Development or Improvement of a Product or Process

The development or improvement of a product or process in the context of the South Carolina Research and Development tax credit refers to activities intended to create a new business component or enhance the functionality, performance, reliability, or quality of an existing one through a systematic process of experimentation. This standard requires that such efforts fundamentally rely on the principles of physical or biological science, engineering, or computer science to resolve technical uncertainties regarding the capability, method, or design of the intended advancement.

The South Carolina Research Expenses Tax Credit, codified under South Carolina Code Section 12-6-3415, serves as a cornerstone of the state’s economic strategy to foster innovation-led growth within its borders. Administered by the South Carolina Department of Revenue (SCDOR), this credit provides a significant incentive for businesses that engage in qualifying research activities specifically conducted within the state. The legislative intent behind the credit is to lower the cost of private research, which often results in spillover benefits for the public and the state’s broader economy. By aligning with the federal standards established under Internal Revenue Code (IRC) Section 41, South Carolina ensures a level of consistency for multi-state taxpayers while maintaining a distinct focus on local expenditures and local industrial development. The determination of what constitutes “development” or “improvement” is not merely a technical evaluation but a legal one, requiring a nexus between physical laboratory or workshop activities and the specific definitions of “qualified research” adopted by the state.

The Statutory Foundation of Development and Improvement in South Carolina

The primary authority for the South Carolina Research Expenses Tax Credit is found in South Carolina Code Section 12-6-3415, which provides a nonrefundable credit equal to five percent of the qualified research expenditures (QREs) incurred by a taxpayer in South Carolina during a given taxable year. To participate in this incentive program, a taxpayer must satisfy a critical prerequisite: they must claim the federal income tax credit for research expenses under IRC Section 41 for the same taxable year. This linkage means that South Carolina’s definition of what qualifies as development or improvement is inherently tied to federal law, yet the application is strictly limited to the economic activities that occur within the geographic boundaries of the state.

The state’s reliance on IRC Section 41 is a structural decision that simplifies compliance for businesses already navigating federal tax requirements. Under this framework, research is considered “qualified” if it is undertaken for the purpose of discovering information that is technological in nature and whose application is intended to be useful in the development of a new or improved business component. A business component is further defined as any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business.

Quantitative Constraints and Credit Mechanics

While the federal credit involves complex calculations based on historical base amounts and incremental increases, the South Carolina credit is generally viewed as more straightforward, applying the 5% rate directly to the state-sourced QREs for the taxable year. However, the state imposes specific limitations on how much of this credit can be used to offset tax liability in any single year.

Feature of the Credit	Specification	Statutory Reference
Credit Rate	5% of South Carolina QREs	S.C. Code §12-6-3415
Annual Limit	50% of remaining tax liability	S.C. Code §12-6-3415
Carryforward	10 years from the year of the expense	S.C. Code §12-6-3415
Eligible Taxes	Income Tax, Corporate License Fees	S.C. Code §12-6-3415
Federal Nexus	Must claim federal IRC §41 credit	S.C. Code §12-6-3415
Base Amount	No state-level base amount calculation	S.C. Code §12-6-3415

The application of the credit follows a strict ordering rule. The credit used in the current year cannot exceed 50% of the taxpayer’s remaining South Carolina income tax and corporate license fee liability after all other available credits have been applied. This ensures that the R&D incentive does not entirely eliminate a firm’s tax contribution but provides a substantial buffer for those making heavy investments in innovation. For instance, if a corporation has a final liability of $200,000 after primary credits, the R&D credit can offset up to $100,000 of that amount. Any excess credit that cannot be used due to this limitation may be carried forward for a period of ten years.

Conceptualizing Development and Improvement: The Four-Part Test

The determination of whether a project constitutes the “development” or “improvement” of a product or process depends on its ability to satisfy the “four-part test” derived from federal law and adopted by the SCDOR. This test serves as the analytical filter to distinguish genuine research from routine business activities, market research, or aesthetic design.

The Permitted Purpose Test

The first pillar of the definition is the “Permitted Purpose.” The objective of the research must be to create a new business component or to improve the functionality, performance, reliability, or quality of an existing one. This is the foundational requirement for “improvement.” If a company is merely changing the packaging of a product for better shelf appeal or conducting consumer surveys to gauge preference, the activity fails this test because it does not relate to the functional or performance metrics of the component.

In a “development” scenario, the firm is often creating a business component that is fundamentally new to the taxpayer. In an “improvement” scenario, the taxpayer is seeking to enhance a specific characteristic of an existing component. For a manufacturer in South Carolina, an improvement project might involve redesigning a component to withstand higher operating temperatures (improving reliability) or modifying a production process to reduce the cycle time for a specific part (improving performance).

The Elimination of Uncertainty Test

Development or improvement cannot exist without technical uncertainty. Under IRC Section 41 and South Carolina’s conforming statutes, uncertainty exists if the information available to the taxpayer at the outset of the project does not establish the capability of developing the component, the method by which it can be achieved, or the appropriate design of the final product.

Technical uncertainty is distinct from business uncertainty. A company may be uncertain whether a product will sell (business uncertainty), but for the R&D credit, the uncertainty must be technical. Capability uncertainty addresses whether the goal is even possible under current scientific knowledge. Methodology uncertainty focuses on the “how,” while design uncertainty focuses on the specific configurations or specifications required to meet performance targets.

The Process of Experimentation Test

The core of “improvement” activities is the “Process of Experimentation.” This requirement dictates that substantially all of the research activities must constitute a systematic process designed to evaluate one or more alternatives. This process typically involves the formulation of a hypothesis, testing and modeling that hypothesis through simulation or trial and error, and subsequently refining or discarding the hypothesis based on the results.

The SCDOR looks for evidence that the taxpayer engaged in a deliberate evaluation of multiple paths. Routine data collection or simple troubleshooting does not constitute a process of experimentation. However, if a South Carolina aerospace company is forced to test different composite materials to find the optimal balance between weight and tensile strength, and they utilize wind-tunnel modeling and destructive testing to reach a conclusion, they have clearly performed a process of experimentation to improve a business component.

The Technological in Nature Test

Finally, the research must be “Technological in Nature.” The process of experimentation must fundamentally rely on the principles of the “hard sciences,” such as engineering, computer science, biological sciences, or physical sciences like chemistry and physics. Research in the social sciences, humanities, or business management is explicitly excluded from the definition of qualified research. This ensures that the state’s tax incentives are channeled into the technical and industrial sectors that drive long-term productivity and innovation.

Local State Revenue Office Guidance and Interpretations

The South Carolina Department of Revenue provides interpretive clarity through several types of advisory opinions, including Revenue Rulings, Private Letter Rulings, and Information Letters. These documents are essential for understanding how the general language of the law is applied to specific industries and fact patterns.

Type of SCDOR Guidance	Legal Standing	Function
Revenue Ruling (RR)	Official advisory opinion for a general group	Provides guidance on applying tax law to specific issues or facts.
Private Letter Ruling (PLR)	Binding only on the specific taxpayer	Applies principles of law to a specific set of facts for an individual entity.
Information Letter (IL)	Non-binding announcement	Used to announce general information or update figures like per capita income.
Revenue Procedure (RP)	Administrative guidance	Outlines procedures for taxpayers to follow in various administrative matters.

Private Letter Ruling #08-3: A Case Study in R&D Interpretation

A critical piece of guidance is Private Letter Ruling (PLR) #08-3, which addresses the application of R&D definitions to the production of genetically enhanced tree seedlings. In this ruling, the SCDOR analyzed whether specialized machinery used in a biotechnology lab qualified for sales tax exemptions under the “machines used in research and development” category.

The department determined that “research and development” means basic and applied research in the sciences and engineering and the design and development of prototypes and processes. The ruling clarified that “development” in this context included the isolation of candidate genes and the construction of transformation plasmids to introduce foreign DNA into trees to create new genetic varieties. “Improvement” was characterized as enhancing existing elite trees to increase productivity, improve wood quality, or reduce the need for chemicals in later processing stages. The SCDOR emphasized that the machines must be used “directly and primarily in research and development, in the experimental or laboratory sense” to qualify, distinguishing this from general laboratory supplies or routine production activities.

Interaction with Property Tax and Facility Classification

The SCDOR also provides guidance on how R&D facilities are classified for property tax purposes. Under South Carolina Code Section 12-43-220(a)(2), real property used primarily for research and development is specifically not considered part of a manufacturing establishment for the purpose of classification, even if the owner is a manufacturer. This distinction is significant because it recognizes R&D as a separate, pre-production function.

For the purpose of property tax exemptions, “research and development” is defined as activities focused on basic and applied research in the sciences and engineering. This includes the design and development of prototypes and processes. South Carolina Code Section 12-37-220(B)(34) provides a five-year county property tax exemption for R&D facilities and additions to existing facilities valued at $50,000 or more. This creates a comprehensive incentive structure where a company’s “improvement” of a process may not only yield an income tax credit but also a temporary property tax shield if a new R&D lab is constructed to house that research.

Qualified Research Expenditures: Defining the Costs of Improvement

To claim the 5% credit, a taxpayer must accurately track their qualified research expenditures (QREs). South Carolina adopts the federal definitions of QREs found in IRC Section 41(b), but the claim must be limited to those costs incurred for research performed in South Carolina.

Categories of QREs in South Carolina

The SCDOR recognizes four primary categories of expenses that can be aggregated to form the basis of the credit.

1. Wages: This includes salaries and wages paid to employees who are directly performing, supervising, or supporting qualified research. In the context of “improvement,” this often covers the time engineers and lab technicians spend conducting tests and analyzing results. The wages must be subject to South Carolina income tax withholding to qualify for the state credit.
2. Supplies: These are non-depreciable materials consumed during the research process. Examples include chemicals, 3D printing filaments for prototypes, and materials used to build one-off test articles.
3. Contract Research: A taxpayer can include 65% of the amounts paid to third-party contractors for qualified research services performed on their behalf. This percentage increases to 75% for payments made to qualified research consortia.
4. Computer Rentals: This category covers the cost of renting or leasing computers used in qualified research. In the modern era, this increasingly includes cloud-computing arrangements where server space is leased for intensive simulation or software testing.

The Software and Internal Use High Threshold

For companies seeking to improve software business components, the SCDOR follows federal guidelines that distinguish between software for sale or lease and software for “internal use”. Software developed primarily for internal use (e.g., HR systems, general ledger software) must meet an additional “high threshold of innovation” test.

To qualify as an “improvement” for internal-use software, the development must:

• Be innovative, resulting in a reduction in cost or improvement in speed that is substantial and economically significant.
• Involve significant economic risk, meaning the taxpayer commits substantial resources and there is technical uncertainty about whether the software can be completed.
• Not be commercially available for purchase.

This stricter definition prevents routine IT upgrades or customizations from draining state tax resources, ensuring that the credit is reserved for software improvements that provide a competitive or technological leap.

Administrative Procedures: Claiming and Defending the Credit

The process of claiming the South Carolina R&D credit is formal and requires significant documentation. The primary form used is Schedule TC-18, which must be attached to the taxpayer’s South Carolina state tax return.

Instructions for Schedule TC-18

Schedule TC-18 acts as the summary document for the year’s research activities. Taxpayers must disclose the following:

• Total South Carolina QREs: A breakdown of the wages, supplies, and contract research costs incurred within the state.
• Credit Calculation: The application of the 5% rate to the state-level QREs.
• Pass-Through Information: If the credit is received from a partnership, S-corporation, or LLC, the claimant must provide the name and FEIN of the pass-through entity that generated the expense.
• Limitation and Carryforward: Calculations showing the application of the 50% liability limit and the amount of any unused credit being carried forward to future years.

Documentation and Audit Preparedness

While Schedule TC-18 is a summary, the SCDOR expects taxpayers to maintain contemporaneous records to support their claims in the event of an audit. Following recent IRS trends, the state increasingly looks for a “business component narrative” for each project. This narrative should clearly articulate the technical uncertainty at the beginning of the project, the specific “improvement” being targeted (e.g., higher accuracy, better durability), and a detailed log of the experimentation process.

Evidence for “improvement” activities often includes:

• Project authorizations and budgets.
• Design drawings, sketches, and 3D models.
• Lab notebooks and test results.
• Meeting minutes where technical challenges and alternatives were discussed.

Example: Improving a Manufacturing Process in the Aerospace Sector

To illustrate the practical application of these rules, consider a hypothetical South Carolina-based aerospace manufacturer that specializes in carbon-fiber wing structures.

The Objective

The manufacturer identifies that the current curing process for their composite wings leads to a 5% rejection rate due to microscopic voids in the material. They initiate a project to “improve the manufacturing process” to achieve a rejection rate of less than 1% while also reducing the total cure time by 10%. This constitutes a “Permitted Purpose” (improving functionality and performance).

Technical Uncertainty

The company’s engineers are uncertain whether increasing the autoclave pressure or altering the ramp-up speed of the temperature will eliminate the voids without causing the material to become brittle. They also do not know if a new resin formula would be compatible with their existing fiber weave. This constitutes “Elimination of Uncertainty” (capability and method).

Process of Experimentation

The engineering team conducts a series of trials. They first use thermal modeling software to simulate different temperature profiles (Process of Experimentation via modeling). They then manufacture twelve small-scale test panels using different combinations of pressure and temperature (Process of Experimentation via systematic trial and error). Each panel is subjected to ultrasonic scanning and stress testing.

Technological in Nature

The research fundamentally relies on material science, thermodynamics, and structural engineering. This satisfies the “Technological in Nature” test.

QRE Calculation

For this project, the company incurs the following costs in South Carolina:

• Wages: $400,000 for aerospace engineers and technicians.
• Supplies: $150,000 in carbon-fiber pre-preg and specialized resins consumed during the testing.
• Computer Rentals: $50,000 for the lease of high-performance computing units for the thermal simulations.
• Total SC QREs: $600,000.

Calculation Step	Value
Total Qualified Expenses	$600,000
State Credit Rate	5%
Calculated State Credit	$30,000
Corporate Tax Liability (Remaining)	$50,000
50% Limitation	$25,000
Credit Used in Current Year	$25,000
Credit Carryforward	$5,000

In this scenario, the company effectively reduces its state tax burden while advancing its manufacturing capabilities, demonstrating how the “improvement” of a process creates value for both the firm and the South Carolina economy.

Broader Economic Incentives and Future Outlook

South Carolina’s R&D tax credit does not operate in isolation. It is part of a broader suite of economic development tools that include the Jobs Tax Credit, the Corporate Headquarters Credit, and the Fee in Lieu of Tax (FILOT) agreements.

Interaction with the Jobs Tax Credit

A business operating an R&D facility in South Carolina may also be eligible for the Jobs Tax Credit under Code Section 12-6-3360. This credit provides a fixed dollar amount per new job created, with the amount varying based on the county’s development tier.

County Tier	Development Level	Job Tax Credit Amount (per job)
Tier IV	Least Developed	$25,000
Tier III	Under Developed	$20,250
Tier II	Moderately Developed	$2,750
Tier I	Developed	$1,500

For a company “improving” a product that requires a new specialized engineering team, the combination of the R&D Tax Credit (5% of wages) and the Jobs Tax Credit can provide a massive financial offset. The SCDOR notes that taxpayers operating “research and development facilities” are specifically eligible for these job credits, reinforcing the state’s commitment to high-tech employment.

The 2025 Legislative Landscape: OBBBA and Section 174A

A major shift in the R&D landscape occurred with the passage of the federal “One Big Beautiful Bill Act” (OBBBA) in 2025. This act permanently restored the “full expensing” of domestic R&D costs under a new Section 174A, reversing a period where companies were required to amortize these costs over five years.

For South Carolina taxpayers, this is a pivotal development. Because South Carolina generally conforms to the Internal Revenue Code as of the most recent year, the restoration of federal expensing significantly enhances the cash-flow benefits for businesses engaged in development or improvement. Furthermore, the OBBBA provides retroactive relief for small businesses (those with under $31 million in gross receipts), allowing them to expense domestic R&D costs for the 2022-2024 tax years via amended returns. This federal change directly supports the state’s goal of encouraging sustained, year-over-year investments in South Carolina-based innovation.

Strategic Synthesis of Development and Improvement

The definition of “development” and “improvement” within the South Carolina tax code is robust, clearly delineated, and deeply integrated with federal standards. It requires a rigorous adherence to scientific principles and a documented evaluation of technical alternatives. For the modern enterprise, “improvement” is often synonymous with digital transformation—automated processes, optimized algorithms, and the integration of smart manufacturing technologies.

Final Thoughts for Stakeholders

• Focus on Functionality: Successful “improvement” claims must target functional, performance, or reliability metrics rather than aesthetic or commercial preferences.
• Document the “Failures”: The SCDOR and IRS view the evaluation of “failed” alternatives as strong evidence of a genuine process of experimentation.
• Establish the Nexus: It is insufficient to merely have an R&D department; expenses must be tied to specific “business components” and specific research activities.
• Monitor State Withholding: For wages to count as QREs for the South Carolina credit, they must be subject to state withholding, emphasizing the “in-state” nature of the incentive.
• Plan for Limitations: The 50% liability limit and 10-year carryforward require careful tax planning, particularly for firms with multiple competing state credits.

South Carolina’s Research Expenses Tax Credit remains a vital instrument for attracting and retaining high-value industries. By rewarding the technical labor required to “improve” a process or “develop” a new product, the state actively participates in the global competition for innovation, ensuring that the “Made in South Carolina” label is associated with technological excellence and scientific rigor.