California Research Credit: How to Qualify and Claim

The California Research Credit is a tax incentive for companies that conduct qualified research and development activities within the state. Its purpose is to encourage innovation by reducing a company’s state income or franchise tax liability. This credit is structured similarly to the federal research credit under Internal Revenue Code Section 41, but with specific modifications. California law conforms to the IRC as of January 1, 2015, and has not adopted subsequent federal changes.

Determining Eligibility for the Credit

To qualify for the California Research Credit, a company’s research activities must satisfy the Four-Part Test. A business component is any product, process, computer software, technique, formula, or invention held for sale, lease, license, or used by the taxpayer. Each business component must independently meet all four criteria.

Permitted Purpose

The research must be undertaken to create a new or improved business component in terms of its function, performance, reliability, or quality. This means the research cannot be for purely cosmetic purposes, such as changes to style or seasonal design. This test is linked to Internal Revenue Code Section 174, which requires the research to discover information that eliminates technical uncertainty. For example, developing a new software algorithm that increases processing speed would meet this test, whereas changing the color scheme of a user interface would not.

Technological in Nature

The process of discovery must be technological in nature, meaning the research activities rely on principles of the physical or biological sciences, engineering, or computer science. Activities that depend on other fields, such as economics, marketing, or management science, do not qualify. An effort to develop a more durable manufacturing material by testing different chemical compositions would be considered technological. Conversely, conducting market research to determine popular product features would not meet this standard.

Elimination of Uncertainty

At the project’s outset, the taxpayer must face uncertainty regarding the capability to develop or improve the business component, the method for doing so, or its appropriate design. This uncertainty must be technical, not merely financial or commercial. An example is a company attempting to develop a battery with a longer life where the method for achieving this is not publicly known. In contrast, if a company is simply choosing between several commercially available software solutions, there is no technical uncertainty to eliminate, and the activity would not qualify.

Process of Experimentation

At least 80% of the research activities must constitute a process of experimentation, measured on a cost or time basis. This process involves evaluating one or more alternatives to achieve a result where the capability or design is uncertain at the beginning. This can include modeling, simulation, and systematic trial and error, such as a pharmaceutical company conducting clinical trials for a new drug. An activity that does not involve this iterative process, such as the routine testing of a product for quality control purposes using standard procedures, would not be considered a process of experimentation.

Identifying Qualified Research Expenses

Once a research activity is deemed eligible, the next step is to identify the associated Qualified Research Expenses (QREs). California follows the federal definitions for QREs, which fall into three categories. Only expenses for research conducted within California can be included.

In-house Research Expenses

In-house research expenses include wages paid to employees for performing, directly supervising, or directly supporting qualified research. For an employee’s wages to qualify, they must be engaged in the actual conduct of research or provide first-level supervision or direct support. Wages for administrative or overhead support, such as human resources or accounting personnel, are not includable. If an employee performs both qualified and non-qualified services, only the portion of their wages for time spent on qualified research can be claimed.

Supply Expenses

Supply expenses are costs for tangible property, other than land or depreciable property, that are used and consumed during qualified research. This includes items like raw materials for a prototype or chemicals for lab experiments. General overhead expenses, such as utilities or rent, are not considered direct supply costs.

Contract Research Expenses

Contract research expenses are costs paid to a third party for performing qualified research. A written agreement must exist before the research begins, the taxpayer must bear the financial risk, and the taxpayer must retain substantial rights to the results. Generally, 65% of the amount paid to the contractor is eligible, which increases to 75% if the research is performed by a qualified research consortium.

Calculating the Credit Amount

After identifying total QREs, the credit amount is calculated using either the Regular Credit method or the Alternative Incremental Credit (AIC) method. A taxpayer must choose one method on a timely filed original tax return, and the choice cannot be changed for that year via an amended return.

Regular Credit Calculation

The Regular Credit is 15% of the current year’s QREs that exceed a calculated “base amount,” plus 24% of basic research payments to qualified universities and research organizations. The base amount is a historical benchmark designed to reward increases in research spending. It is determined by multiplying a “fixed-base percentage” by the average annual gross receipts of the preceding four years, but it cannot be less than 50% of the current year’s QREs. The fixed-base percentage is based on the ratio of research expenses to gross receipts from a prior period. For start-up companies without this history, a statutory fixed-base percentage is used for their first five years of operation before being calculated based on their actual history.

Alternative Incremental Credit

As an alternative, taxpayers may elect the AIC method, which avoids the complex base amount calculation. The AIC uses a three-tiered rate structure of 1.49%, 1.98%, and 2.48%. Each rate applies to QREs that fall within specific brackets determined by the company’s historical research spending. This method can be advantageous for companies that may not benefit from the Regular Credit calculation but still have significant research expenditures.

Required Documentation and Forms

Properly documenting research activities and associated costs is a requirement for claiming the California Research Credit. The Franchise Tax Board (FTB) can disallow a claim if the taxpayer cannot provide adequate substantiation. This documentation should be created as the research is being performed, not retroactively.

A project narrative for each research initiative is needed to describe the technical uncertainties, the process of experimentation, and how the project met the Four-Part Test. It should identify the personnel involved and provide a timeline of the project’s key phases and milestones. To support the claimed expenses, taxpayers must maintain specific records:

• Detailed time-tracking records showing the hours each employee spent on qualified projects.
• Invoices, purchase orders, and inventory records for supplies to show they were used in the research process.
• Written agreements and proof of payment for any contract research.

The primary form for calculating and claiming the credit is FTB Form 3523, Research Credit. Part I of the form is used to list the QREs, and Part II is where the credit calculation is performed using either the Regular or Alternative Incremental Credit method.

Claiming the Credit

Once Form FTB 3523 is complete, it must be attached to the taxpayer’s annual California income or franchise tax return. The specific primary return depends on the business entity type, such as Form 100 for corporations or Form 565 for partnerships. For pass-through entities, the credit is calculated at the entity level and then passed through to partners or shareholders to claim on their personal returns.

For taxable years from January 1, 2024, to December 31, 2026, the total of all business credits that can be used to reduce tax is limited to $5,000,000 per year.

If the calculated credit is greater than the tax liability for that year, the unused portion can be carried forward to subsequent tax years. California allows this credit to be carried forward indefinitely until it is fully used. A taxpayer with carryover credits from multiple years must use the credits from the oldest year first before applying newer credits.