Business Component

The conceptualization of the business component is not merely a definitional exercise but the foundational requirement for any taxpayer seeking to leverage the South Carolina Research Expenses Credit under S.C. Code Section 12-6-3415. Because South Carolina maintains substantial conformity with the Internal Revenue Code (IRC), specifically Section 41, the state’s interpretation of what constitutes a business component is inextricably linked to federal Treasury Regulations and judicial precedents. This reliance on the federal “four-part test” mandates that research activities must be evaluated at the level of the specific business component rather than at the level of the project or the department. The South Carolina Department of Revenue (SCDOR) utilizes this framework to distinguish between routine business activities and the high-level innovation that the credit is designed to incentivize.

Statutory Foundations and Regulatory Conformity

The South Carolina Research Expenses Credit is governed by S.C. Code Section 12-6-3415, which provides a nonrefundable credit against corporate income tax, individual income tax, and corporate license fees. The state’s approach to economic development incentives is characterized by a “piggyback” system, where the qualification for state benefits is predicated on the taxpayer’s ability to satisfy the requirements for the federal research credit under IRC Section 41.

The Mechanism of Federal Conformity

South Carolina’s conformity to the IRC is established through S.C. Code Section 12-6-40, which generally adopts the federal tax code as of a specific date, usually December 31st of the preceding year. For the purposes of the R&D credit, Section 12-6-3415(A) explicitly states that a taxpayer claiming a federal income tax credit pursuant to Section 41 of the Internal Revenue Code is allowed a credit equal to five percent of the taxpayer’s qualified research expenses made in South Carolina.

This linkage ensures that the definition of a “business component” remains consistent across both jurisdictions. As defined in IRC Section 41(d)(2)(B), a business component encompasses any product, process, computer software, technique, formula, or invention that is to be held for sale, lease, or license, or used by the taxpayer in a trade or business. The SCDOR does not issue independent definitions of these terms but instead directs taxpayers to federal standards and the instructions for Form TC-18.

Comparative Analysis of Federal and State R&D Incentives

While the definitions are harmonized, the application and calculation of the credit in South Carolina diverge significantly from the federal model. South Carolina offers a more straightforward 5% credit on the total qualified research expenditures (QREs) incurred within the state, whereas the federal credit is typically an incremental calculation based on exceeding a historical base amount.

Parameter	Federal R&D Credit (IRC § 41)	South Carolina R&D Credit (§ 12-6-3415)
Credit Rate	20% (Regular) or 14% (ASC)	5% of SC-sourced QREs
Base Amount	Required (Historical/Gross Receipts)	None (Straight percentage)
Sourcing	United States (including PR/Possessions)	South Carolina state borders only
Utilization Limit	Varies; can offset AMT for some SMEs	50% of remaining liability after other credits
Carryforward	20 years	10 years
Tax Offset	Federal Income Tax; Payroll Tax for startups	SC Income Tax; Corporate License Fees

This structural difference places a high premium on the accurate identification of the business component. In a federal audit, a taxpayer might have a buffer provided by the base amount; in South Carolina, every dollar of the 5% credit is subject to scrutiny regarding whether the underlying activity truly constitutes a “qualified research activity” tied to a specific business component.

Categories of Business Components in South Carolina

The identification of the business component is the first step in the “four-part test” required by IRC Section 41(d). In the South Carolina context, the nature of the business component often dictates the type of documentation the SCDOR expects during an examination.

Products and Inventions

A product is the most common form of a business component for South Carolina’s manufacturing sector. This includes discrete physical items such as automotive parts, aerospace components, or specialized machinery. An invention is a subset of this category, referring to a novel and non-obvious utility or design that is eligible for patent protection, although a patent is not required for the credit.

The research must aim to improve the functionality, performance, reliability, or quality of the product. If a South Carolina manufacturer develops a new alloy for turbine blades to withstand higher temperatures, the “blade” is the business component. The research activities—such as stress testing, metallurgical analysis, and thermal modeling—are all evaluated based on their contribution to improving this specific component.

Processes and Techniques

In many industrial settings, the innovation is not found in the product itself but in the methodology used to create it. A “process” business component refers to the manufacturing, production, or extraction methods. A “technique” refers to the specific application of scientific or engineering principles to achieve a result.

For instance, a chemical plant in South Carolina might utilize existing formulas but develop a new “process” business component for catalytic cracking that reduces waste by 20%. In this scenario, the plant must document that the development of the new process involved technical uncertainty and a systematic process of experimentation.

Computer Software

The treatment of software as a business component is one of the most complex areas of South Carolina tax law. Software qualifies if it is intended for sale, lease, or license, such as a mobile application developed by a Charleston-based tech startup. However, software developed for “internal use” (IUS) faces a higher threshold.

SCDOR Private Letter Ruling (PLR) #12-2 provides critical insight into the intersection of software and data processing. Although the ruling primarily addresses sales tax, its analysis of “true object” and the “manipulation of information” parallels the R&D credit’s distinction between routine data processing (which is excluded) and qualified software development. For software to be a business component in an R&D context, the development must resolve a technical uncertainty rather than a business or functional uncertainty.

Formulas and Techniques

A “formula” typically applies to the life sciences, pharmaceutical, and chemical industries, which are significant contributors to the South Carolina economy. This includes the molecular composition of a new drug or the chemical balance of a new fertilizer. A “technique” might involve a novel way of using existing laboratory instruments to achieve a higher degree of precision in measurements.

The Four-Part Test at the Business Component Level

The SCDOR requires that every business component for which a credit is claimed must independently satisfy a rigorous four-part test. Failure to meet even one part of the test for a specific component results in the disqualification of all associated expenses.

The Section 174 Test (Elimination of Uncertainty)

The research must be undertaken to discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if the information available to the taxpayer does not establish the capability of development, the method of development, or the appropriate design of the component.

In a South Carolina audit, “business uncertainty” (e.g., whether a product will sell) is insufficient. The taxpayer must demonstrate “technical uncertainty” (e.g., whether the product can be manufactured within certain tolerances using a specific material).

The Process of Experimentation Test

Substantially all of the research activities (generally interpreted as 80% or more) must constitute a process of experimentation. This involves:

• Evaluation of one or more alternatives;
• Testing and modeling (e.g., computer simulations or physical prototypes);
• Hypothesis formation and systematic trial-and-error.

A key takeaway from Phoenix Design Group, Inc. v. Commissioner is that a linear design process—one that moves from concept to completion without iterative testing of alternatives—does not qualify as a process of experimentation. South Carolina taxpayers must document their “failed” attempts and alternative designs to substantiate this requirement.

The Technological in Nature Test

The process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science. Research based on the social sciences, arts, humanities, or management techniques is expressly excluded.

The Permitted Purpose Test

The research must be conducted with the intent to improve the functionality, performance, reliability, or quality of the business component. Activities related to style, taste, cosmetic design, or seasonal changes do not satisfy this requirement.

Criterion	Qualified Activity	Non-Qualified Activity
Purpose	Improving engine durability	Changing the color of the engine cover
Technology	Aerospace engineering	Market research on airline trends
Uncertainty	Determining if a component will melt	Determining if a component will be popular
Experimentation	Testing five different prototype designs	Following a standard industry blueprint

The “Shrinking-Back Rule” and Its Critical Role

A common error among South Carolina taxpayers is evaluating research at too high a level. If a project as a whole fails the four-part test, the “shrinking-back rule” allows the taxpayer to apply the test to the next most significant subset of the business component.

Treasury Regulation Section 1.41-4(b)(2) mandates that if the requirements for the credit cannot be met at the level of the entire product, they are applied to the next most significant subset of the product, and so on, until a qualifying component is found or the process is exhausted. For example, if a South Carolina shipbuilder develops a new vessel where most of the hull is routine, but the specialized stabilization system is novel, the taxpayer “shrinks back” from the entire ship to the stabilization system business component.

The danger of failing to understand this rule was highlighted in Trinity Industries, Inc. v. United States, where the court disallowed credits because the taxpayer took an “all-or-nothing” approach and failed to provide evidence of expenses at the sub-component level. In South Carolina, taxpayers must maintain contemporaneous records that allow for this “shrink back” to the specific technical unknown.

South Carolina Revenue Office Guidance (SCDOR)

The SCDOR provides specific procedural guidance for claiming the credit, primarily through the “Tax Incentives for Economic Development” manual and Form TC-18.

Form TC-18 and Administrative Requirements

Taxpayers must use Form TC-18, “Research Expenses Credit,” to calculate and claim the credit. The form requires a calculation of qualified research expenses made in South Carolina, which is then multiplied by 5%.

A unique South Carolina requirement is the ordering of credits. According to the SCDOR manual, the Research Expenses Credit is applied after all other credits have been utilized. Furthermore, the credit is limited to 50% of the taxpayer’s remaining tax liability.

The 50% Liability Cap and Carryforward Mechanism

If a taxpayer has a total tax liability of $100,000 and other credits (such as the Jobs Tax Credit) reduce that liability to $40,000, the Research Expenses Credit can only be used to offset 50% of that $40,000 balance.

$$Credit_{usable} \leq 0.50 \times (Liability_{total} – Credits_{other})$$

Any unused credit can be carried forward for up to 10 years. It is important to note that the carryforward period does not extend for years in which the taxpayer fails to meet other qualifying criteria, such as the employment requirements sometimes associated with the Headquarters Credit if both are claimed simultaneously.

SCDOR Policy Manual Analysis

The SCDOR manual (2025 Edition) emphasizes that for the purpose of the state credit, “qualified research expenses” have the same meaning as provided in IRC Section 41(b). This includes:

• Wages: Payments to employees performing, supervising, or supporting research.
• Supplies: Tangible property (other than land or depreciable property) used in the research.
• Contract Research: 65% of amounts paid to third parties for qualified research conducted on the taxpayer’s behalf.

The manual also clarifies that for pass-through entities (Partnerships, S Corporations, LLCs), the credit is earned at the entity level but flows through to the partners or shareholders based on their ownership share.

Audit and Documentation Standards for 2024-2025

Recent shifts in IRS policy, which directly influence South Carolina enforcement, have dramatically increased the documentation burden. Starting with tax year 2024, Form 6765 has been expanded to include “Section G,” which requires project-level (business component-level) disclosure of costs and technical narratives.

Section G Requirements

Taxpayers must now identify:

• The name and type of each business component;
• A description of the research activities performed for each component;
• Specific wage, supply, and contract research expenses allocated to each component.

For South Carolina businesses, this means that “hybrid” roles (e.g., an engineer who also does production work) must be documented with contemporaneous time-tracking that maps directly to the specific business component being improved.

Common Audit Pitfalls in South Carolina

The SCDOR and IRS often challenge credits based on “non-qualified” activities that are mistakenly bundled with the business component development. These include:

• Adaptation: Modifying an existing component for a specific customer’s needs.
• Duplication: Reverse engineering an existing component from plans or physical examination.
• Pre-Production Research: Research conducted after the beginning of commercial production.

Excluded Activity	Reason for Disqualification
Customer Adaptation	Relates to requirements, not technical uncertainty
Reverse Engineering	Does not involve the discovery of new information
Routine Quality Control	Not part of a process of experimentation
Market Research	Not technological in nature

Detailed Example: Palmetto Advanced Materials, LLC

To illustrate the application of the business component concept within South Carolina law, consider the following example of a fictional manufacturing firm.

Project Background

Palmetto Advanced Materials, LLC, based in Spartanburg, South Carolina, is developing a “Next-Generation Heat-Resistant Coating” for industrial kilns. This project involves two distinct business components:

1. Component A (The Formula): A new chemical composition designed to withstand temperatures exceeding 3,000 degrees Celsius.
2. Component B (The Application Process): A novel robotic spraying technique required because the new formula is more viscous than standard coatings.

Applying the Four-Part Test

For Component A (The Formula), the firm is uncertain about the chemical stability of the mixture at peak temperatures (Elimination of Uncertainty). They rely on chemistry and thermodynamics (Technological in Nature). They create 20 different batches with varying concentrations and subject each to thermal stress tests (Process of Experimentation). The goal is to improve the performance and reliability of the kiln (Permitted Purpose).

For Component B (The Application Process), the firm is uncertain if existing robotic arms can maintain a uniform thickness given the formula’s viscosity (Elimination of Uncertainty). They utilize mechanical engineering and computer science (Technological in Nature). They model different spraying patterns and pressures using CAD software and conduct pilot runs (Process of Experimentation). The goal is to improve the quality of the coating application (Permitted Purpose).

QRE Calculation and Credit Determination

Palmetto Advanced Materials, LLC identifies the following expenses incurred in South Carolina:

Expense Category	Component A (Formula)	Component B (Process)	Total SC QREs
Engineer Wages	$250,000	$150,000	$400,000
Lab Supplies	$75,000	$25,000	$100,000
Contract Research	$50,000 (at 65%)	$0	$32,500
Total QREs	$357,500	$175,000	$532,500

Step 1: Calculate the Credit Earned

$$Credit = \$532,500 \times 0.05 = \$26,625$$

Step 2: Apply South Carolina Liability Limitations

The firm has a South Carolina tax liability of $80,000. They have already used $40,000 in Job Development Credits (JDCs).

• Remaining Liability: $80,000 – $40,000 = $40,000.
• Allowable R&D Offset (50%): $40,000 \times 0.50 = $20,000.
• Credit Used This Year: $20,000.
• Credit Carryforward: $6,625 (Available for 10 years).

Second and Third-Order Insights

The “business component” serves as the nexus between technical innovation and tax policy. A deeper analysis reveals several emerging trends that South Carolina taxpayers must navigate.

The Rise of “Substantial Evidence” and Documentation Automation

The 2025 landscape for R&D credits is shifting toward a requirement for “contemporaneous documentation” that is nearly impossible to generate retroactively. For South Carolina tech firms, this is driving the adoption of “R&D Intelligence” platforms that integrate with project management tools like Jira or GitHub. These systems automatically identify business components and technical uncertainties as they arise, creating an audit trail that meets the high standards of both the IRS and the SCDOR.

Interaction with the “One Big Beautiful Bill Act” (OBBBA)

The OBBBA, signed into law in 2025, significantly impacts the “Business Component” context by restoring immediate expensing for domestic research costs under Section 174. Previously, taxpayers were required to amortize these costs over five years. For South Carolina companies, this change increases the immediate “deduction” value of R&D, which lowers state taxable income, potentially reducing the tax liability to a point where the 50% R&D credit cap becomes a larger factor.

The Causal Relationship Between Headquarters and R&D Credits

There is a frequent crossover between the South Carolina Headquarters Credit (§ 12-6-3410) and the Research Expenses Credit (§ 12-6-3415). Historically, R&D jobs were counted toward the job creation requirements for the Headquarters Credit. However, the new version of the law (effective for years beginning after 2023) stipulates that jobs for research and development related functions do not count toward the 40-job creation requirement for the Headquarters Credit. This creates a siloed approach where R&D activities must be justified solely on their own merits as business components under Section 12-6-3415.

Strategic Implications for Controlled Groups

Under the “consistency rule” and aggregated group rules, South Carolina taxpayers who are part of a controlled group must be careful to identify business components consistently across all entities. If one entity in the group is audited and a specific component is disqualified, it can have a ripple effect on the entire group’s credit calculation, as the “qualified research” status is tethered to the component itself, not the specific taxpayer claiming it.

Final Thoughts

The business component is the essential unit of measurement for the South Carolina Research Expenses Credit. Taxpayers must look beyond aggregate R&D spending and focus on the technical uncertainties and iterative testing associated with specific products, processes, software, techniques, formulas, or inventions. By adhering to the SCDOR’s requirement for federal conformity and maintaining granular documentation that supports the “four-part test” and the “shrinking-back rule,” South Carolina businesses can successfully monetize their innovations and contribute to the state’s growing reputation as a hub for advanced manufacturing and technology. The complexity of the 50% liability cap and the 10-year carryforward further emphasizes the need for strategic, project-level tax planning in alignment with current state revenue office guidance.