R&D Carryforward - How Long Do R&D Credits Last? How Far Back Can You Claim?

What is a “carryforward” for a tax credit?

A "carryforward" for taxes refers to the ability to transfer an unused portion of a tax credit from one tax year to a future tax year. Essentially, it allows you to offset future tax liabilities with a credit you couldn't use in full in the year you earned it.

How does the carryforward apply to the R&D tax credit?

The R&D tax credit allows taxpayers to carry forward unused credits for up to 20 years from the year they are earned. This part is simple, but it gets a little more complicated when figuring out how far back you can go to claim credits from past years. It’s much easier to understand how this works when you think about the overall goal of the R&D credit.

What is the purpose of the carryforward in R&D?

The R&D credit itself is a dollar for dollar reduction in your income tax liability. So based on the amount of qualified research expenses you accrue in a year, there is a corresponding amount that your income tax is reduced by.

So why would you ever need to carry forward these credits? Wouldn’t you just use them to reduce your income taxes the year you claim them?

The problem is that many companies that are doing research and development are not yet profitable. If the credit was only usable by companies already making a profit, this might only encourage incumbents to invest in R&D, which might skew or reduce innovation.

In order to maintain an environment of dynamic innovation and incentivize smaller companies to invest in R&D, the government has provided 2 ways for smaller companies to be able to benefit from the credit.

The payroll deduction. This lets small companies reduce the amount they pay in payroll taxes, which may be a more significant burden on them than income tax in early stages.
The carryforward period. This lets companies accrue R&D credits they have earned and carry them forward for up to 20 years into the future. The idea here is that they are rewarded for their investment in R&D by reducing their income tax in the future when they eventually make profits on the new products they have created.

The Statute of Limitations on the R&D Credit

Basically, you can claim the R&D credit for an open tax year, which means the last 3 years. Beyond that, you can’t go back and claim it, unless you had non-taxable or loss years before that which you should have originally claimed but didn’t.

This gets a little confusing. When you hear about the statute of limitations for the first time, you may be confused about the difference between the past 3 years and other further years in the past where you could not claim the credit.

Here’s the difference:

You can always go back and claim the R&D credit at any point within the statute of limitations (in this case, the past 3 years.) So if you didn’t know about the credit, paid all your taxes, and then a year later realized that you could have claimed the R&D credit last year but didn’t, you can go back and amend it and claim however much you can based on your qualified research expenses from that year.
If however, you realize that 5 years ago you could have claimed the R&D credit, but didn’t, there’s nothing you can do. You paid the taxes then, and it’s already settled. It’s important to note, this is the norm, but there is an edge case where you can go back further to claim the credit.
This edge case is if, 5 years ago you could have claimed the R&D credit, AND you had a non-taxable or loss year (basically, you didn’t make a profit) you might be able to claim those credits and carry them forward for the 20 year period mentioned before.

This setup can be confusing, but makes sense when you think about the overall purpose of the R&D credit, which is to incentivize companies to invest in innovation.

California R&D Credit Carryforward

The details above are probably going to be the most relevant for the average business owner in the United States, but if you are a business owner, CEO, or financial officer for a young startup, you might be located in Silicon Valley in California.

If this applies to you, you should know that there is not only the federal credit, but there is also a California R&D tax credit which you can likely claim.

As it applies to the carry forward, California has a slightly different approach. They mandate that you use the credit in the earliest year possible, but these credits can be retained indefinitely into the future instead of the 20 year limit at the federal level.

How should you use your R&D credits as a startup?

Apart from using the above guidelines on the carryforward, and ensuring you take advantage of both the federal and any applicable state credit, how should you as a small company think about the R&D credit?

As mentioned above, small companies are in a slightly different situation. If you aren’t yet profitable, but have a decent amount of qualified research expenses accruing each year, what should you do?

If you are a new company (started within the last 5 years) and are still small (less than 5 million in gross receipts the year you are filing for) using those credits now to reduce payroll taxes may be a good option, particularly if the company is in a difficult position in the near term and needs the cash flow relief. Keeping more cash might also help to avoid diluting equity in future fund raising rounds that may be necessary with less cash.

On the other hand, saving these credits for when the company becomes profitable may be a smart choice if profitability is imminent and you aren’t concerned with short term cash flow. It may also be worth projecting how much you will pay in taxes when you reach profitability. An extra tax credit may help to reduce your income tax liability which can be significant if you end up in a higher tax bracket.

Figuring out the right path for your company can be tricky and requires some thought. At Open Advisor, we work with the top R&D tax credit companies and can help find you a partner that will work for your situation and get you the best rate.