California R&D Tax Credit - All You Need to Know

The California Research and Development Tax program is a vital tax relief program designed to encourage innovation and advancements at the state level. This credit is underpinned by California’s strong economy, which is driven by technology, biotechnology, and manufacturing sectors.

This can make the program relatively competitive, meaning that you should apply as soon as possible to avoid falling behind.

The program helps you recover a part of your expenses by providing tax credits for qualified research expenses against your overall tax liability. As a result, you pay lesser taxes providing more cash flow to your business, and helping to offset the cost of in-house research expenses.

In this article, we will explore the details of the California research and development credit and provide a guide for businesses to maximize their tax savings through their R&D initiatives.

What are California R&D Tax Credits?

California research tax credits are designed to incentivize businesses to invest in research and development so that they have less of a tax liability when the tax season kicks in. These tax credits contribute to additional capital, which businesses can use to hire additional research staff, purchase advanced equipment, and generally expand their research operations over time.

Research and development tax credits are widely available to businesses in California, regardless of size or industry. However, you have to meet the state definition of research and development, which is outlined in the four-part qualifying test that is routine at both the federal and state levels. This credit’s vast availability is beneficial for a broad spectrum of businesses to drive innovation in their sector.

What Code Governs California R&D Credit?

The California Revenue and Taxation Code governs the specific regulations and guidelines surrounding the research and development tax credit program. This includes which California gross receipts to collect, what falls under qualified research expenses, and understanding what to do with any leftover or unused credit.

This code serves as a critical resource for businesses and tax professionals who want to find specific information about the research and development program.

One of the most notable rules about these tax credits is there is a $5 million dollar cap on the amount that a business can claim annually. This rule is in effect from the year 2020 to 2023, and while it may limit benefits for very large corporations, you can still save a substantial amount by claiming the most that you can.

Another important note is that businesses that claim the California research credit are subject to the four-year audit window from the original filing date. This means that the governing body, the California Franchise Tax Board, has four years from the date a tax return is filed to verify the accuracy of all of the claimed credits.

So keep all the documentation about your qualified research expenses handy, as you may need them years after the original date!

Eligibility Criteria for California R&D Tax Credits

To qualify for the California R&D tax credit system, businesses must improve and develop an essential function in their field. This means a wide range of entities can qualify for this credit! Eligible entities include C-corporations, S-corporations, limited liability companies, and partnerships.

S-corporations can only claim up to one-third of the credit against the 1.5% entity-level tax, which means they cannot use it to eliminate their tax liability entirely.

For financial S-corporations that engage in services such as banking and lending, they can claim the research and development tax credit against a 3.5% entity-level tax. This ensures that the credit is appropriate for the level of tax burden the corporation has.

One of the unique requirements for eligibility is that more than 80% of the activities that you claim on the credit must be within the process of experimentation. This standard is rigorous and ensures that only genuinely innovative acts qualify for a reduction in liability.

All of these activities must be performed within the state of California as well, which allows businesses to explore their options and conduct scientific research on a local and state level rather than outsourcing these activities outside of the state.

Four-Part Test for Qualifying Activities

In the state of California, your qualified research expenditures have to pass a four-part test to be claimed against your overall tax liabilities:

Technological in Nature

The first part of this test is that your qualified research expense has to be for an activity that is technological in nature. This means that the qualified research activities must rely on physical or biological sciences, computer science, or engineering principles. These activities should involve the scientific methods and techniques from these fields in order to achieve your goal.

Permitted Purpose

This criterion requires that the activity have a permitted purpose. This involves innovating existing procedures or creating entirely new ones. It can’t just improve a process that already has a reasonable solution; it must result in considerable and tangible advancements and improvements in the field.

Eliminate Uncertainty

Another criterion your activity must meet is eliminating uncertainty regarding a subject. This means identifying and addressing gaps in knowledge or technological capabilities. This ensures that the credit supports efforts to overcome challenges and push the boundaries of what is possible in the field.

Experimentation

Qualifying activities must also have a process of experimentation, which includes trial and error, testing, and evaluation. The researching firm must provide documentation to support these processes. It has to be conducted in a structured manner, using scientific methods to test hypotheses and validate results.

Calculating the California R&D Tax Credit

Calculating research and development tax credit follows a rigorous approach to ensure businesses get the most out of their financial benefits for their development activities.

The only method that California allows to calculate this tax credit is using its regular method, meaning there is no alternative simplified method for businesses that have been claiming qualified research expenses for more than 3 years.

Under the regular method, businesses can claim 15% of their qualified research expenses that exceed a base amount. This percentage encourages businesses to invest more in research over time thanks to the increasing returns.

In addition to this, businesses can also claim 24% of basic research payments made to organizations that take up some of the research burden, such as universities or scientific research institutions. This extra credit encourages collaboration between the private sector and academic or non-profit research entities in the long term.

To prevent businesses from receiving high credit, the base amount cannot be less than 50% of the current year’s qualified expenses. This is to ensure that the credit is also specifically rewarding sustained development, rather than spikes in investment during certain years.

While there is an alternative incremental credit option for businesses that are calculating their research credit, there is no alternative simplified method.

The alternative incremental credit option is a three-tiered base percentage option that adjusts based on the average gross receipts of a business’s research expenses over a specific period of time. These credit rates are 1.49%, 1.98%, and 2.48% respectively.

Carrying Forward and Refunding the California R&D Tax Credit

This research credit is not refundable, meaning that businesses can’t receive a refund in cash if the credit amount exceeds their liability. Instead, businesses can maximize their excess credit by using the carryforward provision to their advantage.

California is one of the few states that allow for indefinite carryforwards for their tax credits, which allows businesses to maximize their return through long-term planning.

Businesses are required to apply the credits to the earliest tax year in which they have a tax liability, which ensures that the credits are used efficiently and keeps them from amassing unreasonable amounts over the years.

California Qualifying Research Expenditures 

To claim this tax credit, businesses should understand and keep a record of any qualifying research and development activities. Expenses related to this generally include:

Wages

Wages to people employed under research and development activities count as qualified. This includes any form of compensation, ranging from salaries to hourly wages, and the employee must be engaged during the design, development, or testing phases of research projects.

Supplies

Supplies used in the conduct of research and development can be claimed against your tax liability, which includes tangible items that are used repeatedly to supplies that are consumed during the experimentation process.

Research

Contracted research expenses that are paid to third-party organizations for conducting research on behalf of the private entity also qualify as creditable against your overall tax liability. This must include payments that are made to universities, research institutions, and other entities that provide specialized research services.

How to Claim the California R&D Tax Credits?

Claiming the California research and development tax credits is a thorough process that requires attention to detail and documentation, so hiring a certified public accountant will be in the best interest of your business if you would like to claim this credit.

The process of claiming involves detailed steps that are consistent across different types of businesses, including:

• Identifying QREs (Qualified Research Expenses): Determine which activities and expenses qualify by reviewing your projects and compiling detailed documentation to support your claim.
• Calculation: Have your certified public accountant help you calculate your base amount, as well as assist in calculating the total amount of QREs that you can claim.
• Complete Forms: The necessary forms include California’s Franchise Tax Board Form 3523 and the Federal Form 6765.
• Maintain Detailed Records: Even after you submit, keep ahold of your documentation to support your claims. This ensures that you have evidence for any audits that come your way.

The filing deadlines for claiming the credit align with Form 3523, as it must be submitted with your California tax return. Working with a CPA will assist in making sure you get your necessary materials on time without sacrificing accuracy.

Next Steps

California businesses have a good opportunity to get their tax credits to fuel growth while reducing their tax liabilities. The savings from these credits can be a significant boost to companies that are looking to expand. While this is compelling for many businesses, the process of claiming these is complicated and requires expertise to do correctly.

Tax Credits can provide you with a CPA to help! If you’re looking to expand into research and development credits, it can be extremely difficult to know if you’re doing it correctly. Using our experts will not only help you claim the most that you can but can also help you prevent unnecessary auditing procedures!

FAQs

What is the fixed base percentage for R&D in California?

In California, the fixed base percentage for the Research and Development tax credit is determined as the lesser of the percentage of the taxpayer’s aggregate qualified research expenses for the years from 1984 to 1988, or 16%.

Does California conform to R&D capitalization?

California does not conform to the federal rules for capitalization under IRC Section 174 under the Tax Cuts and Jobs Act. The difference between federal and California state tax laws can lead to discrepancies in taxable income and tax liability for businesses.

Does California follow IRC 174?

No! While the federal rules under IRC 174 require capitalization and amortization of research and development expenses over five years, California allows for the immediate expensing of research and development costs.

What is a gross receipt for California R&D credit?

The research credit for California tax credit, “gross receipts,” are the total amount derived by the taxpayer from all sources, including but not limited to the sale of products or services. Gross receipts are used to calculate your fixed-base percentage, which is used to determine the research and development activities.