R&D Tax Credits in California 

Qualified research expenses are determined in the same manner as for a federal claim. They must follow federal guidelines for being technology oriented. While not mandatory, California expects substantially all or at least 80% of R&D to involve experimentation. In regards to contracted research expenses, normal commercial outsourced expenses are subject to a 65% limit. Research expenses incurred through a university are subject to a 75% limit. Credits may be carried forward until fully expended, but may not be carried back.

Items that would not be considered qualified research expenses are the following:

  • General and administrative payroll
  • Supplies not involved directly in the R&D
  • Depreciable property
  • Advertising, marketing, utilities, small tools and shipping costs

R&D Credit Rates and Calculation

The credit is calculated by comparing the taxpayer’s QRE’s to their gross receipts. The California Research Credit defines gross receipts as receipts from the sale of real, tangible, or intangible property held for sale to customers in the ordinary course of the taxpayer’s trade or business that is delivered or shipped to a purchaser in California, regardless of free on board (FOB) shipping point or other conditions of sale. The difference between the taxpayer’s gross receipts and qualified research expenses can significantly maximize the credit.Extrapolated data is not acceptable. California is not required to accept estimates when it is reasonable to expect documentation to exist.

  • There are two ways to calculate the credit on form 3523; the taxpayer can select the regular method in section A on the form or the Alternative incremental credit on section B of the form.
  • For start up companies, the R&D credit is 3% of QRE’s for the first 5 years. For years 6-10, the rate gradually increases as specified in the internal revenue code. At the end of year 10, a permanent base rate is calculated.
  • When a taxpayer selects the regular method, a permanent base rate is the basis of the calculations. The credit calculates to 15% of the excess QRE over the base amount + 24% of the basic research payments to universities. The base period must be a minimum of  50% of the current year QRE.
  • The Alternative Incremental Credit method is used when the taxpayer does not have a base period. This method assigns a smaller three-tiered fixed percentage base and a reduced three-tiered credit rate of 1.49%, 1.98% and 2.48%.
  • The offset of deductions is the equivalent of the federal 280C election. It precludes a double benefit for the same expense. It uses rates of 87.7% for individuals, trusts, and estates; 91.16% for C-Corps; and 98.5% for S-Corps.
  • When using research from a University the expenses are subject to a 75% limit. R&D conducted at a university generated a credit of 24% of the excess over the base period.
  • When claiming the credit as an S-corporation, an optional one third of the credit can be applied at entity level. Based on the previous discussion, two thirds to 100% of the credit can be passed to the shareholders.

 

Case Study

A construction company in California started developing an innovative software in 2012. This project lasted for 3 years and allowed them to claim a significant credit for the years in which qualified activities were conducted.

Summary of credits:

FEDERALCALIFORNIA
YearTotal QREsCreditTotal QREsCredit
2014$650,000$39,000$650,000$48,750
2013$700,000$42,000$700,000$52,500
2012$300,000$18,000$300,000$22,500
Total$1,650,000$99,000$1,650,000$132,750

 

California R&D Tax Credit Claim Form

The California R&D Tax Credit is claimed on a form 3523. Current year claims are submitted with the return. Amended claims are submitted in accordance with standard amending rules. California requires the same amount of substantiation as for the federal returns. The taxpayer must be able to put their hands on receipts, key documents and financial statements if and when required to support expenses claimed.