Research credit limitations

ARTICLE | September 16, 2021

Authored by RSM US LLP

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.