The Geographic Mandate: Defining “Research Conducted in this State (Illinois)” for the R&D Tax Credit

The Illinois Research and Development (R&D) Tax Credit is a powerful, nonrefundable incentive calculated as 6.5% of the increase in qualified research expenditures (QREs) exceeding a historical base amount. Compliance for this credit is strictly tethered to geography, demanding that all activities and expenses claimed must be physically sourced within the State of Illinois.

This report delivers a comprehensive analysis of the statutory and administrative requirements governing the sourcing of research activities to Illinois, a critical compliance issue, especially for multi-state businesses claiming the credit under the Illinois Income Tax Act (IITA) Section 201(k). The law and corresponding administrative rules, codified in 86 Ill. Adm. Code 100.2160, create a stringent, activity-based nexus standard distinct from general income tax apportionment methodologies. Businesses operating in multiple jurisdictions must precisely isolate costs directly linked to physical research performance in Illinois to maximize credit utilization while mitigating audit risk.

I. Executive Summary: The Geographic Mandate of Illinois R&D

The Illinois Research and Development (R&D) Tax Credit (Credit Code 5340) serves as a key economic development tool, providing a nonrefundable 6.5% credit on qualified research expenditures (QREs) that surpass a statutorily defined historical base.1 Authorized under 35 ILCS 5/201(k), the credit is specifically intended to foster technological advancement and innovation within Illinois.3

1.1. Statutory and Administrative Framework

The legislative foundation of the credit is robust, providing stability for long-term planning. The credit aligns closely with the federal research credit guidelines established under Internal Revenue Code (IRC) Section 41, adopting the same definitions for “qualified research” and “qualified research expenses”.1 However, the application of these rules is strictly limited to Illinois-sourced activities.1

Administration falls under the purview of the Illinois Department of Revenue (IDOR), which issues guidance via administrative rules, notably 86 Ill. Adm. Code 100.2160.3 Taxpayers generally claim the credit by filing Schedule 1299-D for corporations and fiduciaries, or Schedule 1299-A for partnerships and S corporations.3 Importantly, the credit has received legislative extensions, now applying to tax years ending on or before December 31, 2031, securing its availability for the next decade.1

The credit is fundamentally nonrefundable, meaning it offsets only current or future Illinois income tax liability; it cannot result in a cash refund. Any unused credit may be carried forward for up to five years.1

1.2. Dual Conformity and the Sourcing Paradox

Illinois employs a dual standard in its R&D credit statute that presents a unique compliance challenge for multi-state taxpayers. The state conforms to the federal definition regarding what constitutes a qualified activity, requiring that the research satisfy the four-part test of IRC $\S 41$: it must be technological in nature, designed for a permitted purpose (improving function, performance, etc.), intended to eliminate technical uncertainty, and involve a process of experimentation.4

However, the state maintains a strictly localized definition of expense sourcing. The expenses funding these federally qualified activities must be incurred specifically for research physically conducted in Illinois.1 This localization requirement demands granular, activity-based tracking of expenditures, such as time logs for employee wages and location tracking for supplies, rather than relying on standard corporate income tax apportionment factors like general payroll or sales percentages. If a multi-state company conducts qualified research activities that meet the federal standard, any portion of the wages, supplies, or contract expenses related to activities performed outside Illinois must be completely excluded from the Illinois QRE base.1

II. Foundation of Eligibility: Federal Alignment and State Exclusions

The eligibility for the Illinois R&D credit begins with meeting the strict technical definitions established at the federal level, followed by applying the geographic filter.

2.1. The Federal Four-Part Test (IRC § 41)

Qualified research activity in Illinois is defined consistently with IRC $\S 41$.4 The activity must meet the following four criteria:

1. Technological in Nature: The activity must fundamentally rely on the principles of physical or biological science, engineering, or computer science.4
2. Permitted Purpose: The objective must be to improve the functionality, performance, reliability, or quality of a new or existing business component.4
3. Eliminate Uncertainty: The activity must be intended to discover information necessary to eliminate technical uncertainty regarding the development or improvement of a product or process.4
4. Experimentation: The process must involve a systematic trial-and-error approach or simulation designed to evaluate alternatives and achieve the desired result.4

2.2. Defining Qualified Research Expenses (QREs)

Once an activity is deemed qualified under the four-part test, the associated expenses must be identified and categorized. The QREs eligible for the Illinois credit mirror the federal categories but are constrained by the Illinois sourcing rules 1:

• Wages: Salaries for employees who are directly performing, supervising, or supporting the qualified research activity.1
• Supplies: Costs for materials and prototypes that are consumed or expended in the process of research (e.g., testing components).1
• Contract Research: Payments made to third-party contractors for performing qualified services on behalf of the taxpayer.1
• Computer Rentals: Costs associated with leased computers or cloud services used directly in the performance of the research.1

2.3. Mandatory Exclusion for Out-of-State Research

The localization rule is absolute: research conducted outside Illinois is explicitly excluded from the definition of a qualified expenditure for the state credit.1 This requirement applies even to companies that are part of a unitary combined group filing in Illinois. The key distinction for the state credit is the physical location where the activity takes place.

Furthermore, Illinois law incorporates standard federal exclusions for certain types of activities, including research conducted after the beginning of commercial production, adapting an existing product for a particular customer’s needs, duplicating an existing product, market surveys or studies, or research funded by a government entity or another person.7 By ensuring these activities are excluded, the state maintains a focus on incremental, high-risk, in-house technical innovation.

III. The Crucial Sourcing Rule: Defining “Research Conducted in this State”

The strict interpretation of “Research Conducted in this State” is the single most critical compliance hurdle for multi-state entities utilizing the Illinois R&D credit. IDOR requires meticulous documentation proving that QREs are “attributable to research in Illinois”.3

3.1. Sourcing Principle: Attribution to Physical Presence (35 ILCS 5/201(k))

Unlike general income tax sourcing, which often relies on complex apportionment formulas (such as single sales factors), the R&D credit demands physical attribution. For an expenditure to qualify, the research activity that the expenditure supports must occur within Illinois borders. This standard mandates that taxpayers track and document the physical location of labor, materials consumption, and contractor performance.

If a company is headquartered in Chicago but performs 40% of its qualified research at a manufacturing plant in Indiana, the QREs associated with the Indiana work must be eliminated from the Illinois claim. This strict exclusion applies even if the costs are managed and paid from the Illinois headquarters.1

3.2. Detailed Sourcing Mechanics for Qualified Wages

Qualified wages—salaries paid to employees performing, supervising, or directly supporting qualified research—must be sourced based on the actual physical location of the service performance.1

Multi-State Allocation for Employees

For employees who engage in qualified research both inside and outside Illinois, wages are prorated based on the percentage of time spent physically conducting the qualified activity within the state. This requires detailed time tracking, often relying on daily activity logs, time sheets, or project-based documentation that clearly delineates location and activity type.

This activity-based sourcing contrasts sharply with general IDOR guidance on state income tax withholding for multi-state employees. General withholding rules consider factors like the employee’s residency or whether out-of-state work is “temporary or transitory”.8 For example, if an Illinois resident engineer travels frequently for non-research company business, their residency and employer location might dictate Illinois withholding on their entire salary. However, for R&D credit purposes, if that same engineer spends 20% of their time performing qualified research in an out-of-state lab, the wages associated with that 20% of time must be excluded from the Illinois R&D QRE calculation, irrespective of the employee’s Illinois tax residency or general payroll sourcing rules.1 The focus is purely on the performance location of the research itself.

3.3. Sourcing Mechanics for Supplies and Computer Rentals

The location of consumption or use dictates the sourcing for non-labor QREs:

• Supplies: Materials, consumables, and prototypes must be physically consumed in qualified research performed in Illinois.1 If a prototype is constructed in an Illinois facility but shipped to a remote testing site in Michigan for destructive testing (a qualified activity), the cost of the prototype material is only included to the extent it was consumed during the Illinois portion of the research activity (e.g., initial construction and internal testing).
• Computer Rentals: The costs for leased computers, hardware, or cloud computing services must be directly tied to and utilized in Illinois-based research activities.1 In a cloud environment, this often means ensuring the costs are allocated based on the physical location of the users (e.g., Illinois-based engineers) who access and utilize the services for R&D purposes.

3.4. Sourcing Mechanics for Contract Research

Contract research expenses, defined as 65% of payments to third parties for qualified research services, are sourced based on the location where the contracted service is physically performed.1 This places a significant compliance burden on the taxpayer to verify and document the contractor’s research location.

If an Illinois company hires a third-party laboratory in California to conduct a key phase of its product development, that expense, while qualifying under IRC $\S 41$, is strictly not an Illinois QRE. Taxpayers must ensure contract documentation explicitly confirms that the contracted R&D services are executed within Illinois to claim the expense. This requirement protects the state’s incentive program from subsidizing research conducted elsewhere.

IV. Calculation Methodology and Base Period Requirements: Detailed IDOR Guidance

The Illinois R&D tax credit is calculated using an incremental methodology, rewarding businesses for increasing their qualified research spending within the state relative to a historical average.

4.1. The Incremental Calculation Formula

The credit is determined by identifying the excess QREs above the base amount and applying the statutory rate:

$$\text{Credit Amount} = 6.5\% \times (\text{Current Year IL QREs} – \text{Base Amount})$$

.1

The credit rate is fixed at 6.5% of these excess QREs.1

4.2. Definition of the Base Period

The Base Period is defined by statute as the three taxable years immediately preceding the taxable year for which the credit determination is being made.4

A critical compliance point is that the base amount calculation must also adhere to the strict sourcing rules. The base QREs must be computed using only QREs that were conducted in Illinois during those three prior years.1 If a company was a multi-state operator during the base period, QREs incurred outside Illinois during those years must be excluded from the base calculation, ensuring that the base reflects a comparison of Illinois-specific activities.1

4.3. IDOR Administrative Rule: Annualization of Base QREs (86 Ill. Adm. Code 100.2160(e)(3))

The IDOR administrative code provides specific instructions for taxpayers who were only doing business in Illinois for a portion of a base period year. This rule, found in 86 Ill. Adm. Code 100.2160(e)(3), requires the annualization of qualified expenditures for that partial year.9

The annualization is calculated as:

$$\text{Annualized Base QREs} = \frac{\text{Actual QREs Incurred} \times 365}{\text{Number of Days Doing Business in Illinois}}$$

.9

The necessity of this rule lies in preventing the artificial suppression of the base amount. For instance, if a company establishes its Illinois nexus late in a base year, incurring R&D expenses for only 60 days, using only that 60-day expenditure would result in an artificially low annual average. By annualizing the QREs to represent a full year’s worth of activity at that level of expenditure, the regulation ensures the base reflects a normalized level of spending. This maintains the integrity of the incremental test, ensuring the credit is only awarded for genuine increases in research intensity, not for computational manipulation resulting from short tax periods.9

Furthermore, special rules apply to business reorganizations: qualifying expenditures incurred by a predecessor corporation must be included in the successor taxpayer’s base period calculation following a corporate merger or acquisition under IITA Section 405(a).9

4.4. Start-Up Rules and Base Period Exceptions

New businesses that did not incur Illinois QREs in the three preceding tax years have a significant advantage: their base amount is considered zero ($0).1 This provision serves as a powerful incentive for start-up companies to establish and grow R&D operations in Illinois, allowing them to claim the full 6.5% credit on their entire amount of current-year Illinois QREs.1

V. Practical Application: Case Study for Multi-State Sourcing and Incremental Calculation

The following case study illustrates the stringent process of isolating Illinois-sourced QREs and calculating the incremental credit for a multi-state enterprise.

5.1. Scenario Setup

Consider Innovate Global Co. (IGC), a multi-state technology firm that files taxes in both Illinois (IL) and Wisconsin (WI). The company’s engineers split their time between R&D labs in Chicago (IL) and Milwaukee (WI). IGC commenced operations in Illinois four years ago (Year 1).

IGC’s internal accounting reports the following QREs, based on detailed time tracking and expense allocation:

Table Title: Innovate Global Co. Qualified Research Expenditures (QREs)

5.2. Step-by-Step Calculation for Year 4 (The Credit Year)

The calculation process must strictly adhere to the Illinois-only QRE figures.

Step 1: Determine Current Year IL QREs

The current year QREs that qualify are only those physically conducted in Illinois.

Current Year IL QREs = $1,500,000.

The Wisconsin-sourced QREs ($800,000) are excluded entirely.1

Step 2: Determine Base Period IL QREs (Years 1, 2, and 3)

The base period includes the three preceding taxable years. Only the Illinois-sourced QREs from these years are included 1:

• Year 1 IL QREs: $600,000
• Year 2 IL QREs: $800,000
• Year 3 IL QREs: $1,000,000
  Base QRE Total = $600,000 + $800,000 + $1,000,000 = $2,400,000

Step 3: Calculate the Base Amount

The Base Amount is the average of the Base Period QREs:

Base Amount = $2,400,000 / 3 = $800,000.1

Step 4: Calculate Excess QREs (Incremental Increase)

Excess QREs are the difference between the current year IL QREs and the Base Amount:

Excess QREs = $1,500,000 (Current) – $800,000 (Base) = $700,000.1

Step 5: Calculate Illinois R&D Tax Credit

Apply the 6.5% credit rate to the Excess QREs:

Credit = 0.065 $\times$ $700,000 = $45,500.1

This calculation demonstrates that even with $2.3 million in total R&D spending, only the $1.5 million attributable to Illinois activities is relevant, yielding a substantial $45,500 credit. This strict sourcing methodology highlights the need for dedicated state-specific R&D tax studies, separate from federal calculations, for multi-state filers.

VI. Filing and Compliance Considerations

Successful claiming and utilization of the Illinois R&D credit requires adherence to specific filing protocols and an extended commitment to documentation retention.

6.1. Filing Requirements and Utilization

The credit is nonrefundable and can only be used to offset the taxpayer’s Illinois income tax liability.1 The credit is claimed by incorporating the calculation onto the appropriate Schedule 1299 form (D for corporations, A for flow-through entities).3

For flow-through entities, such as partnerships and S corporations, the credit is calculated at the entity level based on the Illinois-sourced QREs, and then passed through to the respective partners or shareholders to claim against their personal income tax liability via Schedule 1299-A.3

6.2. Credit Carryforward and Extended Documentation Burden

A key feature of the credit is the ability to carry forward any unused credit amount for up to five years.1 This carryforward provision is crucial for start-up and growth-stage companies that may have significant R&D expenditures but limited current tax liability.

Because the credit can be carried forward for a period of five years, the statutory audit retention period for the underlying documentation supporting the QREs must be maintained for at least the entire carryforward period, plus the standard statute of limitations for the year the credit is utilized.1 For example, a credit generated in Year 1 and fully utilized in Year 5 requires the taxpayer to maintain the detailed documentation (e.g., employee time studies, contract invoices, supply consumption logs) supporting the Year 1 QRE calculation well into Year 6 or Year 7. This necessity significantly increases the long-term administrative burden on the taxpayer and must be accounted for in compliance strategy.

6.3. IDOR Documentation Emphasis

The geographical sourcing mandate places a heavy focus on contemporaneous documentation.1 IDOR auditors reviewing R&D credit claims will require evidence that explicitly links the expenditure to the physical performance in Illinois. For labor costs, this requires detailed time-tracking that differentiates between: (a) qualified versus non-qualified activity, and (b) in-state versus out-of-state activity. Similarly, invoices for contract research must either explicitly confirm the research location within Illinois or be supported by additional contractor documentation detailing the physical performance of services.

Furthermore, compliance must address the specific administrative rules regarding base period calculation. Taxpayers who have experienced a short base year, or who have undergone mergers/acquisitions, must be prepared to demonstrate adherence to the annualization rule (86 Ill. Adm. Code 100.2160(e)(3)) or the successor rule (100.2160(e)(1)).9

VII. Broader Context and Strategic Implications

The Illinois R&D credit operates within a dynamic state tax environment, serving as a pillar of economic encouragement for high-value industries.

7.1. Legislative Stability and Economic Incentive

The recent legislative action extending the R&D credit through tax years ending on or before December 31, 2031, provides substantial long-term planning certainty for businesses considering investing in or expanding their research infrastructure in Illinois.1 This stability is particularly appealing to capital-intensive sectors like manufacturing, technology, and pharmaceuticals.1

While specific recent utilization statistics from IDOR are limited in the public domain, the credit is a known significant tax expenditure, being explicitly noted alongside major credits like the High Impact Business Building Materials Exemption.10 Case studies confirm its tangible value, illustrating that successful multi-year claims for manufacturers result in cumulative state credits reaching into the tens to hundreds of thousands of dollars, demonstrating its real impact on the state tax burden.1 For instance, one manufacturing company claimed a combined federal and state credit of over $88,000, with $26,000 attributed to the Illinois portion in a single year.1

7.2. Strategic Planning for Non-Refundable Credits

The non-refundable nature of the Illinois R&D credit means that its immediate value is entirely dependent on the existence of a corresponding Illinois income tax liability.1 Taxpayers with significant Illinois QREs but who operate at a loss or have minimal state tax due may generate large credits that can only be realized years later through the carryforward mechanism.

This presents a strategic planning challenge. Taxpayers must continually monitor the projected expiration of the 5-year carryforward period against their expected future state income tax liability. If a taxpayer anticipates insufficient liability to utilize the credit within five years, the economic value of the credit diminishes, despite the high quality of the underlying research activity. This necessitates integrating R&D credit utilization forecasting directly into multi-year state tax planning models.

7.3. Integration with Other State Incentives

Illinois offers a wide array of specialized tax incentives, including the Economic Development for a Growing Economy (EDGE) credit, the Quantum Computing Campuses credit, and various enterprise zone benefits.5 For certain “startup taxpayers” under the EDGE program, there is even an option to use that credit against withholding liability.12

However, the R&D credit must be claimed independently, utilizing its specific sourcing rules. Taxpayers are encouraged to analyze the interplay between these different programs to ensure full capture of all available state tax reductions, particularly considering that the R&D credit’s definition of “in-state research” relies on physical activity, which may differ from the location requirements of other geographically sensitive incentives.

VIII. Conclusion and Recommendations

The definition of “Research Conducted in this State (Illinois)” is not merely an advisory guideline but a fundamental statutory prerequisite for claiming the Illinois R&D Tax Credit. The state legislature and IDOR have implemented a strict geographical filter on QREs, requiring an activity-based nexus that demands detailed, verifiable proof of physical performance within Illinois.

8.1. Nuanced Conclusions

1. Strict Sourcing is Non-Negotiable: For multi-state entities, total federal QREs cannot be simply allocated based on general apportionment factors. Every component of the QRE—wages, supplies, contracted services, and computer rentals—must be specifically traced and proven to be physically conducted or consumed in Illinois. Failure to strictly exclude out-of-state activities, even if performed by Illinois residents or managed from Illinois offices, will lead to claim reductions upon audit.1
2. Base Period Accuracy Requires Specific Code Adherence: The administrative guidance in 86 Ill. Adm. Code 100.2160(e)(3) regarding the annualization of QREs for short base years is a subtle but potent compliance requirement. Taxpayers that commenced or reorganized operations during the base period must apply this rule to avoid inadvertent suppression of the base amount, which ensures that the resulting incremental credit accurately reflects genuine growth in research intensity.9
3. Extended Documentation Risk: The five-year carryforward rule for unused credits necessitates an extended documentation retention strategy.1 Companies must maintain time studies, project details, and sourcing evidence for substantially longer periods than typically required for general income tax compliance.

8.2. Actionable Recommendations

Taxpayers seeking to maximize and defend the Illinois R&D credit should implement the following internal compliance measures:

• Implement Location-Based Time Tracking: Establish mandatory time-tracking procedures for R&D personnel that capture not only qualified vs. non-qualified activities but also the physical location (Illinois vs. Out-of-State) where those qualified services were performed.
• Audit Contract Language: Review and update contracts with third-party researchers to include specific language that requires the contractor to perform the qualified activities within Illinois borders and provides the taxpayer with the documentation necessary to prove this geographical nexus.
• Integrate Base Annualization into Modeling: Ensure that financial models used for calculating the credit, especially during the first few years of Illinois operation or following a change in business structure, explicitly apply the annualization provisions outlined in IDOR administrative rules to calculate a defensible base amount.

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