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Research and Development Tax Credit Limitations

There are a couple of limitations that come into play when calculating R&D tax credits. Firstly, IRC Section 41(g) limits R&D credits for shareholders and members of pass-through entities. This section limits R&D credit usage to income tax liability attributable to income from the entity generating the credits. In other words, if an individual shareholder has income tax liability from multiple business interests, that shareholder can only use R&D tax credits to offset taxes from the entity that is conducting qualified R&D activity.

Another limitation to credit usage relates to a 2015 provision to the Research & Development credit. In 2015, as part of the Protection Against Tax Hikes Act, congress created a beneficial “start-up” provision to the R&D credit. This provision allows eligible start-up companies to utilize tax credits for research and development to offset their payroll taxes. This change is advantageous to companies that are in their early stages of development, which may not have significant income streams and income taxes to offset. Companies that qualify for the start-up provision can now use R&D tax credits to offset their payroll taxes. However, this provision is limited to $250,000 of payroll tax offset per year.

In terms of qualifying activity, Section 41 limits the types of activities that can qualify for research and development credit purposes. For example, work in soft sciences, such as psychology and social sciences, does not qualify as R&D activity for purposes of claiming the R&D credit. Additionally, development activity aimed at creating or improving purely aesthetic product enhancements is also disqualified from generating R&D credits. Work associated solely with seasonality, taste, color, and other non-functional factors does not fit the definition of Section 41 R&D.

This page was last updated by Steven Jefferies

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