Schedule K-1 and the Hawaii R&D Tax Credit: Navigating Pass-Through Allocations and State Revenue Guidance

I. Executive Summary: The Mechanism of Pass-Through R&D Credits

The Hawaii Schedule K-1 (Pass-Through Allocation) is the mandatory tax document used by Partnerships and S Corporations to distribute the state’s financial incentives, including the Tax Credit for Research Activities (TCRA), to their respective owners. This document serves as the legal conduit, ensuring the refundable credit earned by the Qualified High Technology Business (QHTB) is properly claimed by the individual partner or shareholder against their Hawaii personal income tax liability.

A. The Foundational Role of Pass-Through Taxation

Pass-through taxation is a core element of the U.S. tax code, designed to shift the tax liability and benefits from the entity level directly to the beneficial owners.1 Entities structured as partnerships, S corporations, estates, and trusts are typically not taxed on their income at the entity level in Hawaii.2 Instead, the owners of these entities—partners, shareholders, or beneficiaries—use the information provided on the Schedule K-1 to prepare their separate tax returns, reflecting their proportionate share of the entity’s financial activities.1

The Schedule K-1, prepared by the pass-through entity (PTE), reports the individual owner’s share of income, losses, deductions, and, critically in this context, tax credits derived from the business’s operations.1 For partnerships, the federal Schedule K-1 corresponds to the entity’s Form 1065; for S corporations, it corresponds to Form 1120S.1 By utilizing the Schedule K-1 to report these shares, the taxation of business income and the monetization of tax credits effectively occurs only once, at the owner’s level.1

B. Hawaii-Specific K-1 Reporting and Owner Responsibility

For state reporting purposes, the Hawaii Department of Taxation (DOTAX) requires flow-through entities to utilize state-specific versions of the Schedule K-1. Partnerships report allocations using Schedule K-1 (Form N-20), while S corporations use Schedule K-1 (Form N-35).2 The purpose of these forms is to detail the partner’s or shareholder’s portion of income, deductions, and credits attributable to Hawaii.2

A key aspect of using the Schedule K-1 to transfer tax attributes is the legal responsibility it places on the owner. While the Schedule K-1 reports the allocated credit amount, the associated instructions explicitly mandate that the partner or shareholder assume responsibility for applying complex federal and state tax limitations.2 These limitations typically involve restrictions related to the partner’s basis in the partnership, the amount for which they are considered at risk, and compliance with passive activity rules.2 Although the highly attractive refundable nature of the Hawaii TCRA often minimizes the impact of these loss limitations on the credit itself, the overall compliance responsibility for the investment’s tax consequences is strategically transferred to the K-1 recipient. This centralization of the compliance burden for complex individual limitations streamlines the review process for the DOTAX.2

II. The Hawaii Tax Credit for Research Activities (TCRA): Statutory Framework and Financial Impact

The Hawaii Tax Credit for Research Activities (TCRA), codified under Hawaii Revised Statutes (HRS) §235-110.91, is a substantial incentive designed to foster innovation and technological advancement within the state.4 The mechanism for claiming this credit, particularly through flow-through entities, requires deep engagement with both the Department of Business, Economic Development, and Tourism (DBEDT) and the DOTAX.

A. Statutory Basis and Eligibility

The TCRA targets businesses that qualify as a Qualified High Technology Business (QHTB).6 The definition of a QHTB is precise: it must be a small business—defined as a company employing no more than five hundred employees—that conducts more than 50% of its activities in qualified research within Hawaii and is registered to do business in the state.4 The credit is specifically designed to support high-tech sectors, including ocean sciences, biotechnology, and software development.4

To qualify for the state credit, the taxpayer must first claim and be eligible for the corresponding federal tax credit for increasing research activities under Internal Revenue Code (IRC) §41.2 This linkage establishes a federal baseline for eligible activities, ensuring that state-level claims align with recognized federal standards.4

B. Calculation Methodology and Federal Nexus

The calculation of the Hawaii TCRA is based directly on the federal credit amount, adjusted by the ratio of research activities conducted within the state.9 Specifically, the state credit amount is calculated by taking the amount of the federal tax credit reported on Federal Form 6765 and multiplying it by a fraction.10 The numerator of this fraction is the amount of eligible research expenses for research conducted exclusively in Hawaii (Hawaii QREs), and the denominator is the total amount of expenses eligible for the federal tax credit.10

A critical legislative development occurred with the enactment of Act 139 (Session Laws of Hawaii 2024), which significantly altered the calculation methodology for tax years beginning after December 31, 2023.7 This Act repealed a prior provision that allowed QHTBs to claim credits for all qualified research expenses without regard to the amount of expenses incurred in previous years.6 By repealing this simplifying measure, Act 139 reinstated the requirement to use the IRC §41 base amount calculation.7

The consequence of reverting to the federal base amount calculation is a necessary complication of longitudinal compliance. Where the prior structure allowed for a simplified, current-year assessment, the new framework mandates that QHTBs establish and track their historical QREs and gross receipts to properly determine the required base amount, as is standard practice for the federal IRC §41 credit.7 This change requires tax teams supporting QHTBs to immediately revise their documentation protocols and data tracking to align with multi-year federal tracking standards, thereby mitigating the risk of audit adjustments or qualification shortfalls in subsequent years.

C. Strategic Advantage: Refundability and Sunset Provisions

One of the most appealing features of the Hawaii TCRA is its refundability.4 Unlike non-refundable credits that can only offset existing tax liability, the TCRA provides that any amount exceeding the owner’s state income tax liability will be paid out to the taxpayer in cash.4 This makes the credit particularly valuable for early-stage QHTBs that may be operating at a loss or have minimal income tax liability.5

Because the credit is fully refundable, state law dictates that there is no credit carryforward provision.8 Unused portions of the credit are refunded directly, making the immediate, accurate claim of the credit paramount. The program is currently set to expire on December 31, 2029, unless the state legislature extends its provisions.4 Furthermore, the statute is inflexible regarding timeliness: all claims for the tax credit must be filed on or before the end of the twelfth month following the close of the taxable year for which the credit is claimed. Failure to properly claim the credit by this deadline constitutes an outright waiver of the right to claim the credit.6

III. Administrative and Strategic Compliance: Navigating DBEDT and DOTAX Guidance

The mechanism for passing the TCRA to owners via Schedule K-1 is inextricably linked to Hawaii’s unique administrative process, which involves mandatory certification by DBEDT to manage the statutory funding cap.

A. The $5 Million Annual Aggregate Cap: A Competitive Landscape

The overall amount of the TCRA certified is subject to a strict annual aggregate cap of $5,000,000 for all taxpayers combined.4 This limitation introduces a strong competitive element to the application process, as the allocation of the available credit under the cap operates on a first-come, first-served basis.4 This prioritization is typically determined by the timestamp of the certification application submission.4

B. Phase I: DBEDT Certification (The Gatekeeper)

Before any credit can be claimed or passed through to owners, the QHTB must undergo a certification process managed by DBEDT. This process is initiated by the submission of Form N-346A, the Certified Statement of Research and Development Costs.7

The QHTB uses Form N-346A to verify its eligible research expenses and request the necessary certificate for itself or, if it is a flow-through entity, for its partners, shareholders, or beneficiaries.7 The application window for this critical submission is tightly controlled, generally requiring submission to DBEDT by March 31 following the close of the taxable year in which the research was conducted.4 Upon approval, DBEDT signs Part II of Form N-346A, which serves as the official certificate confirming the credit amount and its allocation under the cap.7 DBEDT typically mails the signed certificate back to the QHTB.7 An administrative fee, often $500 for claims exceeding $25,000 (though sometimes waived), may apply to this certification process.4

C. Phase II: PTE Allocation and DOTAX Claiming

Once the QHTB, acting as the flow-through entity, receives the certified N-346A Part II, it initiates the pass-through process to its owners. This involves several critical steps managed in coordination with the DOTAX.

The QHTB is responsible for two key actions related to the flow-through:

1. Allocation and Reporting: The total certified credit amount is calculated and then allocated pro-rata to the partners or shareholders based on their distributive share.4 This allocated amount is reported on the respective Hawaii Schedule K-1 (N-20 or N-35).2
2. Certificate Distribution: The QHTB is specifically mandated to mail copies of the signed DBEDT certificate (N-346A Part II) to the individual partners or shareholders who are claiming the credit.7

At the entity level, the QHTB must attach Form N-346 (the credit calculation form), Form N-346A (the certification statement), and the federal Form 6765 to its Hawaii income tax return (e.g., Form N-20 for partnerships).6

For the owner, claiming the credit requires the attachment of three specific documents to the individual income tax return (e.g., Form N-11): the completed Form N-346, the Schedule K-1 reporting the credit, and the copy of the DBEDT-certified N-346A Part II.6

The administrative framework reveals that the successful monetization of the credit by the individual owner is entirely dependent on the QHTB’s administrative competence. If the QHTB fails to secure timely DBEDT certification, or subsequently fails to provide the certified N-346A Part II to its owners, the reported credit amount on the K-1 becomes unclaimable by the owner.12 This establishes a strong fiduciary duty for QHTB management, as their failure to meet the DBEDT deadline or the required documentation distribution directly leads to the loss of refundable cash for their investors.

Furthermore, the 12-month deadline for claiming the credit is a hard statutory limitation, reinforcing the risk of waiver.6 This relatively short statute of limitations for state tax claims, especially when compared to federal statutes, means that the window for filing the initial claim or any necessary amended claims is severely restricted.

Table 1 summarizes the mandatory compliance flow.

TCRA Compliance Flow and Critical Deadlines

IV. Detailed Analysis of Schedule K-1 Line Item Allocation

The Schedule K-1 is the final step in the allocation process, providing the individual owner with the necessary data to complete their state tax filing. The instructions issued by the DOTAX ensure that the individual taxpayer correctly integrates the allocated, certified amount into their personal return without duplicating the entity’s calculation steps.

A. Reporting Mechanics on the Hawaii K-1

The total certified TCRA amount is allocated to partners or shareholders on a pro-rata basis, corresponding to their ownership interest in the flow-through entity.4 For Hawaii partnerships filing Form N-20, the Tax Credit for Research Activities (TCRA) is typically reported on a specific line item within Schedule K-1, often designated as Line 25 (Other Credits), or an equivalent line requiring the attachment of a detailed schedule.2

The Schedule K-1 provides information related to the source of income and credits, differentiating between amounts attributable everywhere and those attributable specifically to Hawaii, depending on the residency status of the partner.2 For the TCRA, since eligibility is based on research activities conducted exclusively in Hawaii, the full allocated credit is considered a Hawaii credit.

B. Individual Taxpayer Instructions (Form N-346)

The DOTAX provides precise, critical instructions to K-1 recipients regarding how to claim the passed-through credit on their individual credit claim form, Form N-346 (Tax Credit for Research Activities).6

Recipients of the credit via Schedule K-1 are explicitly instructed to skip lines 1 through 4 of Form N-346 and begin their calculation on Line 5.6 Lines 1 through 4 are reserved for the entity or individual taxpayer who calculated the initial credit amount, including the complex step of determining the federal credit multiplied by the Hawaii QRE ratio.10

The instruction to skip the calculation lines serves as an administrative control mechanism. By requiring the individual to use only the allocated amount reported on the K-1, the state ensures that the only credit amount claimed is the one previously certified by DBEDT and correctly distributed by the QHTB.10 This centralization of the credit calculation standardizes the claiming process, maintains the integrity of the total $5 million cap allocation, and minimizes the risk of calculation errors by individual taxpayers.6

C. K-1 Attachments and Verification

For the claim to be valid, the taxpayer must fulfill strict documentation requirements.6 The individual must attach the following to their Hawaii income tax return:

1. The completed Form N-346 (Claiming the credit amount).
2. The Schedule K-1 (Proving the allocated share of the credit).
3. The certified Part II of Form N-346A (Proving state certification and inclusion within the cap).12

The Schedule K-1 provides proof of the owner’s legal interest and allocated amount, but the certified N-346A Part II is non-negotiable proof that the entity met the DBEDT certification requirements, including applying for and receiving allocation under the highly competitive annual cap.6 Failure to satisfy these requirements constitutes a waiver of the right to claim the credit.6

V. Case Study: Allocation of the Hawaii R&D Credit via Schedule K-1

This detailed example illustrates the procedural steps and resulting K-1 entries required for a flow-through entity to successfully pass the TCRA to its owners.

A. Scenario Setup: QHTB Partnership

• Entity: Island Innovations LP (a Qualified High Technology Business registered in Hawaii, filing Form N-20).
• QHTB Status: Certified by DBEDT for the 2024 tax year and allocated a portion of the $5 million aggregate cap.
• Partnership Structure: Owned 50/50 by two equal partners, Partner A and Partner B.
• Research Metrics (2024):

• Federal R&D Tax Credit (IRC §41, calculated on Form 6765): $200,000
• Total Qualified Research Expenses (QREs, Everywhere): $1,500,000
• Hawaii Qualified Research Expenses (QREs, In-State): $1,050,000

B. Step 1: Calculating the Hawaii TCRA (Entity Level)

The QHTB must first calculate the total certified credit amount using the required federal-to-state expense ratio.9

1. Determine Hawaii QRE Ratio: The ratio is calculated as the portion of qualified research expenses conducted in Hawaii relative to total QREs eligible for the federal credit:
   
   $$\text{Hawaii QRE Ratio} = \frac{\text{Hawaii QREs}}{\text{Total QREs}} = \frac{\$1,050,000}{\$1,500,000} = 0.70 \text{ (or } 70\% \text{)}$$
2. Calculate Total Certified TCRA: The Hawaii credit is the federal credit multiplied by the Hawaii QRE ratio.9
   $$\text{Total Certified TCRA} = \text{Federal Credit} \times \text{Hawaii QRE Ratio} = \$200,000 \times 0.70 = \mathbf{\$140,000}$$
3. Entity Filing Note: Island Innovations LP submits Form N-346 to the DOTAX, reporting $140,000 as the total credit allowed. The partnership attaches the certified Form N-346A Part II from DBEDT, validating the expense calculation and cap allocation.6

C. Step 2: Allocation to Partners via Schedule K-1 (N-20)

The total certified credit of $140,000 is allocated to the partners based on their 50/50 distributive share ratio.

• Partner A Allocation: $\$140,000 \times 50\% = \mathbf{\$70,000}$
• Partner B Allocation: $\$140,000 \times 50\% = \mathbf{\$70,000}$

Island Innovations LP prepares a Schedule K-1 (N-20) for each partner, reporting the $\$ 70,000$ allocation.

Table 2: Schedule K-1 Allocation Summary (Partner A)

D. Step 3: Partner A’s Individual Tax Impact

Partner A receives the Schedule K-1 and the certified N-346A certificate copy from the partnership. Partner A uses the $\$ 70,000$ allocated credit when filing their individual Hawaii income tax return (Form N-11).

Assume Partner A’s total Hawaii tax liability, calculated before applying credits, is $40,000.

• Tax Liability Offset: $40,000 (Taxable Liability)
• TCRA Applied: -$70,000 (Refundable Credit)
• Resultant Tax Status: $-\$30,000$

Since the TCRA is fully refundable, the credit of $\$ 70,000$ fully offsets the $\$ 40,000$ liability, and Partner A receives a $30,000 cash refund from the State of Hawaii.4 Partner A must ensure Form N-346 is completed, the K-1 is attached, and the certified N-346A Part II is attached to meet all compliance requirements, thereby successfully monetizing the refundable credit.6

VI. Conclusion and Strategic Recommendations

The Schedule K-1 is the definitive mechanism for realizing the financial benefit of the Hawaii Tax Credit for Research Activities (TCRA) for owners of flow-through entities. The efficacy of the K-1 allocation, however, is entirely conditional on meticulous pre-filing compliance involving dual state agencies and strict adherence to unique state regulations.

The analysis confirms that while the Schedule K-1 legally shifts the credit benefit and responsibility to the owner, the administrative success hinges on the QHTB’s ability to secure timely DBEDT certification to penetrate the competitive $5 million annual aggregate cap. The state has implemented procedural controls, such as instructing K-1 recipients to bypass the calculation section of Form N-346, which centralizes the calculation and ensures only the certified amount is claimed, thereby safeguarding the integrity of the state’s limited incentive funds.

Key Strategic Takeaways

1. Prioritization of the Certification Race: Due to the $\$ 5$ million annual cap, the submission of Form N-346A to DBEDT by the established deadline (typically March 31) is the most critical administrative step. The allocation of the credit is based on a first-come, first-served basis, compelling QHTBs to integrate the completion of their federal and state R&D studies into Q1 operational processes immediately following the close of the tax year.4
2. Immediate Adaptation to New Calculation Rules: The 2024 legislative changes reinstating the federal IRC $\S 41$ base amount calculation necessitate a fundamental shift in compliance. QHTBs must now maintain comprehensive, multi-year records of all Hawaii QREs and gross receipts. The historical tracking is indispensable for correctly calculating the TCRA under the revised rules, transforming the tax preparation from a simple current-year calculation to a complex, ongoing compliance exercise.7
3. Mandatory Documentation Flow-Through: The allocated credit amount reported on the Schedule K-1 is insufficient documentation by itself. Flow-through entities must ensure that copies of the official DBEDT-certified N-346A Part II are meticulously distributed to every partner or shareholder claiming the credit. Failure by the individual taxpayer to attach both the K-1 and the official certification document to their Hawaii return constitutes an immediate waiver of the claim.6
4. Strict Adherence to Filing Deadlines: The 12-month statute of limitations for claiming the TCRA after the close of the taxable year is a non-negotiable deadline for both initial and amended returns.6 Given the highly desirable refundable nature of the credit and the absence of any carryforward relief, prompt and accurate filing is essential to monetize the investment in research activities successfully.8

R&D Tax Credit Preparation Services

Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states.

If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725.
Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.

R&D Tax Credit Audit Advisory Services

creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.

Our Fees

Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/about-us/research-tax-credit-consulting/our-fees/