Section 41 R&D Credits for Pass-Through Entities After Tax Reform: Maximizing Tax Credits for Research Expenditures

Description

The Section 41 R&D tax credit remains one of the most underutilized of all tax benefits available to small businesses. Calculation of QREs is often highly complex, and both partnerships and S Corporations face the additional challenges of allocating credits to shareholders. The 2017 tax reform leaves the credit mostly intact and contains features that potentially enhance the value of the R&D credit, particularly for pass-through entities (PTEs).

Section 41 allows a credit for a percentage of a QRE that a taxpayer incurs while engaging in research activities. The Code provides a four-part test to determine whether an activity can be considered a QRA. Expenditures, including wage expenses that have sufficient nexus to the QRA, can be included in calculating the expenditure base. However, substantiating that the activity qualifies as a QRA can be onerous, and tax advisers must know the standards and limits in utilizing this critical and overlooked credit.

The 2017 tax reform act created significant tax savings for pass-through entities to claim the R&D credit. The lowering of the top corporate tax rate directly impacts the value of a 280C election. Taxpayers claiming an R&D credit are required under Section 280C(c)(1) to reduce their allowable research expenses by the amount equal to their claimed Section 41(a) credit. However, the Code permits taxpayers to elect to reduce the claimed credit by the maximum corporate tax rate in lieu of this “add back.” The new Section 11(b)(1) top corporate rate of 21% effectively reduces the credit offset, allowing taxpayers electing under Section 280C(c)(3) to recognize 79% of the value of the 41(a) credit, instead of the previous maximum 65% benefit.

Additionally, the and the new centralized audit regime for partnerships provide opportunities in allocating tax credits to venture capital partnership investment. However, looming changes to Section 174(a) which will require amortization of experimental expenditures instead of current deduction treatment, create some urgency for companies to maximize the tax benefits of R&D expenses.

Listen as our experienced panel provides a thorough and practical review of calculating, claiming and substantiating a Section 41 R&D credit.