Contract Research Expenses (IRC § 41)

Contract research expenses refer to the statutory portion of payments made to third parties for performing qualified research activities where the taxpayer retains substantial rights and bears the economic risk. In South Carolina, these expenses qualify for a five percent credit against state income tax and license fees, provided the research is conducted within the state’s borders.

The conceptualization of contract research expenses within the South Carolina tax code is a sophisticated integration of state-level economic policy and federal compliance requirements. While the federal government utilizes the research credit primarily as a tool for national technological advancement, South Carolina employs it as a targeted incentive designed to anchor high-value technical activities within its jurisdiction. Consequently, the eligibility of a contract research expense in South Carolina is predicated on a dual-track validation: it must first satisfy the rigorous requirements of Internal Revenue Code (IRC) Section 41(d) at the federal level, and it must subsequently satisfy the geographical nexus of being conducted within South Carolina to qualify for the state-level credit.

The Statutory Architecture of Contract Research Expenses

To comprehend the meaning of contract research expenses (CRE), one must first look to the federal definition, as South Carolina expressly adopts this meaning through S.C. Code Section 12-6-3415(A). Under IRC Section 41(b)(3), contract research expenses are defined as 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research. This thirty-five percent reduction, often referred to as the “haircut,” is a legislative mechanism designed to isolate the actual research costs from the contractor’s embedded profit margins, administrative overhead, and other non-qualifying expenses that are typically bundled into a third-party contract price.

The federal framework provides for varying inclusion percentages based on the nature of the research performer and the type of research being conducted. These nuances are critical for South Carolina taxpayers who may be collaborating with local universities or participating in energy-related research initiatives.

A “qualified research consortium” is strictly defined as a tax-exempt organization under Section 501(c)(3) or 501(c)(6) that is organized and operated primarily to conduct scientific research and is not a private foundation. For a South Carolina taxpayer, ensuring that a contractor meets these specific federal criteria is a prerequisite for claiming the enhanced 75% inclusion rate on their state tax return.

South Carolina’s Adoption of Federal Standards and the Conformity Principle

South Carolina’s tax system is built upon the principle of federal conformity. S.C. Code Section 12-6-40 provides that the state’s income tax laws conform to the Internal Revenue Code of 1986, as amended through a specific date—currently December 31, 2024—subject to certain modifications listed in Section 12-6-50. This conformity simplifies the filing process by adopting federal taxable income as the starting point for state tax determinations and ensures that the definitions of complex tax concepts, such as “qualified research,” remain consistent across both jurisdictions.

Section 12-6-3415 of the South Carolina Code of Laws establishes the Research Expenses Credit. It mandates that a taxpayer must claim a federal income tax credit pursuant to Section 41 for the same taxable year to be eligible for the state credit. This dependency means that if the Internal Revenue Service (IRS) were to disallow a claim for contract research expenses on a federal audit, the South Carolina Department of Revenue (SCDOR) would likely follow suit, as the state statute explicitly states that qualified research expenses have the same meaning as provided in the IRC.

The Geographical Nexus: Research Conducted Within the State

The most significant divergence between the federal and state research credits lies in the geographical nexus. While the federal credit applies to research performed anywhere within the United States, the South Carolina credit is restricted to expenses “made in South Carolina”. For contract research, this creates a nuanced requirement: the taxpayer must prove that the third-party contractor physically performed the research activities within the borders of South Carolina.

If a South Carolina-based corporation hires a specialized engineering firm located in North Carolina to design a new prototype, the payments to that firm may qualify as CRE for the federal credit. However, they would be excluded from the South Carolina credit calculation because the technical activity occurred outside the state. This requires meticulous record-keeping, as taxpayers must often bifurcate their contract research ledger between in-state and out-of-state performers.

The “Funded Research” Doctrine and the Two-Pronged Test

For a payment to a third party to qualify as a contract research expense, the arrangement must not constitute “funded research.” Under Treas. Reg. Section 1.41-4A(d), research is considered funded if the taxpayer does not bear the economic risk of the research or if the taxpayer does not retain substantial rights to the research results.

Economic Risk: The Burden of Failure

The “economic risk” prong dictates that the entity claiming the credit must be the one with “something to lose”. In a contract research context, this means the taxpayer must be obligated to pay the contractor regardless of whether the research succeeds or fails. If a contract is structured such that payment is contingent upon the contractor achieving a specific technological milestone or successful outcome, the contractor is deemed to bear the risk. In such an instance, the contractor may be eligible to claim the research as in-house research, but the taxpayer cannot claim it as contract research.

South Carolina taxpayers often enter into fixed-price contracts. While a fixed-price contract can signal economic risk—because the taxpayer is paying a set amount for an uncertain outcome—the specific language of the contract is paramount. Courts and the SCDOR look for provisions that require payment for services rendered, even if the research objective is not met.

Substantial Rights: Ownership of Innovation

The “substantial rights” prong requires that the taxpayer retain a right to use the research results in their trade or business without paying a fee. It is a common misconception that the taxpayer must have exclusive rights to the research. Under federal regulations adopted by South Carolina, both the taxpayer and the contractor can share rights to the results. However, if the contractor retains all intellectual property and the taxpayer merely receives a limited license to a final product, the taxpayer has not retained substantial rights and the expense is disqualified.

The Fourth Circuit, which has jurisdiction over South Carolina, has historically scrutinized these rights through cases like Lewin v. Commissioner, emphasizing that the taxpayer must have a functional right to exploit the research in their business. For a contract research expense to be valid, the underlying agreement should explicitly state that the work product, inventions, and discoveries arising from the research belong to the taxpayer, or at minimum, that the taxpayer has an irrevocable, royalty-free right to use them.

Local State Revenue Office Guidance and Policy Manuals

The South Carolina Department of Revenue provides extensive guidance on the administration of tax credits through its policy manuals and advisory opinions. The South Carolina Tax Incentives for Economic Development (SCTIED) manual, specifically the 2025 edition, serves as the primary resource for understanding the SCDOR’s position on research credits.

SCDOR Advisory Opinions and Their Application

The SCDOR issues four types of advisory opinions: Revenue Rulings, Revenue Procedures, Private Letter Rulings, and Information Letters. These documents are intended to provide clarity when the law is not explicitly detailed or when taxpayers require specific guidance on a set of facts.

While there are few Revenue Rulings exclusively dedicated to the calculation of contract research expenses, RR #08-3 provides a critical definition of “research and development” in the context of sales and use tax for machines. It defines the activity as being “in the experimental or laboratory sense, of new products, new uses for existing products, or improvement of existing products”. This definition aligns perfectly with the federal IRC Section 174 definition, which is the “gatekeeper” for Section 41 research credits. By maintaining this consistency, the SCDOR ensures that if a technical activity qualifies for the federal credit, it likely satisfies the “qualified research” definition for state purposes.

The SCTIED-2025 Manual: Chapter 2, Section 17-20

The SCTIED manual clarifies that the Research Expenses Credit is a nonrefundable credit that can be applied against income tax (Chapter 6) and corporate license fees (Section 12-20-50). It reiterates that the credit amount is 5% of qualified research expenses made in South Carolina and that any unused credit may be carried forward for 10 years.

The manual also emphasizes the “ordering rules” for credits. Under South Carolina law, certain credits, like the Research Expenses Credit, are limited to the remaining tax liability after all other credits have been applied. This means that the R&D credit is effectively at the bottom of the “credit stack,” which can lead to larger carryforwards if a taxpayer is already using robust credits like the Jobs Tax Credit or the Headquarters Credit.

Calculation Mechanics and the 50% Liability Limitation

The South Carolina R&D credit is calculated differently than its federal counterpart. While the federal credit typically rewards an increase in research activities over a historical base amount, the South Carolina credit is a “flat” credit based on the total qualifying spend in the current year.

The 5% Calculation

The statutory formula for the credit is simple: SC Research Credit = South Carolina QREs × 0.05

Within the “South Carolina QREs” bucket, contract research expenses are included at the 65% rate. Therefore, if a company spends $1,000,000 on an eligible third-party contractor in South Carolina, the qualified expense is $650,000, and the resulting state credit is $32,500.

The 50% Liability Cap

Section 12-6-3415(B) imposes a strict limitation on the amount of credit that can be used in a single year. The credit taken may not exceed fifty percent of the taxpayer’s remaining tax liability after all other credits have been applied. This limitation ensures that taxpayers always pay at least some portion of their state tax liability (unless they have other credits that can offset the first 50%) and prevents the research credit from entirely wiping out corporate tax revenue in a single period.

Any unused portion of the credit can be carried forward for up to 10 years from the date the research expenses were incurred. It is important to note that the carryforward period is not extended for any year in which the taxpayer fails to meet other qualifying requirements, such as maintaining employment in the case of hybrid headquarters/research facilities.

Procedural Requirements: Claiming the Credit on Form TC-18

To claim the credit, a taxpayer must complete SC Schedule TC-18, “Research Expenses Credit,” and attach it to their South Carolina income tax return (e.g., SC1120 for corporations or SC1040 for individuals).

Form TC-18 Walkthrough

The form requires the taxpayer to calculate the credit before limitations and then apply the 50% cap based on their specific tax liability.

Electronic Filing and Record Keeping

SCDOR requires corporate taxpayers with a liability of $15,000 or more to file and pay electronically. Even if filing electronically, taxpayers must maintain a copy of their federal Form 6765 (Credit for Increasing Research Activities) and the supporting documentation for their contract research expenses, including contracts and proof of South Carolina location, for audit purposes.

Pass-Through Entities: S Corporations and Partnerships

For S corporations, partnerships, and limited liability companies (LLCs) treated as pass-through entities, the credit is earned at the entity level but used by the shareholders, partners, or members. The entity calculates the qualified research expenses and the resulting credit, which is then allocated to the owners via South Carolina Schedule K-1 based on their ownership share.

Individual taxpayers receiving a credit from a pass-through entity must enter the name and Federal Employer Identification Number (FEIN) of the entity on their TC-18 form. The 50% liability limitation applies at the individual level, meaning the credit can only offset 50% of the individual’s total South Carolina income tax liability remaining after other credits.

The Impact of Federal Section 174 Amortization

A significant development in the research tax landscape is the mandatory capitalization and amortization of research and experimental (R&E) expenditures under IRC Section 174, effective for tax years beginning after December 31, 2021. Previously, companies could immediately deduct 100% of these costs. Now, domestic R&E expenditures, including contract research, must be amortized over five years (fifteen years for foreign research).

Because South Carolina conforms to the IRC, this mandatory capitalization also applies for state income tax purposes. While this does not directly change the calculation of the research credit—which is based on the expenses incurred—it does impact the taxpayer’s overall taxable income and, consequently, their tax liability. This can affect the 50% liability limitation, as a higher taxable income (due to less immediate deductions) creates a higher tax liability, potentially allowing for greater utilization of the R&D credit in the current year.

Comprehensive Example: “Palmetto Innovators, Inc.”

To illustrate the interplay of these complex rules, consider the case of Palmetto Innovators, Inc., a manufacturing firm based in Spartanburg, South Carolina.

Technical Context

Palmetto Innovators is developing a revolutionary automated sorting system for agricultural products. To complete this project, they require specialized sensor calibration and fluid dynamic modeling.

Expense Profile for Tax Year 2024

1. In-House Research Wages: $400,000 for engineers working at the Spartanburg plant.
2. Research Supplies: $50,000 for sensor prototypes and wiring.
3. Contract Research (Performer A): Palmetto pays $200,000 to a research lab in Clemson, SC, for sensor testing. The contract is a fixed-fee arrangement, and Palmetto owns the resulting data.
4. Contract Research (Performer B): Palmetto pays $100,000 to a specialized modeling consultant in Boston, MA.
5. Contract Research (Performer C): Palmetto pays $50,000 to a local firm for routine inspection and quality control of existing systems.

Analysis of Eligibility

• In-House Wages and Supplies: These are 100% includable as QREs for both federal and state purposes because the activities and materials are in South Carolina.
• Contract Performer A: This meets the risk and rights tests (fixed fee, Palmetto ownership). It is includable at 65% for both federal and state credits because the lab is in South Carolina.
• Contract Performer B: This meets the federal definition of CRE (65% inclusion). However, because the consultant is in Massachusetts, the expense is excluded from the South Carolina credit calculation.
• Contract Performer C: This is disqualified for both credits. Routine quality control is an excluded activity under IRC Section 41(d)(4)(D).

Calculation of the South Carolina Credit

South Carolina Credit Earned: $580,000 × 0.05 = $29,000.

Application of Limitations

Palmetto Innovators has a 2024 South Carolina tax liability of $100,000. They are already claiming a New Jobs Credit of $60,000.

1. Tax Liability: $100,000
2. Less: New Jobs Credit: ($60,000)
3. Remaining Tax Liability: $40,000
4. 50% Limitation: $40,000 × 0.50 = $20,000.

Palmetto Innovators can use $20,000 of their Research Expenses Credit in 2024. The remaining $9,000 ($29,000 – $20,000) is recorded as a carryforward and can be used to offset tax in any of the next 10 years.

Audit Defense and Documentation Strategy

Due to the significant value of research credits, they are high-priority items for both IRS and SCDOR audits. Taxpayers claiming contract research expenses must be prepared to defend both the technical nature of the work and the contractual terms of the arrangement.

The “Four-Part Test” Documentation

Taxpayers must demonstrate that the third-party research met all four requirements of IRC Section 41(d):

1. Permitted Purpose: The research aimed to create a new or improved business component (product, process, or software).
2. Elimination of Uncertainty: There was a technical uncertainty at the outset regarding the capability, method, or design of the component.
3. Process of Experimentation: The contractor engaged in a systematic trial-and-error process (modeling, simulation, or testing) to resolve the uncertainty.
4. Technological in Nature: The research relied on principles of physical science, biological science, engineering, or computer science.

For contract research, the taxpayer should maintain a “Project Narrative” that links the contractor’s invoices to these specific four parts.

Contractual Evidence

To defend the “funded research” exclusion, the taxpayer must maintain:

• Original Signed Contracts: These must be dated prior to the research beginning.
• Statements of Work (SOW): Detailed descriptions of the technical milestones.
• Proof of Payment: Bank statements or cancelled checks showing the taxpayer bore the cost.
• Location Documentation: For the South Carolina credit, a letter from the contractor or a copy of the contractor’s utility bills/lease at the research site can provide the necessary proof of nexus.

Interaction with Other South Carolina Incentives

South Carolina is known for a “layered” approach to tax incentives. While the Research Expenses Credit is powerful, it is often used in conjunction with the Headquarters Credit and the Jobs Tax Credit.

The Headquarters Credit (§ 12-6-3410)

The Headquarters Credit allows a 20% credit against income taxes for real property and tangible personal property costs incurred in establishing or expanding a headquarters facility. If a company builds a new research and development headquarters in South Carolina, they may qualify for the 20% property credit under Section 3410 and the 5% research expense credit under Section 3415 for the ongoing operational costs (wages, supplies, and contract research) performed at that facility.

The Jobs Tax Credit (§ 12-6-3360)

Taxpayers operating a “research and development facility” are eligible for the Job Tax Credit if they create a minimum of 10 new, full-time jobs (or 2 for small businesses). The amount of the credit depends on the county’s tier ranking, ranging from $1,500 to $8,000 per job per year for five years.

When multiple credits are available, the ordering of their application is governed by the specific limitations of each statute. Because the Research Expenses Credit is limited by the remaining liability after other credits, it is usually the last credit to be applied. This structure encourages companies to use their job-based credits first, as they often have shorter carryforward periods than the 10-year period granted to the research credit.

Final Thoughts: Strategic Implications for South Carolina Taxpayers

Contract research expenses represent a vital component of the South Carolina Research Expenses Credit, allowing businesses to leverage external expertise while reducing their state tax burden. By strictly adhering to the federal 65% inclusion rule and focusing on in-state contractors, South Carolina firms can effectively subsidize their innovation pipelines.

The “meaning” of these expenses is ultimately found at the intersection of federal technical standards and state geographical requirements. To maximize the benefit, taxpayers must ensure their contracts are robustly drafted to maintain economic risk and substantial rights, and they must maintain a clear documentary trail identifying the physical location of all third-party research activities. As South Carolina continues to attract advanced manufacturing and technology firms, the Research Expenses Credit will remain a cornerstone of the state’s value proposition for innovative enterprises.