Funded Research (Exclusion)

The funded research exclusion refers to the statutory disqualification of research expenditures from tax credit eligibility when those activities are financed by a third party who assumes the financial risk or retains primary ownership of the results. In the context of the South Carolina Research and Development tax credit, this exclusion ensures that the five percent state incentive is reserved solely for taxpayers who deploy their own capital into uncertain technological endeavors where they bear the economic loss of failure.

The South Carolina Research and Development (R&D) tax credit serves as a cornerstone of the state’s efforts to cultivate a knowledge-based economy, providing a significant financial incentive for businesses to engage in high-level technological innovation within the state’s borders. Governed primarily by South Carolina Code Section 12-6-3415, the credit is explicitly designed to piggyback on the federal research credit established under Section 41 of the Internal Revenue Code (IRC). This statutory structure creates a seamless, albeit complex, integration between state and federal law, where the definitions and exclusions established at the federal level are imported directly into the South Carolina tax code. Central to this integration is the funded research exclusion, a mandate derived from IRC Section 41(d)(4)(H), which prevents a taxpayer from claiming a credit for research to the extent that it is funded by any grant, contract, or otherwise by another person or governmental entity. The underlying policy objective is the prevention of double-dipping—ensuring that the public does not subsidize a private entity for work that is already being paid for by another source—and the preservation of the credit as an incentive for genuine private-sector risk-taking.

Statutory Foundations and the South Carolina Alignment with Federal Standards

The legal architecture of the South Carolina R&D credit is defined by its mirroring of federal qualified research expenditures (QREs). Under S.C. Code Section 12-6-3415(A), a taxpayer that claims a federal income tax credit pursuant to Section 41 of the Internal Revenue Code for increasing research activities for the taxable year is allowed a state credit. This credit is equal to five percent of the taxpayer’s qualified research expenses made in South Carolina during the tax year. The statute explicitly mandates that qualified research expenses shall have the same meaning as provided for in Section 41 of the Internal Revenue Code, effectively making the federal definition of what constitutes a qualified activity the absolute standard for South Carolina. Consequently, the various exclusions found in federal law, specifically the exclusion for funded research under IRC Section 41(d)(4)(H), are not merely persuasive; they are mandatory components of the state’s tax regime.

The South Carolina Department of Revenue (SCDOR) administers this credit with a focus on in-state innovation. For an expense to be eligible for the five percent credit, it must not only meet the federal definition of a QRE but must also be attributed to in-state research. This geographical limitation distinguishes the state credit from its federal counterpart and requires a meticulous allocation of costs, particularly for businesses that operate in multiple jurisdictions. The credit is nonrefundable and is used to offset corporate income tax, corporate license fees, and individual income tax liabilities under Chapter 6 of the South Carolina Code. Furthermore, the credit is limited to 50% of the taxpayer’s remaining tax liability after all other credits have been applied, with any unused portion eligible for a ten-year carryforward period.

Statutory Feature	South Carolina Provision (S.C. Code § 12-6-3415)	Federal Provision (IRC § 41)
Credit Rate	5% of Qualified Research Expenses (QREs)	20% of QREs over Base (Regular) or 14% (ASC)
Expense Definition	Explicitly adopts IRC § 41(b) definitions	Defined in IRC § 41(b) and (d)
Location of Research	Must be conducted within South Carolina	Must be conducted within the United States
Primary Exclusions	Adopts IRC § 41(d)(4) including “Funded Research”	IRC § 41(d)(4) enumerates specific exclusions
Application Limit	50% of tax liability after other credits	Subject to general business credit limitations
Carryforward	10 taxable years	20 taxable years

The Doctrine of Funded Research and the Two-Pronged Evaluation

The concept of funded research is perhaps one of the most litigated and technically demanding aspects of the R&D tax credit. The federal statute and its corresponding Treasury Regulations establish that research is considered funded—and therefore excluded from the credit—unless the taxpayer can demonstrate that they meet a two-pronged test regarding the financial risk of the project and the retention of substantial rights to the results. South Carolina, by virtue of its statutory link to the IRC, follows this two-pronged analysis with exacting rigor.

The Financial Risk Standard (The “Risk of Loss” Test)

The first prong of the analysis, the financial risk standard, focuses on the economic reality of the payment structure between the researcher and the third-party funder. Under Treasury Regulation Section 1.41-4A(d), research is considered funded if the taxpayer’s right to payment is not contingent on the success of the research. If a researcher is guaranteed payment regardless of whether the technical uncertainty is resolved, or if the research is a failure, the researcher is not at economic risk. In such instances, the third party is effectively the one funding the research, and the credit belongs to the payor, not the performing taxpayer.

The analysis of financial risk often centers on the type of contract governing the relationship. Fixed-price contracts are frequently viewed as carrying inherent risk for the contractor because the contractor is obligated to deliver a successful result for a set fee; if the research fails or costs more than anticipated, the contractor absorbs the loss. Conversely, cost-plus contracts are generally treated as funded research because the payor reimburses the contractor for all expenses plus a fee, shielding the contractor from the financial consequences of a technical failure. However, recent federal case law, such as Meyer, Borgman & Johnson, Inc. v. Commissioner and United States v. Grigsby, has clarified that the label of a contract as fixed-price is not a safe harbor. Courts and revenue agencies look past the labels to inspection and acceptance clauses. If a client has the right to reject a deliverable and withhold payment based on a failure to resolve a technical uncertainty, the risk is deemed to remain with the researcher.

The Substantial Rights Standard

The second prong of the funded research exclusion is the substantial rights standard. Even if a taxpayer bears the entire financial risk of a project, the research is still considered funded if the taxpayer does not retain substantial rights in the research results. A taxpayer retains substantial rights if they have the right to use the research results in their own trade or business without paying a fee to the other person.

It is a common misconception that a taxpayer must retain exclusive rights to the research to qualify for the credit. Federal interpretations, which are applied in South Carolina audits, clarify that the right to use the research results, even if shared with the funding party, constitutes a substantial right. For example, in Lockheed Martin Corp. v. United States, the court ruled that the contractor retained substantial rights because it could use the technological advancements developed under government contracts in its commercial operations, even though the government also held rights to the technology. However, if a contract mandates that all work product, including patents, copyrights, and know-how, becomes the sole and exclusive property of the funder, the researcher is deemed to have transferred away their substantial rights, rendering the research funded and the expenses ineligible for the state R&D credit.

SCDOR Administrative Guidance and Compliance Requirements

The South Carolina Department of Revenue provides guidance on the R&D tax credit through its tax forms, instructions, and occasional policy documents. The primary vehicle for claiming the credit is South Carolina Schedule TC-18, “Research Expenses Credit”. The instructions for this form reinforce the requirement that a taxpayer must be claiming the federal R&D credit under IRC Section 41 for the same taxable year to be eligible for the South Carolina credit.

Documentation and the Burden of Proof

Taxpayers in South Carolina bear the burden of proving that their research is not funded. SCDOR emphasizes that businesses must maintain detailed documentation for audit compliance purposes, pertaining to the underlying R&D activities and the associated QREs. In the context of the funded research exclusion, this documentation must move beyond simple wage and supply ledgers and include:

• Signed Contracts and Agreements: Taxpayers must be prepared to provide the full text of contracts with customers or government entities to allow auditors to evaluate the “risk of loss” and “ownership of rights” provisions.
• Project Deliverables and Technical Reports: To demonstrate that payment was contingent on “success,” taxpayers should maintain records of milestone completions, test failures, and eventual technical resolutions.
• IP Registrations and Licenses: Documentation showing that the taxpayer has retained the right to use the results—such as internal-use software licenses or subsequent patent applications—is critical for satisfying the substantial rights prong.

The SCDOR’s stance on documentation is increasingly rigorous, as evidenced by recent litigation in the state. For instance, the Kyocera AVX Components Corp. case in the US Tax Court and South Carolina District Court highlights how a lack of adequate time-tracking and project-level documentation can lead to the total disallowance of credits, even for large, established technology firms. The government’s position has become increasingly hardline, asserting that the failure to create or retain the documents required to substantiate entitlement to the credit is a sufficient ground for denial.

The Impact of Recent Legislative Changes (H.B. 4087)

The landscape of South Carolina’s R&D incentives was significantly altered by the passage of House Bill 4087 (2024), which revamped several key credits. Notably, the bill amended Section 12-6-3410, the corporate headquarters credit. Under the prior version of the law, jobs with research and development related functions could be counted toward the job creation requirements for the lucrative headquarters tax credit. H.B. 4087 explicitly ends the application of the corporate headquarters tax credit to research and development facilities and removes all language that allowed for jobs with R&D related functions and services to meet the qualification criteria.

This change has profound implications for South Carolina businesses. It effectively decouples R&D activities from the management-focused headquarters credit, forcing businesses to rely solely on the R&D tax credit under Section 12-6-3415 for their innovation-related expenditures. Furthermore, this legislative shift signals a sharpening of the state’s tax policy, where different activities are now strictly categorized, making the funded research analysis even more critical, as businesses can no longer repackage R&D jobs as headquarters staff if the underlying research fails the funded exclusion test.

Jurisprudential Interpretations and Causal Relationships

Because South Carolina law explicitly adopts federal IRC Section 41, federal case law serves as the primary source of interpretative authority for the state’s revenue officers and administrative law judges. The evolution of the funded research doctrine over the last three decades demonstrates a clear trend toward increasing complexity and rigorous scrutiny of contract language.

The “Risk of Loss” Precedents

The causal relationship between a taxpayer’s financial commitment and their credit eligibility was most clearly established in Fairchild Industries, Inc. v. United States. In this case, the Federal Circuit reversed a lower court’s decision, finding that the sole inquiry in evaluating financial risk is who bears the research costs upon failure. This decision established the contingency rule: if a contractor must fix defects at their own expense, they are at risk.

This principle was further refined in Geosyntec Consultants v. United States (2013). The court analyzed different types of contracts and made a pivotal distinction between firm fixed-price and capped contracts. The court agreed that firm fixed-price contracts are inherently risky because unsuccessful performance must be remedied without additional compensation. However, capped contracts—where a taxpayer is reimbursed for predefined tasks at predefined rates up to a maximum—were deemed funded because the client was still paying for the effort rather than the result. This distinction creates a significant ripple effect for South Carolina professional services firms (such as engineering or architecture firms) that often work under not-to-exceed budgets; these arrangements are likely to be flagged as funded research by state auditors unless they contain explicit performance-based contingency clauses.

The Rights Retention Paradox

Recent cases like Perficient Inc. v. Commissioner (2022) and Grigsby (2022) highlight the substantial rights prong as a major point of contention. In Perficient, the taxpayer challenged the validity of the substantial rights standard itself, arguing that Congress did not intend to include a rights-retention requirement in the definition of funded. The IRS, however, maintained that skills, advancements, and know-how developed during a contract are merely incidental benefits rather than substantial rights. For South Carolina software and information technology firms, this interpretation means that the mere fact that their developers learned something new while building a system for a client does not satisfy the law; the firm must retain a legal right to use the underlying code or methodologies in future projects without needing client permission.

Case Name	Outcome Category	Key Implication for South Carolina Taxpayers
Fairchild Industries	Pro-Taxpayer (Risk)	Established that fixed-price contracts with progress payments carry risk.
Lockheed Martin	Pro-Taxpayer (Rights)	Confirmed that “right to use” is a substantial right; exclusivity is not required.
Geosyntec	Split (Risk)	Capped/hourly contracts are funded; firm fixed-price are generally not.
Grigsby	Pro-Government (Rights)	Transfer of all “work product” title to a client constitutes funded research.
MBJ, Inc. v. Comm.	Pro-Government (Risk)	Routine engineering services without explicit contingency are funded research.
Smith v. Comm.	Pro-Taxpayer (Risk)	Design milestones may be sufficient to establish risk in architectural services.

Quantitative Example and Calculation Methodology

To illustrate the application of these principles in a South Carolina-specific context, consider the following hypothetical scenario involving an aerospace manufacturing company based in North Charleston.

Hypothetical Scenario: Palmetto Aerospace Solutions (PAS)

Palmetto Aerospace Solutions (PAS) is engaged in the development of lightweight composite materials for use in unmanned aerial vehicles (UAVs). In the 2024 tax year, PAS has three primary projects conducted entirely within South Carolina.

1. Project Alpha (Internal R&D): PAS spends $500,000 developing a proprietary resin-infusion process. This is self-funded.
2. Project Beta (Defense Subcontract): PAS enters into a “firm fixed-price” contract with a prime contractor to develop a specialized UAV wing. PAS is paid $1,000,000 only upon successful delivery. If the wing fails weight-limit tests, PAS must redesign it at its own cost. PAS retains the right to use the composite findings in its other commercial projects.
3. Project Gamma (University Research Grant): PAS receives a $200,000 grant from a state university to study certain heat-resistant alloys. The university owns all the research findings, and PAS is paid for its time and materials.

Step 1: Identification of Funded Research (Exclusions)

• Project Alpha: Not funded. Eligible for credit.
• Project Beta: Not funded. Although it is a contract for another person, PAS bears the financial risk (fixed-price with success contingency) and retains substantial rights (right to use in other projects).
• Project Gamma: Funded Research (Excluded). PAS does not bear the financial risk (paid for time/materials) and does not retain substantial rights (university owns findings).

Step 2: Calculation of South Carolina QREs

Assume PAS incurred the following expenses for the eligible projects (Alpha and Beta) within South Carolina:

Expense Category	Project Alpha (Self-Funded)	Project Beta (Qualified Contract)	Total QREs
South Carolina Wages	$300,000	$400,000	$700,000
South Carolina Supplies	$100,000	$200,000	$300,000
Contract Research (SC)	$0	$100,000 (at 65%)	$65,000
Project Totals	$400,000	$665,000	$1,065,000

Step 3: Application of the South Carolina Credit

1. Calculate Pre-Limitation Credit: $1,065,000 x 0.05 = $53,250
2. Apply Tax Liability Limit: If PAS has a South Carolina tax liability of $100,000 after all other credits:
   • Maximum allowable credit = $100,000 x 0.50 = $50,000.
3. Current Year Credit Used: $50,000.
4. Carryforward: $3,250 (Eligible for use for the next 10 years).

Theoretical Implications and Future Outlook

The funded research exclusion acts as a critical filter that separates service providers from technological innovators. As South Carolina continues to attract global manufacturers—particularly in the automotive and aerospace sectors—the interaction between contracted research and the state credit will become increasingly complex. The trend toward as-a-service models in software and engineering suggests that more research activities will be performed under contract rather as pure internal R&D.

The Role of Intragroup Payments

For controlled groups of corporations (parent-subsidiary or brother-sister structures), the funded research exclusion is applied in a unique manner. Under IRC Section 41(f) and Treasury Regulation Section 1.41-6, related entities are treated as a single taxpayer. Consequently, payments between members of a controlled group for research are generally disregarded; the entity performing the research claims the in-house QREs (wages and supplies), and the payor does not claim contract research expenses. For South Carolina businesses with out-of-state parents, this means that if a South Carolina subsidiary is paid by its North Carolina parent to perform R&D, the South Carolina subsidiary can claim the state credit on its own in-house expenses, as the funding is disregarded within the group context, provided the group as a whole meets the risk and rights tests.

Interaction with Section 174 Amortization

A significant emerging issue is the interaction between the R&D credit and the mandatory capitalization rules under IRC Section 174. Since 2022, research expenditures must be amortized over five years for domestic research and fifteen years for foreign research. While the Section 41 credit remains available, the requirement to capitalize these costs for federal income tax purposes creates a significant divergence in how funded research is handled for deductions versus credits. In South Carolina, where corporate income is generally determined based on federal taxable income, these amortization rules will directly affect a company’s cash flow, making the 5% R&D credit even more valuable as a source of immediate tax relief.

Synthesis and Actionable Conclusions

The South Carolina Research and Development Tax Credit offers a robust incentive for companies to anchor their technological development within the state, but the funded research exclusion serves as a significant roadblock for the unwary. The causal relationship between contract drafting and credit eligibility cannot be overstated: the presence of a single work for hire clause or the absence of an acceptance milestone can result in the loss of hundreds of thousands of dollars in state tax benefits.

For professional peers and tax practitioners, the following conclusions emerge from the data:

1. Contractual Dominance: The legal language of the agreement governing the research activity is the primary determinant of funding status. Taxpayers must move beyond accounting labels and ensure that their contracts explicitly allocate technical risk to the performing party and secure a “right to use” license for all technological findings.
2. SCDOR Rigor: The South Carolina Department of Revenue is increasingly focused on documentation. The lessons from the Kyocera litigation suggest that contemporaneously maintained time-tracking and project logs are the only effective defense against an audit challenge on the funded research exclusion.
3. Legislative Pivot: The enactment of H.B. 4087 marks the end of an era where R&D and headquarters functions were conflated. Businesses must now ensure their R&D operations are substantiated as a discrete business component under Section 12-6-3415 to avoid the loss of benefits previously available under the headquarters credit.
4. Strategic Alignment: The most successful credit claims in South Carolina are those that demonstrate a clear nexus between the expense incurred, the technical uncertainty addressed, and the financial risk borne by the taxpayer. By aligning their business practices with these three pillars, South Carolina companies can effectively navigate the funded research exclusion and maximize their innovation-related tax savings.

This analysis underscores that the South Carolina R&D credit is a tool for those who genuinely invest in the state’s technological future. By understanding the nuanced mechanics of the funded research exclusion, businesses can ensure that their commitment to innovation is met with the full measure of support provided by the state’s tax laws.

Final Thoughts