Increasing Research Activities

In the context of the South Carolina tax code, the term Increasing Research Activities refers to the performance of qualified research and development within the state that meets the criteria defined under Internal Revenue Code Section 41. This statutory designation serves as the prerequisite for taxpayers to claim a nonrefundable five percent credit against state income tax and corporate license fees for qualified expenditures incurred during the pursuit of innovation.

The concept of increasing research activities is fundamentally rooted in a federalist approach to economic development, where South Carolina leverages the definitions established by the Internal Revenue Service (IRS) while tailoring the financial incentives to meet local industrial needs. While the federal credit is traditionally incremental—measuring current research spending against a historical base amount—South Carolina’s application of the “increasing research activities” language under Code Section 12-6-3415 functions more broadly by allowing a credit based on the gross amount of qualified research expenses (QREs) conducted within the state’s borders, provided a federal claim is also made. This creates a unique regulatory environment where the “meaning” of the term is both a semantic legacy of the federal Internal Revenue Code and a functional trigger for state-level financial benefits. For a business operating in South Carolina, increasing research activities signifies a commitment to the four-part test of technological uncertainty, experimentation, and business component improvement, which in turn unlocks a multi-layered system of tax offsets designed to reduce the effective cost of high-stakes technical development.

Statutory Framework and Federal Conformity

The South Carolina Research Expenses Credit is primarily governed by S.C. Code Ann. § 12-6-3415, which was enacted to align the state’s fiscal policy with the national goal of fostering technological advancement. The legal architecture of this credit is built upon the principle of federal conformity, as outlined in S.C. Code Ann. § 12-6-40, which dictates that South Carolina income tax laws generally conform to the Internal Revenue Code (IRC) of 1986, as amended. This conformity simplifies the administration of the credit, as it allows the South Carolina Department of Revenue (SCDOR) to adopt federal definitions for what constitutes “qualified research” and “qualified research expenses”.

Under the South Carolina Income Tax Act, the credit for increasing research activities is available to any taxpayer that claims a federal income tax credit pursuant to IRC Section 41 for the same taxable year. This “tethering” mechanism ensures that the state only incentivizes activities that have already met the rigorous standards of federal review. The state credit is equal to 5% of the taxpayer’s qualified research expenses made in South Carolina. Unlike the federal credit, which may involve complex “base amount” calculations to determine the “incremental” increase in research, the South Carolina credit is calculated directly on the total QREs incurred within the state.

Tax Types and Applicability

The South Carolina credit is versatile in its application, providing relief across multiple tax types. It can be used to offset:

• Corporate Income Tax: Levied on the net income of C corporations operating within the state.
• Individual Income Tax: Applicable to sole proprietors, partners in partnerships, or shareholders in S corporations who receive allocated credits through pass-through entities.
• Corporate License Fees: Specifically those imposed under Section 12-20-50, which are based on a corporation’s capital stock and paid-in surplus.

The inclusion of corporate license fees is a significant distinction from many other state R&D credits. For capital-intensive industries such as aerospace and automotive manufacturing—pillars of the South Carolina economy—the ability to reduce license fees can be as impactful as the reduction of income tax liability, especially in years where the company may be in a net operating loss (NOL) position but still maintains significant capital investments.

Detailed Analysis of Qualified Research Activities (QRAs)

To understand the meaning of “increasing research activities” in a practical sense, one must analyze the “Four-Part Test” established under IRC Section 41(d). Since South Carolina law adopts these federal standards, an activity only qualifies for the 5% state credit if it satisfies every element of this test.

The Permitted Purpose Test

The research must be conducted for a “permitted purpose,” meaning it must relate to a new or improved business component’s function, performance, reliability, or quality. In the manufacturing context of South Carolina, this often involves the engineering of more durable composite materials for aeronautics or the refinement of chemical formulas for industrial coatings. A business component is defined as any product, process, computer software, technique, formula, or invention that the taxpayer intends to hold for sale, lease, or license, or use in its own trade or business.

The Elimination of Uncertainty Test

The activity must be intended to discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if the information available to the taxpayer does not establish either:

1. The capability of developing or improving the business component.
2. The method for developing or improving it.
3. The appropriate design of the business component.

For example, a South Carolina textile firm attempting to develop a fire-retardant fabric using a novel molecular bonding technique faces technical uncertainty if they do not know whether the bonding method will compromise the fabric’s structural integrity or which specific chemical ratios will yield the desired fire-resistance rating.

The Process of Experimentation Test

Substantially all of the research activities (generally 80% or more) must constitute a process of experimentation. This involves a systematic evaluation of one or more alternatives to achieve the desired result. Methods of experimentation can include modeling, simulation, systematic trial and error, or other scientific methods. The “substantially all” rule is a high bar; it requires that the vast majority of the project’s activities be focused on resolving the technical uncertainties rather than routine data collection or aesthetic design.

The Technological in Nature Test

The process of experimentation must fundamentally rely on the principles of physical or biological sciences, engineering, or computer science. Research that relies primarily on social sciences, arts, or humanities is strictly excluded. In South Carolina’s burgeoning life sciences sector, this requirement ensures that drug discovery and medical device engineering are incentivized, while market research for those products is not.

Qualified Research Expenditures (QREs) and Local Guidance

Once an activity is deemed qualified, the taxpayer must identify the associated “Qualified Research Expenditures” (QREs). South Carolina follows IRC Section 41(b) for these definitions but imposes a strict nexus requirement: the expenses must be “made in South Carolina”.

Wage Expenses

Wages paid to employees for “qualified services” constitute the largest portion of most R&D claims. These services include:

• Direct Research: Performing the actual lab work, engineering, or coding.
• Direct Supervision: The immediate management of those performing direct research.
• Direct Support: Activities that directly aid the research, such as a lab assistant cleaning equipment or a machinist building a prototype specifically for testing.

South Carolina guidance requires that these wages be subject to South Carolina withholding, effectively ensuring that the credit supports the state’s labor market. The “80% Rule” applies here as well: if an employee spends at least 80% of their time on qualified services, 100% of their wages may be included in the QRE calculation.

Supply Expenses

Supplies include tangible property (other than land or improvements to land) that is consumed or used in the conduct of qualified research. This includes the cost of materials used for prototypes and chemicals used in experiments. Crucially, supplies do not include property of a character subject to the allowance for depreciation.

Contract Research Expenses

If a South Carolina business outsources research to a third party (such as a university or a private lab), it can claim 65% of the amount paid as a QRE, provided the research is conducted within the state. If the contractor is a “qualified research consortium”—typically a non-profit scientific research organization or university—the taxpayer may claim 75% of the payments.

Computer Rental and Leasing

Costs incurred for the right to use computers in the conduct of qualified research (such as cloud-based high-performance computing for aerospace simulations) are qualifying expenses. This does not include the purchase of hardware, which is a depreciable asset.

State Revenue Office Guidance and Administrative Procedures

The South Carolina Department of Revenue (SCDOR) provides specific administrative frameworks for claiming and substantiating the credit. The primary vehicle for this is Form TC-18, “Research Expenses Credit”.

Completing Form TC-18

The instructions for Form TC-18 delineate the precise steps a taxpayer must take to claim the 5% credit. The form acts as a bridge between the federal claim and the state liability.

1. Line 1 (Qualified Expenses): The taxpayer enters the total dollar amount of QREs made specifically in South Carolina.
2. Line 2 (Credit Earned): The total from Line 1 is multiplied by 5% (0.05). If the credit is received from a pass-through entity (Partnership, S Corporation, or LLC), the amount from the SC K-1 is entered here.
3. Line 3 (Carryforward): Any unused research credits from the previous 10 tax years are listed here.
4. Lines 5-9 (Limitations): These lines calculate the “50% limitation.” The credit used in any one year cannot exceed 50% of the taxpayer’s tax liability remaining after all other credits have been applied.

SCDOR Policy and Revenue Rulings

The SCDOR issues guidance through several channels, including Revenue Rulings (RR), Information Letters (IL), and the “South Carolina Tax Incentives for Economic Development” (SCTIED) manual.

• Revenue Ruling #14-5 and others: These rulings provide specific interpretations of how the credit applies to various business structures and industries.
• Information Letters (e.g., IL 25-23): These provide updated figures for per capita income, which are crucial for other credits (like the Headquarters Credit) that often interact with the R&D credit.
• Audit Guidance: The SCDOR manual emphasizes that while the state credit follows federal rules, the taxpayer bears the burden of proving that the expenses were incurred within South Carolina. This necessitates distinct accounting for in-state vs. out-of-state research teams.

Interaction with the 50% Tax Liability Limitation

A critical nuance of the South Carolina Research Expenses Credit is its “ordering” rule and the 50% cap. Unlike some credits that can wipe out a taxpayer’s entire liability, the R&D credit is designed to ensure that the taxpayer still contributes to the state’s general fund.

The law dictates that the credit cannot exceed 50% of the taxpayer’s remaining tax liability after all other credits have been applied. This makes the R&D credit a “residual” credit, often used after more restrictive incentives like the Jobs Tax Credit.

This limitation underscores the importance of the 10-year carryforward provision. Because the credit is applied last and is capped at 50% of the residual, companies with significant R&D spend and other job-creation incentives often generate “excess” credits that must be managed over a decade.

The Nexus Requirement: “Made in South Carolina”

The phrase “made in South Carolina” is the pivot point of the state’s R&D credit. While federal law allows for QREs incurred anywhere in the United States, the South Carolina credit is strictly geographically bound.

Payroll and Multi-State Teams

For companies with research teams spanning multiple states, South Carolina requires a meticulous allocation of wages. Only the portion of an employee’s salary attributable to work performed within South Carolina is eligible. If a researcher lives in North Carolina but works at a lab in Rock Hill, South Carolina, their wages generally qualify because the “service” is performed in the state and is subject to South Carolina withholding. Conversely, a researcher employed by a South Carolina firm who works remotely from a home office in Georgia would generally not generate South Carolina QREs, as the research activity is not “conducted within the state”.

Supply Sourcing vs. Usage

The SCDOR focuses on where the supplies are “used in the conduct of qualified research”. While the materials may be purchased from out-of-state vendors, they must be consumed at a research facility located in South Carolina to qualify for the 5% credit. This distinction is vital for manufacturing firms that may source specialized chemicals or components globally but perform their experimental bonding or stress-testing at South Carolina plants.

Example: Palmetto Advanced Materials, Inc.

To illustrate the application of these rules, consider Palmetto Advanced Materials (PAM), a hypothetical C corporation operating in Spartanburg, South Carolina. In the 2024 tax year, PAM engaged in a project to develop a new “smart” polymer for use in automotive sensors.

1. Identifying Qualified Activities

The project was led by a team of chemical engineers who conducted a systematic process of trial and error (experimentation) to overcome a technical uncertainty: the polymer’s ability to remain conductive at extreme temperatures (technological in nature). They evaluated four different chemical formulations before finding one that met the performance specifications (permitted purpose).

2. Calculating South Carolina QREs

PAM’s R&D expenses for the year were as follows:

• Wages: PAM paid $800,000 to engineers based in Spartanburg. One engineer spent 85% of her time on the project, so 100% of her $100,000 salary was included. Others were allocated by actual time spent.
• Supplies: PAM spent $150,000 on specialized resins and testing materials consumed in the Spartanburg lab.
• Contract Research: PAM paid Clemson University (a South Carolina institution) $100,000 to perform advanced molecular modeling.

Total SC QRE Calculation:

• Wages: $800,000
• Supplies: $150,000
• Contract Research: $100,000 × 65% = $65,000
• Total SC QREs: $1,015,000

3. Calculating the Earned Credit

The earned South Carolina Research Expenses Credit is:

Credit = $1,015,000 × 0.05 = $50,750

4. Applying the Credit and Limitations

PAM’s tax situation for 2024:

• Corporate Income Tax Liability: $80,000
• Corporate License Fee: $10,000
• Total Initial Liability: $90,000
• Other Credits (Jobs Tax Credit): PAM created 15 jobs, earning a $22,500 credit (not limited to 50% in this scenario for simplicity).
• Remaining Liability: $90,000 – $22,500 = $67,500
• R&D Credit Limitation: $67,500 × 50% = $33,750

Final Result:

• PAM uses $33,750 of its R&D credit to reduce its total tax bill to $33,750 ($67,500 – $33,750).
• PAM carries forward the unused $17,000 ($50,750 – $33,750) for up to 10 years.

Ancillary R&D Incentives: Sales and Use Tax Exemptions

The meaning of “increasing research activities” in South Carolina also extends into the realm of sales and use tax. While the income tax credit incentivizes spending on labor and materials, Code Section 12-36-2120(56) provides an exemption for the equipment used to conduct the research.

The Research and Development Machine Exemption

South Carolina exempts from sales and use tax any “machines used in research and development”. This is a powerful “front-end” incentive that reduces the capital cost of setting up a laboratory or experimental production line.

SCDOR guidance (specifically Revenue Ruling #10-1) establishes two primary requirements for this exemption:

1. Direct Use: The machine must be used “directly” in research and development in the experimental or laboratory sense. This excludes machines used for administrative, teaching, or non-experimental purposes.
2. Primary Use: More than 50% of the machine’s total use must be devoted to direct R&D. If a machine is used 40% for research and 60% for routine quality control of existing products, the entire machine is subject to sales tax.

This exemption is particularly valuable because it has no annual cap and applies at the time of purchase, providing immediate cash-flow benefits that the income tax credit (claimed months later) cannot.

Relationship with the Corporate Headquarters Credit

For many large-scale innovators, increasing research activities is a component of a larger project, such as establishing a national or regional headquarters. S.C. Code Ann. § 12-6-3410 provides a 20% credit for real and personal property costs associated with headquarters facilities.

Interaction and Strategy

Historically, R&D-related functions and services counted toward the job-creation requirements of the headquarters credit. However, recent legislative changes (House Bill 4087, effective after 2023) have refined these boundaries. While R&D personnel may no longer be the primary driver for “headquarters” job counts in some contexts, the facilities they occupy still qualify for the 20% property credit if they are part of a larger headquarters establishment or expansion.

A strategic taxpayer will often “stack” these incentives:

1. Use the Corporate Headquarters Credit to offset 20% of the cost of building the research facility and furnishing it with computers and lab benches.
2. Use the Sales and Use Tax Exemption for R&D Machines to avoid taxes on the specialized scientific equipment housed within that facility.
3. Use the Research Expenses Credit to annually offset 5% of the wages paid to the researchers working in that facility.

Audit Risks and Substantiation Requirements

Because the South Carolina credit is tethered to a federal claim, a state audit of “increasing research activities” is essentially an audit of the taxpayer’s compliance with IRC Section 41. Both the IRS and the SCDOR have significantly increased their documentation requirements in recent years.

Contemporary Documentation Standards

The IRS’s 2025 finalization of Form 6765 changes marks a shift toward “project-level” substantiation. Taxpayers can no longer rely on high-level aggregations of expenses. For each project, the taxpayer must maintain:

• Technical Records: Lab notebooks, design drawings, testing logs, and prototypes that document the “process of experimentation”.
• Time Tracking: Contemporaneous records (such as project-coded timesheets) that support the allocation of wages to specific business components.
• Financial Records: Invoices and general ledger detail for supplies and contract research, clearly identified as being used for the specific R&D project.

The Consistency Requirement

A major audit pitfall is the “Consistency Requirement” under IRC Section 41(c)(5). This rule requires that QREs used in the current year’s calculation be determined on a basis consistent with the QREs in the base years. While South Carolina does not use a state base amount, the federal credit does. If a taxpayer’s federal credit is disallowed because they failed the consistency test (e.g., they included a type of expense in the current year that they didn’t include in their historical base years), their state credit is jeopardized.

Pass-Through Entities and Allocated Credits

For taxpayers operating as S Corporations, Partnerships, or LLCs, the “meaning” of the R&D credit is realized at the individual level. The entity itself does not pay income tax; instead, it files Form TC-18 to calculate the credit and then passes it through to its owners.

The K-1 Mechanism

The credit is distributed to partners or shareholders via the South Carolina Schedule K-1. The instructions for Form TC-18 require the individual taxpayer to provide the Name and FEIN of the pass-through entity from which they received the credit. This allows the SCDOR to trace the individual’s claim back to the entity that actually performed the qualified research.

Liability Limits for Individuals

An individual partner is subject to the same 50% liability limit as a C corporation. However, for an individual, this means the R&D credit can only offset 50% of the tax liability generated by their entire taxable income, not just the income from the research-performing entity. This can be particularly beneficial for high-net-worth individuals with diverse income streams, as the research credit from one business can effectively shield half of their total state tax liability.

Final Thoughts and Strategic Outlook

Increasing research activities in South Carolina represents a sophisticated intersection of state and federal law, designed to reward the financial risks inherent in technical innovation. By adopting the federal IRC Section 41 framework but simplifying it with a flat 5% rate on in-state expenditures, South Carolina has created a predictable, high-value incentive that is accessible to both global manufacturers and local startups.

For the practitioner and the business owner, the primary takeaways are clear:

1. Alignment is Key: Ensure the activity meets the federal Four-Part Test; without a federal claim, there is no state credit.
2. Accounting is Critical: Segregate South Carolina-based wages and supplies to meet the “made in South Carolina” nexus requirement.
3. Stacking is Efficient: Coordinate the R&D credit with Sales Tax exemptions and Headquarters credits to maximize the total return on investment.
4. Carryforwards are Assets: Given the 50% liability cap, think of the R&D credit as a long-term tax asset that can provide value for up to 10 years.

As the South Carolina economy continues to transition toward advanced manufacturing, biotechnology, and aerospace engineering, the importance of “increasing research activities” will only grow. The state’s commitment to these incentives provides a foundational support system that allows innovative firms to push the boundaries of technology while maintaining a competitive fiscal position.