During the height of the COVID-19 crisis in 2020, California put its R&D tax credit program on hold due to the severe impact on the state’s economy and finances. In 2022, Governor Gavin Newsom signed a bill to restore the credit, allocating nearly $5.5 billion to the program.
If your business in California is focused on technology, engineering, architecture, or any other innovation-driven sector in health or science, now is the time to take advantage of California’s R&D tax credit. This credit is a straightforward way to lower your tax bill by documenting the experimental work you’re likely already doing. With more cash on hand, you can reinvest in your company’s growth and innovation.
What Is an R&D Tax Credit?
The R&D Tax Credit is a general business credit under Section 41 of the Internal Revenue Code for companies that incur research and development expenses in the United States. This program has been available since 1981.
Through the R&D Tax Credit program, the U.S. government provides billions of dollars annually to innovative companies developing new or improved technologies, products, materials, or processes. Most states also offer their own R&D tax credit programs. For a detailed overview of the U.S. R&D Tax Credit, read our comprehensive guide.
R&D Tax Credit in California
California’s state R&D tax credit is worth 15% of your qualifying research and development expenses. This credit is non-refundable, so it reduces your tax liability but does not provide a direct cash refund.
To qualify for California’s state tax credit, your R&D activities must take place within the state, and you must complete the Franchise Tax Board’s Form 3523. The maximum amount any taxpayer can claim in business tax credits in California—including the R&D credit—is $5 million for tax years starting on or after January 1, 2020, and before January 1, 2023.
Documentation is both the most time-consuming and the most critical part of claiming R&D tax credits. California has its own requirements for the state credit, while also following certain federal rules. Knowing these details is key—if your company is audited, being prepared can mean the difference between a smooth process and missing out on the credit.
What Activities Qualify for the California R&D Tax Credit?
In California, an activity must meet all four criteria to qualify as research activity. According to the California Franchise Tax Board, qualified research activities must:
- Be eligible 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
- Ensure that at least 80% of the research activities involve a process of experimentation
Activities that do not qualify in California include research in social sciences, arts, or humanities, quality control, consumer research, research funded by grants or outside parties, and research conducted outside California.
At the federal level, research and development work falls into four broad categories, including:
- Permitted purpose – Efforts to develop new or improved products or processes
- Technological uncertainty – Work to solve problems or develop methods not previously resolved with publicly available knowledge
- Process of experimentation – Systematic work to evaluate one or more alternatives
- Technological in nature – Activities in physical sciences, biology, engineering, or computer science
Expenses That Qualify for the California R&D Tax Credit
The California government considers qualified research expenses (QREs) to generally include wages, supplies, and contract research. The state also follows IRS guidelines, which include patents and costs for renting off-site computers and other technology as QREs.
Documentation Required for the California R&D Tax Credit
The California Franchise Tax Board typically relies on the following documents to support R&D tax credit claims:
- Contracts
- General ledgers
- Field and laboratory summary data
- Human resources documents
- Federal and state tax returns
- Materials explaining research activities, such as brochures, pamphlets, press releases, and similar documents
- Minutes or notes from budget, board, management, or other meetings where research activities are discussed
The Franchise Tax Board requires taxpayers to keep records detailing gross income, deductions, credits, and other relevant information for a specified period. In California, auditors have four years from the filing date to review returns. If your business lacks sufficient documentation during an audit, the state will deny your credit claim.
Generally, California tax authorities do not accept estimates for qualified research expenses. However, in rare cases, estimates may be accepted if the claimed expenses are for qualified research activities and if the lack of precise documentation was not due to the company’s own oversight.
California follows most IRS standards for R&D tax credit documentation. The requirements are:
- Documents must be contemporaneous, meaning you need to record R&D expenses as they happen. The larger your claim, the more documentation you’ll need.
- You must prove the work was performed in the fiscal year you’re claiming. All supporting documents for QREs must be dated.
- Your claim should highlight technical challenges and provide evidence of the R&D work performed. These challenges should fit one of the four main categories (as defined by the IRS) that qualify as R&D.
Frequently Asked Questions About R&D Tax Credits
What can you recover with R&D tax credits?
R&D tax credits are available at both the federal and state levels. The federal credit is about 10% of eligible expenses and can be used to offset up to $250,000 per year in Social Security taxes, as well as income taxes or the alternative minimum tax (AMT). State credits vary by state.
What are the benefits of R&D tax credits?
You can use R&D tax credits to offset the employer portion of Social Security taxes, up to $250,000 per year.
The Social Security tax offset lets eligible small businesses benefit from their research activities, even if they aren’t profitable. R&D tax credits can also be used to reduce income taxes if you owe them, based on your previous tax returns.
R&D tax credits can also offset the alternative minimum tax (AMT) if your average revenue for the past three years is under $50 million and you owe AMT this year.
How do you prepare documents for R&D tax credits?
While the R&D Tax Credit program can help your business recover a significant portion of your R&D spending, claiming these credits is complex. You’ll need to provide receipts and invoices as proof of your QREs.
Tax professionals with industry expertise can ensure your R&D tax credit claim is well-supported and provide clear explanations of your R&D activities in case of an IRS audit.
Boast Finds Your Credits — With No Upfront Fee
Boast combines AI-powered software that identifies credit opportunities with the expertise of our in-house R&D and SRED tax specialists. We help you get bigger returns, faster, with less effort.
Our team includes engineers and finance professionals with over 20 years of experience. We stay involved with your business year-round to spot R&D-eligible work and inform you about other technology grants and funding options.
If the IRS reviews your R&D claim, we’ll stand by you throughout the process to help ensure your claim succeeds. Contact us today for a free assessment and to get started on your next R&D claim.
Use our R&D tax credit calculator to estimate your refund.
