Comprehensive Analysis of the Indiana Research Expense Credit Pass-Through Mechanism: Schedule IN K-1 and IDOR Compliance

I. Executive Summary: The Meaning of Schedule IN K-1 (Pass-Through Credit)

The Schedule IN K-1 (Pass-Through Credit) reports an owner’s pro rata share of the Research Expense Tax Credit calculated by the pass-through entity. This credit is a nonrefundable incentive, established under Indiana Code § 6-3.1-4, designed to reduce an individual owner’s state income tax liability based on qualified research activities performed entirely within Indiana.

The Indiana Research Expense Tax Credit (R&D Credit) functions as a strategic fiscal incentive aimed at bolstering in-state innovation and capital investment.1 For entities structured as partnerships, S corporations, Limited Liability Companies (LLCs), and Limited Liability Partnerships (LLPs)—collectively referred to as pass-through entities (PTEs)—the credit is generally not utilized at the entity level. Instead, the total credit must be calculated by the entity and subsequently allocated, or “passed through,” to the owners.1 The Schedule IN K-1 serves as the mandatory compliance document used by the Indiana Department of Revenue (IDOR) to formalize this allocation, transmitting the state tax benefit derived from the entity’s Schedule IT-20REC calculation to the individual or corporate owners who claim the reduction against their Indiana adjusted gross income tax.4

II. Statutory and Regulatory Foundation of the Indiana R&D Incentive (IC 6-3.1-4)

A. Legislative Intent and Economic Goals

The statutory basis for the Indiana R&D Tax Credit is found in Indiana Code (IC) § 6-3.1-4-1, which provides a defined mechanism for taxpayers incurring Qualified Research Expenses (QREs) within Indiana to secure offsets against their state income tax liabilities.3 The underlying legislative objective is to spur technological advancement and economic development by mitigating the financial burdens associated with qualified research conducted within the state’s borders.1

Beyond the income tax credit, Indiana also offers a 100% exemption from sales and use tax on qualified R&D equipment and property purchased for use in Indiana.1 This dual incentive approach reflects the state’s recognition that supporting the “input” side of innovation—the expenses incurred—is a highly effective way to encourage private investment, regardless of the immediate success or failure of the research project itself.2

B. Defining Indiana Qualified Research Expense (QRE)

The qualification requirements for Indiana R&D expenditures mirror federal standards established under IRC § 41, but with two significant state-specific modifications that are essential for compliance:

1. Federal Definition Vintage: Indiana utilizes the definition of QREs provided under IRC § 41(b), specifically as in effect on January 1, 2001.6 This means that Indiana tax professionals must reference an older version of the federal code when substantiating QREs, regardless of current federal tax law changes. This historical reference point creates a distinct compliance challenge, demanding that QRE documentation adheres to the specific scope and eligibility rules that existed federally over two decades ago, potentially requiring separate tracking and substantiation methodologies from the current federal Form 6765.6
2. In-State Mandate: To qualify for the state credit, research activities and all associated QREs must be incurred for research conducted exclusively in Indiana.1 This local requirement applies to eligible expenditures, which include in-house wages for employees performing, supervising, or directly supporting research; the cost of supplies consumed in research (such as materials for prototypes); and certain contract research expenses (65% of payments to unrelated third parties, or 75% to research consortia).3

C. Eligibility for Pass-Through Entities (PTEs)

Indiana law explicitly recognizes PTEs—S Corporations, partnerships, LLCs, and LLPs—as eligible entities that can generate and subsequently allocate the R&D credit.3 When a PTE “claims the credit,” the entity undertakes the necessary calculations and administrative steps to make the credit available for use by the individual owners on their personal state returns.1

However, the flow-through structure has distinct limitations compared to the federal system. Specifically, while trusts and estates may claim the credit against their own Indiana tax liabilities, the pass-through provision is not afforded to beneficiaries of trusts and estates (other than Grantor Trusts) for state tax purposes.6 This difference is a critical consideration for taxpayers using complex legal structures, as it limits the ultimate use of the credit only to the entity or the grantor.

III. Entity-Level Credit Calculation: Compliance via Form IT-20REC

The process of generating the pass-through credit begins with the PTE’s meticulous calculation on Schedule IT-20REC, which functions as the official state worksheet for research activities. This completed form must be enclosed with the entity’s annual income tax return.4

A. Traditional Calculation Method: Tiered Credit Rates (IC 6-3.1-4-2)

The traditional method closely parallels the fixed-base method used federally, but it specifically incorporates Indiana QREs and Indiana gross receipts to determine the base amount.3

1. Base Amount Rule: The base amount is calculated using a fixed-base percentage multiplied by the average Indiana gross receipts for the preceding four years.3 A key statutory guardrail requires that the computed base amount cannot be less than 50% of the current year’s Indiana QREs.6 This minimum ensures that only incremental research spending, beyond a substantial historical baseline, qualifies for the incentive.
2. Credit Application: The resulting credit is applied to the excess of the current year’s QREs over this calculated, or mandated minimum, base amount.3 Indiana employs a tiered rate structure:

• A rate of 15% is applied to the first $1,000,000 of the calculated excess QREs.3
• A reduced rate of 10% is applied to any amount of excess QREs that exceeds $1,000,000.3

B. Alternative Simplified Credit (ASC) Method (IC 6-3.1-4-2.5)

For tax years beginning after 2009, PTEs have the option to elect the Alternative Simplified Credit (ASC) method, simplifying the base calculation.11 This option is generally attractive for businesses with fluctuating QREs or those seeking straightforward compliance.3

1. Standard ASC Rate: Under the standard ASC, the credit equals 10% of the portion of the current year’s Indiana QREs that exceeds 50% of the taxpayer’s average Indiana QREs for the three preceding taxable years.3
2. Startup/Fallback Rate: If the taxpayer did not have Indiana QREs in any one of the three preceding tax years, a simplified fallback rate applies, limiting the credit to 5% of the current year’s Indiana QREs.7

The availability of both calculation methods requires strategic analysis. While the traditional method offers a substantial initial credit rate of 15%, the ASC provides a reliable, if lower, 10% rate based on recent history.3 Businesses must model both scenarios to determine which approach yields the greater economic benefit, especially considering that the fixed-base calculation in the traditional method can sometimes result in a higher base than the 50% three-year average used in the ASC, thereby reducing the incremental excess available for credit.

Table 1 summarizes the core differences between these two calculation methodologies.

Table 1: Indiana R&D Tax Credit Calculation Methodologies Comparison (IDOR Guidance)

IV. The Pass-Through Mechanism: Allocation via Schedule IN K-1

A. The Critical Role of Schedule IN K-1

The Schedule IN K-1 is the formal mechanism for transferring the tax benefit from the entity to its owners. The total available annual research expense credit for the entity is calculated and finalized on Line 24 of Schedule IT-20REC.4 This is the exact amount that must be allocated.

The IDOR mandates that S corporations, partnerships, LLCs, and LLPs must prorate this Line 24 amount among the shareholders, partners, or members.4 This proration must strictly follow the percentage of distributive share of income to which each owner is entitled, maintaining proportionality between the financial benefits and the tax benefits received.4

B. IDOR Reporting and Documentation Requirements

For the individual owner’s credit claim to be valid, the PTE must adhere to precise reporting standards:

1. Issuance: The pro rata distributive share amount must be reported on the corresponding Schedule IN K-1 issued to each owner.4
2. Credit Identification: The IN K-1 must include the credit name and the specific dollar amount passed through.13
3. Substantiation Mandate: The PTE must enclose the completed Schedule IT-20REC with its annual return (e.g., Form IT-65 or IT-20S).4 Furthermore, the PTE must provide the owner with a copy of their Schedule IN K-1 and supporting documentation (often including the entity’s IT-20REC).4 The Schedule IN K-1 acts as the evidence of allocation, but the underlying calculation on IT-20REC is the source of the credit’s validity.

This documentation flow underscores a vital compliance point: the Schedule IN K-1 is not a self-sufficient claim form. Its validity depends entirely on the accuracy and completeness of the entity’s calculation on Schedule IT-20REC. If the entity fails to properly file the IT-20REC, the credit claimed by the owner based on the K-1 amount is subject to disallowance upon IDOR audit.

C. Owner-Level Reporting and Credit Utilization

The owner utilizes the allocated credit on their individual income tax return (Form IT-40 for residents or IT-40PNR for nonresidents).4

1. Claiming the Credit: The owner combines their current year pro rata share from the Schedule IN K-1 attachment with any unused state R&D credit carryforward.4 This amount is typically reported on a supporting credit schedule, such as Schedule IN-OCC (Other Certified Credits), before being applied against the Indiana adjusted gross income tax liability.14 The owner must attach their Schedule IN K-1, the IT-20REC, and the federal Form 6765 (or 8820) to their personal return for full substantiation.4
2. Credit Utilization Hierarchy and Carryforward: The Indiana Research Expense Credit is a nonrefundable credit.3 Any unused credit may be carried forward for up to 10 succeeding taxable years; however, there is no provision for carrying the credit back to prior years.3

The IDOR imposes a critical, strict rule regarding the application order of R&D credits: Indiana Code § 6-3.1-4-3(b) requires that a current year R&D credit must be fully used to offset the current year’s tax liability before any R&D credit carryforward may be applied.1 This rule is contrary to the general tax practice of utilizing credits with the shortest remaining life (FIFO) first. For taxpayers holding both current credits and expiring carryforwards, this mandate means the use of the current credit takes precedence, potentially leading to the expiration of an older, unused carryforward if insufficient tax liability remains. This necessitates careful tax planning and year-by-year management of credit vintages to maximize utilization within the 10-year expiration window.

V. Detailed Example: R&D Credit Generation and K-1 Allocation

This example demonstrates the required entity-level calculation using the Traditional Method, incorporating the statutory minimum base rule, and the subsequent allocation to the partners via Schedule IN K-1.

A. Scenario Setup

• Entity: Hoosier Innovations LP (Limited Partnership).
• Ownership: Two partners, allocating income 70% (Partner X) and 30% (Partner Y).
• Calculation Method: Traditional Tiered Method.
• Current Year Indiana QREs (CY QREs): $3,500,000.
• Fixed-Base Calculation Result (Theoretical): $1,000,000 (Based on 4 years of Indiana Gross Receipts and the fixed-base percentage).

B. Calculation of Total Entity Credit (Schedule IT-20REC)

The partnership uses Schedule IT-20REC to compute the total credit available. The calculation must account for the mandatory minimum base requirement, which prevents the base from falling below 50% of the current QREs.6

C. Allocation via Distributive Share (Schedule IN K-1)

The total credit of $225,000 is prorated to the partners according to their agreed-upon distributive share of income (70%/30%).4

• Partner X (70% Share): $\$225,000 \times 0.70 = \mathbf{\$157,500}$
• Partner Y (30% Share): $\$225,000 \times 0.30 = \mathbf{\$67,500}$

Hoosier Innovations LP will report $157,500 on Partner X’s Schedule IN K-1 and $67,500 on Partner Y’s Schedule IN K-1, accompanied by the necessary substantiating attachments.4

D. Owner Utilization Example (Partner X)

Partner X receives the Schedule IN K-1 allocation of $157,500. Partner X’s current Indiana AGI tax liability is $100,000. Partner X also holds a $50,000 R&D credit carryforward from a prior year (Year 1).

In this case, the $100,000 liability is extinguished using the current-year credit (Year 2 credit) as required by IC 6-3.1-4-3(b).1 The remaining $57,500 of the current credit and the entire $50,000 carryforward (Year 1 credit) are preserved for future use, provided they are claimed within the respective 10-year limitation periods.

VI. Conclusion and Strategic Compliance Recommendations

The Schedule IN K-1 (Pass-Through Credit) is the final link in Indiana’s statutory effort to incentivize research and development. It provides the legal authority for PTE owners to realize the tax reduction generated by the entity’s qualified activities. The entire process requires intricate compliance, spanning historical federal tax code interpretation to unique state utilization rules.

The successful utilization of this credit relies heavily on three key compliance mandates:

1. Dual-Track QRE Substantiation: Companies must manage two separate definitions for qualified research expenses—the current federal IRC § 41 definition and the specific Indiana rule tethered to the IRC as in effect on January 1, 2001.6 All QRE documentation must verify not only the nature of the expense but also the fact that the research was conducted solely in Indiana.1
2. IT-20REC Integrity: The total credit amount allocated on the Schedule IN K-1 must be precisely derived from and fully supported by the entity’s filing of Schedule IT-20REC. Any discrepancy or failure to properly document the calculation methods—Traditional or ASC—will jeopardize the owner’s ability to claim the credit upon audit.4
3. Strict Credit Utilization Order: Owners must understand and adhere to the state’s utilization priority, which requires applying the current year R&D credit first before using any R&D credit carryforwards.1 This rule contrasts with standard tax practices and necessitates that owners with large carryforward balances closely monitor the expiration dates of those older credits to ensure they are used within the 10-year limit.3

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/