Expert Compliance Report: Partnership Flow-Through Entities and the Hawaii R&D Tax Credit (HRS §235-110.91)

I. Executive Summary: The Hawaii TCRA for Flow-Through Entities

A Partnership (Flow-Through Entity) is a business structure where income, deductions, and tax credits are calculated at the entity level but are passed directly to its owners, avoiding taxation at the business level. The partners are individually responsible for reporting the entity’s financial results and claiming the allocated portion of the Hawaii Tax Credit for Research Activities (TCRA) on their personal state income tax returns.1

The Hawaii TCRA, codified under Hawaii Revised Statutes (HRS) §235-110.91, is a valuable, refundable income tax credit designed to incentivize Qualified High Technology Businesses (QHTBs) that perform research activities within the state.3 The mechanism for claiming this credit is highly complex for flow-through entities, involving mandatory pre-approval by the Department of Business, Economic Development and Tourism (DBEDT) via Form N-346A.4 This pre-approval is crucial because the credit is subject to a strict $5 million annual aggregate cap for all taxpayers.3 After certification, the partnership must file the state calculation (Form N-346) along with the federal substantiation (Federal Form 6765) to the Department of Taxation (DOTax). The resulting credit amount is then allocated to partners using Schedule K-1 (Form N-20), which the individual partners use to claim the refundable amount on their Hawaii personal income tax returns.4

II. Definitional and Legal Framework of Flow-Through Taxation

A. The Mechanics of Partnership Taxation

A partnership, including a Limited Liability Company (LLC) treated as a partnership for tax purposes, is fundamentally defined as a flow-through or pass-through entity.1 This classification is rooted in Subchapter K of the Internal Revenue Code (IRC), which stipulates that the entity itself is not generally liable for income tax (IRC §701). Instead, the partnership serves as a conduit: it calculates its income, deductions, losses, and credits, which are then passed directly to its partners (owners).2

This mechanism results in a single layer of taxation, thereby avoiding the “double taxation” typically faced by C Corporations, where corporate profits are taxed at the entity level and then taxed again when distributed as dividends to shareholders.1 While avoiding corporate-level tax is beneficial, the flow-through structure places the tax liability squarely on the individual partner. Partners are liable to pay taxes on their distributive share of the partnership’s profit or dividends, even if the partnership retains those funds and does not make a cash distribution.1 This exposure to tax liability on retained earnings, sometimes referred to as “phantom income,” can impose a substantial tax burden on the individual partner, potentially resulting in higher personal taxes than initially anticipated.1

The nature of the Hawaii TCRA—being a refundable credit—provides a significant counterpoint to the traditional cash flow drawback associated with flow-through phantom income. A refundable credit means that any amount of the credit that exceeds the partner’s Hawaii income tax liability is returned directly to the partner as a cash payment.3 Therefore, where a partner is allocated substantial income but little cash, the allocated refundable credit can partially or fully mitigate the resulting tax liability, and in many cases, generate a positive cash flow by returning the excess credit directly to the partner.3 This feature makes the TCRA exceptionally valuable to early-stage, capital-intensive QHTBs that frequently retain earnings for future research and development, providing liquidity to the partners despite the flow-through tax obligation.

B. Allocation via Schedule K-1 (Form N-20)

For the purpose of reporting and distributing tax items, the partnership must prepare a Schedule K-1 for each partner. In Hawaii, this documentation is tied to the state partnership return, Form N-20.6 The Schedule K-1 is the authoritative document that details each partner’s specific share of the partnership’s income, losses, deductions, and, critically, tax credits, including the TCRA.3

The flow-through credit reporting requires meticulous compliance. Any partnership, S corporation, estate, trust, or cooperative that allocates the TCRA must attach specific forms to its income tax return, including Form N-346, Form N-346A, and the federal substantiating documentation, Federal Form 6765.4 The final step for the entity is communicating the pro rata share of the credit to the partners via the Schedule K-1. Taxpayers claiming this pro rata share of the credit must, in turn, attach a copy of their Schedule K-1 (Form N-20) to their personal Hawaii income tax returns (such as Form N-11 or N-15), along with Form N-346, to substantiate the claim.4

III. Hawaii Tax Credit for Research Activities (TCRA) Statute (HRS §235-110.91)

A. Current Law and Sunset Provisions

The legal foundation for the credit is found in HRS §235-110.91, titled “Tax credit for research activities”.8 This state statute establishes the parameters under which a credit for increasing research activities, mirroring the structure of federal IRC §41, is allowed.8

The legislation has a predefined expiration period. While amendments have extended its applicability, the TCRA is currently scheduled to expire for research expenses incurred after December 31, 2029.3 This definitive sunset date necessitates that QHTBs engage in strategic, time-sensitive planning to maximize the utilization of qualified research expenses (QREs) within the remaining years of the credit’s availability.

B. Qualified High Technology Business (QHTB) Requirements

The TCRA is restricted solely to businesses that qualify as a Qualified High Technology Business (QHTB).3 The definition of QHTB imposes rigid requirements that ensure the credit benefits companies substantially committed to in-state research.4

The business must meet two primary quantitative and qualitative criteria:

1. Small Business Definition: The entity must maintain an employee count of no more than five hundred employees.3
2. Activity Test: The QHTB must be registered to do business in Hawaii and must conduct more than 50 percent of its total activities in qualified research within Hawaii.4

The definition of “qualified research” within Hawaii is aligned with the federal definition under IRC §41(d) but also explicitly includes state-specific high-tech fields relevant to the regional economy. These fields encompass biotechnology, the development and design of computer software for commercial marketing, ocean sciences, astronomy, and non-fossil fuel energy-related technology.11

The requirement that a business conduct more than 50% of its qualified research activities within Hawaii is significant, especially for multi-state partnerships. This threshold acts as a targeted economic incentive, directing the benefit exclusively toward operations that maintain a substantial research presence in the state.4 Partnerships operating across multiple jurisdictions must implement meticulous tracking mechanisms to segregate and document both their overall activities and their QREs to ensure continuous compliance with this strict 50% in-state threshold. If the partnership fails this crucial test, the QHTB status is revoked, and the entire credit is disallowed, regardless of the magnitude of the actual Hawaii-sourced QREs.

C. Refundability and the Annual Aggregate Cap

The Hawaii TCRA is structured as a refundable credit.3 This key feature dictates that if the calculated credit exceeds the taxpayer’s liability for Hawaii income tax, the unused portion is not carried forward but is instead returned as a cash payment.3

However, the availability of the credit is severely limited by a mandatory funding mechanism: a $5 million annual aggregate cap on the total amount of certified tax credits issued across all taxpayers in a given taxable year.3

The state revenue mechanism for managing this cap is based on a first-come, first-served basis.3 This rule establishes a critical element of execution risk for QHTBs and their partners. The ability of the partnership to realize the economic benefit of the credit is entirely contingent upon securing certification from DBEDT (Form N-346A) before the statewide cap is reached. Given the competitive nature of this cap, prompt preparation and submission of the certification application during the designated window (e.g., March 3–31 for the 2025 application cycle) is paramount.3 Delays can result in the inability to claim the credit, irrespective of the validity or amount of the underlying QREs incurred.

Table III.A: QHTB Eligibility Criteria (HRS §235-110.91)

IV. Calculation Methodology: Linking Federal and State Credit

A. Mandatory Federal Claim Requirement

Hawaii’s TCRA calculation is directly linked to the federal R&D tax credit framework under IRC §41.8 Therefore, a mandatory prerequisite for claiming the Hawaii credit is that the QHTB partnership must also claim the federal tax credit for increasing research activities.4 This necessitates the full computation and documentation of the federal credit using Federal Form 6765, which must be attached to the Hawaii income tax return for substantiation.4

B. Impact of 2024 Legislative Updates (Act 139)

The determination of the federal credit amount, which serves as the basis for the Hawaii TCRA calculation, has been significantly affected by recent legislative updates, specifically Act 139 (from SB 2497) in 2024.

Historically, Hawaii law modified the application of IRC §41 by providing that the base amount requirement, which measures current-year QREs against historical averages, was disregarded.8 This meant that QHTBs could take the credit for all qualified research expenses without reference to expenses incurred in previous years.

However, the updated guidance explicitly states that the federal tax provisions in section 41 of the Internal Revenue Code regarding the base amount will now apply.3 Consequently, QHTBs must now compute the federal base amount per IRC §41—typically a fixed-base percentage multiplied by the average annual gross receipts for the four preceding tax years—to determine the “excess” QREs.3 The federal credit is then calculated only on these incremental, excess QREs.3

This re-introduction of the federal base amount substantially increases the complexity of the calculation process, as the partnership must now calculate a federal incremental credit using the methodology of Form 6765 before applying the state-specific ratio. Furthermore, this change potentially diminishes the realized value of the Hawaii credit, especially for mature QHTBs with historically high levels of R&D activity, as the credit is no longer applied to total Hawaii QREs but only to the portion deemed incremental by federal standards.3

An additional complexity arises for partnerships operating on a fiscal year. DOTax guidance notes that after the 2024 tax year, a fiscal year taxpayer receiving an allocated credit may have eligible research expenses that span the current calendar year and the previous tax year.4 In such instances, the partnership may be required to attach Federal Forms 6765 that were filed for more than one tax year, necessitating careful chronological alignment of federal and state documentation.4

C. Pro-Rata Share Calculation Formula

Once the qualified federal tax credit is determined, the Hawaii TCRA is calculated by applying a pro-rata ratio that limits the credit to expenses conducted within the state.3

The statutory formula is:

$$\text{Hawaii TCRA} = \text{Federal Tax Credit} \times \left( \frac{\text{Eligible QREs Conducted in Hawaii}}{\text{Total Expenses Eligible for Federal Credit}} \right)$$

The numerator of this fraction must include only eligible QREs directly attributable to research activity conducted within the State of Hawaii.4 The denominator is the total amount of expenses eligible for the federal tax credit for increasing research activities, regardless of the jurisdiction in which those expenses were incurred.4 This calculation effectively scales down the total federal credit based on the percentage of QREs sourced to Hawaii.3

D. Qualified Research Expenses (QREs)

The QREs eligible for the numerator must meet the standards of IRC §41 and pertain to qualified high-tech activities conducted in Hawaii.3 These expenses include wages for employees performing, supervising, or directly supporting qualified research; the cost of supplies and materials consumed in the R&D process; 65% of payments made to unaffiliated third parties for contract research performed in Hawaii; and the costs associated with the rental or lease of computers used exclusively in Hawaii R&D.3

Table IV.B: Hawaii TCRA Calculation Formula Summary

V. Hawaii State Revenue Office Guidance: Compliance and Filing Procedures

A. DBEDT Certification Process (Form N-346A)

The administrative procedures dictated by the state are equally as crucial as the calculation methodology. The process begins with securing mandatory certification from the Department of Business, Economic Development and Tourism (DBEDT).4

This certification is formalized through the submission of Form N-346A and a corresponding questionnaire, which must be completed during the annual application window (typically from March 3rd to March 31st).3 The primary function of this application is to reserve the QHTB’s portion of the highly constrained $5 million annual aggregate credit cap.5 DBEDT reviews and verifies the information submitted, and upon acceptance, returns an approved certificate to the taxpayer.9

There is a significant chronological sequencing challenge imposed by this procedure. While the application window closes in March, DBEDT anticipates that certifications will be approved and returned later in the year (e.g., around June 30).9 This means the partnership cannot finalize its tax returns or confidently issue accurate Schedule K-1s showing the allocated credit until the official N-346A certificate is secured, even though the tax return due date may occur earlier. This necessitates provisional tax planning and often requires filing the partnership’s tax return on extension pending receipt of the certificate.

Furthermore, compliance requires the QHTB to complete an annual survey as prescribed by DBEDT. The failure to satisfy this annual requirement constitutes a statutory waiver of the right to claim the credit, underscoring the ongoing administrative burden placed on QHTBs.4

B. DOTax Reporting Requirements (Partnership Level)

Upon receiving the approved certificate from DBEDT, the QHTB partnership must file the following mandatory documents with the Hawaii Department of Taxation (DOTax) as attachments to its Form N-20 income tax return 4:

1. Form N-346: Used by the QHTB to figure and formally claim the state TCRA.4
2. Approved Form N-346A: The official certificate verifying DBEDT approval and reservation of the credit under the $5 million cap.4
3. Federal Form 6765: Used to substantiate the underlying federal credit calculation required by IRC §41.4

The high volume of mandatory supporting documentation implies that the Hawaii TCRA is subject to rigorous audit scrutiny. This makes maintaining a complete, auditable file for all QREs—including detailed payroll records, material consumption records, and activity journals tied directly to the QHTB status and the in-state QRE numerator—critical for defending the credit claim.

A final administrative constraint is the deadline to claim the credit. The partnership must file its claim, including any amended claims, 12 months after the close of the taxable year.4 This is a strict deadline beyond which the credit cannot be claimed.

C. Partner Reporting Requirements (Individual Level)

After the partnership files Form N-346 and receives certification, it allocates the calculated credit amount to its partners. This is achieved by entering the share of the credit on the partners’ Schedule K-1 (Form N-20), typically noted on Line 25 of the K-1 instructions.6

The individual partner then claims this amount on their personal Hawaii income tax return (e.g., Form N-11 or N-15). The partners claiming the allocated share must attach a copy of the Schedule K-1 (Form N-20) received from the partnership to their return.4 They also complete Form N-346, entering the flow-through amount received from the entity on Line 3 of that form.7

Table V.C: Mandatory Compliance Forms and Deadlines

VI. Allocation Mechanics and Federal Limitation Considerations

A. Allocation of Credits to Partners

The final, calculated Hawaii TCRA amount (determined on Form N-346) is passed through to the partners on a pro-rata basis via the Schedule K-1.3 The allocation ensures that the tax benefit, which is realized at the individual level, accurately reflects the partners’ ownership and profit-sharing interests in the QHTB partnership.

B. IRC §704(b) Considerations for Special Allocations

Hawaii Revised Statutes §235 confirms that IRC §704 (governing a partner’s distributive share) is operative for purposes of the Hawaii tax chapter.12 Under IRC §704(b), partnership allocations must be respected if they meet the substantial economic effect test, which generally requires that partners’ capital accounts are properly maintained, liquidating distributions follow capital account balances, and partners must restore any resulting deficit balance.13

While Hawaii statutes explicitly carve out certain other tax credits (such as the high technology business investment tax credit) from the strict IRC §704(b)(2) substantial economic effect requirements, the TCRA is not listed among these exceptions.12 This omission indicates that allocations of the TCRA should generally comply with the requirements of IRC §704(b).

If a partnership attempts a special allocation—where the credit is distributed in a ratio different from the general profit/loss sharing or the specific ratio used to deduct the underlying QREs—it must demonstrate that the allocation is “substantial.” Substantiality requires a reasonable possibility that the allocation will materially affect the dollar amounts received by the partners from the partnership, independent of favorable tax consequences.13 Given that the Hawaii TCRA is a refundable credit, it inherently generates a cash return independent of the partner’s actual tax liability. This makes demonstrating substantiality challenging for special allocations of the credit alone. Therefore, the most defensible allocation position is to distribute the TCRA in the same pro-rata share used to allocate the underlying QRE deductions that generated the credit.

C. Basis and At-Risk Limitations (IRC §704(d) and §465)

Individual partners claiming a distributive share of partnership items must clear several federal hurdles before utilizing allocated items, applied in sequence: the basis limitation (IRC §704(d)), the at-risk limitation (IRC §465), and the passive activity loss limitation (IRC §469).14

Although the Hawaii TCRA is a refundable tax credit and is thus claimed against the resulting tax liability (rather than being a deduction that reduces taxable income), the underlying Qualified Research Expenses (QREs) are typically deductions that flow through the partnership. These deductions directly reduce the partner’s outside basis (IRC §704(d)) and the amount they have at-risk (IRC §465). If the QRE deductions, combined with other partnership losses, exceed the partner’s basis or at-risk amount, those deductions are suspended and carried over to future tax years.14

For leveraged partnerships or those incurring significant startup losses from R&D (QREs), monitoring basis and at-risk amounts is paramount. Failure to maintain sufficient basis or at-risk capital can lead to suspended QRE deductions. Furthermore, if a partner’s at-risk amount falls below zero, the rules can mandate “at-risk recapture,” treating the amount as taxable income.14 While the refundability of the Hawaii credit provides immediate cash benefit, the long-term tax implication remains tied to the federal limitations on the underlying deductions. Robust basis calculation maintenance (IRC §705) for each partner is therefore essential to avoid the suspension of QRE deductions and to preserve the overall economic benefit of the R&D activity.

VII. Detailed Case Study and Numerical Allocation Example

This case study illustrates the required calculation and allocation steps for a QHTB partnership claiming the Hawaii TCRA, incorporating the new federal base calculation requirement.

A. Scenario Setup: Aloha Tech Ventures, LP

• Entity: Aloha Tech Ventures, LP (Partnership, QHTB Certified for Tax Year 2025).
• Partnership Structure: Partner A and Partner B, sharing profits and losses 50/50.
• QHTB Status: Compliant with the 500-employee limit and the >50% in-state activity test.
• DBEDT Certification: Form N-346A was approved and certificate received.

B. Federal Credit Calculation (IRS Form 6765 Equivalent)

The calculation must adhere to the 2024 legislative update mandating the use of the federal base amount.3

• Step 1: Determine the Federal Base Amount (IRC §41):

• Calculation: Fixed-Base Percentage (10%) $\times$ Average Gross Receipts ($5,000,000) = $500,000.
• Limitation: The base amount cannot be less than 50% of the current year’s Federal QREs. (50% $\times$ $2,000,000) = $1,000,000.
• Conclusion: The required Federal Base Amount is the greater of the calculation or the limitation: $1,000,000.

• Step 2: Calculate Excess QREs:

• Excess QREs = Total Federal QREs – Federal Base Amount
• Excess QREs = $2,000,000 – $1,000,000 = $1,000,000.

• Step 3: Calculate Total Federal Credit (Line 44, Federal Form 6765):

• Federal Credit = Excess QREs $\times$ Federal Rate (20%)
• Federal Credit = $1,000,000 $\times$ 20% = $200,000.

C. Hawaii TCRA Calculation (Hawaii Form N-346)

• Step 4: Calculate Hawaii QREs Ratio 3:

• Ratio = Eligible QREs conducted in Hawaii / Total Federal QREs
• Ratio = $800,000 / $2,000,000 = 40%.

• Step 5: Calculate Final Hawaii TCRA Amount:

• Hawaii TCRA = Total Federal Credit $\times$ Hawaii QREs Ratio
• Hawaii TCRA = $200,000 $\times$ 40% = $80,000. (This is the amount claimed on Form N-346)

D. Partner Allocation via Schedule K-1 (Form N-20)

• Step 6: Allocate Credit to Partners: The $80,000 credit is allocated 50/50 to the partners.

Table VII.D: Partnership TCRA Allocation Example

Partner A and Partner B each receive a refundable $40,000 credit. They attach their Schedule K-1 to their respective personal tax returns (Form N-11 or N-15) and claim this amount. Any portion of the $40,000 that exceeds their Hawaii income tax liability is paid to them directly as a refund.3

VIII. Conclusion and Recommendations

A. Summary of Critical Compliance Milestones

The successful utilization of the Hawaii TCRA by a flow-through partnership hinges on strict adherence to both a complex, federally-aligned calculation methodology and an administratively constrained certification process. The requirement to integrate the IRC §41 base amount calculation, combined with the stringent sourcing ratio (Hawaii QREs/Total Federal QREs), means the effective state credit is limited to incremental research activities conducted specifically in Hawaii.3 The partnership must manage the high documentation burden, ensuring three key forms (N-346, N-346A, and Federal Form 6765) are attached to the entity’s return to substantiate the allocation passed through to partners via Schedule K-1.4

A major factor governing realization is the $5 million annual aggregate cap, which mandates that the economic benefit is secured not by calculation, but by administrative diligence.3 Furthermore, the timing gap between the March application window for the N-346A and the anticipated DBEDT approval later in the year requires proactive tax planning, likely involving extensions for the partnership’s tax return, as the final allocated credit amount cannot be confirmed until certification is received.9

B. Strategic Recommendations for Partnerships

1. Prioritize DBEDT Certification Timeline: Given the competitive, first-come, first-served mechanism governing the $5 million cap, partnerships should treat the Form N-346A application as a critical cash management function, rather than standard compliance.3 All necessary QRE determination and documentation must be finalized well in advance of the annual application window to ensure immediate submission upon opening.
2. Ensure Defensible Credit Allocation: To minimize exposure to potential challenges under IRC §704(b) regarding substantial economic effect, the partnership should allocate the Hawaii TCRA to partners in the same proportion as the underlying Qualified Research Expense deductions that generated the credit. This is the most conservative and defensible methodology.12
3. Implement Dual QRE Tracking Systems: Partnerships operating in multiple states must establish robust internal accounting procedures capable of tracking QREs globally (for the denominator) and specifically isolating QREs conducted strictly within Hawaii (for the numerator).3 This granular tracking is also essential to demonstrate compliance with the QHTB’s mandatory >50% in-state activity threshold.
4. Mandatory Partner Basis and At-Risk Monitoring: While the TCRA is refundable, partners must rigorously monitor their basis (IRC §704(d)) and at-risk amounts (IRC §465) to ensure they can deduct the flow-through QREs. Failure to maintain sufficient tax basis will result in suspended QRE deductions that carry over to future years, diminishing the overall tax efficiency of the research activity.14

R&D Tax Credit Preparation Services

Swanson Reed is one of the only companies in the United States to exclusively focus on R&D tax credit preparation. Swanson Reed provides state and federal R&D tax credit preparation and audit services to all 50 states.

If you have any questions or need further assistance, please call or email our CEO, Damian Smyth on (800) 986-4725.
Feel free to book a quick teleconference with one of our national R&D tax credit specialists at a time that is convenient for you.

R&D Tax Credit Audit Advisory Services

creditARMOR is a sophisticated R&D tax credit insurance and AI-driven risk management platform. It mitigates audit exposure by covering defense expenses, including CPA, tax attorney, and specialist consultant fees—delivering robust, compliant support for R&D credit claims. Click here for more information about R&D tax credit management and implementation.

Our Fees

Swanson Reed offers R&D tax credit preparation and audit services at our hourly rates of between $195 – $395 per hour. We are also able offer fixed fees and success fees in special circumstances. Learn more at https://www.swansonreed.com/about-us/research-tax-credit-consulting/our-fees/