The R&D tax credit is vital to keeping companies at the forefront of innovation by rewarding companies that develop new processes and products.
In 2020, California suspended its R&D tax incentives due to the economic shock following the pandemic. However, the state recently had a budget surplus, and in February 2022, Governor Newsom signed into law a budget bill to restore R&D tax credits in the state.
Qualifying for this credit is slightly different from the federal R&D credit, but we’ve got you covered with this guide to the California R&D tax credit — keep reading to see if your business can benefit.
Unsure if your business qualifies for the R&D tax credit? We’ll help you determine your eligibility and how much you can expect to receive!
Related: Tax Credits for Hiring Veterans
What Is California’s R&D Credit?
The California state R&D tax credit reduces franchise or income tax — businesses qualify for this credit if they incurred or paid qualified research expenses (QREs) while conducting qualified research in the state.
Businesses can receive 15% of their excess of current year expenditures over a base amount, which is a minimum of 50% of their current year’s research expenses. They can claim the R&D credit on their return for the taxable year in which the business incurred the qualified expenses.
Sound confusing? Don’t worry; we’ll cover what these terms mean and help you determine if your business qualifies for the California R&D tax credit.
Does California Conform to the Federal R&D Tax Credit Provisions?
Generally, California law conforms to the federal R&D credit enacted under the Small Business Job Protection Act. However, it does make some modifications, including:
- Qualified organizations include specific cancer centers and hospitals run by public universities
- Basic and qualified research must happen in California to qualify
- Businesses cannot carry back the California R&D tax credit
- The state doesn’t conform to the federal government’s definition of gross receipts
What Research Qualifies for California’s R&D Credit?
Qualified research activities in California must meet four criteria — they must
- Qualify as a business deduction as outlined in Internal Revenue Code (IRC) §174.
- Aim to discover something that is technological in nature
- Aim to discover information for developing or improving a business component of the taxpayer
- Substantially all involve a process of experimentation (80% or more of research activities must undergo experimentation)
Any research activity that meets all four requirements can be eligible for California’s R&D credit.
What Research Does Not Qualify for California’s R&D Credit?
California specifically excludes the following research activities from qualifying for the tax credit:
- Any research that happens outside of the state
- Efficiency surveys and management studies
- Research conducted in the arts, social sciences, or humanities
- Software for internal use (unless it meets additional criteria)
- Regular inspection or testing of products or materials for quality purposes
- Consumer and market research
- Research to locate or evaluate mineral deposits, oil, or gas
- Research regarding style, cosmetic, taste, or seasonal design
- Acquiring or improving land or depletable/depreciable property used in research
- Promotional or advertising expenses
- Research conducted after starting commercial production
- Research aimed at duplicating an existing business component
- Research funded by a grant, contract, another person, or government entity
- Research related to adapting an existing business component
Related: What Is the WOTC?
California’s R&D Tax Credit: Guide to Qualified Research Expenses
Qualified research expenses for California’s R&D tax credit typically include the following three costs:
For wages to be eligible for the credit, they must be paid to someone performing qualified services that directly relate to research activities. In addition, the taxpayer must pay or incur them.
Qualified services include direct support, supervision, or performance of qualified research.
Eligible supplies include tangible property that is utilized to develop or consumed directly by research activity. Businesses must use the supplies to conduct qualified research.
Supplies do not include property, improvements to the property, or land subject to the allowance for depreciation. In addition, small tools, shipping costs, and utilities do not qualify as supply expenses.
- Contract Research
Finally, contract research expenses are paid to non-employees who perform qualified research. The business must have a written agreement to conduct research before the performance and bear the costs, whether successful or not.
To qualify, the consultant must perform their research in California. If they conduct it inside and outside the state, only their expenditures incurred in California will be eligible for the credit.
What Documents Do You Need to Claim the R&D Credit in California?
If you want to claim the California R&D tax credit, you must retain any relevant documentation regarding your research. While it’s impossible to list every document your business might need to have, the most common ones include the following:
- Materials explaining research activities (press releases, brochures, pamphlets, etc.)
- Quarterly and annual reports that refer to research activities in any manner
- Project budgets, work orders, and authorization that initiate your research
- Progress reports, project summaries, and project meeting minutes
- Research credit studies performed by outside consultants.
- HR documents (annual reviews, self-appraisals, time reports, etc.)
- Contracts, memorandums of understanding, or letter agreements for research performed by a third party
- Your company’s general ledger
- Submissions to review committees, management, board of directors, etc., about research projects, expenditures, and credits
- Notes, minutes, and recordings from meetings concerning research activities
- Internal authorization policies approving a research project
- Field and lab summary and verification data
- Papers, patents, and their supporting documentation about your research
- Travel reimbursement forms
- Federal and state tax returns (including apportionment work papers)
In addition, credible oral testimony by employees or consultants with personal knowledge about the research can help supplement your documentation. However, this testimony is not a substitute for maintaining the proper documentation regarding your research activities.
Related: What Is the ERC?
Work With the R&D Tax Experts
Claiming tax credits is complicated. You know your business can benefit from California’s R&D tax credit (and likely the federal one, too), but filing and getting your maximum refund is a whole other story.
At TaxRobot, we combine in-house tax experts with AI-driven software to help businesses of all sizes automate the process of claiming their R&D credits.
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