The Research and Development (R&D) tax credit is a federal benefit that provides companies cash savings for performing activities related to the development, design, or improvement of products, processes, formulas, or software. As such, the R&D tax credit is beneficial to business owners in different ways and is available across a wide variety of industries. Like many US tax credit programs, the R&D tax credit helps business owners optimize cash flow opportunities at both federal and state levels. However, the R&D tax credit landscape is constantly changing, making it challenging for taxpayers to establish eligibility for their existing operational expenses. Taking this into consideration, it is important for them to understand federal and state standards for the R&D tax credits and obtain potentially significant returns. This blog is part of a series exploring different state requirements. Read on to learn more about California’s R&D tax credit.
California’s R&D Tax Credit
California’s R&D tax credit generally conforms to IRC §41, and the federal R&D tax credit calculation methodology, modified by California Revenue & Taxation Code. The tax credit reduces income or franchise tax and business owners qualify if they paid or incurred qualified research expenses while conducting qualified research in California. As a result, they can receive 15 percent of the excess of current year research expenditures over a computed base amount and claim the credit on the return for the taxable year they incurred the qualified expenses.
California law generally conforms to the federal research credit as enacted under the Small Business Job Protection Act of 1996. However, California’s R&D tax credit includes some modifications, such as:
- The definition of a qualified organization includes hospitals run by public universities and certain cancer centers;
- Basic research and qualified research must be conducted in California to qualify;
- For taxable years beginning on or after 1/1/2000, the credit is 15 percent of qualified research expenses for all taxpayers. In addition, corporations may be eligible for the basic research credit, which is equal to 24 percent of the excess of basic research payments paid or incurred during the year over the base period amount. The basic research rate is 24 percent. This rule does not refer to S Corporations, personal holding companies, and service organizations;
- California conformed to the Alternative Incremental Credit, except for some differences in the rates and the fact that California requires a separate election. For taxable years beginning on or after 1/1/2000, the percentages for the Alternative Incremental Credit are 1.49 percent, 1.98 percent, and 2.48 percent;
- California has not conformed to the 2006 federal amendments to IRC §41. Thus, the Alternative Simplified Credit is not available;
- California’s R&D tax credit cannot be carried back;
- California does not conform to the federal definition of gross receipts;
- The termination dates provided under federal law do not apply. Currently, there is no termination date for California’s R&D tax credit.
Taxpayers claim California R&D tax credit on FTB Form 3523, Research Credit, for the year they paid or incurred qualified research and development expenses in California.
Qualified Research for California’s R&D Tax Credit
Research activity is considered qualified research for California’s R&D tax credit if it meets the IRS four-part test requirements. On the other hand, the following research activities do not qualify for California’s R&D tax credit:
- Research undertaken outside California;
- Research conducted in the social sciences, arts, or humanities;
- Ordinary testing or inspection of materials or products for quality control;
- Market and consumer research;
- Research relating to style, taste, cosmetic, or seasonal design;
- Advertising and promotional expenses;
- Management studies and efficiency surveys;
- Computer software for internal use of the taxpayer, unless it meets additional tests;
- Research to locate and evaluate mineral deposits, including oil and gas;
- Acquisition and improvement of land and of certain depreciable or depletable property used in research;
- Research conducted after the beginning of commercial production;
- Research related to adaptation of an existing business component;
- Research related to duplication of an existing business component from a physical inspection, plans, blueprints, detailed specifications, and more;
- Any research funded by any grant, contract, or otherwise by another person or governmental entity.
Qualified research expenses for California’s R&D tax credit generally include wages, supplies, and contract research costs.
California’s R&D Tax Credit Documentation Requirements
With few exceptions, California’s R&D tax credit conforms to the federal research credit computation. Therefore, taxpayers are required to maintain records in sufficiently usable form and detail to substantiate that the expenditures claimed qualify for California’s R&D tax credit. In other words, taxpayers must keep permanent books and records sufficient to establish the amount of gross income, deductions, credits, or other matters for as long as they may become material in the administration of the revenue and taxation law.
Failure to meet documentation requirements is a basis for disallowing the credit while presenting detailed and well-maintained records to California’s Franchise Tax Board (FTB) upon request can help expedite the audit of R&D tax credits.
Taking Advantage of California’s R&D Tax Credit
Unlike the federal R&D tax credit, California’s R&D tax credit cannot be carried back. However, unused credit can be carried forward indefinitely until utilized. Also, while several states impose a dollar limit on the amount of expenses that can qualify for the research tax credit and some states limit the amount of their research tax credits that taxpayers can claim in any one tax year, California’s R&D tax credit does not have a dollar limitation.
To take advantage of state-specific tax credits such as California’s R&D tax credit, it is necessary to meet a number of requirements regarding deadlines, eligibility, the application process, calculation method, and more. As a result, navigating through federal and state R&D tax credit legislation can prove to be a complex and time-consuming task. However, outsourcing the R&D tax credit management allows taxpayers to minimize the burden, gain invaluable information and benefit from cash-infusing credit opportunities.