Distributive Share and the Kentucky Qualified Research Facility Tax Credit: A Comprehensive Analysis of KRS 141.395 Compliance

The Distributive Share of Income serves as the mandated mechanism for allocating the Kentucky Qualified Research Facility Tax Credit (QRFTC) from a pass-through entity (PTE) to its owners. This strictly proportional methodology requires that the nonrefundable 5% credit be distributed to partners, members, or shareholders precisely in line with their agreed-upon percentages for sharing the entity’s taxable income, losses, and deductions.1

The Kentucky Qualified Research Facility Tax Credit (QRFTC), established under Kentucky Revised Statute (KRS) 141.395, is a key component of the Commonwealth’s strategy to incentivize long-term capital investment in research and development infrastructure.2 This incentive structure, administered by the Kentucky Department of Revenue (DOR), differs fundamentally from the federal research credit (IRC § 41) because it focuses exclusively on fixed asset investment—tangible, depreciable property—rather than day-to-day operational research expenses like wages or supplies.2 For entities structured as partnerships, S-corporations, or limited liability companies (LLCs)—collectively referred to as pass-through entities (PTEs)—the mechanism for transferring this valuable credit to the ultimate taxpayers (the owners) is governed by stringent proportional allocation rules, summarized by the term “Distributive Share of Income.” Understanding this allocation mandate is essential for accurate compliance and effective tax planning for entities operating in Kentucky.

II. Statutory Foundation of the Qualified Research Facility Tax Credit (QRFTC)

The ability to claim the research facility credit hinges on adherence to the statutory framework outlined in KRS 141.395, which details the calculation, qualified expenses, and utilization rules for the incentive.

2.1. Legislative Mandate and Credit Calculation (KRS 141.395)

The QRFTC is permitted against taxes imposed by KRS 141.020 (individual income tax), KRS 141.040 (corporation income tax), and KRS 141.0401 (Limited Liability Entity Tax, or LLET).1 The credit rate is a generous five percent (5%) of the qualified costs incurred.2 Unlike the complex incremental formulas often associated with the federal R&D credit, the Kentucky QRFTC calculation is exceptionally straightforward: there is no requirement for a fixed-base percentage calculation, nor is any prior-year averaging required.2 All eligible current-year costs qualify fully for the 5% credit, provided the qualified property is placed in service in Kentucky.2

2.2. Defining Qualified Facility Costs

The specific definition of eligible costs underscores the Commonwealth’s policy focus on long-term capital commitment. “Construction of research facilities” is narrowly construed to mean constructing, remodeling, equipping, or expanding existing facilities in Kentucky specifically for the purpose of qualified research.1

The key limitation is that costs must relate only to tangible, depreciable property.1 This strict focus means that the credit is explicitly designed to capture permanent physical investment, such as specialized laboratory buildings, machinery, testing gear, and other fixed assets necessary to support technological uncertainty resolution, which aligns with the definition of “qualified research” provided in Section 41 of the Internal Revenue Code (IRC § 41).1 The statutory language explicitly excludes any amounts paid or incurred for replacement property, reinforcing the incentive’s focus on new capital formation rather than routine maintenance or replacement cycles.1 By limiting the credit to facility investments, KRS 141.395 establishes a strategic intent: to capture fixed capital commitment and infrastructure within the state, signaling a legislative goal of promoting long-term physical presence and capital improvement over the subsidization of more transient operational costs like wages or supplies.

2.3. Statutory Limitations: Nonrefundable Status and Carryforward Provisions

The credit generated under KRS 141.395 is explicitly nonrefundable.1 It can only offset existing Kentucky tax liability and cannot result in a cash refund to the taxpayer.2 The law anticipates that large capital investments may generate credits exceeding current-year liability; thus, any portion of the credit that cannot be utilized in the current tax year may be carried forward for a maximum period of ten (10) years.1 This decade-long carryforward provision is essential for maximizing the credit’s value for both corporate taxpayers and PTE owners.

III. The Principle of Proportional Allocation: Distributive Share Defined

The allocation rule for the QRFTC is the central compliance point for PTEs, mandating that the credit must flow to the owners based on their economic stake in the entity, known as the Distributive Share of Income.

3.1. Distributive Share as the Allocation Mandate

For pass-through entities—including Partnerships, S-Corporations, LLCs, and general partnerships generating the QRFTC 1—the calculated entity-level credit is passed through to the ultimate taxpayers. The legal requirement is clear: the credit must be passed through to its owners only in the same proportion as the distributive share of income is passed through.1

This proportional requirement ensures administrative consistency across Kentucky tax reporting. For instance, in the case of S-corporations, KRS 141.040(4) requires shareholders to take into account their total distributive share of the S-corporation’s income, loss, and deduction when determining their Kentucky tax liability.4 By requiring the credit to follow the same allocation path as the taxable income, the DOR ensures that the benefit is aligned directly with the economic interest responsible for generating that income.

3.2. Prohibiting Special Allocations and Tax Planning Constraints

A key limitation imposed by this rule is the explicit prohibition of “special allocations” for the QRFTC. Under federal tax law, particularly for partnerships, agreements can often be structured to allocate specific items of income or credit disproportionately among partners, provided the allocation meets the substantial economic effect test (IRC § 704(b)).

Kentucky’s “same proportion” requirement supersedes this flexibility for state purposes. The strict, mandatory linkage between the owner’s income percentage and the credit percentage prevents PTEs from allocating the credit solely to those partners or members who have the necessary tax liability to utilize it immediately.1 This approach simplifies the state’s administrative oversight and review process; the DOR can verify the allocation simply by reviewing the income percentages on the Kentucky Schedule K-1, rather than undertaking complex analyses of specialized tax arrangements. Any language in a partnership or operating agreement attempting to allocate the Kentucky QRFTC disproportionately to the income share is ineffective for state tax reporting.

3.3. Importance of Ownership Timing

The timing of ownership is critical for compliance, particularly for entities experiencing ownership changes. Kentucky guidance specifies that the allocation is targeted specifically to those individuals or entities who were partners, members, or shareholders at the time of the application and subsequent approval of the credit.1 This provision ensures that the capital investment incentive is linked directly to the individuals who held an interest in the entity when the facility investment was made and the property was placed in service, thereby requiring PTEs to maintain precise records regarding ownership status during the year of credit generation.

IV. Kentucky Department of Revenue (DOR) Guidance and Compliance Documentation

Seamless claiming of the QRFTC requires adherence to specific forms and documentation procedures defined by the Kentucky Department of Revenue.

4.1. Entity-Level Reporting: Generating the Credit (Schedule QR)

The entity that incurs the qualified facility costs (the PTE) is responsible for filing the foundational documentation: Schedule QR, Qualified Research Facility Tax Credit.1 This schedule determines the total credit amount based on qualified facility costs and must be filed with the entity’s income tax return.1

Procedurally, the PTE must file a separate Schedule QR each year that a new project qualifies.1 To support the figures claimed, the PTE must mandatorily include a detailed supporting schedule listing all tangible, depreciable property associated with the facility, including the date purchased, date placed in service, description, and cost.1

4.2. Owner Notification via Kentucky Schedule K-1

The allocated portion of the QRFTC is formally reported to the owners on the Kentucky Schedule K-1.1 The K-1 acts as the primary document confirming the pass-through status of the credit and substantiating the owner’s legal right to claim their distributive share.

4.3. Owner-Level Claiming Process (ITC and TCS)

To utilize the allocated credit against their individual or corporate Kentucky tax liability, taxpayers must file specific schedules depending on their filing status:

Required Compliance Forms for QRFTC Claiming

4.4. The Critical Attachment Requirement

The utilization of the QRFTC, particularly through its 10-year carryforward period, is heavily reliant on persistent documentation. DOR guidance stipulates that taxpayers receiving a share of the credit must attach a copy of the Schedule QR to their return, along with the Schedule ITC or Schedule TCS.1 This requirement is crucial because it applies not only in the year the credit is first claimed but also each subsequent year the credit, or any carryforward portion, is utilized.1 This ongoing documentary requirement ensures the DOR can verify the validity of the original facility investment and the calculated credit amount years after the facility was placed in service.

V. Utilization Constraints: Credit Ordering and LLET Interaction

The utilization of the allocated QRFTC is heavily constrained by Kentucky’s mandated credit ordering statute, KRS 141.0205, which governs how nonrefundable credits are applied against tax liabilities.

5.1. The Priority Statute: KRS 141.0205

KRS 141.0205 dictates the strict priority sequence for applying credits against the tax imposed by KRS 141.020, 141.040, and 141.0401.1 The placement of the QRFTC within this sequence determines the likelihood of its immediate absorption.

When applying the nonrefundable business incentive credits against individual income tax (KRS 141.020), the QRFTC permitted by KRS 141.395 falls relatively late in the sequence, specifically at rank (j).6

5.2. Interaction with High-Priority Credits

The QRFTC must await the utilization or exhaustion of numerous higher-priority credits, including:

• Limited Liability Entity Tax (LLET) Credit (Rank (a)): Resident and nonresident individual shareholders are entitled to a nonrefundable LLET credit.7 This is applied first against income tax assessed on the income derived from the S-corporation.7
• Economic Development Credits (Rank (b)): This includes high-value credits such as those generated under KREDA, KIRA, and other incentive programs.6

The low priority ranking (j) within the KRS 141.0205 hierarchy carries significant implications. If a taxpayer is involved in multiple Kentucky incentive programs, their tax liability may be substantially reduced or eliminated by higher-priority credits, converting the QRFTC into a deferred asset. Since the credit is nonrefundable, this low ranking substantially increases the probability that the credit will need to be carried forward for multiple years. The practical result is that the current economic benefit of the QRFTC is diminished due to its long-term deferred recovery and the corresponding decrease in its Net Present Value (NPV). This necessitates a strategic view, treating the credit primarily as a long-term future tax offset, relying heavily on the 10-year carryforward provision.2

5.3. LLET Minimum Constraint

When applied at the entity level against the LLET, or when claimed by a corporate partner against its LLET liability, the credit is further constrained: total credits taken against the LLET may not reduce the tax below the statutory minimum of $175.2

VI. Comprehensive Numerical Example: Allocation of the QRFTC

This example demonstrates the proportional allocation based on the Distributive Share of Income and illustrates the owner-level claiming process.

6.1. Scenario Setup: R&D Partnership

Tech-Innovate Partners LLP (TIP) is a Kentucky partnership established on January 1, 2024. The partnership agreement dictates that Partner J (an individual) holds a 75% Distributive Share of Income, and Partner K (a corporation) holds a 25% Distributive Share of Income.

In 2024, TIP incurs $2,500,000 in qualified costs for construction and equipping of a new research facility in Louisville, placed in service that year. The facility supports qualified research activities under IRC § 41.

6.2. Entity-Level Credit Generation and Filing

TIP must first calculate the total QRFTC:

TIP files its partnership return for 2024 and attaches Schedule QR, documenting the $125,000 generated credit and the detailed list of tangible, depreciable property.

6.3. Allocation Based on Distributive Share

The total $125,000 credit must be allocated strictly according to the 75%/25% Distributive Share of Income.1

Numerical Allocation of the QRFTC

6.4. Owner-Level Reporting and Utilization Example

Partner J (Resident Individual)

Partner J receives a $93,750 credit allocation. J files Kentucky Form 740, supported by Schedule ITC.

• Utilization: Assume Partner J’s 2024 Kentucky income tax liability, after applying the LLET credit (rank (a)) and other higher-priority credits (ranks (b) through (i) in KRS 141.0205 6), stands at $20,000.
• Current Year Claim: J applies $20,000 of the QRFTC to offset the remaining liability.
• Carryforward Management: The unutilized portion, $93,750 – $20,000 = $73,750, is carried forward for the remaining nine years of the 10-year limit.2
• Annual Compliance: Partner J must attach a copy of TIP’s original Schedule QR to the 2024 return and again to the return for every year until 2034, or until the $73,750 carryforward is exhausted.

Partner K (C-Corporation)

Partner K receives a $31,250 credit allocation. K files Kentucky Form 720, supported by Schedule TCS.5

• Utilization: Partner K applies the credit against its corporate income tax liability. Assume Partner K has a corporate income tax liability of $10,000 and an LLET liability of $5,000.
• Application: K applies the $31,250 credit first against the income tax, reducing it to zero ($10,000 utilized). K then applies the remaining credit against the LLET, noting the $175 minimum tax constraint. K utilizes $4,825 against the LLET ($5,000 – $175). Total utilized credit is $10,000 + $4,825 = $14,825.
• Carryforward Management: The remaining credit, $31,250 – $14,825 = $16,425, is carried forward for the remaining nine years.
• Annual Compliance: Partner K must attach a copy of TIP’s original Schedule QR to its 2024 return and every return thereafter until the carryforward is fully utilized.

VII. Conclusion and Strategic Tax Considerations

The Kentucky Qualified Research Facility Tax Credit is a vital incentive promoting substantial capital investment in R&D infrastructure. However, its implementation for pass-through entities is characterized by two defining constraints: rigid allocation and delayed utility.

1. Rigid Allocation: The mandated use of the Distributive Share of Income for credit allocation establishes a direct and unalterable link between the partner’s economic interest and their allocated tax benefit.1 This mechanism prevents tax manipulation through special allocations, prioritizing administrative compliance for the DOR while requiring that PTEs adhere strictly to their partnership or operating agreement income percentages when distributing the credit.
2. Delayed Utility: Due to the low priority ranking of the QRFTC (rank (j) in KRS 141.0205) 6 and its nonrefundable nature, taxpayers often find the credit serves as a long-term tax deferral asset rather than an immediate tax shield. This structural placement diminishes the current-year value of the credit, making sophisticated tracking of the ten-year carryforward period absolutely critical for maximizing the incentive’s long-term worth.
3. Administrative Diligence: The DOR’s requirement that the entity’s original Schedule QR must be attached to the owner’s Schedule ITC or Schedule TCS annually 1 transforms the one-time capital investment into a sustained administrative responsibility lasting up to a decade. Robust record-keeping is therefore paramount for all PTEs and their owners utilizing the QRFTC.

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