Leveraging Innovation: The Kentucky Qualified Research Facility Tax Credit (KRS 141.395) and Strategic Reduction of Individual Income Tax Liability (KRS 141.020)

KRS 141.020 mandates an annual income tax on the net income of Kentucky resident individuals and, by extension, on nonresidents’ Kentucky-sourced income. This statute simultaneously provides the mechanism for subtracting allowable tax credits to determine the final tax due.1

This analysis provides a detailed, expert-level review of how the Kentucky Qualified Research Facility Tax Credit (QRFTC), authorized under KRS 141.395, strategically reduces the tax liability imposed by KRS 141.020. The report incorporates local state revenue guidance, specific compliance requirements, and practical application examples for businesses and high-net-worth individuals utilizing this significant incentive.

I. Executive Summary: The Nexus of Income Tax and R&D Incentives

KRS 141.020 defines the foundation of the individual tax obligation within the Commonwealth, explicitly allowing for the subtraction of permissible tax credits—a provision that legally integrates incentive programs into the tax determination process.1 The Kentucky QRFTC is a powerful economic development tool designed to spur investment in research infrastructure within the state. It provides a nonrefundable credit equal to 5% of the qualified costs associated with the construction and equipping of research facilities.3 This credit is directly applicable to offsetting the tax liability generated under KRS 141.020, offering a dollar-for-dollar reduction for individuals who invest in or own pass-through entities engaged in qualified R&D activities.5

The structure of the QRFTC, which focuses specifically on the costs related to “tangible, depreciable property” 6, represents a deliberate policy decision by the Commonwealth. By limiting the 5% credit exclusively to fixed capital investments—such as facility construction and equipment—and excluding routine replacement property, the state incentivizes large, non-mobile infrastructure projects. This mechanism ties the economic benefit to long-term physical assets, securing the residency of the subsidized capital within Kentucky, and ensuring the economic impact stabilizes over the credit’s generous 10-year carryforward period.3

II. Foundational Tax Liability: Analyzing KRS 141.020, Individual Income Tax

Statutory Mandate and Scope

KRS 141.020 imposes the annual tax burden on residents and establishes the calculation framework. Subsection (1) mandates that the tax shall be determined by applying the rates specified in subsection (2) to the taxpayer’s net income, followed by the subtraction of allowable tax credits provided in subsection (3).1 Therefore, the QRFTC functions as a post-calculation reduction of the tax assessed, rather than a reduction of the underlying net income.

The scope of this statute extends beyond full-year residents. Administrative regulations, such as 103 KAR 17:060, prescribe the methods necessary for determining the Kentucky portion of income and deductions for part-year residents and nonresidents.2 This regulatory framework ensures that any non-resident who owns an interest in a Kentucky pass-through entity (PTE) that generates income taxable under KRS 141.020 must adhere to rigorous apportionment rules. The ability of that non-resident to effectively use a QRFTC passed through to them is entirely contingent upon the accuracy of their Kentucky-source income calculation as mandated by these administrative provisions.

The Statutory Function of Credits and Ordering Rules

The language in KRS 141.020(1) formally establishes the legal mechanism for applying tax incentives. The Qualified Research Facility Tax Credit is a nonrefundable credit.9 This characteristic makes the ordering of credits, which is formalized by KRS 141.0205, critically important for utilization.9

If a taxpayer holds multiple state credits, the sequence in which they are applied against the KRS 141.020 liability dictates whether the nonrefundable QRFTC can be maximized or if it might be partially wasted. Strategic planning requires ensuring that credits with short expiration periods or nonrefundable status, like the QRFTC, are utilized efficiently within the statutory ordering framework provided by KRS 141.0205 before the tax liability is exhausted by other credits.

III. The Qualified Research Facility Tax Credit (KRS 141.395): Eligibility and Mechanics

Statutory Authority and Calculation

The QRFTC, codified in KRS 141.395, is equal to five percent (5%) of the qualified costs incurred for the construction of research facilities.4 This nonrefundable credit can be applied against the individual income tax imposed by KRS 141.020, the corporation income tax imposed by KRS 141.040, and the Limited Liability Entity Tax (LLET) imposed by KRS 141.0401.3 Any portion of the credit that cannot be used in the year it is generated may be carried forward for up to ten (10) years.3

Defining “Construction of Research Facilities”

Eligibility for the credit is strictly tied to the nature of the investment. “Construction of research facilities” means constructing, remodeling, and equipping new facilities, or expanding existing facilities, located in Kentucky for the purpose of qualified research.6

To qualify, the costs must meet two specific requirements:

1. Tangible and Depreciable Property: The expenditure must be limited exclusively to tangible, depreciable property.4 This inherently excludes costs associated with land acquisition, ongoing operational expenses, and intangible assets.
2. Exclusion of Replacements: Amounts paid or incurred for replacement property are explicitly excluded from qualified costs.3 This ensures the credit encourages net new investment and facility expansion, rather than routine asset swapping or maintenance.

The credit officially becomes available once the qualifying tangible, depreciable property has been placed in service.7

Defining “Qualified Research” and Federal Conformity

Kentucky adopts the definition of “qualified research” by reference to federal law, specifically Section 41 of the Internal Revenue Code (IRC § 41).3 This requires the underlying research activities conducted within the facility to satisfy the federal four-part test, generally confirming the work is aimed at resolving technological uncertainty through a process of experimentation.

It is necessary to acknowledge Kentucky’s position regarding federal conformity, particularly with respect to IRC Section 174.12 For taxable years beginning on or after January 1, 2023, Kentucky conforms to the federal requirement mandating the capitalization and amortization of Research and Experimental (R&E) expenses.12 This capitalization requirement increases the amount of taxable net income subject to KRS 141.020, thereby raising the individual’s tax liability. A larger KRS 141.020 tax liability base consequently enhances the utility of the nonrefundable QRFTC (KRS 141.395) because there is a greater tax due amount to offset, which facilitates the faster and more complete utilization of the credit before the 10-year carryforward period expires.

Table 1: Key Features of the Kentucky Qualified Research Facility Tax Credit

IV. Alignment with Individual Tax: The KRS 141.020 Offset Mechanism

The QRFTC is utilized by individuals through two main avenues: direct claim by a sole proprietor or via flow-through treatment from a Pass-Through Entity (PTE).

Pass-Through Entity Flow-Through

For most sophisticated research operations, the credit is generated by a PTE (such as a partnership, S-Corporation, or LLC). The law stipulates that the approved credit is passed through to the partners, members, or shareholders who were owners at the time of the application and approval.5 This pro rata share of the credit is reported on the Kentucky Schedule K-1 received by the owner. This Schedule K-1 acts as the documentary evidence that allows the individual owner to apply the entity-level investment directly against their personal individual income tax liability imposed by KRS 141.020.5

Sole Proprietor Direct Claim and Marital Rules

An individual operating as a sole proprietor who reports business income on federal Schedule C may claim the credit directly under the business name against their KRS 141.020 liability.3

For married taxpayers, the Department of Revenue (DOR) provides administrative guidance specific to credit ownership. If both spouses constructed the facility and their names are listed on the application, the credit can be claimed wholly if they file jointly, or it must be split if they file separately. However, if the application lists only one spouse, that listed spouse is entitled to claim the entire credit, regardless of their filing status.3 This DOR requirement, which ties credit entitlement directly to the name(s) on the application, underscores the necessity of strategic planning at the initial application stage. Taxpayers may intentionally designate the spouse with the highest anticipated KRS 141.020 liability as the primary or sole applicant to ensure the most efficient and rapid utilization of the nonrefundable credit, thereby maximizing its total value.

The Mandate for Separate Tracking

A critical administrative requirement mandated by the DOR is the calculation and tracking of the credit balance separately for Income Tax (KRS 141.020/141.040) and the Limited Liability Entity Tax (LLET) (KRS 141.0401).10

The balance available for Income Tax cannot be used to offset the LLET, and conversely, the LLET balance cannot be used to offset the Income Tax liability.10 This bifurcation has significant tax efficiency implications. The LLET is a liability that, by law, cannot be reduced below a minimum of $175.9 For entities with small LLET obligations, the LLET portion of a large QRFTC is highly susceptible to becoming stranded and expiring unused after the 10-year carryforward period, resulting in wastage. Therefore, entities must strictly track this separation to ensure that the Income Tax portion (which flows to the individual KRS 141.020 filer) is accurately applied and utilized.

V. Kentucky Department of Revenue (DOR) Guidance and Compliance

Compliance with the QRFTC regulations centers around filing the Schedule QR and properly transferring the credit to the individual taxpayer via the Schedule K-1.

The Central Form: Schedule QR

The Schedule QR, Qualified Research Facility Tax Credit, must be filed with the tax return claiming the credit.3 It serves three primary functions:

1. Computation (Part I): This section calculates the total allowable tax credit by taking 5% of the total qualified costs, which include construction and equipment costs.10 Taxpayers must attach a supporting schedule listing the tangible, depreciable property, its date of purchase, date placed in service, description, and cost.3
2. Current Application (Part II): This allocates the current year credit claimed against LLET (Line 1), Corporate Income Tax (Line 2), and Individual Income Tax (Line 3).10 For PTEs, the amount on Line 3 is the basis for the allocation distributed to the owners.
3. Tracking (Part III): This mandatory section records the credit claimed each year and tracks the remaining balance available for both Income Tax and LLET separately, ensuring the 10-year carryforward is monitored.10 A copy of Schedule QR must be submitted annually until the full credit is utilized or the carryforward period expires.3

Individual Taxpayer Reporting

An individual filer subject to KRS 141.020 who receives the credit via a Kentucky Schedule K-1 must use Schedule ITC (Individual Tax Credit Summary) to summarize their claimed credit and apply it against their final tax liability on Form 740, the Individual Income Tax Return.13 For corporations and pass-through entities, Schedule TCS (Tax Credit Summary) is utilized for claiming the credit against the entity’s LLET or corporate income tax.3

Table 2: DOR Compliance Checklist: Required Forms and Actions

VI. Case Study: Calculating and Applying the Credit Against KRS 141.020 Liability

This example demonstrates the calculation and application of the QRFTC as it flows from a PTE to an individual taxpayer subject to the KRS 141.020 tax.

Scenario Setup: Innovate Labs LLC and John Doe

Innovate Labs LLC, a Kentucky partnership, completes the construction and equipping of a qualified research facility in 2024. The total cost of the tangible, depreciable property placed in service is $1,500,000.

1. Credit Generation (Schedule QR, Part I):

• Total Qualified Costs: $1,500,000.
• Allowable Tax Credit (5%): $\$1,500,000 \times 0.05 = \$75,000$.

Innovate Labs LLC allocates this $75,000 total credit balance separately between the Income Tax and LLET accounts, as mandated. For simplicity, assume the entire credit is tracked against the Income Tax liability since the LLET balance is often impractical to utilize fully.

2. Individual Allocation:

John Doe is a 40% member of Innovate Labs LLC. His pro rata share of the Income Tax credit is: $\$75,000 \times 40\% = \$30,000$.

This $30,000 credit is reported on John Doe’s Kentucky Schedule K-1.

Year 1 Application: Utilizing the Credit

In 2024, John Doe reports sufficient net income under KRS 141.020, resulting in a calculated Kentucky Individual Income Tax liability of $45,000 (before credits).

• Credit Claimed: John Doe enters the $30,000 allocated credit on his Schedule ITC.
• Final Tax Due: $\$45,000 \text{ (Liability)} – \$30,000 \text{ (Credit Claimed)} = \mathbf{\$15,000} \text{ (Final Tax Due)}$.
• Carryforward: $\$0$.

Multi-Year Carryforward Scenario (Tracking on Schedule QR, Part III)

If the liability were lower, the nonrefundable credit would be carried forward. Assume John Doe’s calculated 2024 KRS 141.020 Liability was only $10,000.

The table demonstrates that the credit accelerates the reduction of the KRS 141.020 liability. However, this scenario also highlights the inherent risk associated with the nonrefundable credit: it must be consumed within the 10-year limit. For large credits flowing through PTEs, owners must model their individual tax burden (KRS 141.020) over the entire carryforward window. If current income is insufficient to absorb the credit, the taxpayer risks allowing a portion of the credit to expire unused. Structuring partnership distributions or special allocations of the credit to maximize its flow to partners with the highest individual KRS 141.020 liability is essential for rapid utilization and maximizing the credit’s net present value.

VII. Strategic Considerations and Advanced Compliance

Documentation and Audit Defense

Since the QRFTC is contingent upon investment in tangible, depreciable property placed in service, comprehensive documentation is non-negotiable for audit defense.7 Taxpayers must maintain detailed records, including invoices, costs, and depreciation schedules, to substantiate that the expenditures meet the strict statutory definition. Furthermore, although the cost calculation is state-based, compliance requires documented evidence that the facility is indeed used for “qualified research” as defined under IRC § 41.3

Mitigating LLET Credit Wastage

The statutory non-transferability between the LLET credit balance and the Income Tax credit balance 14 means that the LLET portion is often fiscally impractical to utilize completely before expiration. The $175 LLET minimum tax floor significantly limits the annual offset possible.9 Tax planning must fully recognize the probability of LLET credit forfeiture and focus resource allocation on ensuring the Income Tax portion (KRS 141.020 offset) is utilized rapidly.

Optimizing the Credit Life Cycle

The credit’s availability hinges on the date the qualifying property is “placed in service”.7 For sophisticated taxpayers managing large investments, strategic timing of this placement date is critical, as it defines the start of the 10-year carryforward clock. By marginally delaying the placed-in-service date from the last week of December to the first week of January, the taxpayer gains a full additional tax year for the credit to offset the individual KRS 141.020 liability, effectively extending the utilization period and mitigating the risk of expiration. Adherence to the statutory credit ordering under KRS 141.0205 must also be maintained to prevent the nonrefundable QRFTC from being preempted by other credits.

VIII. Conclusion: Compliance and Opportunity

The Qualified Research Facility Tax Credit (KRS 141.395) represents a robust opportunity for individuals and pass-through entities investing in Kentucky’s R&D infrastructure to directly reduce their individual income tax liability imposed by KRS 141.020. This incentive offers a substantial 5% credit rate and a valuable 10-year carryforward period.

Successful utilization requires a granular focus on administrative compliance, especially concerning the rigorous documentation of tangible, depreciable property costs and the adherence to the Department of Revenue’s separate tracking mandate for Income Tax and LLET balances on Schedule QR. For high-net-worth individuals, the primary strategic objective must be the acceleration of credit usage against the KRS 141.020 liability to minimize the risk of forfeiture, recognizing that the nonrefundable nature and the fixed 10-year carryforward period place a significant premium on timing and planning.

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