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How to Get the California R&D Tax Credit

The Open Advisor guide to the California R&D tax credit offers a brief overview for businesses interested in finding out if they’re eligible for and claiming the California R&D tax credit. Although the credit had been suspended during the Covid-19 pandemic, as of 2022 it has been reinstated for qualifying businesses.

 

This will help you understand your eligibility, the difference between the federal and the California credit, and the logistics of the California credit. To understand your options and get the best rate for your company, contact Open Advisor about the R&D tax credit.

Overview: Here are the main steps to getting your R&D credit in California

1. Determine Eligibility:

Assess if your company's activities qualify as R&D under California's specific guidelines, focusing on technological research and development conducted within the state. Like the federal credit, there is a similar, but not identical four part test to determine eligibility. 

 

2. Calculate Qualified Research Expenses:

Identify and sum up all qualified research expenses (QREs), including wages, supplies, and contract research costs directly related to R&D activities in California. All the specific details on eligibility can be found further below in this guide.

 

3. Complete Relevant Forms:

Fill out California Form 3523 (Research Credit) to calculate your tax credit. Ensure accuracy in documenting QREs and other required financial details. You can find the California specific instructions here when you scroll down to the section titled "Specific Line Instructions."

 

4. Attach to State Tax Return:

Attach the completed Form 3523 to your California state tax return. Ensure that all related documentation is organized and accessible for reference or audit purposes. This credit is not filed separately, and is attached to your state return.

 

5. Make Sure to Keep Detailed Records:

Maintain comprehensive records of all R&D activities and expenses, as California may require detailed documentation for verification during an audit. The R&D credit (for both federal and California) may require a good amount of up front work to count up and calculate your credit, but this is a relatively minor issue compared to the potential headache of an audit and cost of a fine from the IRS or the state of California. 

 

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How does the California R&D tax credit actually work?

California's R&D tax credit rewards businesses for conducting qualified research within the state. Companies can claim 15% of qualifying expenses that exceed a base amount, directly reducing their state income tax liability. This base amount is based on the past three years of research expenses. 

 

The credit's main benefit is to reduce the amount of tax payable to the state. The amount claimed offsets your state income tax liability. This reduction can be significant, depending on the extent of your qualifying research expenses.

 

As mentioned above, companies must be eligible by passing the four part test. There's no specific limit to the number of years you can claim the credit. It can be claimed annually as long as you have qualifying expenses. 

How do you file for the California R&D credit?

Filing for the California R&D Tax Credit involves specific steps and considerations.

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Form 3523 and Filing Process: To claim the California R&D Tax Credit, businesses must complete the California Franchise Tax Board's Form 3523. This form requires detailed information about your qualified research expenses (QREs) and must be filed as part of your California state tax return. It's important to note that you don't need to claim the federal R&D credit to claim the state credit. The form is part of the 1120 C-Corporation Income Tax Return, generally due April 15th every year, with an extension available up to October 15th​​​​​​.

Timing for Filing:

Briefly describe your degree and any other highlights about your studies you want to share. Be sure to include relevant skills you gained, accomplishments you achieved or milestones you reached during your education.

Documentation Requirements:

Keeping meticulous records is crucial for claiming the R&D Tax Credit. Taxpayers in California are required to maintain detailed records of gross income, deductions, credits, and other relevant information for the period of time that the credit is claimed. California auditors have four years from the filing date to reassess returns, and the state will disallow the credit if sufficient documentation is not provided during an audit. Estimates for qualified research expenditures are generally not accepted unless in rare cases where the expenses being claimed are qualified research activities and the failure to accurately document R&D expenses was not due to the company's inexactitude​​.

Accounting Implications:

Claiming the credit can affect a company's financial statements. It may reduce tax expenses and increase net income, thereby impacting the balance sheet and income statement. Companies must ensure accurate tracking and reporting of qualifying expenses and maintain documentation to substantiate the claim. Staying on the same page across all business units is especially important for the R&D credit, both in calculating and accounting for the credit. 

The Federal vs. The State of California's R&D Tax Credit

Both the California and federal research and development credits reduce your income tax bill, and follow the general rule of reducing that tax liability in return for spending money to create new and innovative solutions to technical problems. 

 

Many business owners don’t realize they can take advantage of the federal R&D credit, and many more don’t realize they can also take advantage of their state specific credit in states that offer the credit. So how do the California and federal R&D tax credits differ from each other?

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  • Separate Tax Bills: The state (such as California) and federal R&D tax credits apply to different tax bills, although both credits apply to income tax liability. They are distinct entities, calculated and claimed separately.

  • Special Considerations for California: California's R&D tax credit has unique aspects compared to the federal credit. For example, the credit rate in California is 15%, as opposed to 20% for federal purposes when using the regular calculation method. Additionally, qualified research must take place in California to qualify for the state credit. There is no Alternative Simplified Credit (ASC) method in California, and specific rules apply to S corporations claiming the credit​​.

  • Simultaneous Claiming: Businesses can claim both state (California) and federal R&D tax credits for the same qualifying activities. This is because many state R&D tax credits, including California's, generally follow the federal regulations and IRS guidance on Qualified Research Expenditures (QREs)​​​​.

  • Claiming Multiple State Credits: Businesses can potentially claim R&D tax credits in different states for separate qualifying activities. However, each state's specific R&D tax credit guidelines must be followed.

  • Maximum Credit Amount: For taxable years beginning on or after January 1, 2020, and before January 1, 2023, the maximum amount each taxpayer can get back in business tax credits in California, including the R&D tax credit, is $5 million​​ for your state return, so it’s important to take into account your other credits when looking at the R&D credit. 

Federal

California

How much can you claim against income tax liability?

There is no specific maximum nominal amount, but typically comes out to around 7% of your annual qualified research expenses. The actual amount is determined by your QRE's this year and past years.

Like federal, there is no specific maximum nominal amount, but is generally 15% of your qualified research expenses. The most you can claim in total business credits in California however is $5 million total, which includes not only the R&D credit but all business tax credits. 

How much can you claim against payroll taxes?

The specific federal maximum you can claim against payroll taxes is $500,000, increased from $250,000 as of 2023. In order to claim the credit against payroll taxes, you must have less than $5 million in gross receipts.

The California R&D credit only applies to income tax liability. 

Eligibility Criteria

  1. Qualified purpose

  2. Based on hard sciences

  3. Aims to reduce technological uncertainty

  4. Process of experimentation

  1. Qualify as a business deduction

  2. Based on hard sciences

  3. Aim to develop/improve a business component

  4. Substantial experimentation

Types of Qualifying Expenditures

Taxable wages, supply costs, and contract research

Taxable wages, supply costs, and contract research

Area-Based Eligibility

Must be conducted in the USA

Must be conducted in California

Carryforward Period

The credits you earn can be saved and used toward future years for up to 20 years. After 20 years of having the credits, they will expire.

Credits don’t expire and can be used in future years, but cannot be applied retroactively to past years

The Four Part Test - Federal vs. California’s Criteria

The Federal and California R&D tax credits both utilize a four-part test to determine eligibility, and although these are both 4 part tests and have overlap both in spirit and in the strict criteria.

Federal

For the Federal R&D tax credit, the four-part test includes: 

  1. A qualified purpose, which is the improvement of functionality, performance, reliability, or quality of a product, process, software, etc.

  2. Reducing uncertainty, where there is something unknown about development or design that the research process is attempting to more accurately understand.

  3. A process of experimentation, involving systematic trial and error or other methods

  4. The requirement that the process is technological in nature, relying on hard sciences like engineering or physics​​.

California

California's four-part test, while generally conforming to the federal criteria, has some distinct elements: 

  1. The research must qualify as a business deduction under the Internal Revenue Code

  2. It must be aimed at discovering something technological in nature, in other words it must be based in the hard science (computer science included)

  3. The goal should be to develop or improve a business component

  4. A substantial part of the research activities (at least 80%) must involve a process of experimentation​​.

The main sticking point in these differences that you have to watch out for and account for is the experimentation criteria. California has more strict rules about experimentation, stating that 80% or more of these deductions must involve experimentation.

If you like the sound of this and are increasingly thinking that you qualify for the California R&D credit, it's probably worthwhile to take 30 seconds and fill out Open Advisor's R&D credit form. Open Advisor works with tax experts across the industry to help you find the partner that works for you at the lowest rate possible. It's especially worth while to go through Open Advisor to see if you can save on your credit by getting your California and federal credit together. Whether you're looking for the right partner to start, or are exploring switching from your existing processor, comparing with Open Advisor can save you weeks of research and thousands of dollars.

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