Mike Silvio, Director of Tax Services
Lucia Valenzuela, Senior Manager, Specialty Tax Consulting
The May 2020 revision of Governor Newsom’s proposed budget includes a provision to temporarily suspend net operating losses and temporarily limit the amounts of credits a taxpayer can use in any given tax year to $5 million. These short-term limitations will generate new revenue of $4.4 billion in 2020-21, $3.3 billion in 2021-22, and $1.5 billion in 2022-23 to increase funding for schools and community colleges and maintain other core services.
California defines the term business credit as including the California Research Credit and the California Competes Tax Credit, among other business credits. Business incentive tax credits directly reduce corporate tax liability. In 2018, businesses reduced their corporate tax liability by over $2.9 billion through the use of credits, with $2.4 billion from the research and development (R&D) tax credit.
The Impact of this Limitation
Don’t let this usage limitation stop you from claiming your share of California R&D tax credits. Even with the $5 million limitation, the credit is a powerful dollar-for-dollar offset to your tax liability and most companies rarely generate more than the $5 million in credits in one taxable year.
For example, a California taxpayer in the business of developing SaaS software with taxable income of $20 million and an effective tax rate of 8.84% will owe about $1.7 million of California taxes. If the same company pays $15 million of employee salary in California and half of that salary cost is directed to individuals involved in qualified research activities as defined by the R&D tax credit rules, the taxpayer could potentially be eligible for a R&D tax credit up to about $1.1 million. For this taxpayer, the R&D tax credit, would reduce the tax liability from $2 million to about $900,000.
If your company has generated R&D tax credits in the past and portions have gone unused, the company may be affected by the proposed limitation, as only $5 million can be used in each year. However, unused California R&D tax credits can be carried forward indefinitely as opposed to federal credits which can only be carried forward twenty years. Therefore the credits are not at risk of being lost in California due to this limitation.
Does your Company Qualify for R&D?
The California R&D tax credit is a government-sponsored tax incentive that rewards companies for conducting research and development in California. The activities defined as R&D in the tax code are broad and encompass much more than activities aimed at obtaining new scientific knowledge. To qualify as R&D, the activities must meet each of the following requirements:
(1) Technological in nature: activities must be based on hard sciences, (2) Permitted purpose: activities must be intended to develop a new or improved product or process, (3) Technical uncertainty: activities must be aimed at eliminating uncertainty with respect to the development of a product or process, and (4) Process of experimentation: activities must involve an iterative or systematic approach of evaluating different alternatives to eliminate uncertainty.
We’re Here to Help
Hall & Company professionals bring over 20 years of R&D tax experience to help you file and defend your R&D tax credit claim. We welcome the opportunity to provide your company with a no-cost R&D tax credit eligibility analysis to determine if this tax incentive can help you fuel your company’s growth.
At Hall & Company, we are an experienced Orange County CPA firm based in Irvine that is committed to providing quality tax and accounting services along with sound financial direction to clients throughout the Orange County and Southern California area. Our top OC accountants offer business development consulting, audit, tax preparation, IRS Audit, retirement planning, business roundtables, estate planning, QuickBooks consulting, Interim Chief Financial Officers, and a full range of traditional public accounting services.
Contact our experienced tax team to learn more.