Congress recently extended the federal research credit under Sec. 41 for amounts paid or incurred before January 1, 2010, and certain states also provide credits for qualified expenditures. However, many states impose additional requirements on the computation of the state credits (e.g., activities must be conducted in the state or computations of base amounts differ) that are easily overlooked but can have substantial impact. Accordingly, it makes sense to revisit how these state rules might affect clients.
Note: At the time of this writing, more than half the states provide some sort of tax credit for expenses paid or incurred with respect to a taxpayer's qualified research activities. Because a review of each state's provisions is beyond the scope of this item, it will focus on some of the more interesting California provisions under CA Rev. & Tax. Code §23609. In addition, the federal and California research credit provisions also provide benefits for amounts paid for "basic research," but those are also outside the scope of this item.
BackgroundThe federal research credit was originally enacted in 1981 and was intended in large part to spur domestic innovation. It took the form of a nonrefundable credit against income tax available to taxpayers for certain qualified expenditures that exceeded a defined base amount (Sec. 41(c)).
In computing the credit for both federal and California purposes, it is important to remember that there are various methods to consider, depending on whether the company had sufficient activity in the 1984–88 time period, whether the taxpayer wants to elect the alternative simplified method or the alternative incremental method, whether the taxpayer is a member of a group of businesses that must aggregate their activities, and so on.
However, for the sake of this discussion, the standard method of computing the credit is as follows (for both federal and California) for businesses that are not startups:
- Take the total of the taxpayer's qualified research expenditures for tax years beginning after December 31, 1983, and before January 1, 1989.
- Divide that total by total gross receipts for those same years. The resulting percentage is the fixed-base percentage, which, per Sec. 41(c)(3)(C), cannot be greater than 16%.
- Take the average gross receipts for the four years preceding the current year and multiply that amount by the fixedbase percentage (Sec. 41(c)(1)). The result is the tentative base amount.
- Compare the tentative base amount against the current-year qualified expenditures.
If the current-year qualified expenditures are less than the tentative base amount, no research credit is available. If the current-year qualified expenditures are greater than the tentative base amount, the increment is the lesser of (1) the difference between the total current-year qualified expenditures and the tentative base amount or (2) one-half of the current-year qualified expenditures (Sec. 41(c)(2)).
The credit is then determined by multiplying the credit rate (20% federal (Sec. 41(a)), 15% California (CA Rev. & Tax. Code §23609(b))) by the increment as calculated above.
Finally, taxpayers need to decide if they prefer to elect under Sec. 280C(c)(3) to reduce the research expense credit and deduct the expenses under Sec. 174.
Note: In this context, a startup company is one that had both qualified research expenses and gross receipts either (1) for the first time in a tax year beginning after December 31, 1983, or (2) for fewer than three tax years beginning after December 31, 1983, and before January 1, 1989.
California Research CreditThe California research credit (effective as of 1987), while based on the federal credit, does contain some notable differences. In the right circumstances, those differences sometimes provide substantial (and unexpected) benefits to those who read the California rules carefully.
The first key difference in the California rules restricts the credit by the location of the qualifying activity. Specifically, CA Rev. & Tax. Code §23609(c)(2) provides that qualified research includes only research conducted in California. While it makes sense that California does not want to provide incentives outside the state, it places the responsibility on the taxpayer to ensure not only that its inhouse expenses (e.g., wages or supplies) are for California activities but that its contract research expenses are as well. This means that the taxpayer must be able to establish that its subcontractors performed their work in California as well as to qualify those expenses for the California research credit.
The second key difference is one with which many California practitioners seem unfamiliar. That provision is in §23609(h)(3), which reads as follows:
Section 41(c)(6) of the Internal Revenue Code, relating to gross receipts, is modified to take into account only those gross receipts from the sale of property held primarily 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, regardless of f.o.b. point or any other condition of the sale.In addition, California FTB Publication 1082, Research & Development Credit: Frequently Asked Questions (2008), provides the following (in relevant part):
Excluded receipts are items such as California "throwback" sales for apportionment purposes, as well as receipts from services, rents, operating leases and interest. In addition, royalties and license payments are generally excluded from the definition of gross receipts for research credit purposes. . . . This California definition of gross receipts applies to both the average annual gross receipts for the prior four years and the base years (1984–1988).
Caution: While the publication does not have the weight of statutory authority, it is seemingly consistent with the statutory language noted above and does represent the Franchise Tax Board's official stance, so practitioners should not ignore it.
As innocuous as this second difference may seem, it represents a fundamental conceptual difference in the computation of the California credit. In short, it redefines gross receipts for California purposes as basically including only inventory sales to California purchasers.
So what does this really mean? Not only should practitioners expect the fixed base percentage to usually differ for federal and California computations, it also means that average gross receipts for the preceding four years will usually differ as well. Moreover, this can (in the right circumstances) provide a large and often beneficial difference to the taxpayer, where California gross receipts are substantially smaller than total gross receipts for federal purposes.
For the sake of illustration, consider the simple
example in the exhibit.
Exhibit: State and federal research credit calculation
|* QREs = qualified research expenditures|
What this example demonstrates is that a taxpayer blindly using the federal rules in this case would have erroneously forgone $840,000 of California research credits to which it was entitled.
ConclusionRelatively few practitioners seem to be well versed in the intricacies of state research credits. However, as shown in the exhibit, practitioners with clients conducting qualified research could find some hidden gems among state research credits.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
The Tax Adviser
would like to acknowledge the special contribution
to the December Tax Clinic of Singer Lewak LLP; Mark G.
Cook, tax partner in the Irvine, CA, office; and Steve
Cupingood, the partner in charge of that firm's tax
For additional information about these items, contact Mr. Koppel at (781) 407-0300 or email@example.com.