Taxpayer Employing Less Than 150 Full-time Employees (Refund Provision)

The South Carolina Research Expenses Tax Credit refund provision permits taxpayers with fewer than 150 full-time employees to receive a cash refund for credits exceeding their tax liability, capped at 75% of said liability. This specialized mechanism, governed by South Carolina Code Section 12-6-3415, functions as a liquidity-enhancing exception to the standard 50% liability limitation and 10-year carryforward rules typically applicable to larger corporate entities.

Statutory Framework and the Evolution of Research Incentives

The South Carolina Research Expenses Tax Credit, codified in Section 12-6-3415 of the South Carolina Code of Laws, represents the state’s commitment to fostering a knowledge-based economy by incentivizing in-state investment in scientific and technological advancement. Historically, the credit was structured as a nonrefundable incentive, meaning it could reduce a taxpayer’s liability to zero but could not result in a direct cash payment from the state treasury. However, the legislative recognition of the unique capital constraints faced by small, high-growth firms led to the introduction of the refund provision for taxpayers employing fewer than 150 full-time employees.

Under the general provisions of Section 12-6-3415(A), a taxpayer that claims a federal income tax credit pursuant to Section 41 of the Internal Revenue Code for increasing research activities is allowed a credit against South Carolina income taxes (Chapter 6 of Title 12) or corporate license fees (Section 12-20-50). The state credit is equal to 5% of the taxpayer’s qualified research expenses (QREs) made specifically within South Carolina during the taxable year. The requirement to claim the federal credit as a prerequisite ensures that the underlying activities meet the rigorous standards of the federal “Four-Part Test,” which requires research to be technological in nature, intended to eliminate uncertainty, involve a process of experimentation, and be aimed at developing or improving a business component.

For most taxpayers, the credit is limited by Section 12-6-3415(B)(1), which stipulates that the credit taken in any single year may not exceed 50% of the taxpayer’s remaining tax liability after all other credits have been applied. Any unused portion of the credit may be carried over for a period of ten years, after which any remaining credit expires. The introduction of the refund provision for small taxpayers—defined as those with fewer than 150 full-time employees—creates a significant departure from these limitations, providing immediate cash flow for businesses that may have significant R&D expenditures but limited current-year tax liability.

The Refund Mechanism for Small Taxpayers

The refund provision is a targeted economic development tool designed to bridge the “innovation valley of death” often experienced by startups and expanding technology firms. According to the language of the provision, the standard 50% limitation on credit usage is waived for taxpayers meeting the headcount requirement. If a qualifying taxpayer generates a credit that exceeds their current year’s liability, the South Carolina Department of Revenue (SCDOR) is authorized to issue a refund for the remaining portion of the credit, subject to certain caps.

Eligibility and Headcount Definitions

To qualify for the refund, the taxpayer must employ fewer than 150 full-time employees, with the term “full-time employee” being defined by reference to Section 12-6-3360, the statute governing the New Jobs Credit. This cross-reference is critical, as it imports the specific definitions and requirements of the state’s primary job creation incentive into the R&D credit framework. Under Section 12-6-3360, a full-time employee is generally defined as an individual who works at least thirty hours per week and is provided with a comprehensive benefits package, including health care.

The headcount calculation is typically based on a monthly average of full-time employees subject to South Carolina income tax withholding during the taxable year. This requires the taxpayer to maintain precise payroll records to demonstrate that they did not exceed the 150-employee threshold. If a business unit of a larger taxpayer is the entity conducting the research, the headcount test may apply to the specific taxpayer entity filing the return, although SCDOR guidance generally looks to the total employment of the taxpayer within the state.

Calculation and Limitations of the Refund

While the refund provision provides significant flexibility, it is not an unlimited entitlement. The law imposes two primary caps on the refundable portion:

1. Individual Taxpayer Cap: The amount of the credit refunded to a single taxpayer may not exceed 75% of the taxpayer’s total tax liability for that taxable year.
2. Statewide Aggregate Cap: The SCDOR is prohibited from issuing more than $5 million in total R&D refunds across all taxpayers in a single year.

The mathematical relationship between the credit, the liability, and the refund can be expressed using the following logic. Let C be the total R&D credit earned, L be the tax liability after other credits, and R be the refund amount. For a qualifying small taxpayer:

If C > L, then R = min(C – L, 0.75 * L)

If the total of all claims R_total exceeds 5,000,000, the SCDOR must reduce each taxpayer’s refund by a proportionate amount. Any portion of the credit that is neither used to offset liability nor refunded due to these caps is eligible to be carried forward for ten years, consistent with the standard rules for the nonrefundable version of the credit.

Federal Conformity and Qualified Research Expenses (QREs)

Because the South Carolina credit is tethered to IRC Section 41, the definition of what constitutes a “qualified research expense” is paramount. South Carolina conforms substantially to federal income tax laws, adopting the Internal Revenue Code as amended through a specific date—most recently through December 31, 2024, subject to specific exceptions.

Categories of Qualified Expenses

Qualifying expenditures for South Carolina purposes must be incurred within the state. These generally fall into three categories defined by federal law and adopted by the state:

For small taxpayers, the “In-House Wages” category is often the most significant. To qualify, these wages must be paid to employees whose activities meet the “Four-Part Test” mentioned previously. Administrative and support staff wages may only be included if they are directly supporting the research activities, a distinction that often serves as a point of contention during audits.

The Four-Part Test in the South Carolina Context

While the Four-Part Test is a federal standard, its application in South Carolina requires careful documentation of the activities performed within the state. The SCDOR emphasizes that only research conducted in South Carolina is eligible for the 5% credit.

1. Permitted Purpose: The research must be intended to develop a new or improved business component. In the context of South Carolina’s industrial base, this often involves manufacturing processes, software development for logistics, or agribusiness innovations.
2. Elimination of Uncertainty: The taxpayer must demonstrate that they were attempting to resolve a technical uncertainty. This could be uncertainty regarding the methodology for a new chemical process or the design of a more efficient mechanical component.
3. Process of Experimentation: This requires evidence of evaluating alternatives. Documentation such as project logs, testing results, and iterative design revisions are essential to prove that a systematic process was followed.
4. Technological in Nature: The research must be based on hard sciences. Social science research, market surveys, and routine data collection do not qualify.

Administrative Guidance and SCDOR Procedures

The South Carolina Department of Revenue provides the administrative framework for claiming the R&D credit and its associated refund through published forms, revenue rulings, and information letters. These documents clarify the department’s position on issues ranging from the definition of software to the statute of limitations for refund claims.

Form TC-18: The Primary Claiming Mechanism

Taxpayers must use Schedule TC-18, “Research Expenses Credit,” to calculate and claim the incentive. This schedule is filed with the taxpayer’s annual income tax return (Form SC1120 for corporations or SC1040 for individuals). The form structure mirrors the statutory requirements, requiring the taxpayer to detail their QREs, calculate the 5% credit, and apply the relevant limitations.

For small taxpayers seeking the refund, the TC-18 acts as the primary evidentiary document. The instructions for TC-18 reiterate that a taxpayer must claim a federal credit for the same year to be eligible for the state credit. Furthermore, taxpayers who receive the credit via a pass-through entity (such as a Partnership or S Corporation) must enter the name and FEIN of the entity on the individual TC-18 to ensure proper tracking of the credit’s origin.

Revenue Ruling #12-1 and Software R&D

One of the most complex areas of R&D tax law involves software development. SCDOR Revenue Ruling #12-1 provides critical guidance on how electronically delivered software and cloud computing relate to the state’s tax laws. While the ruling primarily addresses sales and use tax, it clarifies the department’s view of software as an intangible asset and distinguishes between the “access or use of a communication system” and the “sale of intangible software”. This distinction is relevant for R&D purposes when determining whether software development activities are aimed at internal-use software (which has a higher threshold for qualification under federal and state law) or software intended for sale, lease, or license.

Statute of Limitations and Refund Claims

The procedure for claiming a refund of overpaid taxes, including those resulting from tax credits, is governed by Section 12-54-85 and further explained in Revenue Rulings #11-1 and #12-1. Generally, a claim for a credit or refund must be filed within three years of the date the return was filed (including extensions) or two years from the date the tax was paid, whichever is later.

For small businesses that discover they were eligible for the R&D credit in prior years, this three-year window is crucial. They may file an amended return (SC1120X or SC1040X) alongside a completed TC-18 to claim the missed credits. If the amendment results in the taxpayer meeting the “less than 150 employees” criteria for a prior year, they may potentially seek a refund for those years, provided the individual and state caps were not already exceeded.

Interplay with Other South Carolina Incentives

The Research Expenses Tax Credit does not exist in a vacuum; it is part of a broader suite of incentives that often overlap, particularly regarding headcount and facility requirements. Small businesses must be aware of how the R&D refund provision interacts with other popular credits such as the New Jobs Credit and the Headquarters Credit.

The New Jobs Credit (Section 12-6-3360)

The New Jobs Credit provides a per-job credit for taxpayers creating a minimum number of new, full-time jobs in the state. Because the R&D refund provision uses the same definition for “full-time employee,” the documentation used to support a New Jobs Credit claim is often the same documentation required to prove eligibility for the R&D refund.

The ordering rules for credits are also a vital administrative consideration. Under SCDOR General Rules, the Research Expenses Credit is applied to the remaining tax liability after all other credits have been applied. This “last-in” positioning makes the R&D credit the most likely to exceed the taxpayer’s liability, thereby triggering the refund provision for small businesses.

The Headquarters Credit (Section 12-6-3410)

For companies establishing or expanding a headquarters facility, Section 12-6-3410 provides credits for both real and personal property costs. A specific provision in Section 12-6-3410(H) allows for an additional credit for personal property used for “research and development related functions and services” if at least 150 new full-time jobs are created. This creates an interesting statutory contrast: while the R&D expenditure credit becomes refundable when employment is below 150, the personal property credit for R&D headquarters functions is enhanced when employment is above 150. Small businesses must carefully evaluate which incentives align with their growth trajectory.

Comprehensive Case Study: BioTech-SC LLC

To illustrate the application of the refund provision and the accompanying guidance, consider BioTech-SC LLC, a small pharmaceutical research firm located in a Tier III county in South Carolina. In the 2024 tax year, the company had the following profile:

• Average Monthly Full-Time Employees: 45.14
• Total South Carolina QREs: $1,500,000 (consisting of $1,000,000 in wages, $200,000 in supplies, and $300,000 in contract research).
• South Carolina Income Tax Liability (Gross): $60,000.
• New Jobs Credit Earned: $15,000.

Step 1: Headcount and Eligibility Confirmation

BioTech-SC LLC employs 45 people, which is well below the 150-employee threshold established in Section 12-6-3415(B)(2). The employees are all full-time (30+ hours/week) and receive health insurance, where the company pays 60% of the premium, satisfying the definition in Section 12-6-3360. The company also claimed the federal R&D credit on Form 6765, satisfying the federal conformity requirement.

Step 2: Calculation of the Research Expenses Credit

The credit is 5% of the total QREs:

Credit = $1,500,000 * 0.05 = $75,000

Step 3: Application of Ordering Rules

The New Jobs Credit is applied first to the liability:

Liability_Remaining = $60,000 – $15,000 = $45,000

Step 4: Application of the R&D Credit and Refund Calculation

Since the taxpayer has fewer than 150 employees, the 50% liability limitation (which would have capped the credit use at $22,500) is waived. The credit is first used to offset the remaining $45,000 liability.

Liability_Final = $45,000 – $45,000 = $0

Credit_Excess = $75,000 – $45,000 = $30,000

The refund is then calculated as the lesser of the excess credit or 75% of the taxpayer’s total liability.

• Excess Credit: $30,000.
• 75% Liability Cap: 0.75 * $60,000 = $45,000.

Because the excess credit ($30,000) is less than the 75% cap ($45,000), the full $30,000 is eligible for a refund.

Step 5: Final Disposition and State Cap Adjustment

BioTech-SC LLC files Form TC-18 with its 2024 return, showing a $0 tax due and a $30,000 refund request. However, if the SCDOR receives a total of $6 million in refund requests from all eligible small businesses in the state, each refund must be reduced proportionately to meet the $5 million state cap.

Refund_Adjusted = $30,000 * ($5,000,000 / $6,000,000) = $25,000

In this scenario, BioTech-SC LLC would receive a cash refund of $25,000. The remaining $5,000 that was not refunded due to the state cap is not lost; it is carried forward to the 2025 tax year and may be used to offset future liability or claimed as part of a future refund.

Documentation Standards and Audit Defense

The “refundable” nature of the credit for small businesses significantly increases the likelihood of a state tax audit. The SCDOR has a mandate to ensure that state funds are only disbursed for qualifying activities. Small businesses must therefore adopt a “contemporaneous documentation” approach to their R&D claims.

The “Nexus” of Research and Expense

Auditors primarily look for a clear nexus between the qualified research activity and the expense claimed. This is often documented through a project-based accounting system. Each project should be documented with:

• Project Title and Objectives: Clearly stating the technical uncertainty being addressed.
• Personnel List: Identifying the researchers and their specific roles in the project.
• Experimental Documentation: Laboratory notebooks, version control histories for software, or testing logs for physical prototypes.
• Financial Reconciliation: A direct link between the hours recorded by researchers and the wages reported on the TC-18.

The Role of Pass-Through Entities

For the many small R&D firms structured as LLCs or S Corporations, the documentation burden remains at the entity level, even though the tax benefit (and potential refund) is realized at the individual level. The entity must provide each partner or shareholder with a South Carolina Schedule K-1 that clearly breaks down their share of the credit and provides the entity-level headcount data necessary for the individual to claim the refund on their SC1040.

Comparative Context and Strategic Implications

While the focus of this report is South Carolina, the state’s refund provision exists within a competitive regional and national landscape. Other states, such as Arizona, have similar programs that provide refunds for small businesses with fewer than 150 employees. In Arizona, the refund is also 75% of the excess credit, but it requires pre-approval from the Arizona Commerce Authority. South Carolina’s model is more directly integrated into the tax filing process, although the $5 million state cap serves a similar role in managing the state’s fiscal exposure.

The 75% liability cap is a unique feature of the South Carolina provision. By linking the refund to the taxpayer’s liability (which is driven by profits and payroll), the state ensures that the refund is proportional to the company’s overall economic footprint. This prevents “shell companies” with no real business activity from capturing state R&D funds. For a small business, this creates a causal link between hiring and R&D benefits: as the company hires more people (increasing payroll and thus potential liability), the cap on their R&D refund also increases, up to the 150-employee threshold.

Strategic Recommendations for Small Taxpayers

Navigating the South Carolina Research Expenses Tax Credit requires a multi-year strategic perspective. Small businesses should consider the following actions to maximize their benefit under the refund provision:

1. Monitor the 150-Employee Cliff: Firms approaching 150 employees must recognize that the transition from the refundable small business provision to the nonrefundable large business provision will have a significant impact on cash flow. This may influence the timing of new hires or the utilization of contractors vs. full-time employees.
2. Harmonize Headcount Data: Ensure that the headcount data used for the R&D credit matches the data submitted for the New Jobs Credit and unemployment insurance filings. Discrepancies between these filings are a common trigger for SCDOR inquiries.
3. Perform an Annual R&D Study: Given the complexities of the Four-Part Test and the requirement for federal conformity, an annual R&D study can provide the necessary documentation to support both state and federal claims. This study should specifically isolate South Carolina-based QREs to comply with state law.
4. Evaluate Corporate License Fee Offsets: The credit can offset corporate license fees in addition to income tax. For capital-intensive startups with high paid-in capital but low income, the license fee offset may be a primary driver of the credit’s value.
5. Maintain Benefit Compliance: Since the refund depends on the definition of a “full-time employee” from the New Jobs Credit statute, firms must ensure they are meeting the 50% health insurance premium contribution requirement for all employees included in the headcount.

The South Carolina R&D tax credit refund provision for taxpayers with fewer than 150 employees is a sophisticated and valuable incentive. By converting tax credits into tangible liquidity, South Carolina provides a vital lifeline to the small businesses that are the engine of technological growth in the state. However, the administrative requirements—ranging from federal conformity to strict headcount monitoring and state-level caps—require a high degree of diligence from taxpayers and their advisors. Through proper documentation and strategic planning, small innovation-driven firms can successfully leverage this provision to fuel their continued development and expansion within the South Carolina economy.