Hawaii Research and Development Tax Credit: Strategic Compliance for S Corporations

The Hawaii S Corporation income tax return is Form N-35, used to report the entity’s financial operations and pass through credits and liabilities to its shareholders. The Hawaii Tax Credit for Research Activities (TCRA) is a highly beneficial, refundable credit designed for Qualified High Technology Businesses (QHTBs), flowing directly to individual owners.

I. Executive Summary: Strategic Positioning of the Refundable TCRA

This report details the operational mechanics and compliance structure surrounding the Hawaii Tax Credit for Research Activities (TCRA), authorized under Hawaii Revised Statutes (HRS) §235-110.91, specifically as it applies to S Corporations. S Corporations must navigate unique state filing requirements and stringent administrative deadlines to monetize this powerful incentive. The credit is particularly valuable because it is refundable, offering shareholders cash payments even when the credit exceeds their total Hawaii income tax liability.1

A. The Function of Hawaii S Corporation Form N-35 and N-20 Clarification

S Corporations conducting business in Hawaii are required to file Form N-35, the Hawaii Income Tax Return for an S Corporation.3 This form serves as the informational return, reporting the corporation’s income, deductions, and credits before they are allocated to the individual shareholders. The form cited in the query, Form N-20, is designated exclusively for reporting the operations of a partnership.5 Incorrect form usage can create significant compliance challenges, especially since Form N-20 instructions address unique partnership requirements, such as the mandated withholding on behalf of nonresident partners.5

Accurate reporting on Form N-35 must also account for critical Hawaii-specific adjustments, notably the non-conformity with federal “bonus” depreciation rules and the state-imposed limitation of $25,000 for the IRC Section 179 expense deduction.4 These adjustments must be finalized before the final taxable income and credits are determined for pass-through to the owners. The correct allocation of the TCRA utilizes Schedule K-1 (Form N-35), distinct from Schedule K-1 (Form N-20) used by partnerships.7

Table 1 details the required forms for Hawaii pass-through entities:

Table 1: Hawaii Pass-Through Entity Forms

II. Statutory Foundation and Eligibility for the TCRA

The TCRA is established under HRS §235-110.91, intended to stimulate investment in research activities conducted within the state, primarily supporting key sectors such as biotechnology, software development, and ocean sciences.1 The credit is scheduled to expire for tax years beginning after December 31, 2029, a crucial consideration for long-term strategic planning.1

A. Qualified High Technology Business (QHTB) Requirements

Eligibility for the TCRA centers on achieving and maintaining QHTB status. To qualify, an S Corporation must meet three primary criteria:

1. Activity Threshold: The business must perform qualified research activities (QRAs) in Hawaii that constitute more than 50% of its total activities.1
2. Size Limitation: The company must have 500 or fewer employees.1 This tight restriction on the employee count serves to focus the economic incentive on supporting small and medium-sized enterprises (SMEs) operating within Hawaii, rather than large, established multi-state corporations.
3. Certification: Certification from the Department of Business, Economic Development, and Tourism (DBEDT) is mandatory before any credit can be claimed.1

B. Calculation Methodology and Federal Alignment

The calculation of the Hawaii TCRA aligns closely with the federal credit provisions outlined in Internal Revenue Code (IRC) §41.1 Research activities must satisfy the IRS’s four-part test: the activity must be technological in nature, intended to develop or improve a product, process, or software, involve the elimination of uncertainty, and utilize a process of experimentation.9

The final Hawaii credit amount is calculated by scaling the federal R&D credit by the ratio of research expenses incurred in Hawaii to the total research expenses incurred nationwide. The formula used is 1:

$$\text{Hawaii TCRA} = \text{Federal R\&D Credit} \times \left( \frac{\text{Hawaii Qualified Research Expenses (QREs)}}{\text{Total Federal QREs}} \right)$$

Hawaii QREs include wages paid for qualified services performed in Hawaii, the cost of supplies used, and rental or lease costs of computers used in the research activity within the state.7 Since the credit is a scaled fraction of the federal credit, companies must implement rigorous documentation systems to demonstrate that a substantial portion of their eligible expenditures are physically incurred within Hawaii. Maximizing the ratio of Hawaii QREs to Federal QREs is essential to realize the maximum possible state tax benefit.1

III. The Administrative Compliance Gauntlet: DBEDT and DoTAX

Successful realization of the TCRA depends heavily on strict adherence to a tight administrative schedule governed by DBEDT and the Department of Taxation (DoTAX).

A. The DBEDT Certification Mandate and Allocation Risk

DBEDT administers the certification process, reviewing the QHTB status and verifying the calculated credit amount. Upon approval, DBEDT issues Form N-346A, which must be attached to the final tax return.8

The critical element of the TCRA program is the $5 million annual statewide aggregate cap.8 This cap is rigidly enforced on a first-come, first-served basis, determined by the date the complete application is submitted to DBEDT.1

The competitive nature of this cap necessitates extremely time-sensitive compliance:

1. Application Submission Deadline: Taxpayers must submit the application (DBEDT Form N-346A) by March 31 following the close of the taxable year.8
2. Annual Survey Requirement: An online questionnaire detailing qualifying expenditures, revenue, and expense data must be completed by June 30. Failure to meet this separate survey deadline results in the disqualification of the entire credit claim.8

Historical data confirms the fierce competition for the $5 million pool. For example, in recent tax years, total claimed credits (e.g., $11.9 million to $13.3 million) significantly surpassed the certified total.10 This suggests that the primary risk to claiming the credit is not the quality of the research itself, but rather the administrative speed in securing a position under the cap. This compels S Corporations to prioritize the DBEDT application process, often requiring completion well ahead of the standard income tax return preparation timeline.

Table 2: Hawaii TCRA Compliance Timeline and Key Risks

IV. S Corporation Pass-Through Mechanics and Refundability

S Corporations are generally pass-through entities; thus, they are limited in claiming the credit at the entity level.1 The certified TCRA is instead passed directly to the shareholders based on their pro-rata ownership share.

The S Corporation reports the certified Hawaii QREs and the final calculated TCRA amount on Hawaii Form N-346 (Tax Credit for Research Activities).7 The resulting flow-through credit is then allocated to the owners via Schedule K-1 (Form N-35).7 Shareholders must then claim the credit on their personal income tax returns (Form N-11 for residents or Form N-15 for nonresidents), attaching their own completed Form N-346, citing the flow-through amount received from the S Corporation.7

A. The Strategic Importance of Refundability

The most advantageous feature of the TCRA is its refundability against corporate or personal income tax.1 When the amount of the certified credit exceeds the shareholder’s total Hawaii income tax liability for that year, the excess portion is refunded directly to the shareholder in cash.1

For startup QHTBs, which frequently generate taxable losses in their early high-growth R&D phases, the shareholders may have minimal or no state income tax liability. This refundability mechanism ensures that the financial benefit is immediately realized as an operational cash injection, effectively bypassing the limitations that usually apply to non-refundable credits (which can only reduce tax liability to zero or require years of carryforward). The Schedule K-1 (Form N-35) also provides necessary information regarding the source of the S Corporation’s income, required under HRS §235-128, which is essential for both resident and nonresident shareholders filing Hawaii tax returns.11

V. Advanced Strategic Planning: Interaction with the Elective PTE Tax (HRS §235-51.5)

Effective for taxable years beginning after December 31, 2023, S Corporations in Hawaii can elect to pay state income taxes at the entity level under HRS §235-51.5, a measure enacted primarily to provide relief from the federal State and Local Tax (SALT) deduction limitation.12 This creates a complex interaction with the refundable TCRA.

The TCRA is refundable 2, while the resulting PTE tax credit passed to eligible members is nonrefundable, though Act 50, Session Laws of Hawaii 2024, permits a carry forward of unused PTE credits to subsequent years.12 When an S Corporation elects the PTE tax, it must determine the proper ordering and application of credits.

If the S Corporation uses the refundable TCRA to offset its elective PTE tax liability, the cash outflow for the state tax is reduced. Consequently, the non-refundable PTE tax credit flowing through to the shareholders is also reduced. This complex arrangement requires detailed tax modeling, guided by the latest DoTAX releases, such as Tax Information Release (TIR) 2024-01, and the Temporary Administrative Rules effective January 2, 2025.12 In many scenarios, maximizing the immediate, refundable cash benefit of the TCRA by passing it directly to shareholders remains the financially superior strategy, even when considering the federal deduction benefits of the elective PTE tax.

VI. Numerical Compliance Example: Calculation and Flow-Through

To illustrate the mechanism, consider MaunaTech Innovations, a certified QHTB operating as an S Corporation, equally owned by two shareholders.

A. Scenario Setup: MaunaTech Innovations (Tax Year 2024)

• Entity Status: QHTB, S Corporation, fully certified by DBEDT.
• Ownership: Shareholder A (Resident, 50%) and Shareholder B (Nonresident, 50%).
• Financial Data: Total Federal QREs = $1,200,000; Hawaii QREs = $960,000.
• Calculated Federal R&D Credit (Form 6765): $120,000.

B. Step-by-Step Calculation of the Hawaii TCRA

The credit is calculated based on the ratio of Hawaii expenses to total federal expenses:

1. Determine Hawaii Expense Ratio:
   
   $$\text{Ratio} = \frac{\text{\$960,000 (Hawaii QREs)}}{\text{\$1,200,000 (Federal QREs)}} = 0.80$$
2. Calculate Total Hawaii Tax Credit (TCRA):
   
   $$\text{TCRA} = \text{\$120,000 (Federal Credit)} \times 0.80 = \mathbf{\$96,000}$$
3. DBEDT Certification: Assume MaunaTech received full certification for the $96,000 amount, confirmed via Form N-346A.

C. Pass-Through Allocation and Individual Refundability

MaunaTech reports the $96,000 TCRA on Hawaii Form N-346 and allocates it 50/50 to the shareholders via Schedule K-1 (Form N-35).

In this example, the total $96,000 credit reduces the shareholders’ collective tax liability of $20,000 to zero, and the remaining $76,000 is directly returned to the shareholders as a cash refund.1 This demonstrates the immediate, high-value monetization of the TCRA, which is secured by the credit’s unique refundable status for both resident and nonresident shareholders.

VII. Conclusion and Expert Recommendations

The Hawaii Tax Credit for Research Activities (TCRA) represents one of the most powerful state-level R&D incentives in the nation due to its refundable nature. However, realizing this benefit requires navigating a precise set of administrative requirements enforced by both the DBEDT and the DoTAX.

Key Compliance Summary:

1. Filing Accuracy: S Corporations must use the correct informational return, Form N-35, and its corresponding flow-through schedule, Schedule K-1 (Form N-35).3 The partnership form, Form N-20, is inappropriate for S Corporation reporting.5
2. Administrative Urgency: The first-come, first-served allocation of the $5 million annual cap necessitates that S Corporations prioritize the DBEDT certification application, which must be submitted by the critical March 31 deadline.8 Failure to secure a spot under the cap, or failure to complete the subsequent annual survey by June 30, results in the complete loss of the credit.1
3. Monetization Strategy: The credit’s refundability ensures that S Corporation shareholders, even those with limited or no Hawaii income tax liability, receive immediate, non-taxable cash benefits, providing critical capital to developing QHTBs.1

Expert Strategic Guidance:

S Corporations should focus their efforts on three strategic areas:

• Maximize Hawaii QRE Sourcing: Rigorous accounting must be maintained to maximize the ratio of QREs sourced within Hawaii, as this directly determines the magnitude of the final state credit.1
• PTE Tax Modeling: Businesses considering the elective Pass-Through Entity (PTE) tax under HRS §235-51.5 must carefully model the interaction between the refundable TCRA and the non-refundable PTE credit, using current DoTAX guidance (TIR 2024-01), to ensure the most advantageous tax outcome.12
• Long-Term Planning: While highly beneficial, the TCRA is currently set to expire on December 31, 2029.1 QHTBs should incorporate this sunset date into their long-term financial projections and monitor legislative action for potential extensions.

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