Tax Reform Offers Individual Benefits for Shareholders of Passthrough Entities with R&D Tax Credits

Individual Owners of “eligible small businesses” can use their R&D tax credits to reduce alternative minimum tax liabilities.

The Tax Cuts and Jobs Act (TCJA) enacted at the end of 2017 did not make specific changes to the research and development (R&D) tax credit, but some of the changes could still provide a little benefit to individual partners and S corporation shareholders who claim the R&D credit on their returns and are subject to the alternative minimum tax (AMT). For example, the amount of income that is exempt from AMT has been raised and so has the phase out of this exemption.

In a previous blog, we discussed provisions of a 2015 law change that allowed certain “eligible small businesses” (ESBs) to apply the R&D tax credit against their AMT due.

Passthrough AMT and R&D Tax Credits

Despite some efforts in the House to repeal the entire AMT instead of just the corporate version, the tax still applies to individual income taxes. As a result, S-corporation shareholders, partners, and sole proprietors need to understand how the AMT offset for ESBs might apply on their individual returns. This post will look more closely at how the credit “flows through” from the ESBs to the personal returns of qualifying owners.

To qualify as an ESB, the average annual receipts of a partnership, S-corp or sole proprietorship for the three-tax-year period prior to the tax-year of the R&D credit claim cannot exceed $50 million. This limitation also applies at the individual level.  Once the business qualifies as an ESB at the entity level, it’s up to each individual owner to determine whether and what portion of an R&D credit could be applied against his or her personal AMT liability.

Calculating R&D Tax Credit Against AMT

That calculation involves figuring out the percentage of personal income attributable to the passthrough credit-eligible activity. For example, assume that $100,000 of profit flows through the business to owner X and the business pays owner X wages of $50,000. X has income from a variety of other sources totaling an additional $50,000.  In addition, $10,000 of R&D credit flows to X from the passthrough entity.

For purposes of this example assume X has a tax liability of $12,000 this year, all of which is AMT.  To figure out how much R&D credit X can use to offset that liability, X needs to calculate the percentage of income attributable to the business. In this case, the profit of $100,000 and the wages of $50,000 are attributable to the business, a total of 75 percent of X’s total taxable income of $200,000. Therefore, X can use the R&D credits to offset 75% of the tax liability or $9,000. 

Of course, in real life the calculations are rarely this simplistic and some limitations could apply. In addition, many questions about taxation of passthroughs under the TCJA have yet to be answered. The law allows owners a deduction of 20 percent of the income from a passthrough, but the Treasury and IRS still need to provide guidance on how that will be implemented on 2018 returns. We will provide updates as that guidance becomes available.

Talk to a Freed Maxick R&D Tax Credit Expert