Comprehensive Analysis of Pass-Through Entity Mechanisms and the Nebraska Advantage Research and Development Tax Credit

Pass-through entities are organizational structures, such as partnerships and S corporations, where tax liabilities and credits flow directly to owners to be settled on individual income tax returns. Within the Nebraska tax system, these entities act as the primary conduit for distributing Research and Development (R&D) credits, allowing stakeholders to offset personal state tax obligations with incentives earned by the business.

The operational philosophy of the pass-through entity (PTE) is foundational to the Nebraska Advantage Research and Development Act. By utilizing the “conduit” theory of taxation, Nebraska ensures that the economic incentives intended to spur innovation reach the ultimate providers of capital—the individual partners, members, and shareholders.1 This structure is not merely a matter of accounting convenience; it represents a strategic legal framework designed to minimize double taxation while maximizing the liquidity of small to mid-sized innovative firms.3 As Nebraska continues to refine its incentive portfolio, the intersection of PTE status and R&D credits has become increasingly complex, particularly with the introduction of the Pass-Through Entity Tax (PTET) election under LB 754.5 This evolution requires a sophisticated understanding of how state revenue office guidance, statutory mandates, and federal tax intersections harmonize to create a functional tax strategy for innovators in the Cornhusker State.

The Statutory Architecture of the Nebraska Advantage Research and Development Act

The Nebraska Advantage Research and Development Act, codified under Nebraska Revised Statutes §§ 77-5801 to 77-5808, serves as the legislative bedrock for these incentives.7 The Act’s primary objective is to reward business firms—including those structured as pass-throughs—that increase their investment in high-level technological experimentation within Nebraska borders.9

Defining the Eligible Business Firm

Under section 77-5803, the term “business firm” is broadly defined to include corporations and a variety of pass-through structures. For a pass-through entity to be eligible, it must meet the federal standards for its respective structure while maintaining a physical or operational footprint in Nebraska.2

The distinction between these entities is vital for R&D purposes because the Nebraska Department of Revenue (DOR) requires the credit to be distributed in the same manner as the entity’s income or loss.5 This ensures that the tax benefit is aligned with the economic risk assumed by each owner.

The Sunset and Extension Framework

Originally enacted in 2005 as part of the LB 312 incentive package, the R&D credit was designed to provide long-term stability for Nebraska’s manufacturing and agricultural sectors.13 While the original sunset date was set for December 31, 2022, recent legislative action has significantly altered the timeline. Under LB 937 (2024), the Act has been extended, allowing new applications for tax credits to be filed through December 31, 2033.1 This extension reflects the state’s commitment to maintaining a competitive tax climate compared to regional neighbors like Iowa and Kansas.13

The Nexus of State and Federal Standards: IRC Sections 41 and 174

Nebraska’s R&D tax credit does not exist in a vacuum; it is fundamentally tied to the federal definitions of research and experimental expenditures. This “piggyback” approach simplifies compliance for PTEs that already claim the federal research credit under Internal Revenue Code (IRC) Section 41.1

The Federal Four-Part Test in a Nebraska Context

For a pass-through entity to generate a valid Nebraska credit, its activities must satisfy the federal “Four-Part Test” 15:

1. Technological in Nature: The research must fundamentally rely on the principles of physical or biological science, engineering, or computer science.15
2. Permitted Purpose: The objective of the research must be to create a new business component or improve the functionality, performance, reliability, or quality of an existing one.15
3. Elimination of Uncertainty: The activity must be intended to discover information that would eliminate uncertainty regarding the development or design of a product or process.15
4. Process of Experimentation: The taxpayer must evaluate alternatives through a systematic process, such as modeling, simulation, or trial and error.15

Nebraska specifically leverages the IRC Section 174 definition of research and experimental expenditures to determine the base of the credit.4 If a pass-through entity’s expenditures are classified as Section 174 costs at the federal level, they are generally eligible for the 15% or 35% Nebraska credit rate.4

Apportionment and Multi-State Operations

For pass-through entities operating both within and outside Nebraska, the state requires a rigorous apportionment process to ensure that only Nebraska-based innovation is rewarded. The DOR allows for two distinct apportionment methods on Form 3800N, Worksheet RD 12:

Method I: Property and Payroll Factor Apportionment

This method uses a traditional two-factor formula to determine the Nebraska portion of the federal credit. The formula is expressed as follows:

$$Apportionment Ratio = \frac{\frac{\text{NE Property}}{\text{Total Property}} + \frac{\text{NE Payroll}}{\text{Total Payroll}}}{2}$$

This method is often preferred by mature PTEs with significant physical facilities and a large Nebraska-based workforce.1

Method II: Actual Expenditure Apportionment

This method is more granular and focuses specifically on where the R&D expenses occurred. It is calculated by dividing the qualified research expenses (QREs) incurred in Nebraska by the total QREs incurred in all states.12

$$Apportionment Ratio = \frac{\text{Qualified NE Research Expenses}}{\text{Total Qualified Research Expenses}}$$

The selection of the apportionment method can have a substantial impact on the final credit amount, especially for technology firms with remote workforces or decentralized laboratory facilities.1

Department of Revenue Guidance: Revenue Ruling 29-10-2

A pivotal piece of local guidance for pass-through entities is Revenue Ruling 29-10-2, which clarifies the application of “enhanced” R&D credits.17 Nebraska law provides for a standard 15% credit rate, but this is increased to 35% for research conducted on a university campus.1

Defining “College or University” and “In This State”

The ruling establishes two critical conclusions that PTEs must follow to qualify for the 35% rate 17:

1. Institutional Definition: A “college or university” is defined as an institution of higher learning that offers courses of study resulting in a bachelor’s, vocational, associate, technical, or professional degree.17
2. Location Mandate: The phrase “in this state” refers to the physical location of the research activity, not the headquarters of the university. Therefore, a PTE collaborating with a university in another state does not qualify for the 35% rate, even if the PTE is based in Nebraska.17

The ruling further clarifies that PTEs must strictly segregate on-campus and off-campus expenditures. If a business firm contracts for a small amount of university research to “taint” its larger in-house research with a 35% rate, the DOR will bifurcate the activities, applying 35% only to the campus-based expenses and 15% to the remainder.17

Procedural Compliance and the E-Verify Mandate

Perhaps the most significant compliance risk for Nebraska pass-through entities is the E-Verify requirement, introduced by LB 403 in 2009.8 This mandate serves as a “cliff” for eligibility; non-compliance results in the total forfeiture of the credit.1

The Scope of Verification

All business firms claiming the R&D credit must verify the work eligibility status of all new employees hired in Nebraska during the tax year for which the credit is claimed.9

• Temporal Requirement: The verification must occur within ninety days of hire or as permitted by E-Verify rules.8
• Universal Application: This requirement is not limited to research staff. If an S corporation hires a receptionist in a Nebraska office and fails to E-Verify that individual, the entire R&D credit generated by its lab scientists may be disqualified.9
• Documentation: PTEs must maintain logs and electronic confirmation reports for at least four years to satisfy audit protocols.1

The Pass-Through Entity Tax (PTET) and LB 754

The enactment of LB 754 in 2023 introduced a paradigm shift for Nebraska PTEs by allowing for an entity-level tax election.5 This law was specifically designed to mitigate the federal $10,000 cap on state and local tax (SALT) deductions.3

Retroactive Election (2018–2022)

One of the most powerful features of Nebraska’s PTET law is its retroactivity. Pass-through entities can elect to pay income tax for tax years beginning on or after January 1, 2018, and before January 1, 2023.10

• Filing Deadline: The retroactive election (Form PTET-ER) must be filed by December 30, 2025.6
• Tax Rate: The retroactive rate is set at 6.84%, reflecting the highest individual tax rate during that period.3
• Mechanism: When the PTE pays this retroactive tax, it creates a federal deduction for the year the payment is made, and the owners receive a refundable credit on their Nebraska returns.3

Interaction with R&D Credits

The interaction between PTET and R&D credits provides a dual-layered strategy for tax minimization. An electing PTE can use its R&D credits to reduce the entity-level tax liability.10

1. Entity-Level Refundability: At the entity level, R&D credits are technically refundable. The PTE can elect to receive a direct refund of sales and use taxes paid rather than offsetting income tax.1
2. Owner-Level Non-refundability: Conversely, once R&D credits are distributed to individual owners via Schedule K-1N, they lose their refundable status.1 They can only be used to offset the owner’s personal Nebraska liability.

Illustrative Example: Precision Ag Analytics LLC

Precision Ag Analytics LLC is a Nebraska-based partnership with three equal partners. In 2024, the entity engages in software development for automated harvest systems.

1. Calculation of Nebraska R&D Credit

The LLC calculates its federal R&D credit on Form 6765, arriving at a total of $200,000. All activities were performed at their facility in Lincoln, which is off-campus.

• Nebraska Rate: 15%
• Nebraska R&D Credit: $200,000 \times 0.15 = $30,000.4

2. PTET Election and Entity-Level Calculation

The LLC generates $1,000,000 in Nebraska taxable income. The partners elect to pay the 2024 PTET at the rate of 5.84%.10

• Gross PTET Liability: $1,000,000 \times 0.0584 = $58,400.
• Application of R&D Credit: The LLC applies its $30,000 R&D credit against this liability.10
• Net PTET Payable: $58,400 – $30,000 = $28,400.

3. Distribution to Partners

The entity issues a Nebraska Schedule K-1N to each of the three partners.

• Distributed PTET Credit: Each partner receives their share of the total $58,400 tax—approximately $19,466 each.10
• Federal Deduction: The $28,400 paid by the entity (after the R&D credit offset) is deductible at the federal level, effectively bypassing the SALT cap for the partners.3

Statistical Performance and Audit Insights

Data from the Nebraska Department of Revenue and the Legislative Audit Office provide a clear picture of the R&D Act’s impact. For activity between 2006 and 2020, 460 companies earned $72.3 million in credits.13

Use of Credits by Industry and Region

The R&D credit is highly concentrated in specific sectors that are critical to the state’s economic identity.

The 2024 Property Assessment Division Annual Report and the Incentives Annual Report confirm that business firms approved for projects have claimed totaling $146.8 million in various tax benefits across all active projects in the 2024-2025 fiscal year.23

Audit Trends and Fiscal Protections

A 2024 performance audit noted that while the R&D program has been successful in retaining companies—89% of firms remained in Nebraska five years after their first credit year—the program lacks a hard annual cap.13 This has occasionally led to “unexpected expense” for the state legislature when credit usage exceeded the $5 million annual estimate.13 Consequently, PTEs should expect continued rigorous auditing by the DOR, particularly regarding the substantiation of QREs and the timeline of E-Verify registrations.1

Future Outlook: ImagiNE Nebraska and Sunset Clauses

As the Nebraska Advantage R&D Act approaches its extended 2033 sunset, pass-through entities must look toward the ImagiNE Nebraska Act as the next generation of incentives.25 ImagiNE Nebraska provides a scaled portfolio of credits for quality jobs, mega-projects, and modernization.27

Strategic Integration

For a pass-through entity, the transition to ImagiNE requires evaluating different thresholds:

• Standard R&D: No pre-approval or minimum employment thresholds are required; the credit is earned purely on expenditures.1
• ImagiNE Nebraska: Requires formal agreements and specific investment levels (e.g., $1 million for “Growth and Expansion” or $5 million for “Quality Jobs”).27

PTEs that are currently using the Advantage R&D credit can continue to do so through 2033, and they may carry forward unused credits for up to 20 years.1 This 20-year window is one of the most generous in the country, providing long-term equity to startups that may not have immediate tax liability but anticipate significant future growth.1

Conclusion: Navigating the Nebraska Innovation Landscape

The strategic utilization of pass-through entities in the context of the Nebraska R&D tax credit offers a powerful mechanism for wealth preservation and reinvestment. By understanding the granular requirements of the PTET election, the rigorous mandates of E-Verify, and the nuances of university-based collaboration, business owners can significantly lower their effective tax rate while fueling the state’s technological advancement.1

The partnership between private innovation and state-level policy is evidenced by the nearly $5 billion in investment reported under tax incentives in the most recent fiscal year.23 As Nebraska’s tax rates are scheduled to drop to 3.99% by 2027, the R&D credit will remain a critical tool for pass-through entities seeking to remain competitive in a rapidly evolving global economy.5 Success in this domain requires more than just innovative research; it demands administrative precision and a proactive approach to the complex guidance issued by the Nebraska Department of Revenue. Owners who master these dynamics will find themselves well-positioned to leverage the Nebraska Advantage for years to come.1

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