The Permitted Purpose Test requires that research activities be undertaken for the purpose of discovering information intended to be useful in the development of a new or improved function, performance, reliability, or quality of a business component. In the context of the South Carolina Research and Development tax credit, this test serves as a mandatory qualitative gatekeeper, ensuring that state fiscal incentives are directed toward substantive technical innovation rather than routine design, aesthetic modifications, or seasonal product adaptations.
Statutory Foundation and the Mechanism of Federal Conformity
The South Carolina Research Expenses Tax Credit is primarily codified under S.C. Code §12-6-3415, which allows a taxpayer a credit against income taxes or corporate license fees equal to five percent of the taxpayer’s qualified research expenses made in South Carolina. To understand the Permitted Purpose Test, one must first recognize the deep structural interdependence between the South Carolina Department of Revenue (SCDOR) and the Internal Revenue Code (IRC). South Carolina law explicitly adopts the definitions provided in IRC Section 41 for “qualified research expenses” and “qualified research”. This “federal nexus” means that a taxpayer’s eligibility for the state credit is fundamentally predicated on their ability to satisfy the federal four-part test, of which the Permitted Purpose Test is the primary directive regarding the objective of the research.
South Carolina’s approach to tax administration is characterized by “rolling conformity,” where the state legislature periodically updates its adoption of the IRC. As of the most recent legislative updates, South Carolina conforms to the IRC of 1986 as amended through December 31, 2024. This ensures that the state’s interpretation of the Permitted Purpose Test remains aligned with contemporary federal standards, including the nuances introduced by the Tax Cuts and Jobs Act (TCJA) and subsequent administrative guidance. A unique administrative requirement in South Carolina is that a taxpayer must actually claim the federal R&D credit under IRC §41 for the same taxable year to be eligible for the state incentive. This effectively offloads the initial technical verification to the Internal Revenue Service (IRS), while the SCDOR focuses its secondary review on the geographic nexus of the expenditures to ensure they were “made in South Carolina”.
The Role of IRC Section 174 in the Permitted Purpose Context
The Permitted Purpose Test is one of four distinct criteria that must be met simultaneously for an activity to qualify for the credit. Under IRC §41(d), “qualified research” is defined as research with respect to which expenditures may be treated as expenses under IRC §174. While Section 174 focuses on the “elimination of uncertainty” regarding the capability, method, or design of a product, the Permitted Purpose Test (often called the Business Component Test) focuses on the utility of the research.
The integration of these two tests implies that it is not enough for a South Carolina business to encounter a technical problem; the effort to solve that problem must be directed toward improving a specific functional aspect of a business component. This relationship is critical for South Carolina’s manufacturing and software sectors, where routine engineering often aims to solve “puzzles” that do not rise to the level of technical uncertainty or do not serve a “permitted purpose” of functional improvement.
Detailed Examination of the Permitted Purpose Test Criteria
The Permitted Purpose Test mandates that research be undertaken to improve one or more of four specific technical metrics: functionality, performance, reliability, or quality. Each of these terms has specific connotations in the eyes of the SCDOR and the IRS, and failure to map activities to these metrics is a common cause for credit disallowance during audits.
The Four Pillars of Technical Improvement
| Metric | Regulatory Objective | Narrative Context |
|---|---|---|
| Functionality | Introduction of new features or operational capabilities. | Focuses on what the business component does. For example, adding an AI-driven predictive maintenance module to a South Carolina textile machine. |
| Performance | Optimization of speed, efficiency, or output metrics. | Focuses on how well the component operates. For instance, reducing the cycle time of an injection molding process by 15% through heat-transfer experimentation. |
| Reliability | Enhancement of consistency and resistance to failure. | Focuses on the durability of the component over time. This includes testing new alloys for maritime drone propellers to resist salt corrosion. |
| Quality | Improvement of material specifications or purity. | Focuses on the integrity of the output. Examples include refining chemical formulations to ensure higher structural strength in aerospace parts. |
The Permitted Purpose Test is fundamentally an “intent-based” test. The law does not require that the research successfully achieve the desired improvement, but it does require that the purpose of the activity at its inception was to seek such an improvement. This is an important distinction for South Carolina startups, where experimental failures are common; as long as the failure occurred during a bona fide attempt to improve a functional metric, the associated expenses remain qualified.
Exclusions and Non-Qualified Purposes
The Permitted Purpose Test acts as a filter to exclude activities that do not contribute to the state’s technological advancement. South Carolina guidance, mirroring IRC §41(d)(4), explicitly excludes several categories of activities because their purpose is not “permitted” for the R&D credit.
Style and Aesthetics: Research related to style, taste, cosmetic, or seasonal design factors is not qualified research. For example, a furniture manufacturer in High Point or a garment maker in the Upstate cannot claim credits for designing a new pattern or a more “visually appealing” chair frame if the change does not improve the chair’s structural integrity or weight-bearing performance.
Post-Commercial Production: Activities conducted after the beginning of commercial production are generally excluded. Once the “uncertainty” regarding the design is resolved and the product is ready for the South Carolina market, subsequent activities like routine quality control or troubleshooting common manufacturing bugs do not meet the test.
Adaptation: Adapting an existing business component to a particular customer’s requirement without resolving a new technical uncertainty is excluded. This is particularly relevant for South Carolina’s custom machine shops; if the adaptation is a routine customization based on known engineering principles, it fails the Permitted Purpose Test.
Reverse Engineering: The duplication of an existing business component from a physical examination or from plans or specifications is not a permitted purpose. The goal must be innovation, not imitation.
The Business Component and the Shrinking-Back Rule
The Permitted Purpose Test must be applied to a specific “business component”. South Carolina law defines this as any product, process, computer software, technique, formula, or invention which is held for sale, lease, or license, or used by the taxpayer in a trade or business.
Definition of Business Components in the South Carolina Context
| Category | Description | South Carolina Industry Example |
|---|---|---|
| Product | Tangible goods manufactured for sale. | A new fuel injection system for the automotive sector in Greenville. |
| Process | Methods or ordered steps to achieve an outcome. | A patented recycling process for industrial polymers used in Charleston. |
| Software | Computer applications, especially non-internal use. | A specialized cybersecurity platform developed in Columbia for logistics firms. |
| Formula | Chemical compounds or mathematical expressions. | A new bio-based coating for sustainable packaging in Spartanburg. |
| Invention | New, non-obvious machines or things. | A dynamic fluid heater system for household appliances (Patent of the Year). |
Application of the Shrinking-Back Rule
A common problem arises when a large-scale project in South Carolina fails the four-part test as a whole. For instance, an entire “smart factory” installation might not qualify because the majority of the components are off-the-shelf. However, the “Shrinking-Back Rule” allows the taxpayer to apply the tests to a smaller subset of the project.
If the overall project fails the Permitted Purpose Test, the analysis “shrinks back” to the most significant subset of elements that does satisfy the test. This continues until the taxpayer identifies a subcomponent (such as a specific innovative sensor or a custom software algorithm) where the research was truly intended to improve function or performance. This rule is essential for maintaining the integrity of South Carolina R&D claims, as it prevents the entire credit from being lost due to the presence of non-qualifying routine elements within a larger innovation project.
South Carolina Department of Revenue (SCDOR) Guidance and Rulings
The SCDOR provides specific guidance on how the R&D credit and the Permitted Purpose Test are administered locally. This guidance often clarifies the intersection of the income tax credit with other incentives, such as sales tax exemptions for R&D machinery and the Job Tax Credit.
Revenue Ruling #12-3: R&D Machines and Primary Use
One of the most significant pieces of local guidance is found in the SCDOR’s interpretation of sales and use tax exemptions for research and development machinery under S.C. Code §12-36-2120(56). While this is a sales tax provision, the definition of R&D used by the department mirrors the Permitted Purpose Test for the income tax credit.
The SCDOR defines “machines used in research and development” as those used “directly and primarily in research and development, in the experimental or laboratory sense, of new products, new uses for existing products, or improvement of existing products”. A critical administrative hurdle introduced in this guidance is the “50% Test.” For a machine to qualify for the exemption, more than 50% of its total use must be devoted to direct R&D. This demonstrates that South Carolina revenue officials require a “primary” commitment to the permitted purpose of innovation; indirect or administrative uses (such as using an R&D computer for billing or general management) are counted as “non-qualifying uses”.
Job Tax Credit and the Definition of an R&D Facility
South Carolina offers a Job Tax Credit for companies that create new full-time jobs at a “research and development facility”. According to SCDOR Revenue Ruling # income-tax-job-tax-credit-computation, to be considered an R&D facility, the establishment must be primarily engaged in activities that satisfy the technical definitions found in the state’s economic development statutes.
This creates a synergistic relationship between the incentives: if a company’s employees are performing work that meets the Permitted Purpose Test for the R&D credit, the company is also likely building the justification for enhanced Job Tax Credits. However, the SCDOR clarifies that these designations are not automatic; for example, “corporate office facilities” must have specific managerial and technical functions present to qualify for separate headquarters credits, and research-related functions must be carefully distinguished from routine administrative support.
Form TC-18 and Administrative Reporting
The mechanism for claiming the credit is South Carolina Schedule TC-18, “Research Expenses Credit”. The instructions for this form emphasize that the credit is nonrefundable and subject to a 50% liability limit.
| Line Item | Description | Legislative Intent |
|---|---|---|
| Line 1 | Qualified research expenses made in South Carolina. | Establishes the geographic nexus requirement. |
| Line 2 | Multiply Line 1 by 5%. | The statutory rate of the state incentive. |
| Line 3 | Research expenses credit carried forward. | Allows for a 10-year utilization period. |
| Line 6 | Total of all other credits. | Implements the “Ordering Rule” where the R&D credit is applied last. |
| Line 9 | 50% of remaining tax liability. | The maximum allowable reduction in state tax. |
The SCDOR requires that taxpayers maintain detailed records to substantiate that the expenses listed on Line 1 were indeed incurred for a “permitted purpose”. This includes project-level accounting and technical descriptions that align with the four metrics of functionality, performance, reliability, or quality.
The Financial Mechanics of the Credit in South Carolina
The South Carolina credit is simpler than the federal credit in its basic calculation but more restrictive in its application.
Calculation of the South Carolina Credit Amount
Unlike the federal Regular Research Credit, which is 20% of expenses above a historical “base amount,” the South Carolina credit is a flat 5% of all qualified research expenses conducted in the state for that year. There is no “base period” calculation for the standard state credit, which makes it particularly valuable for South Carolina companies that are maintaining a steady level of R&D rather than experiencing rapid year-over-year growth.
The mathematical representation is:
CreditSC = ∑(QRESC) × 0.05
Where QRESC includes wages, supplies, 65% of contract research, and computer rental costs.
The 50% Liability Limitation and Ordering Rules
The most critical restriction on the South Carolina R&D credit is the 50% liability cap. Under S.C. Code §12-6-3415(B), the credit taken in any single year cannot exceed 50% of the taxpayer’s remaining tax liability after all other credits have been applied.
This creates an “ordering” effect: because the R&D credit is capped based on the remaining liability, it is effectively the last credit to be used. If a South Carolina manufacturer has multiple credits (e.g., Jobs Tax Credit, Investment Tax Credit, and R&D Credit), they must first reduce their liability with the other credits before calculating the 50% ceiling for the R&D credit. Any amount that exceeds this 50% cap cannot be used in the current year but may be carried forward for up to 10 years.
Case Law Analysis: Phoenix Design Group and Documentation Standards
The 2024 U.S. Tax Court decision in Phoenix Design Group, Inc. v. Commissioner (T.C. Memo 2024-113) serves as a vital cautionary tale for South Carolina taxpayers regarding the documentation of the Permitted Purpose and Experimentation tests. While South Carolina has its own Administrative Law Court (ALC), the state’s conformity to federal rules means that U.S. Tax Court decisions on IRC §41 are effectively binding on how the SCDOR will interpret state-level claims.
The Failure of “Routine Engineering”
In Phoenix Design, an engineering firm claimed R&D credits for several mechanical, electrical, plumbing, and fire protection (MEPF) system designs. The IRS and the taxpayer stipulated that the activities met the Permitted Purpose Test—meaning the court accepted that the firm intended to improve the functionality and performance of building systems. However, the court disallowed the credits because the firm failed the “Process of Experimentation” and “Section 174 (Uncertainty)” tests.
The court found that the firm’s work consisted primarily of “routine engineering” and “standard calculations”. The firm used existing industry data and standard computer-aided design (CAD) software to reach its results. The court famously held that “performing calculations on available data is not an investigative activity because the taxpayer already had all the information necessary to address that uncertainty”. For example, determining the size of an air duct based on standard airflow requirements was a routine task, not an experimental one, even if it served the “permitted purpose” of improving system performance.
Implications for South Carolina Audits
For a South Carolina business, the Phoenix Design ruling emphasizes that meeting the Permitted Purpose Test is only the first hurdle. To successfully claim the credit, the taxpayer must prove that achieving that permitted purpose required a “process of experimentation”. The SCDOR will look for:
- Iterative Testing: Documentation of multiple alternatives being evaluated.
- Hypothesis and Failure: Evidence that the initial design or method was uncertain and that the solution was not immediately apparent to an engineer in the field.
- Contemporaneous Records: Lab notes, test logs, and design change orders created at the time the research was performed, rather than summaries created years later for a tax study.
The Funded Research Exclusion in South Carolina
Another significant legal hurdle for the Permitted Purpose Test is the exclusion for “funded research”. Under IRC §41(d)(4)(H), research is not qualified if it is “funded by any grant, contract, or otherwise by another person”.
The Economic Risk Requirement
For a South Carolina company to claim the credit, it must bear the “economic risk” of the research. If a client pays a South Carolina engineering firm to develop a new part, and that payment is guaranteed regardless of whether the part actually works, the research is considered “funded” by the client. In this scenario, the client may be eligible for the credit, but the engineering firm is not.
In the case of Moore v. Commissioner, the court denied R&D credits because the firm was paid to deliver “design services” rather than being paid based on the success of the research. For South Carolina contractors, this means that their contracts must be structured such that payment is contingent on the research achieving its permitted purpose. Furthermore, the taxpayer must retain “substantial rights” to the research results; if the contract transfers all intellectual property and rights to the client without the taxpayer retaining at least a non-exclusive license, the research is disqualified.
Comprehensive Example: Manufacturing Innovation in South Carolina
To illustrate the practical application of the Permitted Purpose Test and the associated SCDOR guidance, consider “Coastal Composites,” a hypothetical manufacturer of sustainable packaging based in Spartanburg, South Carolina.
The Project: Bio-Based Barrier Film Development
Coastal Composites intends to replace traditional plastic films with a new bio-degradable composite derived from agricultural waste.
- Permitted Purpose: The objective is to improve the “Quality” and “Performance” of the packaging by achieving the same moisture barrier properties as plastic while ensuring it is fully compostable.
- Technical Uncertainty: At the outset, it is unknown whether the bio-material can withstand the heat of high-speed extrusion lines without degrading (Section 174 Test).
- Process of Experimentation: The engineering team conducts three rounds of trials using different resin formulations and extruder temperatures, documenting the failures of the first two rounds (Experimentation Test).
- Technological in Nature: The research fundamentally relies on polymer chemistry and material science.
Identification of South Carolina QREs
Coastal Composites incurs the following costs at its Spartanburg facility:
| Expense Category | Amount | Reasoning |
|---|---|---|
| Wages | $250,000 | Salaries for process engineers running the extrusion trials and chemical technicians testing barrier properties. |
| Supplies | $75,000 | Raw bio-resins and additives consumed during the three rounds of pilot production. |
| Contract Research | $50,000 | Payments to a material science lab in Greenville for tensile strength and moisture-permeability testing. |
Total South Carolina QREs:
QRESC = $250,000 + $75,000 + (0.65 × $50,000) = $357,500
Calculation of the State Tax Credit
Coastal Composites calculates its potential credit on Form TC-18:
CreditSC = $357,500 × 0.05 = $17,875
Applying SCDOR Liability Limits
Assume Coastal Composites has a total state income tax and license fee liability of $40,000. It also claims a small business Job Tax Credit of $10,000.
- Total Liability: $40,000
- Less Other Credits: $10,000 (Job Tax Credit)
- Remaining Liability: $30,000
- 50% Limitation: $30,000 × 0.50 = $15,000
Final Result: Coastal Composites can use $15,000 of its R&D credit in the current year. The remaining $2,875 is carried forward to the following year, where it will again be subject to the 50% limit.
Broader Economic and Legislative Implications
The Permitted Purpose Test and the R&D credit are vital components of South Carolina’s “Economic Impact Zone” strategy. The state uses these incentives to attract capital-intensive industries that will create high-wage jobs and invest in long-term infrastructure.
Interaction with the Investment Tax Credit
South Carolina also offers an Investment Tax Credit under S.C. Code §12-14-60 for manufacturing and productive equipment. In a recent 2025 appellate court decision, the court overruled the SCDOR’s attempt to impose a “lifetime cap” on this credit, holding that the statutory limit of $5 million applies annually.
This is highly relevant for R&D-intensive companies: if they are purchasing advanced equipment for their research labs (such as 3D printers or spectroscopic sensors), they may be eligible for both the Investment Tax Credit for the equipment purchase and the R&D Tax Credit for the labor and materials used in the research performed with that equipment. However, the SCDOR’s “anti-overlap” rules may require a taxpayer to choose between certain credits for the same underlying costs, making a “Permitted Purpose” analysis essential for determining which incentive provides the highest net present value.
Future Outlook: Amortization and Federal Conformity
One of the most significant risks to the value of the R&D credit in South Carolina is the change in IRC Section 174. Since 2022, companies can no longer immediately deduct their R&D expenses for federal purposes; instead, they must capitalize and amortize them over five years. Because South Carolina’s income tax is based on federal taxable income, this change automatically increased the state tax burden for South Carolina innovators.
However, the 2025 “One Big Beautiful Bill Act” (OBBBA) and other legislative proposals aim to reinstate immediate expensing. If these federal changes are finalized, South Carolina’s rolling conformity will likely restore the immediate deduction for state purposes, significantly increasing the cash flow benefits for local firms performing research with a qualified permitted purpose.
Final Thoughts and Strategic Recommendations
The Permitted Purpose Test is more than a technicality; it is the qualitative soul of the South Carolina R&D credit regime. By tethering state tax benefits to the metrics of functionality, performance, reliability, and quality, the law ensures that South Carolina remains a competitive landscape for high-value engineering and scientific discovery. For taxpayers, the “simple meaning” of the test—improving a product or process—belies a complex administrative requirement for project-level documentation, geographic tracking of expenses, and a clear distinction between routine engineering and experimental innovation.
To maximize the benefits of the credit while minimizing audit risk, South Carolina businesses should:
- Adopt a Business Component Framework: Identify and document each product or process as a distinct business component and apply the “shrinking-back” rule where necessary.
- Focus on Intent and Metrics: Ensure that project documentation explicitly states which of the four functional metrics (Functionality, Performance, Reliability, or Quality) the research is intended to improve.
- Maintain Audit-Ready Evidence: Preserve lab notebooks, CAD versions, and test results that show an iterative process of experimentation and the resolution of technical uncertainty.
- Structure Contracts for Risk: For those engaged in contract research, ensure that legal agreements reflect the taxpayer’s economic risk and ownership of the research results to avoid the “funded research” exclusion.
As South Carolina continues to conform to federal standards, the integration of the Permitted Purpose Test with other state incentives—such as machine exemptions and Job Tax Credits—will remain a powerful, albeit complex, tool for fueling the state’s next wave of economic growth.
