Pass-through Entities (S Corporations, Partnerships, LLCs)

The South Carolina Research and Development tax credit allows pass-through entities to generate state tax benefits from qualifying research expenses that flow directly to the individual income tax returns of owners and shareholders. This mechanism ensures that the financial incentive for innovation is utilized to offset the personal tax liabilities of those who provide the business’s capital and leadership.

The structural relationship between pass-through entities—specifically S Corporations, Partnerships, and Limited Liability Companies—and the South Carolina Department of Revenue’s incentive programs represents a sophisticated intersection of state statutory law and federal tax conformity. In the Palmetto State, the primary vehicle for rewarding industrial and technological innovation is the Research Expenses Credit, governed by South Carolina Code Section 12-6-3415. Unlike traditional C Corporations, which utilize tax credits to reduce corporate-level income tax, pass-through entities serve as conduits. The qualified research expenditures (QREs) incurred at the operational level are calculated and then apportioned to the individual owners, who then apply their pro-rata share of the credit against their South Carolina individual income tax or corporate license fees. This analysis explores the legal definitions, administrative guidance, and practical applications of this credit within the unique tax climate of South Carolina.

Structural Taxonomy of Pass-Through Entities in South Carolina

The term “pass-through entity” in South Carolina tax law encompasses a variety of legal structures that share a common trait: the entity itself is generally not subject to the state’s 5% corporate income tax. Instead, the tax liability is “passed through” to the owners, who report the entity’s income, losses, and credits on their personal or corporate tax returns. The South Carolina Department of Revenue (SCDOR) generally follows federal tax classification for these entities, ensuring a level of administrative consistency for multi-state operations.

Partnerships and Multi-Member LLCs

Under South Carolina Code Section 12-6-18, the state adopts the federal definition of a partnership. Every partnership, which includes any multi-member Limited Liability Company (LLC) that has not elected to be taxed as a corporation, must file Form SC1065 if it conducts business or owns property within the state. The partnership serves as a reporting mechanism rather than a taxpayer. It calculates its net income and its distributive share of tax credits, such as the Research Expenses Credit, and provides each partner with a South Carolina Schedule K-1. For LLCs, this flexibility is a hallmark of their utility; an LLC may be disregarded for tax purposes if it has a single member, or it may be treated as a partnership if it has multiple members, unless it affirmatively elects corporate taxation.

S Corporations and the License Fee Nuance

S Corporations are treated as pass-through entities for income tax purposes under South Carolina law, mirroring Subchapter S of the Internal Revenue Code. However, South Carolina imposes a unique requirement on S Corporations that distinguishes them from partnerships: the Corporate License Fee. While S Corporations do not pay entity-level income tax, they are subject to an annual license fee of 0.1% of their capital and paid-in surplus, plus $15, with a minimum fee of $25. This is a critical distinction for the R&D credit, as the credit can be used to offset both income tax and corporate license fees. If an S Corporation generates a Research Expenses Credit, it may apply that credit against its own license fee liability before passing the remaining credit through to its shareholders.

Disregarded Entities and Sole Proprietorships

For individual entrepreneurs operating as sole proprietors or single-member LLCs, the R&D credit is claimed directly on their individual income tax return (SC1040). These entities are considered “disregarded” for tax purposes, meaning the activities of the business are treated as the activities of the individual owner. Consequently, the owner calculates the QREs of the business and reports the resulting credit on Form TC-18 as part of their personal filing.

Comparison of Pass-Through Entity Characteristics in South Carolina

Statutory Framework of the Research Expenses Credit

The Research Expenses Credit is codifed in South Carolina Code Section 12-6-3415. The statute is characterized by its direct conformity to federal standards while maintaining strict geographic boundaries. The intent of the legislature was to incentivize high-value technological and scientific activities within the state to bolster the local economy.

Federal Conformity and the Claim Requirement

A fundamental requirement for claiming the South Carolina credit is that the taxpayer must also claim a federal income tax credit for research expenses under Internal Revenue Code (IRC) Section 41 for the same taxable year. This dependency serves two purposes: it ensures that the research conducted meets the rigorous “Four-Part Test” established by the IRS, and it aligns the state’s tax incentives with federal industrial policy.

The credit is equal to 5% of the taxpayer’s qualified research expenses (QREs) made within South Carolina. While the federal credit involves a complex calculation based on a “base amount” or an “alternative simplified credit” formula, the South Carolina credit is a straightforward 5% of the current year’s state-based QREs. This simplifies the calculation for pass-through entities, which may not have the historical data required for some federal calculation methods.

Defining Qualified Research Expenses (QREs)

South Carolina adopts the definition of QREs found in IRC Section 41(b). This generally includes three categories of expenditures: wages, supplies, and contract research. However, the state’s geographic nexus requirement is paramount. Only those expenses incurred for activities physically performed in South Carolina can be included in the 5% calculation.

Wages qualify if they are paid to employees for “qualified services,” which includes the direct performance of research, the direct supervision of research, or the direct support of research. In the context of pass-through entities, this often includes the owners themselves if they are actively engaged in the technical aspects of the business. Supplies qualify if they are tangible property, other than land or improvements to land, used in the research process. Finally, contract research is included at 65% of the amount paid to an outside vendor, provided the vendor performs the research within South Carolina on behalf of the taxpayer.

The 50% Tax Liability Limitation

Under Section 12-6-3415(B), the amount of credit that may be used in any single tax year is limited to 50% of the taxpayer’s tax liability that remains after all other available credits have been applied. This ordering rule is vital for tax planning. Because the R&D credit is applied after most other incentives, its immediate utility may be constrained if the taxpayer has already utilized credits such as the New Jobs Credit (Section 12-6-3360) or the Investment Tax Credit (Section 12-14-60).

For example, if an individual partner has an initial South Carolina tax liability of $100,000 and utilizes $40,000 in other credits, their remaining liability is $60,000. The Research Expenses Credit is then limited to 50% of that remaining $60,000, or $30,000 for that year. Any unused portion of the credit can be carried forward for up to 10 years from the year the expenses were incurred.

Mechanics of Pass-Through Credit Allocation

The process of moving the R&D credit from the business entity to the individual taxpayer involves several administrative steps and specific SCDOR forms. For professional peers managing these filings, understanding the flow of information is essential for audit defense.

The Role of Schedule K-1 and Form TC-18

When a partnership or S Corporation earns an R&D credit, it must communicate the specific amount to each owner. This is done via the South Carolina Schedule K-1, which mirrors the federal K-1 but provides state-specific credit amounts. The entity itself does not “claim” the credit on its SC1065 or SC1120S in the sense of reducing tax (as there is typically no entity tax to reduce), but it acts as the reporting originator.

Individual owners then use Form TC-18 (“Research Expenses Credit”) to compute the actual credit they can apply to their returns. The instructions for TC-18 require the taxpayer to provide the following data:

• The name and Federal Employer Identification Number (FEIN) of the pass-through entity that made the qualifying research expense.
• The amount of the credit specifically identified on their SC K-1.
• Their current year tax liability before credits and the total of all other credits claimed.

Nonresident Withholding and Credits

South Carolina law requires pass-through entities to withhold and remit income tax on behalf of their nonresident owners at a rate of 5%. This withholding is treated as a “payment of estimated tax” for the nonresident individual. However, the R&D credit can be a powerful tool for these nonresidents. When a nonresident files their South Carolina income tax return (SC1040NR), they claim the R&D credit to reduce their tax liability. If the credit reduces their liability below the amount already withheld by the entity, the nonresident taxpayer is entitled to a refund of the excess withholding.

To avoid the withholding requirement, a nonresident partner may file an affidavit (Form I-309) with the SCDOR, stating that they are subject to the personal jurisdiction of the state and will file their own returns and pay taxes as required. In such cases, the R&D credit is applied directly by the partner on their return without the need to reconcile against withheld amounts.

Ordering and Carryforward Dynamics

The SCDOR provides specific guidance on the order in which credits must be taken. Nonrefundable credits like the Research Expenses Credit cannot reduce tax liability below zero. Furthermore, credits that have an annual limitation must be computed one at a time. The R&D credit’s status as a “secondary” 50% limit (50% of the remaining liability) means it is effectively applied after primary credits.

Administrative Guidance from the South Carolina Department of Revenue

The SCDOR issues several types of advisory opinions—Revenue Rulings, Information Letters, and Private Revenue Opinions—to interpret the law. For R&D credits in pass-through entities, several key rulings provide the current administrative posture.

Revenue Ruling #21-15: The PTE Tax Election

One of the most significant changes to the South Carolina tax landscape for pass-through entities occurred with the passage of Act 61 in 2021, which introduced the Pass-Through Entity (PTE) Tax Election (Code Section 12-6-545(G)). This election allows a qualifying partnership or S Corporation to pay tax at the entity level on its “active trade or business income”. The rate for this tax was initially 3%, designed to circumvent the federal $10,000 SALT deduction cap for individuals.

Revenue Ruling #21-15 provides critical guidance on how credits interact with this election. For S Corporations making this election, the entity must apply its earned credits against the entity-level tax before passing any remaining credit to its shareholders. For partnerships, the rule is more flexible; the partnership may choose to apply the credit at the entity level or pass it through entirely to the partners on a credit-by-credit basis. This election represents a strategic opportunity for R&D-heavy entities to utilize credits immediately at the entity level to reduce a 3% tax, which in turn generates a federal tax deduction for the owners.

Revenue Ruling #08-3: Defining R&D Equipment

Although focused on Sales and Use Tax, Revenue Ruling #08-3 is essential for understanding the state’s rigorous definition of R&D. The ruling addresses the exemption for machines used in research and development and establishes that “primarily” means more than 50% of the machine’s use must be for qualifying R&D. It further clarifies that “research and development” must be in the “experimental or laboratory sense” and must involve new products or improvement of existing ones. This strict definition is often mirrored in audits of the income tax R&D credit, where the SCDOR may challenge expenses that are administrative or indirect in nature.

Private Revenue Opinion #01-1: License Fees and Credits

This private opinion addresses the use of tax credits to offset the Corporate License Fee. It concludes that taxpayers subject to the license tax may use credits generated under Section 12-6-3410 (Headquarters Credit) to offset that liability. By extension, this logic applies to the Research Expenses Credit under Section 12-6-3415, which explicitly allows for the offset of both income tax and license fees. This is particularly relevant for S Corporations that may have high capitalization but low taxable income, as it allows the R&D credit to reduce their non-income-based tax burden.

Analysis of Qualified Research Activities and Documentation

To secure the credit, a pass-through entity must demonstrate that its activities meet the federal definition of qualified research. This is established through a Four-Part Test, which the SCDOR evaluates with technical precision.

The Four-Part Test in South Carolina

1. Technological in Nature: The research must fundamentally rely on principles of physical science, biological science, engineering, or computer science.
2. Permitted Purpose: The activity must be intended to develop a new or improved business component, focusing on functionality, performance, reliability, or quality.
3. Elimination of Uncertainty: The taxpayer must have intended to discover information that would eliminate technical uncertainty regarding the capability, method, or design of the product or process.
4. Process of Experimentation: The taxpayer must have engaged in a systematic process of trial and error, modeling, simulation, or other evaluative techniques to resolve the technical uncertainty.

For many South Carolina businesses in the manufacturing and aerospace sectors, these requirements are met through the development of specialized prototypes or custom parts. However, the SCDOR requires “detailed documentation for audit compliance purposes”. This includes time-tracking records for employees, project descriptions that articulate the technical challenges, and evidence of the nexus of the work within the state.

Geographic Nexus and Remote Work Implications

The requirement that QREs be “made in South Carolina” creates a significant hurdle for entities with a decentralized workforce. Under the South Carolina Income Tax Act, only wages for services performed within the state qualify. If a pass-through entity employs a researcher who works from a home office in North Carolina or Georgia, those wages are generally excluded from the state credit calculation, even if the business itself is headquartered in Charleston or Greenville.

Recent legislative changes, such as House Bill 4087 (2024), have begun to address “remote employees” in the context of the Jobs Development Credit (JDC), but the R&D credit remains strictly tied to the geographic location of the research activity itself.

Practical Modeling: A Multi-Partner Scenario

To integrate the diverse statutory and administrative rules discussed, consider a comprehensive example involving a South Carolina S Corporation.

Scenario: Innovation Dynamics, S Corp

Innovation Dynamics (ID) is an S Corporation based in Columbia, SC, specializing in automotive sensor technology. It has two equal shareholders: Smith (SC Resident) and Jones (Nonresident).

QRE Identification (Entity Level)

In 2023, ID incurred the following expenses:

• SC-Based Research Wages: $500,000
• Supplies for Sensors: $100,000
• Contracted Lab Testing (performed in SC): $50,000
• Wages for Remote Researcher (lives in GA): $80,000
• Qualified SC QREs: $500,000 + $100,000 + ($50,000 * 0.65) = $632,500.
• Note: The $80,000 for the remote researcher is excluded because the activity was not performed in SC.

Credit Generation

The entity-level Research Expenses Credit is:

• $632,500 * 5% = $31,625.

Application to License Fees

Innovation Dynamics has a capital and surplus base that results in a $1,000 Corporate License Fee. The entity chooses to use the credit to offset this fee.

• License Fee: $1,000
• Credit Applied: $500 (Limited to 50% of the liability).
• Remaining Credit: $31,125 ($31,625 – $500).

Pass-Through Allocation

The remaining credit is allocated to Smith and Jones via SC K-1:

• Smith (50%): $15,562.50
• Jones (50%): $15,562.50.

Taxpayer Utilization: Smith (SC Resident)

Smith has other income and a gross SC tax liability of $40,000. He also has $10,000 in New Jobs Credits from another entity.

• Gross Tax: $40,000
• New Jobs Credit: $10,000 used (within 50% limit of $20,000).
• Remaining Tax: $30,000
• R&D Credit Limit: 50% of remaining $30,000 = $15,000.
• Credit Used: $15,000
• Carryforward: $62.50 (to be used over next 10 years).

Taxpayer Utilization: Jones (Nonresident)

Jones has a gross SC tax liability of $20,000. ID withheld 5% of Jones’s $300,000 share of income ($15,000) throughout the year.

• Gross Tax: $20,000
• R&D Credit Limit: 50% of $20,000 = $10,000.
• Credit Used: $10,000
• Final Tax Due: $10,000
• Withholding Reconciliation: Jones has already “paid” $15,000 via withholding. Since his final tax is $10,000, he receives a $5,000 refund from the state.
• Carryforward: $5,562.50 ($15,562.50 – $10,000).

Interaction with the 2024 Legislative Updates (HB 4087)

The South Carolina General Assembly’s 2024 legislative session introduced significant updates that, while not amending Section 12-6-3415 directly, altered the ecosystem in which R&D entities operate. House Bill 4087 rebranded the “Corporate Headquarters Credit” as the “Headquarters Facility Credit” and replaced the word “Corporation” with “A taxpayer or a business unit of a taxpayer”.

This change is critical for pass-through entities engaged in R&D. Historically, an S Corp or Partnership that built a new research facility could only pass through the Research Expenses Credit (5% of QREs). Under the new law, if that facility qualifies as a “headquarters facility” or a “research and development facility” under the amended Section 12-6-3410, the entity can now also claim a 20% credit on the real property costs of that facility and a 20% credit on the tangible personal property costs.

However, the “Research and Development” functions are now more closely scrutinized under the new wage requirements. To qualify for the property components of the headquarters credit, the new jobs created must have gross wages equal to or greater than twice the per capita income of the state. As of 2023, the state per capita income was $56,123, meaning qualifying R&D jobs must pay at least $112,246 to trigger the headquarters property credits. This creates a bifurcated incentive structure where the R&D credit (5%) remains accessible for a wide range of wages, but the property-related credits (20%) are reserved for high-wage innovation hubs.

Per Capita Income Thresholds for Ancillary R&D Benefits

Audit and Compliance Considerations for Pass-Through Entities

The SCDOR maintains a three-year statute of limitations for auditing and amending returns. For pass-through entities, an audit at the entity level can have a cascading effect on all owners. If the SCDOR disallows a portion of the entity’s QREs, it will adjust the K-1s of every partner or shareholder, leading to individual-level tax assessments and interest.

Common Audit Triggers

1. Discrepancy in QRE Nexus: Claiming wages for employees who are domiciled outside of South Carolina or whose time is spent in non-qualifying activities.
2. Failure to Claim Federal Credit: Since the SC credit is contingent upon the federal IRC 41 credit, a taxpayer who does not file federal Form 6765 will automatically be disqualified at the state level.
3. Inadequate Project Documentation: Lack of contemporaneous records that link supply costs or contractor fees to specific technological experiments.
4. Improper Calculation of the 50% Limit: Applying the R&D credit before primary credits or neglecting the “remaining liability” rule.

The Role of Section 280C

South Carolina follows the federal rule regarding the deductibility of research expenses. Under IRC Section 280C, a taxpayer must reduce their business expense deduction by the amount of the federal R&D credit claimed, unless they elect a reduced credit. South Carolina generally adopts this federal modification to taxable income, meaning that the “pass-through” income reported to owners on their K-1s will already reflect the reduction in deductible expenses caused by the federal credit.

Final Thoughts

The South Carolina Research and Development tax credit remains a vital component of the state’s economic strategy, specifically tailored to reward innovation within the flexible frameworks of S Corporations, Partnerships, and LLCs. By allowing these benefits to flow through to individual owners, the state effectively lowers the cost of capital for high-tech ventures and rewards the personal risk taken by entrepreneurs.

However, the utility of the credit is not automatic. It requires a deep understanding of the ordering rules—particularly the secondary 50% limitation—and a vigilant approach to geographic nexus. The introduction of the PTE tax election in 2021 and the rebranding of headquarters incentives in 2024 further demonstrate that South Carolina is actively evolving its tax code to support modern business structures. For professional peers in tax and finance, the priority must be the integration of these state-level nuances with federal compliance to maximize the total incentive package available to South Carolina’s innovative core.