(d)(1) dictates that for research to qualify, “substantially all” of the activities must constitute elements of a process of experimentation.5 This provision acts as a critical filter. If a significant portion of a project is comprised of activities that do not involve genuine technical investigation—such as routine programming, project planning and management, developing user requirements, or software maintenance—the entire activity may fail to qualify.5

The necessity of satisfying this “substantially all” rule (often interpreted as 80% or more of the effort) profoundly impacts how companies must document employee time. Since federal guidance explicitly excludes specific non-qualifying activities, businesses must establish that the vast majority of the time claimed for a technical employee was spent on systematic trial and error, testing, and hypothesis evaluation. Without rigorous, task-based time tracking linked directly to the experimental process, it becomes exceptionally difficult to defend the percentage of a technical employee’s salary claimed as a QRE, leading to potential disallowance by IDOR auditors.9

PoE Methodologies: Systematic Evaluation of Alternatives

The systematic process does not require a formal laboratory environment but rather a demonstrable methodology for resolving technical uncertainties. The common types of experimentation recognized include 8:

• Iterative Experimentation: Involves sequentially revising alternatives based on theoretical models, simulations, or early results. For instance, a company might incrementally adjust a design based on computational fluid dynamics results.
• Trial-and-Error Experimentation: Based on empirical results, where alternatives are tested physically or computationally to observe performance, leading to subsequent revisions.
• Scientific Method: The formal application of observation, hypothesis formation, experiment execution, data analysis, and conclusion drawing.

Applying “Shrink-Back” in Complex Projects

For projects involving the improvement of existing technologies, the PoE and the four-part test must be applied only to the smallest unit of the component under investigation. This is known as the “shrink-back” rule. For a company developing new features on an existing software platform, qualification must be measured against the new feature itself, not the entire legacy platform. If the original platform qualified in Year 1, a new data protection feature developed in Year 2 must be treated as the distinct business component against which the qualification tests are applied.11 This prevents taxpayers from claiming credit for maintaining or integrating established technology.

Illinois Adoption and Jurisdictional Constraints

Illinois statute ensures that the technical requirements remain consistent with federal law (35 ILCS 5/201(k)), stating that the credit covers expenditures qualifying under IRC § 41.1 This adoption is beneficial as it centralizes the technical definition of qualified research.

However, the state introduces a critical jurisdictional hurdle: research must be “attributable to research in Illinois”.1 This means a company operating across multiple states must precisely allocate qualified activities and expenditures to the Illinois location. This geographic restriction necessitates specialized tracking protocols to ensure that wages, supplies, and contract research expenses are verifiably incurred for work physically performed within the state. This location requirement adds administrative complexity beyond standard federal R&D credit compliance.

Illinois Department of Revenue (IDOR) Rules and Compliance Mechanics

IDOR enforces qualification requirements through specific rules governing QRE categories, statutory exclusions, and the mandated calculation method.

Qualified Research Expenditures (QREs) in Illinois

The Illinois R&D tax credit permits four types of expenditures, mirroring the federal definition, provided they are tied to activities performed within the state 1:

1. Wages for Qualified Services: Compensation paid to employees engaged in performing, supervising, or directly supporting qualified research activities. This remains the most significant and most scrutinized QRE category.2
2. Cost of Supplies: The cost of tangible materials and prototypes consumed or used in the execution of the research activities.2
3. Rental or Lease Costs of Computers: This covers costs for leased computers or cloud services utilized directly for R&D purposes, such as running simulations or processing research data.2
4. Contract Research Expenses: Payments made to third parties for qualified research services performed on the taxpayer’s behalf. Generally, 65% of these expenses are includible in the QRE calculation.1

Statutory Exclusions Mandated by IDOR

The IDOR, through Schedule 1299 instructions and administrative rules, reinforces federal exclusions, ensuring that routine business operations or non-scientific endeavors do not receive the credit.9 Activities that fail to meet the PoE or other parts of the four-part test, or are specifically excluded by statute, include 1:

• Research conducted after the beginning of commercial production.
• Research aimed at adapting an existing product or process to a specific customer’s requirement.12
• Duplication of an existing product or process using public information, plans, or physical examination.12
• Surveys or studies.
• Research relating to certain internal-use computer software (highly restricted).
• Research conducted outside the State of Illinois.
• Research in the social sciences, arts, or humanities.
• Research funded by another person or a government entity.

Calculating the Credit: The Alternative Simplified Method (ASM)

Illinois mandates the use of the Alternative Simplified Method (ASM) for calculating the R&D credit.3 This method is incremental, meaning the credit is generated only on the growth of R&D expenditures.

The calculation proceeds as follows:

1. Determine the Base Amount: The base amount is calculated by averaging the Illinois-sourced QREs incurred during the three taxable years immediately preceding the current tax year.1 If the taxpayer was not in existence or incurred no QREs during the base period, the base is zero.13
2. Calculate Excess QREs: The base amount is subtracted from the current year’s QREs.14 If the result is zero or negative, no credit is generated for the year.
3. Apply the Credit Rate: The credit is calculated as 6.5% ($\text{0.065}$) of the resulting excess QREs.3

This incremental structure demonstrates a policy focus on incentivizing R&D growth. Since the calculation involves subtracting the three-year average of prior QREs from the current year’s QREs, a business receives maximum benefit only if it consistently increases its R&D spending over time. If a company maintains flat or declining expenditures, the credit is either minimal or zero. Thus, the ASM acts as a sophisticated mechanism designed to stimulate R&D momentum within Illinois.3

The credit is nonrefundable and may be carried forward for a maximum of five years to offset future Illinois income tax liability.2

Filing Requirements and Documentation Standards

The credit is claimed by corporations and fiduciaries filing Schedule 1299-D.9 Pass-through entities calculate the credit and allocate it to owners via Schedule K-1, who then utilize Schedule 1299-C.1

IDOR emphasizes that rigorous record-keeping is non-negotiable, requiring records that support the line-by-line items reported on the tax returns.16 Failure to attach required documentation, which may include transfer documentation, partnership K-1s, or certificates issued by state agencies like the Department of Commerce and Economic Opportunity (DCEO), can result in processing delays or outright disallowance of the credit.17 Specific guidance for income tax record-keeping is found in the Illinois Administrative Code, Title 86, Section 100.9530.16

Operationalizing PoE: Documentation and Audit Preparedness

Substantiating the Process of Experimentation is the single most important factor in audit defense. Robust documentation must establish the chronological and technical nexus between the expenses incurred and the systematic search for technical solutions.

Connecting PoE to Uncertainty and Technical Nature

The documentation must clearly define the technical risk that required the research and then detail the steps taken under the PoE to resolve that risk.

1. Defining Uncertainty and Hypothesis: Project initiation documents, work orders, and budgets must identify the specific information the team lacked (the technical uncertainty) and describe the systematic plan (the PoE) to test alternatives and resolve the issue.18
2. Recording Systematic Evaluation: It is crucial to document not just success, but also trials, failures, and subsequent modifications. The research credit rewards the process of overcoming technical roadblocks; detailed records of unsuccessful prototypes, abandoned methodologies, and negative test data provide compelling evidence that the solution was not obvious and required genuine experimentation.8

Documentation Best Practices for Substantiating PoE

Contemporaneous records are the backbone of a successful R&D claim.18 Taxpayers should organize documentation into distinct categories to prove the four-part test and the resulting expenses.

Table 2: Key Documentation to Substantiate the Process of Experimentation

Strategic Wage Allocation and Cost Center Management

Wage documentation is consistently identified by IDOR as a common audit challenge due to the lack of detail.9

The intense scrutiny on wage documentation is a direct corollary of the federal “substantially all” requirement for the Process of Experimentation. Because non-qualifying activities such as developing user requirements or routine maintenance are statutorily excluded from QREs 5, a taxpayer must possess granular proof that the time claimed for an engineer, technician, or supervisor was overwhelmingly dedicated to the systematic experimentation phase of research.

Companies are strongly advised to establish dedicated cost centers to capture the basis of the Illinois credit.9 The preferred method for substantiating wages is direct, daily time tracking. Where direct tracking is impractical, businesses may rely on alternative documentation methods that establish a linking nexus between the employee, the project, and the qualified activities. Such linking nexus documentation—which can include detailed project meeting minutes, technical presentations, external communications (e.g., white papers), or technical drawings—can be used to estimate qualified time under audit guidelines.20

Case Study: Implementing the Process of Experimentation in a Manufacturing Environment

The following example demonstrates how an Illinois manufacturer successfully navigates the PoE requirements and utilizes the Alternative Simplified Method calculation.

Scenario Setup: Developing a Novel Automation Process

ElectroFab Inc., an electronic components manufacturer located in Aurora, Illinois, undertook a multi-year initiative to automate a precision assembly line, seeking to improve product quality and performance while reducing material defects.21

• Technical Uncertainty: The engineering team determined they did not know the optimal machine vision algorithms, mechanical tolerances, or robot sequencing required to handle fragile components consistently at a high speed without introducing defects (i.e., eliminating uncertainty regarding design and methodology).
• Permitted Purpose: Improving the quality and reliability of the final electronic component.4
• Technological Nature: Relying on principles of advanced computer science and mechanical engineering.

The Systematic Experimentation (PoE in Action)

ElectroFab’s R&D team applied a combination of iterative and trial-and-error methodologies to resolve the uncertainty.

1. Phase I: Hypothesis and Initial Trials: The team hypothesized that integrating specialized robotic arms with proprietary control software could achieve the necessary precision. Initial trials revealed unpredictable component warping due to thermal inconsistencies during the high-speed manipulation process. This failure confirmed the necessity of continued experimentation. The documentation, which included project summaries and field verification data, detailed the specific limitations encountered in the initial design.19
2. Phase II: Iterative Refinement and Testing: The engineers systematically evaluated alternatives. They tested three different material coatings for the robotic grippers and ran dozens of simulations (utilizing leased computer resources) to model thermal transfer dynamics.2 Each simulation and physical prototype test represented an element of the Process of Experimentation. The team meticulously logged all test results, design modifications, and failed runs in version-controlled documents, providing clear evidence of a systematic search for the optimal solution.18
3. Phase III: Successful Resolution: After months of systematic testing, the team identified the optimal coating and validated a custom-written algorithm that dynamically adjusted robotic force based on ambient temperature sensors. All employee time and supply costs associated with the hypothesis, testing, data collection, and analysis throughout these phases were tracked against a dedicated R&D cost center to ensure accurate allocation and proof of the PoE.

QRE Calculation and Credit Determination Example

ElectroFab Inc. accurately tracked its Illinois QREs. The calculation for the 2024 tax year uses the Alternative Simplified Method (ASM).

Table 3: Example Illinois R&D Tax Credit Calculation (Alternative Simplified Method)

In 2024, ElectroFab’s current QREs of $2,050,000 exceeded their three-year average base of $1,241,667, demonstrating incremental growth in R&D investment. This incremental increase of $808,333 generated a nonrefundable Illinois R&D tax credit of $52,542 for that year.14

Conclusion and Strategic Recommendations

The Illinois R&D Tax Credit offers substantial tax savings for businesses committed to technical innovation within the state. However, the credit’s value is inseparable from the rigorous application and meticulous documentation of the Process of Experimentation (PoE). Compliance requires treating the credit claim not as a routine tax calculation, but as a technically defensible report proving the systematic nature of research.

Final Recommendations for Compliance and Audit Mitigation

1. Mandate Granular Time Tracking for Wages: Recognize that the highest audit risk lies in wage substantiation. To meet the IRC § 41 requirement that “substantially all” activities relate to the PoE, companies must implement detailed, task-based time tracking systems that differentiate between qualified experimental services and excluded routine activities, aligning closely with IDOR’s guidance on cost center management.5
2. Establish a Standardized Chronological Audit Trail: Ensure that documentation exists for every stage of a qualified project: project initiation to define the technical uncertainty, intermediate technical reports detailing trials, failures, and systematic refinements (the PoE), and final records confirming the resolution of uncertainty.18
3. Strictly Adhere to Statutory Exclusions: Conduct internal reviews to screen all projects against specific exclusions, such as post-commercial production activities and the development of internal-use software primarily for administrative functions, which frequently cause state-level claims to be disallowed.1
4. Incorporate ASM into Financial Planning: Since the credit is calculated incrementally based on the three-year average of QREs, sustained, planned growth in R&D spending is essential to maximize the credit benefit. Strategic financial planning should account for the five-year carryforward period to ensure full utilization of nonrefundable credits.2
5. Maintain Audit-Ready Documentation Sets: Organize records—including technical specifications, progress reports, contracts, and financial ledgers—in a readily accessible format, prepared to satisfy IDOR requirements under 86 Ill. Admin. Code 100.9530.16 Failure to provide comprehensive support documentation can lead directly to claim disallowance.17

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