In 2020, during the worst of the COVID-19 outbreak, California suspended its R&D tax credit because of the pandemic’s dire impact on the economy and state finances. In 2022, Gov. Gavin Newsom signed a bill to reinstate the credit, allotting the program nearly $5.5 billion.
If you’re operating a California business that’s focused on technology, engineering, architecture, or another industry centered on innovation in health and science, it’s time to start taking advantage of California’s R&D tax credit. R&D tax credits are a simple way to reduce your tax bill by providing proof of the experimental work you’re likely already conducting. With more capital in your business’ arsenal, you’ll have more to invest back into the company to grow and innovate further.
What is an R&D Tax Credit?
The R&D Tax Credit program is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development costs in the United States and has been around since 1981.
Under the R&D Tax Credit program, the US government provides billions of dollars every year to innovative businesses for developing new or improving existing technologies, products, materials, and processes. Most states also operate their own R&D tax credit programs. For a comprehensive overview of the US’s R&D Tax Credit program, check out our guide.
R&D Tax Credit in California
The state tax credit in California amounts to 15% of expenses spent on research and development activity. The credit is not refundable, meaning it will reduce your tax bill but not provide a direct cash refund.
Activities that qualify for the California state tax credit must be conducted in California, and, in order to claim the credit, organizations must complete the California Franchise Tax Board’s 3523 form. $5 million is the maximum amount each taxpayer can get back in business tax credits in California, including the R&D tax credit for taxable years beginning on or after January 1, 2020, and before January 1, 2023.
Documentation is the most time consuming and important part of filling for R&D tax credits. California has its own rules for its state tax credit, and it also follows some of the federal R&D tax credit rules. Knowing the specifics, if your company should be audited, is the difference between passing smoothly and not earning the credit.
Activities that Qualify for the California R&D Tax Credit
In California, the definition of qualified research activity (QRA) must meet all four criteria. According to the California Franchise Tax Board, QRAs must:
- Qualify as a business deduction under IRC §174
- Discover information that is technological in nature
- Discover information intended to be useful for developing a new or improved business component
- 80% or more of the research activities must involve a process of experimentation
Examples of activities that do not qualify in California include social science, arts, and humanities research, quality control work, consumer research, research funded by a grant or other person/group, and research that occurs outside the state.
Four broad categories define research and development work on a federal tax level. They include:
- Permitted purpose – Work done to develop new or improved products or processes
- Technological uncertainty – Work done to find a new solution or method that’s previously been unsolvable with publicly available information or knowledge
- Process of experimentation – Work done in a systematic process to evaluate one or more alternatives
- Technological in nature – Work done in physical sciences, biology, engineering, or computer science
Expenses that Qualify for the California R&D Tax Credit
The Californian government says qualified research expenses (QREs) generally include wages, supplies, and contract research. The state also follows the IRS’s guidelines that list patents and hosting costs for rentals for off-premise computers and other tech as QREs.
Documentation for the California R&D Tax Credit
Common documents the California Franchise Tax Board relies on to substantiate R&D tax credit claims include:
- General ledgers
- Field and lab summary data
- Human resource documents
- Federal and state tax returns
- Materials that explain research activities, including brochures, pamphlets, press releases, and other similar documents
- Minutes or notes from budget, board of directors, managerial, or other meetings that discuss research activities
The California Franchise Tax Board states that taxpayers must keep records that detail gross income, deductions, credits, and other relevant information for a relevant period of time. In California, auditors have four years from the filing date to reassess returns. The state will disallow the credit if a business doesn’t have sufficient documentation for its claim during an audit.
Generally, tax collectors in California do not accept estimates for qualified research expenditures. However, in rare cases, the state will accept estimates if the expenses being claimed are qualified research activities and if the failure to accurately document R&D expenses was not an “inexactitude of [a company’s] own making.”
California follows most of the IRS’s standards for R&D tax credit documentation. The agency’s standards are as follows:
- Documents need to be contemporaneous, meaning the R&D expense needs to be documented as it occurs. The bigger the claim, the more documents you’ll need to collect.
- There needs to be proof the work occurred in the fiscal year being claimed. All documents supporting the QREs need to be dated.
- Your claim needs to highlight technical challenges and substantiate the R&D work that was done. The challenges should reflect one of the four broad categories (as defined by the IRS) that qualify as R&D work.
Frequently Asked Questions About R&D Tax Credits
What can you recover with R&D tax credits?
The R&D tax credits you can recover can be broken down into two parts — federal and state. The Federal portion is approximately 10% of eligible expenditures that can be used to offset Social Security taxes up to $250,000 per year, income taxes, or the alternative minimum tax (AMT). However, the state portion is different from state to state.
What are the benefits of R&D tax credits?
R&D tax credits can be used to offset the employer portion of Social Security taxes up to $250,000 for each fiscal year.
The Social Security tax offset allows qualified small businesses to receive a benefit for their research activities regardless of profitability. R&D tax credits can also be used to offset income taxes if you’re in a taxable position, which is dependent on your previous tax return statements.
R&D tax credits can also be used to offset the alternative minimum tax (AMT) if you have less than $50 million in average revenue for the three previous years and you owe AMT in the current year.
How do you prepare the documents for R&D tax credits?
Although the R&D Tax Credit program can help your business recover large amounts of your research and development spend, claiming the tax credits is a complicated process. You’ll need to provide evidence in the form of receipts and invoices for QREs.
Tax professionals with industry experience assure your claim for R&D tax credits is backed up well and offer a sufficient explanation of R&D activities should the IRS audit your organization.
Boast Finds the Credits for You — With No Upfront Fee
Boast combines AI-driven software that finds opportunities for credits with the professional touch of our in-house R&D and SRED tax experts. We’ll work to get your business larger returns faster with less work.
Our staff is made up of engineers and finance professionals backed by over 20 years of experience in the field. We stay engaged with your business throughout the year to help you identify R&D-eligible work, which enables us to provide information on other technology grants and financing opportunities.
And if the IRS reviews your R&D claim, we’ll defend you in the process and help to ensure your claim is successful. Get in touch with us now to request a free assessment and get started on your next R&D claim.
Use our R&D tax credit calculator to calculate your tax refund.