R&D Tax Credit: Tax Return Reporting & Limitations (e.g. S-Corps & LLCs)

Claiming the R&D Tax Credit: Small Businesses Overlooking the R&D Credit

Historically, the mass majority of R&D tax credits are claimed by large corporations (see U.S. Government Accountability Office, The Research Tax Credit’s Design and Administration Can Be Improved (GAO-10-136), p. 13 (Nov. 2009). However, most Tax analyst have observed that most small to mid-size companies (usually pass-through entities, such as partnerships and S corporations) may be overlooking the R&D tax credit. Often these small businesses are unaware that they are engaged in eligible R&D credit activities, mistakenly do not believe their activities are qualified, or do not think they can meet the contemporaneous documentation requirements when claiming the R&D credit.

Despite these often mistaken omissions to claim the R&D credit by small to mid-size companies, it's important to realize many kinds of products, processes, or various technical activities undertaken by small business, pass-through entities, across the U.S. may actually be eligible for the R&D credit. 

Small and mid-size companies, similar to large businesses, are eligible for a R&D tax credit of up to 20% of the amount by which their qualified research expenses (QREs) in a tax year exceed their statutorily determined base amount for that year (see IRC 41), and may be carryforward period 20 years. (see Taxpayer Relief Act of 1997, P.L. 105-34). 
 

When claiming qualified federal or state R&D credits, the benefits are generally utilized against the following tax liabilities or opportunities:

  • Income Tax Liability: non-refundable unused credit portion(s) may be carried forward / back depending on jurisdiction.

  • Excess of Income Tax Liability: applicable state jurisdictions may provide a tax refund in excess of income tax liabilities​

  • FICA Payroll Taxes: up to $250K of eligible R&D credits per year for 5 years, for qualifying "start-ups" against federal payroll taxes. Note, some state jurisdictions (e.g. Georgia) may also provide a similar credit offset option against state payroll taxes.

    • Additional tax forms, elections, and procedures are generally required when the credits are be utilized against payroll taxes each quarter (941 Form quarterly federal filing due dates: January 31, April 30, July 31 and October 31).

    • Your payroll processing company (ADP, TriNet, Gusto, Justworks, etc.) will generally provide additional support and information on how your credits are utilized and the benefits are retained.

  • Additional State Taxes & Opportunities: it may offset excise taxes, franchise taxes, sales & use taxes, allow transfer / sale of credits, etc. See State R&D Tax Credits link for further details.

  • Amending Prior Year Tax Returns: potential federal and/or state tax refunds may be available for prior year income / applicable taxes paid.

Cost Benefit Analysis - Amending Return for R&D Credit Worth It?

The R&D tax credit for either a corporation or flow-through entity should be investigated by an R&D tax specialist, and the benefits deemed large enough, to merit amending a prior year tax return. For example, a $250,000 benefit from a flow-through entity, spread over 5 equal shareholders, is worth approximately $50,000 per shareholder. However, amending returns often authorizes the IRS to review the entire year and may subject your other claims, in addition to the R&D tax credit, to further scrutiny.

 

As such, when claiming the R&D credit, it is importance to ensure the claim or amended filing is properly performed, calculated, and documented to avoid additional issues upon a potential exam. If the R&D credit is reviewed or audited by the IRS / state taxing authority, and contains numerous errors, it may create a presumption to the taxing authorities that the entire return and associated claims may also contain similar errors, miscalculations, or lack of substantive documentation support and may lead to additional tax issues.

Confirming Your Entity & Tax Election Filings Prior to R&D Credit Claims

Prior to utilizing the R&D credit, the process of actually claiming the R&D Tax Credit generally begins with confirming your company's organization structure and filing status. Once confirmed, it's important to understand the procedural differences when claiming the R&D tax credit, how the benefit is utilized by the company and/or its shareholders, and the overall general process.

In general, for companies incorporated as C-corporations, the R&D credit will either be claimed against applicable income tax liabilities or its FICA payroll taxes. But for "flow-through" tax entities (unincorporated business, partnerships, S-corporations, LLCs), the credit benefits will generally flow from the company to its shareholders to offset their individual taxes derived from the business. As such, assessing both the entity and shareholder tax situation prior to claiming or amending for a refund is critical for effective tax planning.

Below summarizes general background and steps to help outline the process for flow-through entities (S-Corp, LLCs) to help explain the process when claiming the R&D credit benefits.

R&D Credit Tax Return Claims: For S-Corporations

S-Corps do not have to profitable for the tax year you may want to claim an R&D credit. However, the S-Corp must generally be actively engaged with carrying on a trade or business and perform qualifying activities to claim the R&D tax credit pursuant to IRC 41. For example, the S-Corp cannot be purely utilized as a channel for another entity or individuals's investing activity.

Moreover, its important to note some state tax laws (e.g. California S-Corporations) provide additional R&D tax credit benefits which may be utilized against entity level tax in addition to the credits that flow through the K-1 to individual shareholders.

Schedule K-1’s - R&D Credit Flow-through to Shareholders

When an S-Corp files an amended return, new K-1’s are generally issued to its shareholders. The K-1’s pass through income, losses, deductions and credits to the shareholders. The shareholders have the option of amending their personal returns with a Form 1040X. The 1040X Form filing will document the gross credit, a tax on that credit, and it will trigger a payment to the shareholder for the net R&D credit utilized as a benefit.

For a shareholder to realize a benefit from an amended year, the S-Corp must have met its cut-off date (e.g. "statute of limitations" for amended filings) for amending its 1120S Form and issuing K-1’s to the shareholders. Without the K-1’s from the S-Corp, the shareholders may have no basis for amending their personal returns, regardless of their filing dates.

R&D credits are generally designated in Part III of the K-1. Subsequently, the “flow through” incomes and credits impact the individual taxpayer’s personal return (Form 1040). As such, the individual shareholders benefits by their share (pro-rata ownership percentage of the business) of the R&D tax credit.

Below is a summary of some of the basics forms and implications for S-Corporations filing an R&D tax credit claim.

S-Corps Federal Forms

S-Corps Federal Filing Dates (including Schedule K-1 for each shareholder)

  • Initial Filing Date: 2 ½ months after the year end date.

  • Extended Filing Date:  6 months after the initial filing date.

  • Example:

    • Year End = December 31

    • Initial Filing = December 31 + 2 ½ months = March 15

    • Extended Filing = March 15 + 6 months = September 15

Federal S-corporations may file amended returns up to 3 years after the date of filing (statue of limitations). For example, if filed on March 15, 2012 then March 15, 2015 would be the last date to file an amended return. However, some state returns may have different (e.g. 4 years) statue of limitations to file an amended return.

 

R&D Credit Tax Return Claims: For Limited Liability Companies (LLCs)

A multi-member limited Liability Company (LLC) is initially treated like a sole proprietorship or partnership with an initial filing date of April 15 and an extended filing date of October 15 (unless an election is made to be taxed as C-corporation which may change its fiscal year end).

The R&D tax credits from an LLC are designated in Part III of the K-1. Similar to S-corporation tax elections, the LLC will “flow-through” incomes and credits to the individual taxpayer’s personal return, Form 1040. The individual, therefore, benefits by his/her share of the R&D tax credit generally allocated by ownership percentage. And as also noted above, careful consideration and specialist tax consultation should be made when amending a prior year return to claim the credit.

Similar to S-corporations, an LLC does not have to be profitable in the year it may claim an R&D credit.  However, it must be carrying on an active trade or business (not merely an investing vehicle).

Schedule K-1’s - R&D Credit Flow-through to Shareholders

Because LLC’s issue K-1’s to the owners and partners, when the LLC files an amended return, new K-1’s are also issued to the owners. As noted above, the K-1’s shall pass through income, losses, deductions and credits to its shareholders. The shareholders will then use Form 1040X to amend their personal returns. The 1040X will reflect the gross R&D credit, a tax on that credit, and the eventual payment (or tax refund) to the owner for the net R&D credit.

In order for an owner to realize a benefit from an amended year, the LCC must have met its cut-off date for amending its Form 1065 and issuing K-1’s to the owners. Without the K-1’s from the LLC, the owners have no basis for amending their personal returns, regardless of their filing dates. If the K-1’s are received in a timely manner, then the owners can amend their personal returns according their circumstances.

Below is a summary of some of the basics forms and implications for LLCs filing an R&D tax credit claim.

LLC Federal Forms

  • LLCs file Form 8832 if it does not want to accept its default federal tax classification (taxation as a partnership)

  • Single-Member LLCs (not elect to be treated as a corporation) file the following for their income tax return:

    • Form 1040 Schedule C, Profit or Loss from Business (Sole Proprietorship) 

    • Form 1040 Schedule E, Supplemental Income or Loss 

    • Form 1040 Schedule F, Profit or Loss from Farming 

  • Multi-Member LLCs (filing as a Corporation or Partnership) file the following for their income tax return:

    • If the LLC is a partnership, Form 1065, U.S. Return of Partnership Income​

    • If the LLC is a corporation, Form 1120, U.S. Corporation Income Tax Return

    • If a qualifying LLC elected to be an S Corporation, Form 1120S, U.S. Income Tax Return for an S Corporation

  • LLCs issue Schedule K-1’s to their shareholders.

LLC Federal Filing Dates (including Schedule K-1 for each shareholder

  • Initial Filing Date:

    • March 15 (Single-member LLC)

    • April 15 (Multiple-member LLC)

  • Extended Filing Date:

    • September 15 (Single-member LLC)

    • October 15 (Multiple-member LLC)

  • Example:

    • Single-member LLC (taxed like a sole proprietorship tax return)

      • Year End = December 31

      • Initial Filing = April 15 (mirrors individual return filing due date)

      • Extended Filing = April 15 + 6 months = October 15

    • Multiple-member LLC

      • Year End = December 31

      • Initial Filing = December 31 + 2 ½ months = March 15

      • Extended Filing = March 15 + 6 months = September 15

The cut-off date (statue of limitations) generally for an LLC amended return is the filing date plus three years. LLC’s may also elect to be change their fiscal year end and be treated like a corporation for tax purposes (see Form 8832). Changing the LLC's fiscal year to corporate treatment allows an LLC to move its tax preparation activities to a date of lower operational activity. Avoiding the April 15th filing date allows the LLC to issue K-1’s to owners and partners before their personal returns are due, thus giving the company more flexibility on its tax planning and preparation strategies.

 

If an LLC elects to be treated like a corporation, then the initial filing date is the last day of the fiscal year plus two and a half months (e.g. March 15). The extended filing date is the initial filing date plus six months (e.g. September 15). The cut-off for an amended return is still the date the claim was filed with the IRS plus three years. 

Limitations, Exceptions, R&D Expense Reporting: Claiming the R&D Credit

 

Individuals’ Limitation under IRC § 41(g): In general, for individuals who are shareholders in a partnership or S-corporation, or beneficiaries of a trust or estate, the allowable passed-through R&D tax credit benefit utilized in an applicable tax year cannot exceed the amount of tax attributable to that portion of the individual’s income that is allocable or apportionable to the individual’s interest in that partnership or S-corporation (see IRC § 41(g)(2) and (4); Treas. Regs. § 1.41-7(a)(1) and (3)).

Because the R&D credit is a expenditure driven benefit, generally it must be allocated among the shareholders in the same proportion that their IRC § 174 (R&D expense deductions) are allocated for that year, as the passthrough of credits are applied in accordance with the principles set forth in Treas. Regs. § 1.53-3. If an individual’s share of the passthrough entity’s R&D credits exceeds his or her regular tax liability, the apportioned credit may be carried forward 20 years, but the limitation on general business credits (GBCs) under IRC § 38 and § 39, which apply to  R&D tax credits, may still apply (see also Treas. Regs. § 1.41-7(a)(5)).

Example: 

In 2018, Shareholder X received a Schedule K-1 with $200,000 of taxable income and $50,000 of R&D credits from an S-corporation in which he is a shareholder. Shareholder X also has $5,000 of interest income related to his personal portfolio and $50,000 of W-2 wages from the S-corporation.

In calculating the amount of R&D credits he can use on his 2018 tax return, Shareholder X must first calculate what portion of his total income is attributable to the activity that generated the credit. Shareholder X achieves this by dividing the net income from the activity that produced the credit (numerator) by the total gross income from all activities (denominator).

The ratio calculated based on the facts above is as follows: $250,000 ($200K S-Corp taxable income & $50K S-Corp wages) ÷ $255,000 ($200K S-Corp taxable income & $50K S-Corp wages & $5K unrelated interest income) = 98.04%.

Next, assuming that all deductions are allocated to these two categories in the same proportions, Shareholder X would multiply his total tax by 98.04% to determine how much of his 2018 tax liability can be offset by the credit. Assuming his total tax after deductions and exemptions is $50,000, Shareholder X would be able to apply $49,020 ($50,000 × 98.04%) of the $50,000 in R&D credits against the tax liability before any limitations imposed under IRC § 38(c).

Note that an additional step would need to be taken if Shareholder X has deductions on his K-1 that are not directly attributable to the activity or if another IRC section limitation applies (i.e. charitable contributions). In this situation, the deduction must be prorated among the items taken into account in computing the deduction. See Treas. Regs. § 1.53-3(d)(1) for more information.

General Business Credit Limitation under IRC § 38(c): IRC § 38(c) imposes a limitation that applies primarily to individuals owning interests in passthrough entities. This limitation states that General Business Credits (e.g. R&D tax credit) for any tax year may not exceed the excess (if any) of the taxpayer’s net income tax over the greater of

  • (1) the taxpayer’s tentative minimum tax for the tax year, or 

  • (2) 25% of the amount by which the taxpayer’s net regular tax liability exceeds $25,000.

Regarding the first limitation, a passthrough entity’s R&D tax credit can reduce its tax only by the amount equal to the difference between the taxpayer’s regular tax liability and tentative minimum tax, not by the full amount of the taxpayer’s R&D tax credit. Any remaining R&D credit may be carried forward 20 years. As such, shareholders with ownership interests in passthrough entities may not fully utilize the full benefits of their R&D credit claim the same year their qualified research expenses (QREs) were incurred.

Alternative Minimum Tax (AMT) Limitation - Taxpayer Friendly Exceptions under Protection Americans from Tax Hikes (PATH) Act & Tax Cuts & Jobs (TCJA) Act

The PATH Act of 2015 provides a key incentive to eligible small businesses for taxable years beginning on or after Jan. 1, 2016 that certain taxpayers ("eligible small businesses") can utilize the federal R&D credit to offset their alternative minimum tax (AMT) liability. In prior years, companies and shareholders facing Alternative Minimum Tax (AMT) liability could not utilize R&D credits against AMT liabilities. However, the PATH Act now provides for eligible small businesses and shareholders to utilize the R&D credit against AMT liabilities.

An eligible small business is defined as a non-publicly traded corporation, partnership or sole proprietorship with an average of $50 million or less in gross receipts over the prior three years. Gross receipts are defined under IRC § 448(c)(3) and the related Treasury Regulations.  Accordingly, gross receipts include total sales (net of returns and allowances) and all receipts received for services, as well as income from investments, including interest, dividends, rents, royalties and annuities. Gross receipts also includes proceeds from the sale of property (IRC § 1221(2)) used in a trade or business, reduced by the adjusted basis in the property. Partnerships, LLCs, and S-corporation shareholders must separately satisfy the gross receipts test in order to be eligible for the AMT liability offset. Any for-profit company meeting the above criteria and that is performing qualified research defined under IRC § 41 may be eligible for R&D credits and this provision.

For tax years beginning on or after Jan. 1, 2018, the TCJA of 2017 also increased the AMT exemption for individual taxpayers, as well as the phaseout amount, for tax years beginning after Dec. 31, 2017, until 2026. These changes, coupled with the new IRC § 164(b)(6) limitation on deducting state and local taxes (preference item for AMT), may provide non-corporate taxpayers additional ways to use the credit. As such, the research credits of an eligible small business may now offset both regular tax and AMT liabilities.

Moreover, the TCJA of 2017, eliminated the federal corporate alternative minimum tax (AMT) pursuant to IRC § 55 and amended IRC § 38(c)(6) for corporate taxpayers as having zero tentative minimum tax. These amendments removed a prior constraint that prevented some corporate taxpayers from using credits under IRC § 41(a), due to the IRC § 38(c) tentative minimum tax limitation.
 

Prior to the PATH Act and TCJA, the R&D credit could not reduce a taxpayer’s tax liability below the AMT.  Previously, many taxpayers (e.g. partnerships and S-corporation shareholders in AMT), did not claim an R&D credit on their original, timely filed tax return, as there were issues utilizing the R&D credit currently and/or within the foreseeable short term.  However, under the PATH & TCJA, taxpayers should now re-examine their eligibility for the R&D credit benefits to improve cash flow, lower future tax liabilities, and take advantage of a federal and/or state incentive intended to benefit businesses and shareholders such as yourself.

AMT Adjustment for IRC § 174 Expenses

Prior to the enactment of the TCJA, taxpayers had the following options on treatment and reporting of research and experimental expenditures as listed below. Note, the regardless of the recent enactment of the TCJA, the current accounting methods under IRC § 174 and Rev. Proc. 2000-50 listed below will remain effective for tax years beginning before Jan. 1, 2022.

  • Currently deduct as immediate R&D expenditures under IRC § 174(a);

  • Amortize over a period of not less than 60 months (beginning the first month benefits are realized) under IRC § 174(b);

  • Amortize over 10 years pursuant to § 174(f)(2), IRC § 59(e), and IRC § 174(a); or 

  • For applicable software development costs under Rev. Proc. 2000-50

    • Current deduction in full or

    • Amortize over a period of not less than 60 months.

      • Taxpayers that paid or incurred expenses for software development may also rely on Rev. Proc. 2000-50 to determine R&D expenditure reporting. Because of the similarity between expenditures identified under IRC § 174, Rev. Proc. 2000-50 provides that the IRS will not disturb a taxpayer's consistent treatment of these costs if deducted in full (similar to those under IRC § 174(a)) or consistently capitalized and recovered through amortization deductions under rules similar to those under IRC § 174(b).

However,  for tax years beginning after Dec. 31, 2021, the TCJA amended the available reporting options per IRC § 174 for research and experimental expenses to the following: 

  • Amortization over 60 months (5 years), beginning with the midpoint of the tax year when said specified research or experimental expenditures are paid or incurred per IRC § 174(a) as amended by the TCJA; 

    • The revision enabling taxpayers to deduct an research and experimental expenditure beginning with the midpoint of the tax year in which the specified research expenditure is paid or incurred is favorable compared to current IRC § 174(b), which does not allow a deduction until the first month that a taxpayer realizes benefits from R&D expenditures.​

  • For foreign research, the amortization period is extended to 15 tax years;

  • For retired, abandoned, or disposed property, expenditures must continue to be amortized over its remaining time period as paid or incurred (immediate deduction no longer permitted) per IRC § 174(d); and

  • Modified the language in IRC § 174 from "research or experimental expenditures" to "specified research or experimental expenditures."

    • Special rule under IRC § 174(c)(3) that provides any amount paid or incurred in connection with the development of software is treated as a "specified research or experimental expenditure."

    • As a result, the TCJA eliminates taxpayers' ability to leverage Rev. Proc. 2000-50 to deduct software development expenditures.

Note, the TCJA modifications above for the 2022 tax year and subsequent years may require certain taxpayers to modify their accounting methods. Moreover, the accounting method change will be applied on a cutoff basis, thus taxpayers may not have a IRC § 481(a) adjustment (IRC § 13206(b) of the TCJA). Taxpayers that have used IRC § 174(a) or Rev. Proc. 2000-50 to expense costs related to research or experimentation or software development, respectively, should consider the temporary timing differences resulting from the future IRC § 174 modifications. Lastly, the different amortization period requirements for domestic and foreign research or experimentation starting in 2022 tax year should prompt taxpayers to reconsider the tax cost of performing R&D activities outside the United States.

Regardless of taxpayers' selection of accounting method for IRC § 174 expenditures, for purposes of the R&D tax credit, IRC § 41(d) defines "qualified research" in part as "research with respect to which expenditures may be treated as expenses under IRC § 174." However, many taxpayers may still be eligible to claim expenditures for the R&D tax credit under IRC § 41 that are deduct elsewhere on their tax return (e.g. IRC § 162, ordinary and necessary business expense).

As such, the present option to expense and deduct expenditures in the current tax year under either IRC § 162 or IRC § 174(a) may not be a significant concern. However, generally  passive shareholders of pass-through entities who pay AMT, must amortize research or experimental expenditures under IRC § 59(e)(2) or amortizing them under IRC § 174(b) over 60 months. Nevertheless, the TCJA amended language of IRC § 174 for tax years beginning after Dec. 31, 2021 may create timing difference considerations when determining classification of a deduction under IRC § 174 or IRC § 162.

The creation of the timing difference in classification of expenditures is a critical issue that taxpayers should consider when analyzing the R&D tax credit for tax years beginning after Dec. 31, 2021. Since the TCJA makes a corresponding amendment to IRC § 41(d)(1)(A) to define qualified research, in part, as "specified research or experimental expenditures under IRC § 174," taxpayers will have to consider the impact to the timing of deductions if they pursue the credit. The IRS is more likely to analyze taxpayers' classification of expenditures for deductions, if they claim the R&D tax credit. Thus, taxpayers will have to validate the expenditures claimed as IRC § 41 expenditures as "specified research or experimental expenditures" under IRC § 174, and will have to amortize those costs over 5 tax years, or 15 tax years for foreign research.

R&D Tax Future Planning Considerations

Due to the delayed effective date of the modifications to IRC § 174 and IRC § 41, taxpayers may continue to take advantage of the current expensing of research or experimental expenditures under IRC § 174(a), while also claiming a reduced credit under IRC § 280C (claiming 79% of the credit). Moreover, taxpayers with expected R&D expenses and activities should evaluate expediting those expenditures to before 2022.

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