California R&D Tax Credit Essentials
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The federal Research & Development (R&D) tax credit has been a lucrative tax savings tool available to Los Angeles businesses for many years. However, recent changes outlined in the Tax Cuts and Jobs Act prohibit deducting eligible expenses in the year incurred. Under new regulations, these expenses must be capitalized and then amortized over a 5-year period. Unfortunately, this change means companies must now wait longer to realize the tax savings. For those relying on the savings to continue funding existing projects or to launch new ones, it has caused a serious issue. For this reason, many are now looking at alternate options, including potential savings arising from state tax incentives. The good news is that the California R&D tax credit offers substantial savings to those who qualify. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
What Benefits are Available Through the California R&D Credit?
The state allows taxpayers to offset franchise tax on the entity level and personal taxes for the owners of pass-through entities. This can translate to significant tax savings for California businesses and owners. In fact, S-Corporations can elect to apportion out a third of the credit to the business to offset franchise tax and then can allocate an additional percentage (87.7%) to the owners of the company to offset personal taxes owed.
In addition, California allows taxpayers to amend a return to claim the credit up to four years back, and any credits not applied can be carried forward indefinitely until used. Moreover, for controlled groups, members have the option to allocate the credit to another related entity, but the transfer cannot be revoked.
What Types of Expenses Can be Included?
The qualification for R&D activities and expenses mirrors the Federal Credit requirements, with one exception – only expenses incurred in the state or activities performed within California can be included. Therefore, for eligible contracted third-party expenses, one could only include the cost if the vendor performed the services within the state. The same is true for employee expenses – only time for qualifying activities that took place in California can be considered.
Calculating the California R&D Credit
The calculation methodologies and requirements are set forth in California Revenue and Tax Code § 23609. Similar to the Federal Credit, California also offers taxpayers a choice between alternative calculation methods, the Regular Credit and Alternative Incremental Credit (AIC).
The Regular Credit offers a generous credit rate allowing taxpayers to capture 15% of the amount of current year (CY) qualified research expenditures (QREs) that are greater than the base amount. The Regular Credit follows the Federal calculations to determine the FB% used to calculate the base amount. One component that varies greatly from the Federal calculations is that companies performing services only that do not have property sales within the state are considered to have zero California gross receipts. These specific requirements are included in Legal Division Guidance 2012-03-01. In these instances, the Regular Credit is the only calculation option available.
The AIC provides a second calculation option for taxpayers that cannot generate a credit through the Regular Credit method. The AIC computes the credit through a series of calculations using percentages of the CY QREs and the average gross receipts for the four prior years. This method uses three-tiered percentages that are smaller (1.49%, 1.98%, and 2.48%) compared to the generous rate through the Regular Credit. As a result, AIC typically will generate a lower amount than the Regular Credit. The benefit of AIC is that an analysis of base period QREs is not needed for the calculation. This option is ideal for taxpayers that do not have prior year data as only prior year gross receipts and CY QREs are required. If you elect AIC, you are locked into this method for future years unless you get consent from the Franchise Tax Board to revoke the election.
Additional Considerations
It is also important to note that for California, you must elect the reduced credit or 280c on your Federal tax return to claim the reduced credit amount for the state calculations. California has also not conformed to the current Federal §174 amortization requirements.
We’re here to help
The state R&D tax credit offers significant savings for those who qualify. The state credit still allows eligible taxpayers to deduct eligible expenses in the year incurred. Since the details are complicated, it is important to consult with a qualified tax advisor who can guide you through the process. If you have questions about the information outlined above or need assistance with the California R&D credit, JLK Rosenberger can help. For additional information, call 949-860-9902 or click here to contact us. We look forward to speaking with you soon.
