How Multiple Entities with Common Ownership Can Benefit from R&D Tax Credits

How Multiple Entities with Common Ownership Can Benefit from R&D Tax Credits

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When businesses operate as part of a controlled group, navigating the complexities of the Research and Development (R&D) Tax Credit can be challenging. Controlled groups—consisting of multiple entities under common ownership—can share resources, expertise, and intellectual property. However, understanding how to allocate R&D tax credits effectively requires careful planning and strategic execution.

In this article, we’ll break down how controlled groups can benefit from R&D tax credits, including key considerations for credit allocation, and how to ensure compliance with IRS regulations.

Understanding Controlled Groups

Controlled groups are combinations of two or more entities under common control or ownership. According to the IRS, “all members of a controlled group are treated as a single taxpayer for purposes of computing the research credit.” The group must calculate the R&D Tax Credit as if it were a single taxpayer and then distribute the credit among its members based on the proportion of R&D activities performed by each entity.

There are three types of controlled groups:

  1. Parent-Subsidiary Controlled Group: One or more entities are connected through stock ownership with a common parent owning more than 50% of the other entities.
  2. Brother-Sister Controlled Group: Two or more entities are owned by five or fewer individuals, trusts, or estates with “controlling interest” (at least 80% ownership) and “effective control” (over 50% identical ownership).
  3. Combined Controlled Group: A mix of parent-subsidiary and brother-sister groups where at least one entity is the common parent of the parent-subsidiary group and a member of the brother-sister group.

Click here for a more detailed explanation of Controlled Groups, including examples.

Allocating R&D Tax Credits Among Controlled Group Members

Allocating R&D tax credits within a controlled group involves two key steps:

  1. Determining Qualified Research Expenses (QREs): Identify the QREs performed by each entity. Per Reg. Section 1.41-6(i)(2), the entity that performs the research claims the in-house QREs (i.e., wage payments and direct supply costs), even if other members reimburse them. The paying entity cannot claim these as contract research expenses.
  2. Proportional Credit Allocation: Once total QREs are calculated for the entire group, the R&D tax credit is allocated proportionally based on each entity’s contribution to the group’s total QREs.

Example:
Assume a controlled group, X, consisting of three entities—B, C, and D—has a total R&D tax credit of $100 for the year. If B, C, and D contributed $200, $300, and $500 in QREs respectively, the credit is allocated as follows:

  • B: $20 credit (20% of total QREs)
  • C: $30 credit (30% of total QREs)
  • D: $50 credit (50% of total QREs)

Strategic Planning for Maximum R&D Credit Utilization

Controlled groups can maximize R&D tax credits through strategic planning:

  • Identify Key R&D Activities: Determine which entities perform the most significant R&D activities and allocate resources accordingly.
  • Document Intercompany Transactions: Keep detailed records of intercompany transactions to justify QRE allocations.
  • Review Entity Structure: Reevaluate entity structures to optimize credit utilization.

Proper planning and documentation are essential to avoid issues with the IRS and ensure that each entity in the controlled group receives its rightful share of the credit.

Conclusion

Controlled groups present unique challenges and opportunities for R&D tax credit utilization. By understanding the definitions and rules around controlled groups, identifying QREs accurately, and strategically allocating credits, businesses can significantly reduce their tax liability.

As regulations and interpretations can be complex, consulting with tax experts experienced in R&D credits and controlled group rules is highly recommended. This approach ensures compliance while maximizing tax savings across all entities involved.

If your business is part of a controlled group and you’re looking to leverage R&D tax credits, reach out to a Swanson Reed R&D tax professional to explore how you can optimize your tax strategy.

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