California R&D Tax Credit
In general, California (CA) allows the R&D tax credit in accordance with IRC § 41, as modified by California Revenue & Taxation Code §§ 17052.12 (Personal Income Tax) and 23609 (Corporation Tax).
On February 9, 2022, the California governor Gavin Newsom signed Senate Bill 113 (S.B. 113), which restores the net operating loss (NOL) deduction and eliminates the $5 million annual cap on business incentive tax credits, effective for tax years beginning on or after January 1, 2022. When initially enacted in 2020, the NOL suspension and credit limit applied to tax years 2020, 2021, and 2022. However, S.B. 113 removes the credit limit and restores the NOL deduction for the 2022 tax year.
See below for additional details and background on the California R&D tax credit.
CA R&D Credit Summary
The R&D tax credit equals:
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15% of the excess of California qualified research expenses for the taxable year over the base period research expenses.
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24% of basic research expenses for university-based research for the taxable year.
Eligible Entities: C-Corporations, S-Corporations, LLCs, Partnerships
Deadline for Tax Filing: Due with California Tax Return (complete Form FTB 3523).
Data Required to Compute Credit:
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Claim Period Qualified R&D Expenses (QREs)
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Gross Receipts for Prior 4 Years
Credit Carryforward: The credit can be carried forward indefinitely, but it cannot be carried back.
California Specific Modifications
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“Qualified research” and “basic research” must be conducted in California to qualify for the California credit.
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California does not conform to the federal “Alternative Simplified Method,” but it allows an election for the “Alternative Incremental Research Credit.”
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Taxpayers may elect the alternative incremental credit in which taxpayers are assigned a smaller three-tiered fixed-base percentage and a reduced three-tiered credit rate (1.49%, 1.98%, and 2.48%).
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The definition of “qualified organization” includes hospitals run by public universities and certain cancer centers.
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Research that has a specific commercial objective may qualify as “basic research.”
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For taxable years beginning on or after January 1, 2000, the credit is equal to 15% of the excess of the qualified research expenses, over the base amount, plus 24% of the basic research payments.
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California gross receipts include receipts from the sale of real, tangible, or intangible property held for sale to customers in the ordinary course of the taxpayer’s trade or business that is delivered or shipped to a purchaser within this state. This would include sales to the U.S. government, which could be identified as delivered in California. Excluded receipts would be items such as “throwback” sales, as well as receipts from services, rents, operating leases, and interest.
- In contrast to federal law, all S corporations are subject to California tax (3.5% tax rate - R&TC Sec. 23802 and 23186) must pay the minimum franchise tax of $800 or an income or franchise tax at a rate of 1.5 percent which may be offset by credits. (R&TC Section 23803). For California purposes, an S corporation and its shareholders are subject to both Corporation Tax Law (CTL) and Personal Income Tax Law (PITL), respectively.
- However, full R&D credit amount as calculated under the PITL may be passed through to the shareholders (R&TC Section 23803(a)(2)(F)) and an additional one-third of the R&D credit calculated may also be utilized to offset the franchise or income tax at the S corporation level. (R&TC Section 23803(a)(2)(F))
The remaining two-thirds is disregarded and may not be carried over (R&TC Section 23803(a)(2)(B)).
- However, full R&D credit amount as calculated under the PITL may be passed through to the shareholders (R&TC Section 23803(a)(2)(F)) and an additional one-third of the R&D credit calculated may also be utilized to offset the franchise or income tax at the S corporation level. (R&TC Section 23803(a)(2)(F))
California Specific Modifications For Start-Up Companies
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Fewer than 3 taxable years beginning after 1983 and before 1989 in which it has both gross receipts and qualified research expenses.
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For taxable years beginning on or after January 1, 1997, the first taxable year for which it has both gross receipts and qualified research expenses is a taxable year beginning on or after January 1, 1984. Prior to taxable years beginning on or before January 1, 1994, all “start-up companies” were assigned a fixed base percentage of 3% for both federal and California purposes. After January 1, 1994, the fixed base percentage of 3% only applies to the taxpayer’s first 5 taxable years beginning after December 31, 1993, for which the taxpayer has qualified research expenses. For the taxpayer’s 6th through 10th taxable years and all taxable years thereafter, see IRC § 41(c)(3)(B)(ii)(II)-(VII).
Refundable/Transferrable Tax Credit: No
S-Corporation Additional Benefits
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S-Corporations may claim an additional S-corp entity level benefit of 1/3 of the research credit calculated for the period against the 1.5% entity-level tax after applying the limitations relating to passive activity losses and credits.
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However, S-Corporations are not eligible for the “basic research” credit. (IRC §41(e)(7)(E)(i)) S-Corporations can pass through 100% of this credit to their shareholders on a pro-rata basis.
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The amount of research credit passed through to the shareholder on the Schedule K-1 may be limited to the amount of tax attributable to the shareholder’s interest in the S-Corporation (IRC §41(g)).
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To determine the shareholder’s credit limitation, see FTB Form 3523 – Line 40 instructions.
2020-2022 Temporary CA NOL Deduction Suspension
Applies to both corporate (flow-throughs, C-corps) and individual (personal) income taxes for tax years beginning on or after January 1, 2020 and before January 1, 2023 with a net business income or a modified adjusted income of greater than $1 million. See CRTC §§ 24416.23 and 17276.23.
The existing 20-year carryforward period for NOLs (10 years for losses incurred in the 2000–2007 tax years) would be extended for up to three years if losses are not used due to the NOL suspension.
The carryover periods for the suspended NOL deductions would be extended. as follows:
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For tax years beginning before January 1, 2020, the extension period is three years.
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For tax years beginning on or after January 1, 2020, and before January 1, 2021, the extension period would be two years.
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For tax years beginning on or after January 1, 2021, and before January 1, 2022, the extension period is one year.
The carryover period for each year’s NOL is extended only when an NOL deduction was denied, in whole or in part, because of the application of the suspension provisions. When a taxpayer has multiple NOL carryforwards, the oldest year must be used first (see FTB Legal Ruling 2011-04; Treas. Regs. §1.172-4(a)(3)). Businesses will continue to compute and carryover NOLs during the suspension period. Each tax year that has an NOL must be considered separately. This is because an NOL carryforward is the balance from an NOL generated in a single tax year—not an aggregate of all losses generated in prior years.
CA Business Tax Credit Limitation
For tax years beginning on or after January 1, 2020 and before January 1, 2023, a business (including all taxpayers that are members of a combined report) may claim a total of only $5 million in credits in a given tax year under both the corporation and individual income tax laws (including the carryover of any business credit). See CRTC §§ 17039.3 and 23036.3.
Most business credits, including the California research and development (R&D credit), are subject to this limitation. However, certain individual income tax credits and the low-income housing credit that applies to both corporate and individual income taxpayers are exempted.
The carryover periods (if applicable) are extended by the number of years that a credit is disallowed by reason of this limitation. The new legislation also allows taxpayers to use the “advanced strategic aircraft credit” to offset the California alternative minimum tax for the 2020 through 2025 tax years.
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