Supplies Used in Conduct of Qualified Research

Supplies used in the conduct of qualified research refer to any tangible property, excluding land and improvements to land or depreciable assets, that is consumed or used directly in the performance of experimental activities within South Carolina. For the purposes of the state’s research credit, these materials must be integral to a process of experimentation intended to discover information that is technological in nature and aimed at developing or improving a business component.

The South Carolina Research Expenses Tax Credit is a cornerstone of the state’s economic development strategy, designed to incentivize high-technology investment and the retention of specialized manufacturing capabilities. Governed by South Carolina Code Section 12-6-3415, the credit operates through a mechanism of substantial conformity to federal standards while maintaining strict geographic boundaries to ensure that the economic benefits of the credit—specifically the consumption of raw materials and the employment of research personnel—remain within the borders of the state. To understand the meaning of supplies in this context, one must navigate the intersection of state statutory law, the Internal Revenue Code (IRC), and the administrative guidance issued by the South Carolina Department of Revenue (SCDOR). This analysis explores the technical definitions, the procedural requirements for claim substantiation, and the interpretive nuances that distinguish qualifying research supplies from general business expenses.

Statutory Foundation and the Mechanism of Federal Conformity

The legal authority for the South Carolina Research Expenses Tax Credit is codified in S.C. Code Ann. § 12-6-3415. The statute is deceptively simple, stating that a taxpayer who is allowed a federal income tax credit for increasing research activities under IRC Section 41 may claim a credit against South Carolina individual or corporate income taxes, as well as corporate license fees. The credit is equal to 5% of the “qualified research expenses” made by the taxpayer in South Carolina during the tax year.

The Evolution of Section 12-6-3415

The history of the South Carolina research credit reveals a legislative intent to align state incentives as closely as possible with federal tax theory to minimize the administrative burden on taxpayers. In 2003, through Senate Bill 274, the South Carolina General Assembly amended Section 12-6-3415 to explicitly adopt the term “qualified research expense” as defined in IRC Section 41. This was a critical corrective measure; prior to this amendment, the state statute had utilized various inconsistent terms such as “qualified research and development expenditures” or “qualified expenditures for research and development”. By standardizing the nomenclature, the state ensured that the vast body of federal Treasury Regulations and judicial precedents interpreting IRC Section 41 would apply to the South Carolina credit, including the specific definitions of what constitutes a “supply”.

Furthermore, the state expanded the utility of the credit by allowing it to offset not just income tax but also the corporate license fees imposed under Section 12-20-50, which are based on a corporation’s capital stock and paid-in surplus. This dual applicability is particularly beneficial for capital-intensive companies that may have low immediate income tax liability but significant license fee obligations due to their large physical footprints in the state.

Conformity to the Internal Revenue Code

South Carolina’s tax code is built upon the principle of “substantial conformity” to the federal Internal Revenue Code. Under S.C. Code Ann. § 12-6-40, the state adopts the IRC as it exists on a specific date—typically December 31st of the prior year—subject to certain exceptions listed in Section 12-6-50. For the purposes of research supplies, the state has not decoupled from the federal definitions. Therefore, when a South Carolina taxpayer identifies “supplies used in the conduct of qualified research,” they are applying the federal definition found in IRC Section 41(b)(2)(C) to their South Carolina-based activities.

Defining Supplies in the Research Environment

Under the federal definition adopted by South Carolina, the term “supplies” means any tangible property other than land or improvements to land and property of a character subject to the allowance for depreciation. This definition creates a narrow window for what qualifies, requiring that the item be both physical and consumed (or non-depreciable) within the research process.

The Tangibility Requirement

The requirement for property to be “tangible” means it must be something that can be seen, felt, or weighed. In the context of a laboratory or manufacturing facility, this includes the raw chemicals, metals, plastics, and electronic components that are used to build prototypes or perform tests. The South Carolina Department of Revenue has historically applied a “true object test” to determine if property is tangible. If the “true object” of a transaction is the physical material itself—such as the resin used in a 3D printer to create a mock-up of a new wing design—the cost of that material qualifies as a supply.

Exclusion of Depreciable Assets

The most significant limitation on what constitutes a “supply” is the exclusion of depreciable property. If an item is of a character that is subject to an allowance for depreciation under IRC Section 167 or 168, it cannot be classified as a research supply. This exclusion is intended to prevent the “double-dipping” of tax benefits where a company could both claim a 5% credit on the purchase price of a machine and then also depreciate that same machine over several years to reduce taxable income.

This distinction is often a point of contention during audits. For example, if a company purchases an specialized sensor to monitor a chemical reaction, and that sensor is destroyed by the heat of the reaction, the sensor might be argued as a supply because it was consumed. However, if the sensor is of a “character” that is typically depreciable (i.e., it has a useful life of more than one year and is not inherently a consumable material), the SCDOR may disqualify the expense. Conversely, “test articles”—which are full-scale or partial models of the final product being developed—generally qualify as supplies because they are not intended to be held for use in the business but are created solely to be tested, often to the point of failure.

Indirect Costs and Administrative Overheads

Administrative guidance and judicial interpretations have consistently held that “supplies” do not include indirect research expenditures or general and administrative (G&A) expenses. This means that items such as office supplies (paper, pens, toner), travel expenses, meals, and rent are strictly excluded from the research credit calculation.

Furthermore, utility costs such as electricity, water, and heating are generally viewed as indirect costs and are therefore excluded. Some taxpayers have argued that “extraordinary” utility costs—such as the massive amounts of electricity required to run a high-energy particle accelerator or the large volumes of water used in a cooling system for a specific experiment—should qualify as supplies. While federal petitions for certiorari have raised this issue, current SCDOR policy remains aligned with the restrictive federal view that utilities are not “tangible property” in the traditional supply sense.

Sourcing and the Geographic Nexus Mandate

A unique and critical aspect of the South Carolina Research Expenses Tax Credit is the requirement that the research must be “conducted in South Carolina”. While the state adopts the federal definition of supplies, it modifies the sourcing of those supplies to ensure they are tied to local economic activity.

The In-State Consumption Requirement

For a supply to qualify for the 5% South Carolina credit, it must be used or consumed in research activities physically performed within the state. This creates a significant documentation burden for multi-state corporations. If a company maintains a centralized procurement office in Charlotte, North Carolina, but ships materials to its laboratory in Spartanburg, South Carolina, it must maintain rigorous inventory tracking to prove that those specific materials were consumed in the Spartanburg facility.

The SCDOR requires that taxpayers identify their qualified research expenses “incurred in South Carolina” following the definition of QREs in IRC Section 41(b). This means that even if a supply would qualify for the federal credit, it is only eligible for the South Carolina credit if the “conduct of research” occurred within the state’s borders.

Apportionment and Inventory Control

Taxpayers must often use specialized accounting protocols to separate South Carolina-sourced supplies from those used in other states. Guidance from other state jurisdictions with similar sourcing rules, which the SCDOR often mirrors in its interpretive philosophy, suggests that the physical consumption of the supply must occur within the designated R&D facility in the state. If a manufacturer uses a centralized warehouse to distribute specialty chemicals to labs in multiple states, they must be able to produce “point-of-use” records to substantiate the South Carolina claim.

The Four-Part Test and its Application to Supplies

For a supply expense to be considered “qualified,” the activity in which the supply is used must satisfy the rigorous “Four-Part Test” established under IRC Section 41(d).

The Section 174 Test (Permitted Purpose)

The research must relate to a new or improved function, performance, reliability, or quality of a business component. Supplies used for aesthetic improvements or routine style changes do not qualify. For example, if a South Carolina furniture manufacturer uses wood and fabric to test a new “ergonomic” chair design that reduces back strain, those materials are qualifying supplies. If they use the same materials simply to test a new color pattern for a current year’s catalog, the materials are excluded as they do not relate to a functional improvement.

Discovering Technological Information (Technological in Nature)

The research must fundamentally rely on the principles of physical or biological science, engineering, or computer science. Supplies used in social science research, market research, or management studies do not qualify. A pharmaceutical company using chemical reagents in South Carolina to develop a new vaccine clearly meets this test, as the consumption of the supplies is rooted in biological and chemical science.

Elimination of Uncertainty

The activity must be intended to discover information that would eliminate uncertainty regarding the capability, method, or appropriate design of a business component. Supplies used in “routine” testing, where the outcome is already known or the method is standardized, are not eligible. The “uncertainty” must be technical; if a company knows how to build a product but isn’t sure if the market will buy it, the supplies used to build the marketing prototypes are non-qualifying.

Process of Experimentation

Substantially all of the activities must constitute a process of experimentation, involving the evaluation of alternatives through systematic trial and error or testing of hypotheses. The supplies must be the “fuel” for this process. If a manufacturer builds five different prototypes using five different aluminum alloys to see which one withstands the highest pressure, the cost of all five alloys qualifies as supplies used in the conduct of research.

South Carolina Revenue Office Guidance and Interpretive Rulings

The South Carolina Department of Revenue provides administrative oversight through the issuance of Revenue Rulings, Information Letters, and specific tax form instructions. These documents provide the “local flavor” to the federal definitions, explaining how the SCDOR applies the law in practice.

Revenue Ruling #11-3: Consumption of Supplies

While Revenue Ruling #11-3 primarily addresses sales tax exemptions for medical supplies, it provides foundational insight into how the SCDOR views the “use” and “consumption” of property. The ruling clarifies that where supplies are furnished to a patient as part of a service, the service provider is deemed the “user or consumer” of those supplies. This logic is analogous to the R&D credit: the taxpayer who performs the research service is the consumer of the materials (the supplies), and thus they are the party entitled to the credit for those expenditures.

Revenue Ruling #03-2 and Information Letter #11-3: Research Machinery

The SCDOR has issued specific guidance on “Machines Used in Research and Development” under Code Section 12-36-2120(56), which provides a sales tax exemption. These documents define research and development in the “experimental or laboratory sense” and emphasize that more than 50% of a machine’s use must be devoted to qualifying research.

While this guidance applies to the sales tax exemption for machinery, it reinforces the state’s narrow view of R&D. The SCDOR explicitly notes that “indirect use” (such as administrative or teaching uses) does not qualify as R&D. For the income tax credit, this supports the exclusion of any supplies used for non-experimental functions within a research facility, such as materials used for training new staff or maintaining the building.

Schedule TC-18 Instructions

The primary procedural document for the credit is the instructions for Schedule TC-18, “Research Expenses Credit”. These instructions confirm that:

• The credit is 5% of qualified research expenses as defined by IRC 41(b).
• The expenses must be “made by the taxpayer in South Carolina”.
• The credit is limited to 50% of the taxpayer’s remaining tax liability after all other credits have been applied.
• Unused credit can be carried forward for up to 10 years.

The instructions also highlight the “pass-through” nature of the credit. If an LLC or S-Corporation incurs research supply expenses, the credit is calculated at the entity level but passed through to individual owners on their SC K-1. The owner then reports the credit on their own individual income tax return using Schedule TC-18.

Identification and Documentation of Research Supplies

Because research credits are frequently subject to audit by both the IRS and the SCDOR, documentation is the most critical element of a successful claim. The SCDOR advises businesses to “maintain detailed documentation for audit compliance purposes, pertaining to the underlying R&D activities and the associated QREs”.

Essential Records for Supply QREs

To substantiate a claim for research supplies, a taxpayer should be prepared to produce:

1. General Ledger Detail: A clear accounting of all supply purchases categorized by project or department.
2. Invoices and Receipts: These must show the date of purchase, the vendor, the cost, and a description of the items to prove they are tangible and non-depreciable.
3. Project Descriptions: Narrative summaries that explain how the supplies were used in a process of experimentation to eliminate technical uncertainty.
4. Lab Notebooks and Test Results: Direct evidence from the researchers showing that the materials were actually consumed in the laboratory or on the test floor.
5. Inventory Sourcing Records: Documents showing that the materials were delivered to or used at a South Carolina facility.

Common Audit Pitfalls

During an examination, the SCDOR typically looks for “bundled” expenses where qualifying supplies are mixed with non-qualifying ones. Common errors include:

• Inclusion of Maintenance, Repair, and Operating (MRO) Supplies: Materials used to fix general plant machinery or clean the facility are not research supplies.
• Inclusion of Small Equipment: Purchasing a $500 tool that has a useful life of three years is technically a depreciable asset (even if the company chooses to expense it for book purposes) and thus is not a “supply” for the research credit.
• Lack of Project Allocation: If a company buys $1 million in aluminum and cannot show which specific pounds were used for the experimental prototype versus the standard production run, the entire expense may be disqualified.

Interactions with Other South Carolina Credits and Incentives

The Research Expenses Tax Credit is part of a “stack” of incentives available to South Carolina businesses. Understanding the interaction between these credits is vital for optimizing the total tax benefit.

Ordering Rules and the 50% Liability Cap

South Carolina law provides specific rules for the order in which credits must be applied. Generally, credits are used in the year they are earned based on tax liability, but some credits (like the Research Expenses Credit) are applied only after all other credits have been taken.

Because the research credit cannot exceed 50% of the remaining liability, its value is often dependent on the use of other “primary” credits like the New Jobs Credit (Section 12-6-3360) or the Investment Tax Credit (Section 12-14-60).

This “last-in-line” status means that for companies with very large Job Tax Credits, the R&D credit will frequently generate a significant carryforward. This is not necessarily a negative outcome, as the 10-year carryforward period allows the company to use the credit as their job growth stabilizes and their taxable income increases.

Synergy with Sales and Use Tax Exemptions

A well-managed R&D department in South Carolina can benefit from both the income tax credit on supplies and the sales tax exemption on machinery. For example, a “Life Sciences Facility” as defined in Section 12-6-3360 that invests $100 million may qualify for a wide range of exemptions.

The SCDOR’s focus on “Technology Intensive Facilities” (Section 12-36-2120(65)) further highlights the synergy. A facility that qualifies as technology-intensive may receive sales tax exemptions on computer equipment, while the materials used by that computer equipment in a research capacity (such as specialized cooling fluids or prototype materials) would qualify for the 5% research credit.

Comprehensive Example: Carolina Aerospace Technologies, Inc.

To illustrate the interplay of state law, federal definitions, and SCDOR guidance, consider the following detailed case study of a hypothetical South Carolina corporation.

Company Profile and Research Context

Carolina Aerospace Technologies, Inc. (CATI) is a Tier 1 aerospace supplier with its primary manufacturing and research hub located in Charleston, South Carolina. CATI specializes in advanced composites and noise-reduction technologies for commercial jet engines. In 2024, CATI undertook “Project Sonic,” an initiative to develop a new “perforated acoustic liner” for jet engines that is 20% lighter than current models but provides 30% more noise suppression.

Qualifying Activities and Supply Identification

Project Sonic required a multi-stage process of experimentation. CATI engineers first used computer-aided design (CAD) to simulate various perforation patterns. They then built ten different physical “sections” of the liner to test in a specialized sound chamber.

The following expenses were incurred at the Charleston facility:

1. Composite Pre-preg Materials: $300,000. These were used to build the ten test sections. Each section was subjected to acoustic stress and eventually destroyed during testing.
2. Epoxy Resins and Hardeners: $50,000. Consumed during the curing process of the test sections.
3. High-Speed Drill Bits: $10,000. Used specifically to create the microscopic perforations in the test sections. These bits wore out quickly due to the toughness of the composite material and were discarded.
4. Laboratory Glassware and Chemicals: $15,000. Used to test the chemical resistance of the composite to jet fuel and de-icing fluids.
5. Acoustic Testing Sensor Array: $25,000. This array is a sophisticated piece of equipment used for many different projects and has a five-year life.
6. Electricity for the Sound Chamber: $12,000. Specifically tracked by a sub-meter during Project Sonic.
7. Office Supplies for the R&D Floor: $4,000. Paper, notebooks, and printer ink for engineering reports.

Analyzing the “Supplies” Eligibility

Following the principles of IRC Section 41 and SCDOR Revenue Rulings:

• Composite Materials and Resins ($350,000): These are Qualifying Supplies. They are tangible, non-depreciable property used in the conduct of qualified research. They were consumed during the process of experimentation.
• High-Speed Drill Bits ($10,000): These are Qualifying Supplies. Although they are “tools,” their short life and immediate consumption in the research process make them more like supplies than depreciable capital assets.
• Laboratory Glassware and Chemicals ($15,000): These are Qualifying Supplies. Chemicals are classic consumables in a laboratory environment.
• Acoustic Testing Sensor Array ($25,000): This is Non-Qualifying. As a depreciable asset with a five-year life, it is specifically excluded from the definition of supplies. CATI may, however, qualify for a Sales and Use Tax exemption on this machine under Section 12-36-2120(56) if it meets the 50% R&D use threshold.
• Electricity ($12,000): This is Non-Qualifying. Despite being sub-metered, electricity is considered an indirect overhead cost and is not “tangible property” for the research credit.
• Office Supplies ($4,000): This is Non-Qualifying. General administrative and office expenses are excluded from the definition of research QREs.

Total South Carolina Supply QREs: $375,000.

Calculation of the Research Expenses Credit

CATI also incurred $800,000 in qualifying research wages for the engineers working on Project Sonic in Charleston.

1. Total SC QREs: $800,000 (Wages) + $375,000 (Supplies) = $1,175,000.
2. Credit Calculation (5%): $1,175,000 × 0.05 = $58,750.

Applying the Credit to CATI’s Tax Liability

For the 2024 tax year, CATI has a pre-credit South Carolina corporate income tax liability of $200,000. They are also claiming a New Jobs Credit of $120,000.

1. Initial Liability: $200,000.
2. Less New Jobs Credit: ($100,000) – Note: The New Jobs Credit is limited to 50% of the $200,000 liability.
3. Remaining Liability after New Jobs Credit: $100,000.
4. Application of Research Credit Limit: The research credit is limited to 50% of the remaining liability. $100,000 × 0.50 = $50,000.
5. Credit Used in 2024: $50,000.
6. Carryforward to 2025: $58,750 (Total Earned) – $50,000 (Used) = $8,750.

CATI will also have a $20,000 carryforward for their New Jobs Credit ($120,000 earned – $100,000 used). In 2025, they will prioritize the use of the remaining New Jobs Credit before applying the $8,750 R&D carryforward.

Documentation for Audit Defense

In the event of an SCDOR audit, CATI would present:

• Invoices for the $300,000 in composite materials showing delivery to the Charleston facility.
• Engineering logs showing the destructive testing of the acoustic liners.
• A “Four-Part Test” narrative for Project Sonic, highlighting the technical uncertainty regarding noise suppression at lighter weights.
• The federal Form 6765, showing that they elected and claimed the research credit at the national level.

Future Outlook and Strategic Implications

The South Carolina Research Expenses Tax Credit remains a stable and predictable incentive, but taxpayers must be vigilant regarding federal changes that flow through to state law via the conformity mechanism.

The Section 174 Amortization Change

A significant recent change at the federal level is the requirement under the Tax Cuts and Jobs Act (TCJA) for taxpayers to capitalize and amortize research and experimental (R&E) expenditures over five years (15 years for foreign research) instead of deducting them immediately under Section 174.

While this change primarily affects the deductibility of expenses, it has increased the importance of the Section 41 credit. Because South Carolina conforms to the IRC, South Carolina taxpayers must also capitalize and amortize these expenses for state income tax purposes. The 5% Research Expenses Credit provides a vital immediate dollar-for-dollar offset to help mitigate the cash-flow impact of this federal and state capitalization requirement.

Audit Trends and “Cloud” Supplies

As technology evolves, the definition of “supplies” is being challenged by digital innovation. The IRS and various state departments of revenue have begun to issue guidance on “cloud computing” costs. While IRC Section 41(b)(2)(A)(iii) allows for expenses paid for the “right to use computers” (often cloud server time), these are technically a separate category from “supplies”.

However, in South Carolina, the 5% credit applies to the sum of all qualifying research expenses, including computer use costs. Taxpayers must be careful to distinguish between cloud storage (often viewed as a non-qualifying utility/service) and cloud processing time for simulations (which is more likely to qualify as “computer use” in the conduct of research).

Final Thoughts

The South Carolina Research Expenses Tax Credit provides a robust incentive for companies to perform their most innovative work within the state. By understanding the specific meaning of “supplies”—as tangible, non-depreciable property used directly in the experimental process—and by adhering to the rigorous sourcing and documentation requirements of the South Carolina Department of Revenue, businesses can significantly reduce their effective tax rate and reinvest those savings into further discovery. The integration of federal definitions into state law creates a high-standard environment where only genuine, documented innovation is rewarded, ensuring that South Carolina remains a premier destination for the aerospace, automotive, and life sciences industries.