Research credit limitations

by | Sep 23, 2021

INSIGHT ARTICLE  | 

Background

Owners and beneficiaries of pass-through entities are generally allowed to take advantage of the section 41 credit for increasing research activities, subject to certain apportionment rules. For S corporations, the credit is apportioned pro rata on a per-share, per-day basis among shareholders.1 For estates and trusts, the credit is apportioned between the estate or trust and the beneficiaries on the basis of the income that is allocable to each.2 Credit allocations for partnerships are a bit more complicated. If a partnership pays or incurs qualified research expenses in carrying on a trade or business under section 41(b)(1), the credit is computed at the partnership level and is allocated to partners in accordance with section 704 and related regulations,3 which generally require apportionment among partners in proportion to their partnership interests unless a valid special allocation is made. In all cases, the amount of the credit that is passed through to owners and beneficiaries is taken into account in the taxable year of the person entitled to the credit in which the particular pass-through entity’s taxable year ends.4

Discussion

A number of special provisions alter the ability of pass-through entities to take full advantage of the credit. One such limitation is found in the flush language of section 41(g), which provides that for a pass-through entity, the credit can only be used to offset the amount of taxes attributable to the taxable income which is allocable to the taxpayer’s interest in such trade or business or entity engaged in the research and generating the credit. For example, if an individual is a partner in a partnership, and the partnership engages in qualified research and is otherwise entitled to an R&D credit, the portions of the credit passed through to individual partners can only be used to offset the tax attributable to partner’s portion of taxable income generated from the partnership engaged in research activities. The credit cannot be used to generally offset the partner’s income tax. Similarly, the credit for an S corporation shareholder cannot exceed the shareholder’s tax attributable to the income of the S corporation that generated the credit.

Pass-through entity owners and beneficiaries are limited in taking the credit in a number of other ways, particularly S corporation’s shareholders. For example, if a C corporation generates a credit that must be carried forward, and it later makes an S election, the shareholders of the new S corporation will not be able to use any of the credit carry forwards except to offset the tax on built-in gains.5 Additionally, the general section 41 rules that allow corporations to subcontract basic research out to exempt organizations do not apply to S corporations, which thereby results in a lower credit.6

Partners and partnerships also face significant limitations in that special allocations of the credit are treated only as valid if the allocation is based on research activity expenditures and the risk associated with making those expenditures.7 In addition, special allocations of research activity expenditures, like other expenditures, must have economic effect in order to be upheld.8 Economic effect is generally present if the effect that is reflected in partnership capital accounts is substantial.9 Not all of the rules are prohibitive, however. For example, if the partnership performing qualified research does not meet the trade or business requirement, but the partners independently satisfy such requirement with respect to research, the qualified expenses of the partnership are treated as paid or incurred directly by the partners and allocated in accordance with section 704 and the related regulations.10 In these cases, the credit is computed at the partner level and the limitation of section 41(g) is inapplicable.

Actions to be taken

Practitioners should pay careful attention. When pass-through entities, such as partnerships, S corporations, trusts and estates, pass the research credit they earn through to their partners, shareholders, and beneficiaries, these taxpayers need to consider the limitation imposed by section 41(g) when planning to claim the credit. In the absence of careful planning, section 41(g) may make the credit much less valuable to these pass-through entities.

 
1 Sections 1366, 1377; Treas. Reg. section1.41-7(a)(1)(i)
2 Treas. Reg. section 1.41-7(a)(2)
3 Treas. Reg. section 1.41-7(a)(3)(i)
4 Treas. Reg. section 1.41-7(a)(4)
See section 1371(b)(1). However, the S corporation can use a research credit carry forward from a C year to offset the tax imposed by section 1374 under IRC section 1374(b)(3)(B)
See sections 41(a)(2), 41(e)(7)(E) 
See Treas. Reg. section 1.704-1(b)(1)(i). 
Treas. Reg. section 1.704-1(b)(2)(ii).
Treas. Reg. section 1.704-1(b)(2)(iv), 1.704-1(b)(2)(iii).
10 See Treas. Reg. section 1.41-2(a)(4)(ii).

Questions or Want to Talk?

Call us directly at 972.221.2500 (Flower Mound) or 940.591.9300 (Denton),
or complete the form below and we’ll contact you to discuss your specific situation.


This article was written by RSM US LLP and originally appeared on 2021-09-17.
2021 RSM US LLP. All rights reserved.
https://rsmus.com/what-we-do/services/tax/research-credit-limitations.html

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

 

RSM

KHA Accountants, PLLC is a proud member of RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.

Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise, and technical resources.

For more information on how KHA Accountants can assist you, please call 972.221.2500.

Growing your Business Through Mergers and Acquisitions

The business world is consolidating rapidly and companies of all sizes are looking to increase their size, power, and efficiency through merger and acquisition (M&A) activity. Learn how a merger or acquisition may help your company grow quickly and efficiently.

Estate planning: Five ways to avoid probate

Estate planning enables you to specify what happens with your assets after death or incapacitation. While every situation is unique, individuals often create estate plans that minimize the need for probate. Probate is the legal process of validating a will and...

Is a Roth IRA Conversion Right for You?

Should I convert my retirement plan to a Roth IRA? It's an important question worth considering. Roth vs. Traditional: What's the Difference?  Taxes now or taxes later. Simply put, that is the main difference between a Roth and Traditional IRA.  Contributions to a...

Inflation and the middle market

The economic growth and emboldened labor market of the past year require a different policy response than the previous two business cycles.

Business Owners: IRS Issues Updated K-2 and K-3 Requirements

February 16, 2022 – The IRS has updated guidance on additional exceptions to the new K-2 and K-3 filing requirements. See FAQ #15 found here. In late 2021, the IRS added new schedules K-2 and K-3 for tax year 2021 for partnerships and S corporations (flow-through...

Family office dream team

An effective family office requires the right mix of internal and external capabilities to balance best-in-cost with best-in-class.