In-house Research Expenses (IRC § 41)

In-house research expenses encompass the direct costs of conducting experimentation—specifically employee wages, laboratory supplies, and computer leasing fees—within a taxpayer’s own business facilities. For South Carolina tax purposes, these expenses must be incurred for activities performed within the state to generate a nonrefundable credit corporate or individual tax liabilities.

The intersection of federal tax law and state-level incentives creates a complex regulatory environment for taxpayers engaged in innovation. At the federal level, Internal Revenue Code (IRC) Section 41 provides the structural definitions for what constitutes "qualified research expenses," a term that is bifurcated into in-house research expenses and contract research expenses. South Carolina, through Section 12-6-3415 of its Code of Laws, adopts these federal definitions while imposing its own geographic and administrative constraints. This report provides an exhaustive examination of the legal meaning of in-house research expenses, the administrative guidance provided by the South Carolina Department of Revenue (SCDOR), and the practical application of these rules within the state’s fiscal framework.

The Federal Foundation: Defining In-house Research Expenses Under IRC § 41

The primary source for defining research-related expenditures is found in the federal tax code, which South Carolina follows closely through its conformity statutes. Under IRC § 41(b)(2), in-house research expenses are specifically identified as the sum of three distinct cost categories: wages, supplies, and computer rental costs. To be considered "qualified," these expenses must be paid or incurred by the taxpayer during the taxable year in carrying on a trade or business.

The Statutory Components of In-house Research Expenses

The federal statute provides a rigorous framework for what may be included in the calculation of the credit. Taxpayers must navigate the definitions of "qualified services" and "qualified research" to substantiate these costs.

The first category, wages, is defined by referencing IRC § 3401(a), encompassing all remuneration for services performed by an employee for their employer, including the cash value of all remuneration paid in any medium other than cash. For purposes of the research credit, these wages must be tied to "qualified services," which include engaging in qualified research, or the direct supervision or direct support of research activities.

The second category involves supplies, which are defined as any tangible property other than land or improvements to land, and property subject to the allowance for depreciation. This exclusion of depreciable property is a common point of contention during audits, as taxpayers often attempt to include the cost of specialized equipment that has a useful life beyond a single year.

The third category, computer rental or leasing costs, has evolved significantly with the advent of cloud computing. Originally intended for time-sharing on mainframes, current regulations and informal guidance often allow for the inclusion of cloud hosting costs (e.g., AWS or Azure) when used for development environments, provided they are not for the right to use software but rather for the underlying computing power.

The Qualified Research Standard: The Four-Part Test

For any in-house expense to be "qualified," the underlying activity must meet the four-part test established by the federal government and adopted by South Carolina.

Section 174 Test: The expenditure must be eligible for treatment as a research and experimental cost under IRC Section 174. This requires that the costs be incurred in connection with the taxpayer's trade or business and represent research and development costs in the experimental or laboratory sense.

Technological Information Test: The research must be undertaken for the purpose of discovering information that is technological in nature. This means the process must fundamentally rely on the principles of physical or biological sciences, engineering, or computer science.

Business Component Test: The activity must be intended to be used to develop a new or improved business component of the taxpayer. A business component is defined as any product, process, computer software, technique, formula, or invention held for sale, lease, or license, or used by the taxpayer in its trade or business.

Process of Experimentation Test: Substantially all of the activities must constitute a process of experimentation relating to a new or improved function, performance, reliability, or quality. This involves a systematic evaluation of alternatives to achieve a result where the capability, method, or design is uncertain at the beginning of the research.

South Carolina Statutory Framework: S.C. Code Section 12-6-3415

The South Carolina Research Expenses Tax Credit is codified in S.C. Code Ann. § 12-6-3415. This statute provides a credit against state income taxes and corporate license fees for taxpayers who increase their investment in research within the state.

Geographic Sourcing and Nexus

Unlike the federal credit, which applies to research conducted anywhere within the United States, the South Carolina credit is strictly limited to "qualified research expenses made in South Carolina". This geographic limitation creates a sourcing challenge for taxpayers with multi-state operations. For in-house research expenses, this typically means the services must be performed by employees located in South Carolina, and the supplies must be consumed in South Carolina labs or facilities.

The nexus requirement for wages is generally determined by the physical location of the employee when the research services are performed. If an engineer performs 60% of their research in a Greenville, SC facility and 40% in a Charlotte, NC facility, only the 60% portion of their qualified wages may be included in the South Carolina credit calculation. Similarly, supply costs must be allocated based on where the research is conducted.

Conformity and Federal Claim Requirement

South Carolina law requires that a taxpayer must claim a federal income tax credit for research expenses under IRC § 41 to be eligible for the state-level credit. This "mirroring" effect ensures that the state benefit is only granted to activities that have met the rigorous federal standards for qualified research. However, while the definitions are mirrored, the calculation differs significantly.

The South Carolina credit is equal to 5% of the qualified research expenses incurred in the state. One of the most important distinctions between the federal and state credits is that South Carolina does not utilize a "base amount" or an incremental threshold to determine the credit earned for the current year. While some practitioners have historically suggested an incremental approach, the prevailing administrative practice and form instructions (Schedule TC-18) indicate that the 5% rate applies directly to total South Carolina QREs for the year.

Detailed Analysis of In-house Wage Expenditures

Wages usually constitute the largest portion of any R&D claim, often representing over 60-70% of total qualified expenditures. Under both IRC § 41 and S.C. Code § 12-6-3415, the documentation and substantiation of these wages are subject to intense scrutiny.

Qualified Services: Direct vs. Indirect

To include employee wages in the credit, the taxpayer must demonstrate that the employee was engaged in qualified services. The three tiers of qualified services are defined as follows:

Engaging in Qualified Research: This is the "hands-on" work of the scientist, engineer, or programmer. It includes activities such as lab testing, software coding for a new algorithm, or designing a mechanical prototype.

Direct Supervision: This involves the immediate management of those performing the research. A manager who reviews the technical progress of a lab team and provides technical guidance is likely performing qualified services. However, high-level corporate officers who only receive high-level reports or manage the budget for the R&D department do not qualify.

Direct Support: This category includes activities that facilitate the research process but do not constitute research themselves. Examples include a lab assistant cleaning specialized equipment, a machinist building a prototype designed by an engineer, or a clerk typing the data from an experimental log into a computer for analysis.

General and administrative services, such as payroll, human resources, or general legal work, are explicitly excluded from being qualified services.

The 80% Rule (Substantially All)

A taxpayer-friendly provision exists for employees who spend the vast majority of their time on research. Under Reg. § 1.41-2(d)(2), if "substantially all" of the services performed by an individual for the taxpayer during a taxable year consist of qualified services, then 100% of the wages paid to that employee are treated as in-house research expenses.

The "substantially all" threshold is defined by the IRS and SCDOR as 80%. This means that if an engineer spends 82% of their time designing a new engine and 18% of their time on general administrative meetings, all 100% of their salary qualifies. Conversely, if they only spend 75% of their time on research, only that 75% may be included in the calculation.

Substantiation and Case Law (Moore v. Commissioner)

The importance of documenting these wages cannot be overstated. In the recent Tax Court case Moore, T.C. Memo. 2023-20, the IRS successfully challenged an S corporation's research credit because the company failed to provide adequate documentation to substantiate the qualified services of its president and COO. The court emphasized that while estimates may sometimes be permitted, they are only acceptable after the taxpayer establishes that qualified research has actually occurred. This case highlights the need for contemporaneous time-tracking records or, at a minimum, detailed project-specific interviews and surveys that can tie wage expenditures to specific R&D milestones.

Supply Expenses in the Research Environment

Supplies qualify as in-house research expenses only if they are used in the conduct of qualified research. The statutory definition is essentially a negative one: supplies include any tangible property other than land, improvements to land, and depreciable property.

Exclusions and the Capital Asset Rule

The exclusion of depreciable property is a major hurdle for many businesses. If a manufacturer builds a testing rig that will be used for multiple projects over several years, that rig is a capital asset and its cost cannot be claimed as a supply expense. However, the raw materials used to build a one-time prototype that is destroyed during testing would typically qualify.

Common examples of qualifying supplies include:

• Chemicals and reagents used in laboratory experiments.
• Materials used for prototypes and models.
• Electronic components consumed during circuit design testing.
• Extraordinary utility costs.

The Extraordinary Utility Exception

Generally, utilities such as water, electricity, and natural gas are considered general and administrative expenses and are non-qualified. However, Treas. Reg. § 1.41-2(b)(2)(ii) provides a narrow exception for "extraordinary expenditures" for utilities. If a taxpayer can establish that the special character of their research required significant additional utility costs (e.g., massive power requirements for a specialized laser or high-volume water usage for a cooling system used in experimentation), those incremental costs can be treated as research supplies.

Computer Rentals and the Shift to Cloud Computing

The third category of in-house research expenses involves amounts paid for the right to use computers in the conduct of research. This provision was originally designed for the 1970s and 80s when companies would rent time on mainframe computers. In the modern era, this has been adapted to cover cloud computing services.

Cloud Infrastructure vs. Software-as-a-Service (SaaS)

There is a critical distinction between Infrastructure-as-a-Service (IaaS) and SaaS. Expenses for IaaS, such as renting virtual server space to run simulations or host development environments, are generally considered qualifying computer rental costs. However, payments for SaaS—such as a project management tool used by an R&D team or a general-purpose software license—do not qualify, as they are not payments for the right to use the computer, but rather for the use of a finished software application.

Under federal and South Carolina law, these costs must be carefully allocated. If a cloud server is used for both production (live customer hosting) and development (research), only the portion of the cost attributable to the research activity is qualified.

Local South Carolina Revenue Office Guidance

The South Carolina Department of Revenue (SCDOR) provides specific guidance through several administrative channels. While South Carolina is a "conformity" state, its administrative requirements for claiming credits are unique.

SCDOR Information Letter #07-16

This information letter provides a summary of major legislative changes that impacted the research credit. It clarified that the Research Expenses Credit can be used against any tax due under Chapter 6 (Income Tax) or against the corporate license fee based on capital stock and paid-in surplus under Code Section 12-20-50. This was a significant expansion, as it allowed companies that might not yet be profitable (and thus have no income tax liability) to still offset their mandatory license fees.

SCDOR Information Letter #24-16 and Legislative Updates

The SCDOR periodically issues "Tax Legislative Updates" (e.g., IL #24-16, IL #21-24) to keep taxpayers informed of changes to the code. These documents serve as a guide for compliance but do not have the same precedential value as a court decision or a Revenue Ruling. They emphasize that taxpayers should always refer to the full text of the legislation for specific requirements.

One recurring theme in SCDOR guidance is the "order of credits." South Carolina law dictates that the Research Expenses Credit is often applied after other credits have been taken, and its use is limited to 50% of the remaining tax liability after all other credits have been applied.

SCDOR Revenue Ruling #03-17

This ruling addressed technical corrections to Section 12-6-3415, ensuring the term "qualified research expense" was consistently defined according to IRC § 41. Prior to this correction, the statute had used varying terminology that caused confusion regarding whether certain types of expenditures were eligible.

Practical Application: Claiming the Credit on State Forms

The primary mechanism for claiming the South Carolina Research Expenses Credit is the filing of SC Schedule TC-18.

Completing Schedule TC-18

The form requires the taxpayer to detail their South Carolina research expenses and calculate the credit before limitations.

Taxpayers must attach Schedule TC-18 to their state income tax return (SC1120 for corporations or SC1040 for individuals/sole proprietors). If the taxpayer is a pass-through entity (S-Corp, LLC, Partnership), the credit is calculated at the entity level and then passed through to the shareholders, members, or partners based on their ownership share. These owners then claim their portion of the credit on their own Schedule TC-18.

Recordkeeping Requirements

The SCDOR requires that taxpayers keep detailed records to substantiate their claims. This includes payroll records, general ledger detail for supply purchases, and technical project documentation. Because the state credit relies on the federal claim, a federal audit that disallows certain expenses will automatically trigger an adjustments process at the state level.

Interaction with IRC Section 174 Amortization

A significant change occurred in federal law beginning on January 1, 2022, which has major implications for how research expenses are reported. Under the Tax Cuts and Jobs Act (TCJA), taxpayers are now required to capitalize and amortize Section 174 research and experimental (R&E) expenditures over five years (for domestic research) or 15 years (for foreign research).

Previously, these costs could be immediately expensed. While Section 41 (the credit) and Section 174 (the deduction/amortization) are distinct, they are linked because only Section 174 expenses can qualify for the Section 41 credit.

South Carolina generally follows the federal treatment of Section 174, meaning that taxpayers must capitalize and amortize their R&D costs for state income tax purposes as well. However, this change does not reduce the 5% credit available under Section 12-6-3415; it simply changes the timing of the tax deduction for the underlying expenses.

Interplay with Other South Carolina Tax Credits

South Carolina offers a suite of economic development incentives, and it is common for a taxpayer to qualify for more than one. However, the ordering and interaction of these credits are strictly regulated.

The New Jobs Credit (§ 12-6-3360)

The New Jobs Credit provides a credit for each new full-time job created in the state. A business that expands its R&D facility and hires 40 new engineers would likely qualify for both the Jobs Credit and the Research Expenses Credit. The SCDOR requires that credits be applied in a specific order, and the total amount of credits claimed in a year often cannot exceed 50% of the taxpayer's liability.

The Headquarters Credit (§ 12-6-3410)

The headquarters credit provides a 20% credit for real and personal property costs incurred in establishing or expanding a regional or national headquarters or research facility. To qualify, the facility must result in the creation of at least 40 new full-time jobs performing headquarters-related or R&D-related functions.

A critical point of distinction is that the Headquarters Credit applies to the capital investment in the building and equipment (tangible personal property), while the Research Expenses Credit applies to the operating costs (wages, supplies, cloud computing). Thus, these two credits complement each other without "double-dipping" into the same expenditures.

Comprehensive Example: Manufacturing and Software Development in Columbia, SC

To illustrate the mechanics of the South Carolina Research Expenses Tax Credit, consider the following scenario involving a hypothetical firm, "Carolina Innovations, Inc." (CII).

Background

CII is a manufacturer of medical devices with its primary research and production facility located in Columbia, South Carolina. In 2024, CII undertook a project to develop a new "smart" insulin pump that uses artificial intelligence to predict glucose levels.

The project involved:

Engineering: Developing the physical casing and mechanical components.

Software Development: Creating the AI algorithm and the mobile app interface.

Testing: Consuming materials in a laboratory setting.

Step 1: Identification of Qualified Research Expenses (QREs)

CII identifies the following costs associated with the project:

• Wages: CII employs ten engineers in South Carolina who spent 90% of their time on this project. Their combined Box 1 wages were $1,000,000.
• Supplies: CII purchased $200,000 worth of specialized polymers and sensors that were consumed during the prototype phase in the Columbia lab.
• Cloud Computing: CII paid AWS $100,000 for server time used to train the AI algorithm.
• Contract Research: CII paid an outside lab in North Carolina $100,000 to perform safety testing.

Step 2: Sourcing for South Carolina

CII must now determine which of these QREs are "South Carolina QREs" under § 12-6-3415.

• Wages: All ten engineers are located in Columbia. Since they spent >80% of their time on research, CII can include 100% of their wages ($1,000,000) as SC QREs under the "substantially all" rule.
• Supplies: The $200,000 in supplies was used in the Columbia facility. These are SC QREs.
• Cloud Computing: The engineers accessing the AWS cloud are in South Carolina. $100,000 is included as an SC in-house research expense.
• Contract Research: The North Carolina testing occurred outside of South Carolina. While CII can claim this for the federal credit (at 65%, or $65,000), it is excluded from the South Carolina credit because it was not "made in South Carolina".

Total South Carolina QREs = $1,000,000 + $200,000 + $100,000 = $1,300,000.

Step 3: Calculation of the State Credit

CII calculates its credit on Schedule TC-18:

Credit = $1,300,000 x 0.05 = $65,000

Step 4: Application and Limitation

Assume CII has a 2024 South Carolina income tax liability of $100,000 and a corporate license fee of $10,000 (Total = $110,000). CII also qualifies for a New Jobs Credit of $20,000.

Total Liability: $110,000.

Subtract other credits: $110,000 - $20,000 (Jobs Credit) = $90,000 remaining liability.

Calculate 50% Limitation: $90,000 x 0.50 = $45,000.

Determine Credit Used: CII can only use $45,000 of its $65,000 R&D credit this year.

Carryforward: CII carries forward the remaining $20,000 ($65,000 - $45,000) for up to 10 years.

Substantiation Strategy and Audit Considerations

Given the subjectivity of what constitutes "research," the SCDOR and IRS often focus on the nexus between spending and specific projects. Successful taxpayers adopt a project-based accounting approach.

Project-Based Accounting

Rather than simply providing a list of employees with an "R&D" tag in the HR system, a robust claim will be structured around specific technical objectives. Each project should have:

• A clear definition of the technical uncertainty being addressed.
• A description of the "alternatives" being evaluated (the process of experimentation).
• A ledger of all supplies and computer costs specifically incurred for that project.

Common Audit Pitfalls

Inclusion of Foreign Research: Taxpayers often forget that only South Carolina-based expenditures qualify for the 5% credit, even if federal law allows for U.S.-wide QREs.

Depreciable Equipment as Supplies: Including the cost of a new 3D printer as a supply is a common mistake; only the filament used in the printer is typically a qualifying supply.

Failure to Subtract Funded Research: If a taxpayer is conducting research under contract for another party (e.g., a government grant or a customer-funded project), those expenses must generally be subtracted from the QRE total, as the taxpayer is not "at risk" for the cost of the research.

Substantial All (80%) Over-Reliance: Claiming 100% of an executive's salary under the 80% rule without detailed time records for their "direct supervision" is frequently challenged.

Final Thoughts: Strategic Value of the In-house Research Credit

The South Carolina Research Expenses Credit represents a powerful tool for businesses that prioritize local innovation. By mirroring the federal IRC § 41 definitions, the state offers a predictable framework for taxpayers already navigating federal compliance requirements. The 5% non-incremental credit, while lower in rate than the federal benefit, provides a reliable incentive that applies to the first dollar of qualified spending, making it particularly valuable for companies with consistent R&D footprints that do not necessarily increase year-over-year.

Taxpayers must remain vigilant in their documentation, ensuring that every wage, supply, and computer rental dollar can be tied to a specific project meeting the four-part test and occurring within the geographic boundaries of South Carolina. As the state continues to recruit technology-intensive industries, the administrative guidance from the SCDOR underscores a commitment to rewarding those companies that invest in the intellectual and technological infrastructure of the state. The interaction of this credit with the mandatory Section 174 capitalization rules further emphasizes the need for sophisticated tax planning to optimize cash flow and maximize the total benefit of state and federal incentives.