The federal research and development (R&D) credit is one of the most overlooked tax breaks out there — and the same holds true for California’s version of the credit, available for research conducted in the state. While the California credit mirrors the federal credit in many ways, some important differences do exist. Here’s what you need to know.
What is the R&D credit?
California’s credit is intended to encourage businesses to conduct R&D work in the state. Similar to the federal R&D credit (also known as the Sec. 41 credit), it generally allows a business doing “qualified research” to apply a percentage of its qualifying research expenses (QREs) against its state tax liability.
California uses the federal definition for QREs. Under that definition, QREs are the sum of in-house research expenses and contract research expenses.
- Taxable wages for employees who perform qualified services (engaging in qualified research or directly supervising or supporting research activities),
- Supplies to conduct the research (for example, supplies used for prototypes), and
- Rental costs for computers used in qualified activities, including cloud computing used to perform research.
As for contract research expenses, you can include 65 percent of any amount paid or incurred to a third party for qualified research. If the research is performed by a qualified research consortium, though, you can claim 75 percent of the expenses. Research consortiums are generally 1) tax-exempt, and 2) organized and operated primarily to conduct scientific research.
Note: To claim the credit, you must complete California FTB Form 3523, “Research Credit.” You don’t need to claim the federal R&D credit to claim the state credit.
Do I qualify for the credit?
California applies the IRS’s four-part test for qualifying research activities:
1. The research is performed to eliminate technical uncertainty about the development or improvement of a product or process, including computer software, techniques, formulas, and inventions (the Section 174 test),
2. The research is undertaken to discover information that’s technological in nature — that is, it relies on physical, biological, engineering, or computer science principles (the technological information test),
3. The research is intended for use in developing a new or improved business product or process (the business component test), and
4. Substantially all (generally, at least 80 percent) of the research activities are elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality (the process of experimentation test).
If your business has pursued such research, you probably qualified for the R&D credit.
Which state taxes can I apply the credit against?
You can generally use the credit to reduce your regular tax, even below the tentative minimum tax.
You can’t use the credit to reduce:
- The minimum franchise tax (for corporations and S corporations),
- Annual tax (partnerships and QSubs),
- Alternative minimum tax (corporations, tax-exempt organizations, individuals, and fiduciaries),
- Built-in gains tax (S corporations), or
- Excess net passive income tax (S corporations).
How much is the credit worth?
The regular R&D credit is 15 percent of the excess of your QREs for the tax year over your research expenses from a base period (the federal credit generally equals 20 percent of the excess) — what’s known as the base amount. Determining the base amount can require some detailed calculations (see below).
C corporations can also claim a credit for 24 percent of their payments for basic research that exceed a base period amount. Basic research must be done under a written contract and performed in California by a qualified organization. The base period generally is the three previous tax years.
What is the “base amount”?
The base amount for the regular 15 percent credit is determined by applying a fixed-based percentage to your average gross receipts for the four most recent taxable years (less returns and allowances). If you had a tax year of less than 12 months during that period, you’ll need to annualize your gross receipts. Just multiply the gross receipts for the short period by 12 and divide the result by the number of months in the short period.
Note: If you conduct business both in and outside of California, you’ll only include the gross receipts from the sale of property held primarily for sale to customers in the state. The federal definition of “gross receipts” is broader than the California definition. It includes the taxpayer’s total revenues from all activities and sources.
The fixed-based percentage depends on whether you’re a startup or an existing company. For purposes of the credit, though, “startup” doesn’t have the usual meaning. You’re considered a startup if you had both gross receipts and QREs:
- For the first time in a tax year beginning after 1983, or
- For fewer than three taxable years beginning after 1983 and before 1989.
The fixed-based percentage for a startup is 3 percent for the first five years after 1993 for which it has QREs. For years six through ten, the calculation of the fixed-base percentage tracks the federal law. The formula is more complicated, but it never exceeds 16 percent.
Note: For both startups and existing companies, the base amount can’t be less than 50 percent of your current-year QREs.
Does California offer the “alternative simplified credit” (ASC) option that’s available under federal tax law?
Taxpayers in California can elect an “alternative incremental credit,” which differs from the federal ASC. Under the federal alternative, the credit generally equals 14 percent of the amount by which your current-year QREs exceeds 50 percent of the average QREs for the three previous tax years:
Alternative incremental credit = .14 x (current QREs – [.50 x average QREs])
If you had no QREs for those years, the ASC rate is 6 percent of the current-year QREs.
In California, taxpayers who elect the alternative incremental credit are assigned a smaller, three-tiered fixed-base percentage (1.0 percent, 1.5 percent, and 2 percent) and a reduced three-tiered credit rate (1.49 percent, 1.98 percent, and 2.48 percent).
Once you elect the alternative credit, you’re required to use it for all subsequent years unless you receive consent from the Franchise Tax Board (the California equivalent of the IRS) to revoke your election. You request consent by filing IRS Form 3115, “Application for Change in Accounting Method.”
What if I don’t have any California gross receipts?
You’re not out of luck. You’ll calculate your fixed-based percentage as if you’re a startup. Your “year one” will be the first taxable year after 1993 in which you have QREs. For the sixth year and beyond, you generally must use a fixed-base percentage of 16 percent.
But you can’t elect the alternative incremental credit if you have no California gross receipts. Your only option is the regular credit.
Can S corporations claim the credit?
Yes, but subject to limits. An S corporation can claim only one-third of the credit against its 1.5 percent entity-level tax (3.5 percent for banks and financial entities organized as S corporations) after applying the limitations relating to passive activity losses and credits. So you calculate the full credit and include one-third of that amount on your Schedule C (100S), S Corporation Tax Credits.
Yes, an S corporation can pass through 100 percent of the credit on a pro rata basis, according to their distributive shares in the business.
Is the California R&D credit refundable?
No. If the available credit exceeds the current year tax liability, you can carry over the unused credit to future years until exhausted. You must apply the carryover to the earliest taxable year. The credit can’t be carried back and applied against a prior year’s tax.
Unused federal credits, by contrast, can be carried forward for 20 years or back one year.
Why would I take a reduced credit?
Whether you opt for the regular credit or the AIC, Form 3523 allows you the option to take a reduced credit. The reduced credit equals:
- 87.7 percent for individuals, estates, and trusts
- 91.16 percent for corporations
- 98.5 percent for S corporations
Claiming the full amount could work against you because you’re required to reduce your otherwise allowable federal Sec. 174 deduction for research expenses by the amount of the credit.
That means you have to add the full credit amount to your taxable income before you apply the credit, and this could land you in a higher tax bracket. If you take the reduced credit, you don’t need to add the reduced credit amount to your taxable income, so you don’t run that risk.