- Allocating R&D tax credit among companies that share intellectual property requires carefully deciding which company performed the activities and how the company is structured.
- The single taxpayer concept in Section 41 is intended to prevent any taxpayer from claiming more than their share of the R&D credit.
- Members of a control group can still claim the R&D tax credit with careful planning and documentation.
Many companies operate as part of controlled groups. These groups may share expertise or intellectual property, allowing for collaboration among several companies, both foreign and domestic. Alternatively, they may simply share common ownership without any significant coordination. According to the IRS, “all members of a controlled group are treated as a single taxpayer for purposes of computing the research credit.” Therefore, the controlled group must calculate the Research and Development (R&D) Tax Credit as if it was a single taxpayer, and then distribute the credit among the members accordingly. These distributions are based on the proportion of R&D performed by each entity.
Given the significant complexities in dealing with this topic, the scope of this article will address the following concepts:
- What are the definitions of a controlled group, given varying circumstances?
- For the purposes of the R&D Tax Credit, which member of the controlled group claims the qualifying research expenses (QREs) if one member is doing R&D on behalf of another?
- How are R&D credits allocated to each member of the controlled group?
Controlled Groups Defined
Controlled groups are combinations of two or more entities under common control or ownership. There are three types of controlled groups: 1) parent-subsidiary; 2) brother-sister; and 3) combined or nested (a combination of the first two). Each is defined below and illustrated in various figures.
A parent-subsidiary controlled group exists when one or more chains of entities are connected through stock ownership with a common parent; and
- The combined amount of the stock owned by one or more of the entities within the group must be more than 50%; and
- The parent company must own 50% or more of the other entity
Consider the following example: The ABC Partnership owns stock equaling 70% of the total combined voting power of all classes of stock entitled to D Corporation. ABC Partnership is the common parent of a parent-subsidiary group of trades or businesses under common control consisting of the ABC Partnership and D Corporation.
Going a step further, assume that D Corporation owns 60% of the profits interest in the EFG Limited Liability Company (LLC). The ABC Partnership is the common parent of a parent-subsidiary group of trades or businesses under common control consisting of the ABC Partnership, D Corporation, and EFG.
A brother-sister controlled group occurs when a group of two or more entities have five or fewer common owners (individuals, trusts, or estates) who own, directly or indirectly, a “controlling interest” in each entity and has “effective control.”
- Controlling interest - the five or fewer owners collectively hold at least 80% or more of the stock of each entity
- Effective control - the five or fewer owners have, in aggregate, at least 50% “identical ownership” in each entity
Corporations P, S, and T are members of a brother-sister controlled group because 1) at least 80% of the stock of each is owned by a group of five or fewer persons who own stock in each corporation (satisfying the 80% test); and 2) identical ownership is 70% (satisfying the more-than-50% test).
Assume the same facts, except that C owns 100% of the stock of Corporation T as follows:
Corporations P and S are members of a brother-sister controlled group since they meet the 80% test and also satisfy the more-than-50% identical ownership test. Corporation T is not a member of the group because an individual's stock ownership in a corporation is not considered in the 80% test unless the individual also owns stock in the other corporation or corporations being tested (in the more-than-50% test) for the controlled group. In other words, the five or fewer persons whose stock is considered to be met for the 80% requirement, must be the same persons whose stock ownership is also considered for the more-than-50% requirement.
A combined, or nested, controlled group is defined as three or more corporations with the following organization:
- Each organization is a member of either a parent-subsidiary or brother-sister group; and
- At least one corporation is the common parent of a parent-subsidiary; and is also a member of a brother-sister group.
A, B, and C are members of a combined controlled group because A and B are members of a brother-sister controlled group, B and C are members of a parent-subsidiary controlled group, and B is both the parent of the parent-subsidiary group and a member of the brother-sister controlled group.
See the full IRS report with examples of each type of controlled group here.
R&D Activities Among Corporations but Within a Controlled Group
Often, entities within a controlled group perform services for each other that span the research and development process. How should these activities be treated if the R&D projects are spread among various members of the controlled group?
Reg. Section 1.41-6(i)(2) states that: “If one member of a group performs qualified research on behalf of another member, the member performing the research shall include in its QREs any in-house research expenses for that work [i.e., wage payments and direct supply costs] and shall not treat any amount received or accrued as funding the research. Conversely, the member for whom the research is performed shall not treat any part of any amount paid or incurred as a contract research expense.”
Essentially, for purposes of the R&D Tax Credit, the entity that performs the research within the group is attributed the QRE, regardless of any intercompany reimbursement. Favorably, it also clarifies that intercompany reimbursement is not considered disqualified “funded research.”
R&D Credit Allocation Within a Controlled Group
Once QREs by entity within a controlled group are determined, all aspects of the R&D Tax Credit must be calculated as if the entire group were one single taxpayer. Once the final credit amount is established, how should the credit amount be allocated to the various members of the controlled group? The credit is allocated to the various members of the controlled group in proportion to the QREs for the taxable year attributable to that entity. That is another reason it is essential to determine to which entity the QRE should be sourced.
For example [from IRS Notice 2013-20]: X, a controlled group consisting of three members, B, C, and D, has a $100 credit for the taxable year. X's total QREs for the taxable year is $1,000. B paid $200 of the QREs, C paid $300 of the QREs, and D paid $500 of the QREs during the taxable year. Based on the proportion of each member’s contribution of QREs to the controlled group’s total QREs for the taxable year, B is allocated a $20 credit, C is allocated a $30 credit, and D is allocated a $50 credit.
Controlled group rules can be a complex area of tax specialty, and it is important to gain a firm understanding of the regulations surrounding these issues. The controlled group member determination for research tax credit purposes is just one of the complexities within a proper R&D credit study. In 1981, when the credit was enacted, the single taxpayer concept was included in Section 41(f) to prevent any taxpayer from claiming more than the appropriate share of credit. Thus, the definition of ‘‘single taxpayer’’ necessitated defining a controlled group.
With the guidance of Strike’s R&D tax experts, members of a controlled group can still take full advantage of the R&D Tax Credit to recoup a portion of their qualified research activities. Reach out to a member of the Strike team if you have any questions about your company’s specific arrangements or how you can tap into the benefit of the R&D Tax Credit at either the federal or state level.