Process of Experimentation

The process of experimentation refers to a systematic methodology used to evaluate one or more technical alternatives to resolve uncertainty regarding the capability, method, or design of a business component. In the context of the South Carolina Research and Development tax credit, this process is the essential qualitative requirement that distinguishes qualified innovation from routine engineering or commercial activity.

The South Carolina Research and Development (R&D) tax credit, codified under South Carolina Code Section 12-6-3415, represents a significant pillar of the state's economic development strategy. Unlike many jurisdictions that maintain separate, decoupled standards for innovation incentives, South Carolina has opted for a regime of strict conformity to the federal standards established under Section 41 of the Internal Revenue Code (IRC). This statutory alignment means that the state’s definitions of qualified research, including the rigorous "four-part test," are inherited directly from federal law and regulations. For a taxpayer to be eligible for the five percent credit against South Carolina corporate income tax, individual income tax, or corporate license fees, it is a jurisdictional prerequisite that the taxpayer also claims a federal income tax credit pursuant to IRC Section 41 for increasing research activities for the same taxable year. Consequently, the "process of experimentation" requirement is not merely a federal guideline but is the central legal standard upon which South Carolina Department of Revenue (SCDOR) auditors rely to validate state-level claims.

Statutory Foundations and the Legislative Evolution of Section 12-6-3415

The legal architecture of the South Carolina Research Expenses Credit is designed to reward businesses that undertake technical risks within the state's borders. Section 12-6-3415(A) stipulates that a taxpayer claiming the federal credit is allowed a state credit equal to five percent of the taxpayer’s qualified research expenses made in South Carolina. The evolution of this statute demonstrates a clear legislative trajectory toward harmonizing state incentives with federal compliance burdens to reduce administrative complexity for innovative firms.

The history of the credit indicates that it was initially enacted to incentivize the manufacturing and technology sectors, but early versions of the law contained technical errors in terminology. In 2003, the General Assembly passed Senate Bill 274 to amend Section 12-6-3415, correcting references that previously utilized the term “qualified research and development expenditures” and replacing them with the federally recognized “qualified research expenses”. This amendment, effective June 18, 2003, solidified the state’s reliance on IRC Section 41 definitions, ensuring that any expense qualifying for the federal credit would, by extension, qualify for the state credit if incurred in South Carolina. Further amendments in 2007 expanded the credit's utility, allowing it to be applied not only against income tax but also against corporate license fees under Section 12-20-50, which are based on capital stock and paid-in surplus.

The South Carolina credit is structurally distinct from the federal credit in its calculation. While the federal government requires a complex "incremental" calculation—comparing current research spending against a historical base amount—South Carolina offers a flat credit based on the total qualifying spend within the state for that tax year. This simplified calculation remains subject to a substantial limitation: the credit taken in any one taxable year cannot exceed fifty percent of the taxpayer’s remaining tax liability after all other credits have been applied. Any unused portion of the credit may be carried forward for ten years, providing a long-term benefit for companies that may be in a net operating loss position during their initial years of high-intensity R&D.

The Mechanics of the Process of Experimentation

The process of experimentation requirement is the final and most difficult prong of the four-part test defined in IRC Section 41(d). For research to be "qualified," it must first meet the Section 174 test (deductibility), be undertaken for a permitted purpose (improving a business component), and be technological in nature. The process of experimentation prong then mandates that "substantially all" of the research activities must involve a systematic evaluative process to resolve technical uncertainty.

Under both federal and South Carolina standards, uncertainty exists if the information available to the taxpayer at the start of the research does not establish the capability of developing the business component, the method for doing so, or the appropriate design of the final product or process. This is an objective standard; it is not enough that the specific engineers at a firm are personally uncertain. The information must not be "objectively available" in the public domain or through standard engineering practices.

The process of experimentation is the vehicle through which this uncertainty is eliminated. It must involve the evaluation of alternatives. If a company knows exactly how to build a product and simply follows a set of blueprints, even if the project is complex, it does not constitute a process of experimentation because there was no technical uncertainty to resolve through the evaluation of different design paths.

A valid process of experimentation is characterized by a systematic approach rather than random activity. The SCDOR and federal regulators recognize several methodologies as meeting this standard:

1. Systematic Trial and Error: This involves the sequential testing of various variables or designs, where the results of one test inform the parameters of the next.
2. Modeling: The use of mathematical or physical representations of a business component to predict how it will behave under specific conditions.
3. Simulation: The use of computer-based environments to stress-test digital versions of a product or process.
4. Prototyping: The creation of preliminary versions of a business component to identify design flaws and validate technical hypotheses.

The "substantially all" requirement is a critical quantitative threshold. For a specific business component to qualify, at least eighty percent of the activities associated with its development must constitute elements of a process of experimentation. If the experimentation portion is deemed to be only sixty percent of the work—with the rest being routine data entry or administrative coordination—the entire project may fail to qualify for the South Carolina credit.

South Carolina Department of Revenue Guidance and Administrative Policy

The SCDOR provides guidance through a tiered system of advisory opinions, including Revenue Rulings, Revenue Procedures, Information Letters, and Private Letter Rulings. Each of these documents plays a specific role in how the state interprets the process of experimentation and its application to the law.

Revenue Procedures, such as SC Revenue Procedure #09-3, establish the uniform system for controlling the formulation and dissemination of tax policies. Revenue Rulings are the most significant of these documents, as they represent the Department’s official interpretation of tax law applied to specific facts and are binding on agency personnel until superseded.

While most SCDOR guidance on R&D focuses on property and sales tax, these rulings provide essential insight into the state’s philosophical approach to what constitutes "research in the experimental sense." One of the most critical documents is SC Revenue Ruling #08-3, which addresses the sales and use tax exemption for R&D machines.

In RR #08-3, the Department interprets the phrase "machines used in research and development" to mean those used directly and primarily in research and development in the "experimental or laboratory sense". The ruling concludes that more than fifty percent of a machine's use must be devoted to such activities to qualify for an exemption. Importantly, the ruling defines "experimental sense" as activities aimed at new products, new uses for existing products, or the improvement of existing products. It explicitly excludes administrative uses, efficiency surveys, management studies, and promotional activities. This definition mirrors the federal exclusions found in IRC Section 41(d)(4) and demonstrates that SCDOR applies a consistent "experimental" standard across different tax categories.

The state’s treatment of R&D equipment further illustrates the distinction between research and manufacturing. SC Revenue Ruling #08-3 and Technical Advice Memorandum (TAM) regarding manufacturer’s equipment clarify that real property and machinery used primarily for R&D are not considered part of the "conduct of the business of the manufacturer" for property classification purposes. Instead, such property is classified separately, and R&D equipment is valued as business personal property. This separation emphasizes that R&D is viewed by the state as a distinct, investigative phase that precedes and is separate from the actual manufacturing process.

Administrative Compliance: Claiming the Credit via Schedule TC-18

The practical application of the South Carolina R&D tax credit is managed through the filing of SC Schedule TC-18, "Research Expenses Credit". This form acts as the conduit between the federal claim on IRS Form 6765 and the South Carolina tax return.

To successfully claim the credit, a taxpayer must satisfy several procedural hurdles:

1. Federal Filing: The taxpayer must actually claim the federal R&D credit under IRC Section 41 for the same taxable year.
2. South Carolina Nexus: The expenses must be "qualified research expenses" as defined by federal law, but they must have occurred specifically within the state of South Carolina.
3. Documentation: Taxpayers are advised to maintain detailed documentation for audit compliance, pertaining to the underlying R&D activities and the associated QREs.

The credit is available to a wide range of entities, including C-Corporations, S-Corporations, LLCs, and Partnerships. For pass-through entities, the credit is calculated at the entity level and then allocated to owners via Schedule K-1 according to their ownership share.

A unique aspect of South Carolina tax administration is the "ordering rule" for credits. Because the Research Expenses Credit is limited to fifty percent of the tax liability remaining after all other credits have been applied, it is effectively the last credit utilized in the tax calculation. This means that if a taxpayer has other credits—such as the New Jobs Credit or the Investment Tax Credit—those are applied first. If those credits already reduce the tax liability significantly, the R&D credit may be pushed into a carryforward position.

The SCDOR provides specific calculation logic for this ordering, which can be visualized in the following table:

Audit Scrutiny and the Role of Contemporaneous Documentation

The process of experimentation is frequently the focal point of SCDOR and IRS audits. Recent case law from the United States Tax Court, which serves as a persuasive or governing precedent for South Carolina’s federally conformed credit, highlights a shift toward stricter documentation requirements.

Three landmark cases provide a roadmap for how the process of experimentation is interpreted in an audit environment:

1. Little Sandy Coal Co., Inc. v. Commissioner (2021): The court denied credits because the taxpayer could not prove that eighty percent of their activities followed a structured process of experimentation. The court emphasized that the mere construction of a "first-of-its-kind" vessel did not automatically qualify the entire project if the taxpayer could not document the specific experimental steps taken for individual components.
2. Phoenix Design Group, Inc. v. Commissioner (2024): This case underscores the "uncertainty" requirement. The taxpayer failed to identify specific technical uncertainties at the outset of their research. The court ruled that performing basic calculations based on available data is not an investigative activity if the taxpayer already has the information necessary to address the unknowns.
3. Meyer, Borgman & Johnson, Inc. v. Commissioner (2024): This case highlights the high bar for refund claims. The IRS and state agencies are now using advanced "classifier" systems to screen claims for a strong narrative explaining the process of experimentation before an examiner even begins a manual review.

To satisfy the process of experimentation prong in a South Carolina audit, taxpayers must move beyond "generic descriptions" and "after-the-fact summaries". Successful audit defense requires contemporaneous evidence that captures the development journey.

A robust documentation system should include:

• Technical Project Records: Design iterations, blueprints, and CAD drawings that show how the design changed over time to resolve uncertainties.
• Testing and Lab Notes: Results from modeling, simulations, and physical trials, including documentation of failed tests.
• Employee Time Tracking: Logs that link specific hours to research activities rather than broad departments.
• Narrative Support: A project-by-project explanation of the "permitted purpose," the specific technical uncertainty encountered, and the systematic process used to resolve it.

Sector-Specific Application of Experimentation

The process of experimentation applies differently across South Carolina’s diverse industrial landscape. The state’s focus on manufacturing, aerospace, automotive, and software development creates unique scenarios for credit qualification.

In South Carolina's manufacturing sector, the process of experimentation often involves refining production processes or developing custom parts. For example, an automotive supplier in the Upstate may attempt to improve the durability of a suspension component using a new alloy. The "experimentation" occurs when the company tests multiple formulations of the alloy, simulates stress points using software, and builds prototypes for field testing.

Software development is inherently iterative, but not all coding is research. To qualify, software development must involve the resolution of "technological uncertainty". Routine upgrades, minor bug fixes, or the adaptation of existing software for a new client generally do not qualify. However, creating a new architecture to handle massive data throughput or developing complex algorithms for autonomous vehicles often requires a systematic process of experimentation to determine the most efficient design.

Biotechnology firms in South Carolina face significant scientific uncertainty. The process of experimentation here involves rigorous laboratory testing and clinical trials to determine the efficacy and safety of new compounds. Because these projects are often multi-year endeavors, contemporaneous documentation is even more critical to track the evolution of hypotheses across different tax years.

Comprehensive Case Study: Process of Experimentation in South Carolina

To illustrate the interplay between South Carolina law and the process of experimentation, consider the following example of a South Carolina-based aerospace manufacturer developing a high-efficiency propeller system.

The taxpayer, "Palmetto Aero," is a C-Corporation with headquarters and a production facility in Sumter, South Carolina. Palmetto Aero aims to develop a new propeller blade that is 20% quieter than current models without sacrificing thrust. This propeller is the "business component" being improved.

At the beginning of the project, Palmetto Aero's engineers face three types of technical uncertainty:

1. Capability: It is unclear if current composite materials can be molded into the aggressive "swept-wing" shape required for noise reduction while maintaining structural integrity at 2,500 RPM.
2. Method: The team is uncertain about the heating and cooling cycles required for the new composite to avoid delamination.
3. Appropriate Design: The exact angle and thickness of the blade tip needed to achieve the 20% noise reduction are unknown.

Palmetto Aero initiates a year-long research project. The process of experimentation consists of the following phases:

1. Hypothesis Formulation: The engineering team hypothesizes that a specific carbon-fiber weave will provide the necessary strength.
2. Modeling and Simulation: Engineers use computer simulations to test fifty different blade designs. This allows them to eliminate forty designs that fail to meet thrust requirements.
3. Prototyping: The team builds five physical prototypes of the most promising designs. The costs of these materials are "qualified supplies".
4. Testing and Analysis: The prototypes are tested in a wind tunnel and a noise-controlled environment. Two prototypes fail (delaminate), which leads to a new "trial and error" phase to adjust the bonding resin.
5. Final Validation: After six months of iterative design, a final version is produced that meets all technical objectives.

Palmetto Aero incurs the following expenses within the state of South Carolina for this project during the 2024 tax year:

To claim the South Carolina credit, Palmetto Aero first ensures they have claimed the federal R&D credit on IRS Form 6765. They then complete South Carolina Schedule TC-18 as follows:

1. Line 1 (SC QREs): $1,015,000
2. Line 2 (Credit Earned): $1,015,000 × 5% = $50,750
3. Line 3 (Carryforward): $0 (assuming this is their first year)
4. Line 4 (Total Credit): $50,750
5. Line 5 (Tax Liability): Assume $120,000 in South Carolina corporate income tax.
6. Line 6 (Other Credits): Assume a $40,000 New Jobs Credit.
7. Line 7 (Remaining Liability): $120,000 - $40,000 = $80,000.
8. Line 8 (Maximum R&D Credit): $80,000 × 50% = $40,000.
9. Line 9 (Credit Allowed): Lesser of $50,750 or $40,000 = $40,000.
10. Line 10 (Carryforward to 2025): $50,750 - $40,000 = $10,750.

Palmetto Aero maintains their CAD logs, simulation reports, and wind-tunnel data as contemporaneous evidence of their process of experimentation to defend against potential SCDOR audit.

The Future Outlook and Legislative Trends

The landscape for R&D tax credits in South Carolina remains stable but subject to the evolving "risk analysis" of both state and federal tax authorities. While the five percent rate is straightforward, the complexity of the process of experimentation requirement continues to grow as the IRS and SCDOR increasingly focus on the "systematic" nature of the work.

There has been legislative interest in making the credit more accessible to smaller firms. For example, House Bill 3592 was introduced to amend Section 12-6-3415 to provide that taxpayers with fewer than 150 employees could claim a refundable portion of the credit if it exceeds their liability. While many such bills remain in the legislative process, they signal a recognition that the current nonrefundable nature and the fifty percent liability limit can be a barrier for early-stage South Carolina startups that are heavily engaged in experimentation but have not yet achieved significant profitability.

Furthermore, the South Carolina courts continue to serve as a check on administrative overreach. The Court of Appeals’ decision in the Duke Energy case—clarifying that statutory limitations on investment credits should be read annually rather than as lifetime caps—reinforces a taxpayer-friendly interpretation of economic development statutes when the plain language supports it. This provides a degree of certainty for companies planning large-scale, multi-year research projects in the state, ensuring that the rules of the game will not be changed mid-process by administrative re-interpretation.

Strategic Summary for Practitioners

The South Carolina Research Expenses Credit is a powerful tool for reducing the after-tax cost of innovation. Its effectiveness, however, is entirely dependent on the taxpayer’s ability to substantiate the process of experimentation.

In conclusion, the process of experimentation is not merely a box to be checked but a narrative of technical struggle and systematic resolution that must be carefully woven from a company’s engineering data. By understanding the rigorous standards of IRC Section 41 as adopted by S.C. Code Section 12-6-3415, and by utilizing the procedural frameworks established by the SCDOR, South Carolina businesses can maximize their return on investment in the technologies that will define the state’s economic future. The interplay between statutory law, administrative guidance, and judicial precedent creates a complex but rewarding environment for those who can prove their work is truly experimental.