Updated: Jul 11, 2021
The federal tax credit for increasing research activities (research credit) provides a permanent tax benefit for many kinds of businesses. For many companies the credit can be a substantial tax savings. However, subsection (g) of the tax code (IRC 41) brings a significant limitation to owners of sole proprietorships and flow-through entities, like LLCs taxed as partnerships and S Corporations. These business owners claim the credit on their personal tax returns, because their business doesn’t generally pay federal income tax. For such business owners, the credit that can be used in the current year, is limited to the amount of their tax liability, resulting from the business that generated the credit. We refer to this as the business income limitation, which applies to individuals claiming the research credit.
When an individual taxpayer’s research credit exceeds the business income limitation, the remaining unused credit can be carried back one year and then carried forward up to twenty years. Carrying the credit back would be useful in claiming a refund of prior year taxes paid, while carrying the credit forward allows the credit to offset future tax liability. The business income limitation rule continues to apply in any given year the credit is carried into.
A business may conclude that claiming the credit in a year with no income or low tax liability is worthwhile, anticipating it can be used in future tax years. However, the cost of documentation and calculation should be considered in comparison to the timing for when they would likely get the benefit and how much benefit being pursued.
The actual calculation of the business income limitation can be tricky because an individual’s tax liability is affected by other variables then just the income from the business generating the credit. Isolating the tax liability related to that particular business activity is an exercise of “with and without” calculations.