Analysis of Pass-Through Entities and the Kentucky Qualified Research Facility Tax Credit (KRS 141.395)

I. EXECUTIVE SUMMARY AND INTRODUCTION

I.A. Definitional Requirement: The Pass-Through Entity (PTE)

A Pass-Through Entity (PTE), also known as a flow-through entity, is a business structure where the tax liability is not imposed at the entity level but is instead directly passed through to the owners. These entities, which include partnerships, S-corporations, and Limited Liability Companies (LLCs), are fundamental to U.S. business activity, enabling owners to report their allocated shares of profits, losses, deductions, and credits on their individual income tax returns.1

The share of business activity represented by pass-through entities has steadily increased over the past several decades.1 Unlike C-corporations, which are subject to a corporate income tax, PTEs avoid the inherent problem of double taxation.2 For federal and state purposes, the entity’s income is reported on the owner’s individual return and taxed at the individual income tax rate. S-corporations, for example, are designed to pass corporate income, losses, deductions, and credits directly to their shareholders, thereby avoiding double taxation on corporate earnings.2

I.B. Report Mandate and Scope

This expert-level analysis is mandated to delineate the precise operational meaning of a Pass-Through Entity within the context of the Kentucky Qualified Research Facility Tax Credit, codified in Kentucky Revised Statutes (KRS) 141.395. The focus includes a detailed examination of the credit’s capital expenditure requirements, the procedural guidance issued by the Kentucky Department of Revenue (DOR), and the complex statutory limitations imposed by the Limited Liability Entity Tax (LLET).

The primary challenge for PTEs utilizing this credit is navigating the mandatory statutory credit ordering (KRS 141.0205) and the non-reductive floor of the LLET, which dictates how the nonrefundable credit may be applied across the entity and owner tax bases. The subsequent sections provide a technical review of the statutory framework and the necessary compliance steps for maximizing this economic development incentive.

II. DEFINITIONAL FRAMEWORK: UNDERSTANDING PASS-THROUGH ENTITIES (PTEs)

II.A. Core Tax Principles of Flow-Through Taxation

The central characteristic defining a pass-through entity is the direct flow of financial results to the owners. This flow-through mechanism ensures that business income is taxed only once, generally at the individual owner’s tax rate.2 Conversely, C-corporations face double taxation: first at the corporate level (currently a 21% federal business income tax rate) and subsequently when shareholders receive dividends or realize gains from stock sales.2

PTEs are required to file an entity tax return, such as Form 1065 for partnerships, primarily to report the organization’s income, gains, losses, deductions, and credits, which are then formally allocated to the partners or members.2 This allocation is then conveyed to the owners for tax reporting purposes via federal and corresponding state Schedule K-1s.3

II.B. Kentucky Classifications of PTEs

For Kentucky state tax purposes, the Department of Revenue (DOR) recognizes the following structures as pass-through vehicles capable of generating and distributing tax credits: partnerships, Limited Liability Companies (LLCs), and S-corporations.1 A sole proprietor, while effectively a flow-through structure, claims the credit directly against individual income tax by reporting business income on Schedule C (federal Form 1040) under the business name, rather than through an entity K-1 mechanism.4

The DOR confirms that the Qualified Research Facility Tax Credit is a business tax credit that, when generated by a partnership, LLC, or S-corporation, is passed through to the partners, members, or shareholders.4 These owners may then use their allocated credit share against their individual income tax (KRS 141.020), corporate income tax (KRS 141.040), or the Limited Liability Entity Tax (LLET).4 The specific allocation to owners is documented on the Kentucky Schedule K-1 (Form PTE).3

II.C. The Portability of Nonrefundable Credits

The Kentucky Qualified Research Facility Tax Credit is explicitly a nonrefundable credit.4 This nonrefundable status introduces a crucial consideration for PTEs and their owners regarding the credit’s utility. The credit can only offset an existing Kentucky tax liability; it cannot generate a refund check if the credit exceeds the tax due.

The entity itself acts as the credit generator, but the actual benefit realization depends entirely on the financial posture of the owners, since the credit passes through. If the PTE allocates a portion of the credit to an owner with minimal or zero Kentucky income tax liability, the current-year utility of that allocated credit is limited. Tax planning must therefore incorporate the individual owners’ ability to utilize the credit immediately. Any unused portion of the credit, whether generated directly by a sole proprietor or passed through from a PTE, can be carried forward for a period of ten (10) years.5 This 10-year carryforward requires robust recordkeeping to ensure the deferred benefit is captured effectively.

III. THE KENTUCKY QUALIFIED RESEARCH FACILITY TAX CREDIT (KRS 141.395)

III.A. Statutory Basis and Scope Definition

The Kentucky Qualified Research Facility Tax Credit is granted under KRS 141.395.5 This tax credit is specifically designed as an economic incentive for capital investment in research infrastructure within the state.

The nonrefundable income tax credit is calculated as five percent (5%) of the qualified costs incurred for the construction of research facilities.4 The statute defines “Construction of research facilities” broadly, including the actions of constructing, remodeling, expanding existing facilities, or equipping new or existing facilities in Kentucky for the purpose of conducting qualified research.4

III.B. Defining “Qualified Costs” and the Capital Focus

A key feature distinguishing the Kentucky research incentive from the more common federal research tax credit (IRC § 41) is its narrow focus on capital expenditures. Eligible costs include only tangible, depreciable property.4 The credit is generated when the qualified property is physically placed in service within Kentucky.5

The statute specifically mandates several exclusions from qualified costs 5:

1. Non-Capital Expenses: Costs for wages, supplies, and contract research, which are the primary focus of the federal R&D credit, are explicitly excluded.
2. Replacement Property: Amounts paid or incurred for the acquisition of replacement property, such as routine asset swaps, do not qualify for the credit.4 The incentive focuses on net new or expansive investments in Kentucky infrastructure.5

This singular focus on tangible, depreciable property means that the credit acts as a direct capital investment incentive, requiring PTEs to maintain detailed fixed asset records to substantiate the claim.

III.C. Alignment with Internal Revenue Code (IRC) § 41

Although the Kentucky credit targets facility costs, the underlying activity within that facility must satisfy the criteria for “Qualified research” as defined in Section 41 of the Internal Revenue Code (IRC).4

To meet the IRC § 41 definition, the research activity conducted in the Kentucky facility must satisfy the four-part test:

1. Technological in Nature: Activities must fundamentally rely on the principles of physical or biological science, engineering, or computer science.6
2. Permitted Purpose: The activities must attempt to improve the functionality, performance, reliability, or quality of a new or existing business component.6
3. Eliminate Uncertainty: The activities must be intended to discover information that resolves or eliminates technical uncertainty regarding the development or improvement of a product.6
4. Experimentation: The process must involve a systematic trial and error approach, including experimentation, testing, modeling, or simulation.6

III.D. Stacking Benefits and Capitalization Requirements

Because the Kentucky credit is restricted to capitalized, depreciable property, it functions complementarily to the federal R&D tax credit, which primarily incentivizes operating expenses (wages, supplies). This design allows companies to simultaneously claim the federal credit for operating research costs and the Kentucky credit for the infrastructure supporting that research, thereby maximizing the total financial incentive for research activity within the state.7 For example, a company may qualify for federal R&D tax credits on payroll and supplies totaling $327,833, while simultaneously qualifying for $210,000 in Kentucky state R&D Tax Credit based on the $4,200,000 spent on facility construction.7

For a cost to be considered eligible for the 5% Kentucky credit, it must be verifiable as a capital expenditure—that is, it must be recorded as a capitalized asset subject to depreciation rules, and the asset must have been placed in service in Kentucky during the tax year.4 The successful claim of the credit therefore necessitates strict segregation of capital investment records from traditional R&D operating expenditures, minimizing the risk of audit adjustments related to ineligible, non-depreciable costs.

Table 1: Comparison of Federal and Kentucky R&D Incentives

IV. MECHANICS OF CREDIT FLOW-THROUGH FOR PTEs (DOR GUIDANCE)

The process by which the Qualified Research Facility Tax Credit is generated by a PTE and allocated to its owners is highly regulated by the Kentucky Department of Revenue (DOR) through specific schedule requirements.

IV.A. Generating the Credit: Schedule QR Filing

The initial calculation of the credit occurs at the entity level via Schedule QR, Qualified Research Facility Tax Credit.4 This schedule is used to determine the allowed credit amount against both the income tax liability and the LLET liability based on the qualified costs placed in service during the year.8

The filing of Schedule QR must be accompanied by detailed documentation 4:

1. A copy of the completed Schedule QR must be attached to the entity’s income tax return each year the credit is claimed until the credit is fully utilized or the 10-year carryforward period expires.4
2. A mandatory supporting schedule must be included, listing the specific tangible, depreciable property, along with its date purchased, date placed in service, detailed description, and cost.4
3. For separate, new research facility projects completed in different years, a separate Schedule QR must be filed for each project year.4

IV.B. Allocation to Owners: Kentucky Schedule K-1 (Form PTE)

Once the total eligible credit is calculated on Schedule QR and any permissible entity-level offset against the LLET has been applied, the remaining credit amount is allocated to the owners. This process confirms the flow-through nature of the incentive.

The allocated credit is reported to each owner based on their proportional share of the entity’s income, deductions, credits, etc..3 This allocation is formally conveyed through the Kentucky Schedule K-1 (Form PTE).4 The PTE must accurately reflect the credit amount on this schedule for the shareholder, partner, or member to claim the credit on their personal or corporate return.4

IV.C. Utilization at the Owner Level (Schedule ITC/TCS)

PTE owners claim the allocated credit against their specific Kentucky tax liability—either individual income tax (KRS 141.020) or corporate income tax (KRS 141.040) and LLET.4 The DOR mandates the use of specific tax credit schedules to formalize the claim.4

The required claiming forms are:

1. Schedule ITC (Individual Tax Credit): Required for individuals filing Form 740 who receive a share of the qualified research facility credit via a Kentucky K-1.4
2. Schedule TCS (Tax Credit Summary): Required for corporations and pass-through entities (that are themselves partners or members of the generating PTE) to reflect their share of the credit.4

A copy of the originating Schedule QR must also be attached to the owner’s final tax return along with the Schedule ITC or TCS, ensuring that the necessary documentation for the claim is present at the recipient level.4

V. THE LIMITED LIABILITY ENTITY TAX (LLET) INTERPLAY (KRS 141.0401)

The interaction between the Research Facilities Credit and the Limited Liability Entity Tax (LLET) represents the most complex mechanical aspect of Kentucky tax compliance for PTEs.

V.A. Overview and Calculation of the LLET

The LLET is an entity-level tax imposed on limited liability entities, including corporations and limited liability pass-through entities, that are “doing business” in Kentucky.9 The LLET liability is calculated based on the greater of the company’s Kentucky gross receipts or its Kentucky gross profits.10

The LLET structure includes an important minimum tax:

• Small Business Exemption: If a business’s total gross receipts or total gross profits from all sources are $\$3,000,000$ or less, the entity pays only the minimum LLET of $\$175$.10
• Standard Rate: If gross receipts or gross profits are $\$6,000,000$ or greater, the LLET is calculated at $0.095\%$ of Kentucky gross receipts or $0.75\%$ of Kentucky gross profits.3

While Kentucky generally allows a nonrefundable credit against income tax for LLET paid above the minimum amount, the LLET itself is not subject to the federal Public Law 86-272 protections, making it a critical tax consideration for businesses operating within the state.9

V.B. Statutory Credit Ordering: KRS 141.0205 Hierarchy

Kentucky mandates a specific, non-negotiable ordering hierarchy for the application of nonrefundable business incentive credits against the income tax liability, as detailed in KRS 141.0205.12

This ordering is critical for tax planning. For PTE owners, the most impactful element is that the nonrefundable credit allowed for LLET paid by the PTE (the LLET credit allowed against income tax) is applied first in the sequence (KRS 141.0205(1)(a)).12 The Qualified Research Facilities Credit (KRS 141.395) is listed much further down the sequence, at subsection (j).12 This means that if a partner has a large LLET credit passed through to them, that credit will reduce their income tax liability substantially before the Research Facilities Credit is even considered. This sequential utilization effectively reduces the available income tax “bucket” against which the Research Facilities Credit can be applied, potentially forcing a greater portion of the research credit into the 10-year carryforward period.

Table 2: Order of Credit Application (Simplified KRS 141.0205 Excerpt)

V.C. The Non-Reductive Floor: LLET Minimum Tax Limitation

The most crucial mechanical nuance regarding the Research Facilities Credit is its inability to fully offset the entity-level LLET liability. Statutory guidance confirms that the research facilities credit, per KRS 141.0205, cannot reduce the LLET liability below the mandatory minimum of $\$175$.5

This restriction establishes a permanent, non-offsettable floor for the entity’s LLET obligation. For example, if a PTE calculates a gross LLET liability of $\$5,000$, only $\$4,825$ (i.e., $\$5,000$ minus the $\$175$ floor) of the Qualified Research Facilities Credit can be utilized against that LLET liability.8 The remaining $\$175$ LLET payment is mandatory. The portion of the research credit that cannot be used against the LLET due to this floor is not lost; it is then available to be passed through to the owners to offset their income tax liability, or it is carried forward for up to 10 years.4

This constraint necessitates separate tracking of the credit’s use. The credit must be calculated and applied separately against the LLET and the Income Tax bases.8 Importantly, any balance of the credit available for use against the income tax liability cannot be cross-applied against the LLET, and conversely, any balance available for LLET use cannot offset the income tax liability.8 This strict separation ensures that while the entity minimizes its LLET obligation, the state retains the minimum $\$175$ tax payment.

VI. DOR COMPLIANCE, REPORTING, AND CARRYFORWARD MANAGEMENT

VI.A. Separate Tracking Mandate

The DOR requires taxpayers to maintain meticulous records because the credit’s utilization against the two distinct tax bases—the entity-level LLET (KRS 141.0401) and the owner-level Income Tax (KRS 141.020/141.040)—must be calculated independently.8

The mandate against cross-usage reinforces the need for accurate modeling of the annual LLET calculation versus the available income tax base. If a corporation applies the credit against its LLET and the LLET credit balance reaches zero, no further credit is allowed against LLET, even if credit remains available for use against the corporation income tax liability.8 This necessitates sophisticated internal accounting to avoid misapplication of the carryforward balance.

VI.B. Carryforward Provisions

Given the nonrefundable nature of the credit and the strict limitations on LLET offset, carryforward provisions are crucial to maximizing the credit’s value. Any unused portion of the Research Facilities Credit may be carried forward for a maximum of ten (10) years.4

Continuous compliance is required throughout this carryforward period. A copy of the initial Schedule QR, which details the original qualified costs and total credit generated, must be attached to the tax return every subsequent year the credit is claimed until the full amount is exhausted.4

VI.C. Audit Preparedness and Record Keeping

The extended 10-year carryforward period significantly elevates the requirements for audit preparedness and documentation retention. The success of a credit claimed ten years after its generation hinges on the adequacy of the initial documentation.

The PTE must maintain an immutable audit trail that links the capitalized asset records—specifically the date purchased, date placed in service, description, and cost—to the Schedule QR submitted in the year the facility was completed.4 Failure to maintain this comprehensive linkage between the financial ledger and the Schedule QR documentation could invalidate the remaining carryforward balance years down the line. Taxpayers claiming the credit must ensure the initial documentation satisfies the statutory requirements for tangible, depreciable property placed in service in Kentucky for qualified research activities.4

VII. COMPREHENSIVE CASE STUDY: PTE ALLOCATION AND LLET LIMITATION

To illustrate the necessary compliance steps and the application of the LLET minimum floor, the following case study analyzes the utilization of the Qualified Research Facility Tax Credit by a PTE.

VII.A. Scenario Setup: Bluegrass Innovations LLC (PTE)

Bluegrass Innovations LLC (BILLC) is a Kentucky-based partnership taxed as a PTE, owned by two members, Member A (40%) and Member B (60%).

In Tax Year 2024, BILLC completed and placed in service a dedicated research facility, incurring substantial capital costs.

Financial Data (2024):

• Total Qualified Facility Costs (QFC) placed in service: $\$2,000,000$
• BILLC LLET Liability (Calculated based on Gross Receipts/Profits): $\$12,000$ (well above the $\$175$ minimum)
• Member A’s KY Income Tax Liability (Pre-Credit): $\$150,000$ (net of other credits, excluding the LLET credit)
• Member B’s KY Income Tax Liability (Pre-Credit): $\$225,000$ (net of other credits, excluding the LLET credit)

VII.B. Step 1: Calculation of Credit Generation (Schedule QR)

The PTE calculates the total Qualified Research Facility Tax Credit generated based on the $5\%$ rate applied to the qualified facility costs:

$ \text{Total Credit Generated} = $2,000,000 \times 0.05 = $100,000 $

BILLC must complete and attach Schedule QR to its 2024 entity return, detailing the $\$2,000,000$ investment.

VII.C. Step 2: Utilization Against Entity LLET (Subject to $175 Floor)

BILLC may first utilize the generated credit against its own LLET liability. This utilization is capped by the statutory requirement that LLET cannot be reduced below $\$175$.5

• BILLC LLET Liability: $\$12,000$
• Minimum LLET Required: $\$175$
• Maximum Credit Use Against LLET: $\$12,000 – \$175 = \$11,825$

The PTE utilizes $\$11,825$ of the Research Facilities Credit against its LLET liability, resulting in a minimum LLET payment of $\$175$.

• Remaining Research Facility Credit Available for Pass-Through: $\$100,000 – \$11,825 = \$88,175$

This calculation clarifies the mechanism: the LLET constraint prevents the full offset of the entity-level tax liability, ensuring the state receives the mandatory minimum tax revenue, while the maximum possible credit is retained for the owners’ benefit.

VII.D. Step 3: Allocation of Remaining Credit to Members (Schedule K-1)

The remaining $\$88,175$ credit is allocated to the members based on their proportionate ownership share and is reported on the Kentucky Schedule K-1 (Form PTE).

Table 3: Allocation of Research Facilities Credit to Members

VII.E. Step 4: Utilization at the Individual Level (Schedule ITC)

Members A and B claim their allocated credit against their individual Kentucky income tax liability using Schedule ITC.4 This utilization is preceded by the application of the LLET credit against income tax (KRS 141.0205(1)(a)). Assuming the remaining income tax liability is sufficient after applying the prioritized LLET credit:

Table 4: Individual Member Credit Utilization

In this scenario, both members have sufficient Kentucky income tax liability to fully absorb the remaining $\$88,175$ of the Research Facilities Credit in the current tax year.

VII.F. Modeling the LLET Credit Interaction

The critical planning element for PTE owners is recognizing that the LLET credit (which is applied first per KRS 141.0205) substantially impacts the available income tax base for the Research Facilities Credit.12 The benefit is two-fold: the $\$11,825$ LLET reduction is achieved at the entity level, and the $\$88,175$ income tax reduction is achieved at the owner level. Effective tax management requires modeling the application sequence precisely to ensure the maximum immediate benefit is realized before any portion is pushed into the 10-year carryforward.

VIII. CONCLUSION AND STRATEGIC TAX RECOMMENDATIONS

VIII.A. Summary of Compliance Priorities

The Kentucky Qualified Research Facility Tax Credit (KRS 141.395) is a powerful, nonrefundable economic incentive rewarding capital investment in research infrastructure, distinct from incentives targeting operational R&D expenditures. Pass-Through Entities are the designated vehicles for leveraging this credit, flowing the 5% facility cost credit to owners to offset their income tax liability or LLET.4

Compliance is heavily dependent on adherence to specific DOR procedures, most notably the requirement to file Schedule QR annually with detailed asset records 4, and rigorous tracking of utilization against two separate tax bases (Income Tax and LLET).8 The complex statutory ordering (KRS 141.0205) and the non-reductive minimum LLET floor of $\$175$ are the primary constraints that must be modeled prior to claiming the benefit.5

VIII.B. Strategic Recommendations for PTE Tax Directors

Based on the statutory analysis, the following strategic recommendations are essential for PTEs operating in Kentucky and seeking to maximize the Research Facilities Credit:

1. LLET Liability Management: Proactively model the LLET liability and ensure the credit utilization at the entity level does not attempt to reduce the LLET below the mandatory $\$175$ minimum tax. This determines the maximum credit that can be passed through to the owners.
2. Statutory Ordering Simulation: Simulate the application of credits at the owner level, strictly following the KRS 141.0205 hierarchy. Recognizing that the LLET credit against income tax is taken before the Research Facilities Credit is paramount, as the prior credits may diminish the available income tax liability, thereby increasing the carryforward balance of the R&D credit.12
3. Mandatory Documentation Retention: Due to the 10-year carryforward period, the initial documentation (Schedule QR and the supporting schedule detailing purchase date, in-service date, and cost of tangible, depreciable property) must be prepared and maintained with the highest degree of diligence, as its validity must persist for a full decade.4
4. Clear K-1 Communication: The PTE must provide clear and detailed instructions accompanying the Kentucky Schedule K-1s, advising owners on the necessity of filing either Schedule ITC (for individuals) or Schedule TCS (for entities) and emphasizing the separate calculation required for credit utilization against income tax versus LLET, ensuring compliance with the DOR mandate.4

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