State & Local Taxes
With much of the focus on federal tax issues such as overhauling the tax system, state tax issues often get lost in the shuffle. This is true with research and development (R&D) tax incentives—so much focus is on the federal R&D tax credit that state incentives are often an afterthought for taxpayers performing R&D activities.
The federal R&D tax credit (in Sec. 41) is a 20% incremental credit on qualified R&D expenses that exceed a base amount or a 14% incremental credit under the alternative simplified credit regime. Due to the federal credit’s incremental nature (where only qualified costs over a base amount are eligible for the credit), the maximum federal benefit is often 6.5% of qualified R&D expenses. In addition to the federal credit, most states offer some kind of R&D tax incentives. State R&D incentives play an important role in states’ ability to compete for and attract new investments and jobs.
States Enhance R&D Incentives
Numerous states have recently enhanced R&D incentives—giving more options to taxpayers looking to invest further in R&D or even relocate some expenses to a more taxpayer-favorable jurisdiction. The following recent enhancements may mean big savings for certain taxpayers:
Minnesota: Beginning in 2010, Minnesota offers a 10% refundable credit (providing cash refunds even if no tax is owed) on the first $2 million of eligible qualified expenses and a 2.5% credit on the remaining eligible expenses (MN Stat. §290.068). The credit is also available to C corporations, shareholders in an S corporation, and partners in a partnership.
California: The state continues to offer a 15% incremental credit on qualified expenses (CA Rev. & Tax. Code §23609). Due to the state’s suspension of the use of net operating loss (NOL) carryforwards, many California taxpayers have found increased value in the R&D credit. The credit can be used to offset up to 50% of tax liability in 2008 and 2009 and up to 100% of tax liability in 2010 and 2011 (CA Rev. & Tax. Code §23036.2).
Utah: Utah phased in R&D tax credit enhancements enacted in 2008 over the past several years. The state now offers two credits—the traditional 5% incremental credit and an additional 9.2% nonincremental credit (UT Code §59-7-612). Taxpayers cannot carry forward any unused nonincremental credit if it is not used in the year generated.
Connecticut: Like Utah, Connecticut has two R&D credits: an incremental 20% credit and a nonincremental credit from 1% to 6%, based on the amount of R&D expenditures and company size (CT Gen. Stat. §§12-217j and 12-217n). Taxpayers with less than $70 million of gross income can either carry forward unused credits or exchange them for a refund from the state for 65 cents on the dollar, making the credit partially refundable (CT Gen. Stat. §12-217ee).
Wisconsin: Effective for tax year 2011, Wisconsin offers an additional “super” R&D credit for the amount of qualified expenses that exceeds 1.25 times the average annual qualified expenses from the previous three years (WI Stat. §71.28(4m)). The credit can be claimed in addition to the traditional 5% incremental R&D credit (WI Stat. §71.28(4)).
Pennsylvania: In 2011, Pennsylvania increased the amount of funds allocated for its R&D credit from $40 million to $55 million (72 PA Cons. Stat. §1602-H). In addition, a taxpayer may now use the credit to eliminate 100% of tax liability. The credit rate is 10% for large companies and 20% for small companies. (Small companies are defined as taxpayers with less than $5 million of total assets.)
New Jersey: Beginning in 2012, New Jersey taxpayers are allowed to offset 100% of their state tax liability with the R&D credit; previously, taxpayers were limited to offsetting 50% of their state tax liability (NJ Stat. §54:10A-5.24). Of note, this new rule can also be applied for unused credits carried into 2012 and beyond from prior tax years.
Arizona: The state implemented a partially refundable credit in 2010 for companies with fewer than 150 full-time employees; these taxpayers may elect to receive a partial refund of 75% of the credit amounts even if no tax is owed (AZ Rev. Stat. §43-1074.01.C). Arizona capped the amount that it will refund under this new provision at $5 million.
Louisiana: Louisiana recently extended its R&D credit program for six years, through 2019. Louisiana offers a credit of up to 40% of eligible expenses for companies with fewer than 50 employees; up to 20% of eligible expenses for companies with 50–99 employees; or up to 8% of eligible expenses for companies with 100 or more employees (LA Rev. Stat. §47:6015).
Indiana: Starting in 2010, the state implemented an alternative credit calculation of 10% of expenses exceeding 50% of the qualified expenses in the prior three years (patterned after the federal alternative simplified credit). Indiana also offers the traditional incremental credit with a rate of 15% (10% for eligible expenses over $1 million) (IN Code §6-3.1-4-2).
Virginia: The state’s first broad-based R&D credit became available starting in 2011. It is a 15% incremental credit for eligible expenses up to $167,000. The credit is refundable; however, the law caps the total amount of annual credits the state will award at $5 million (VA Code §58.1-439.12:06.B).
Other: In addition to those discussed above, many other states offer R&D tax incentives, and several state legislatures are considering provisions to modify and enhance their R&D incentives. For example, Massachusetts is considering modifying the base amount rules for its R&D credit.
As a discussion of all state R&D incentives is beyond the scope of this item, taxpayers should consult with their tax advisers to fully explore the R&D tax incentives available in their state.
Look Beyond the Rate
Most state R&D incentives are patterned after the federal credit in that they follow the federal definition of qualified activities and allow for the same types of costs to qualify: wages, supplies, and contract research costs incurred during R&D efforts. Like the federal credit, most state credits are incremental—allowing a credit only for qualified costs expended over a computed base amount. Despite these similarities, there are many differences in the design and benefits derived from state credits (as illustrated above). Taxpayers making decisions about whether to make R&D investments or the best location for R&D activities should be aware of these differences.
When looking at the potential tax impact of R&D initiatives, many taxpayers focus on the credit rate to judge how generous a particular state’s R&D incentive is; however, taxpayers need to look beyond the rate that different states offer, as the value of state incentives often goes much deeper than which state offers the highest credit rate. The factors that determine the value of a state R&D incentive can vary for different taxpayers. For example, refundable credits often offer the most enticing and immediate rewards for start-up and prerevenue companies that are making significant investments in R&D. Larger companies that are paying tax may benefit more from a state that offers a nonincremental credit—rewarding every eligible dollar of R&D spent and not just expenditures over a base amount.
Other ways that the true value of the credit may be different than it appears at first glance include:
- Some states offer a generous credit but aggressively audit and regularly disallow credits that taxpayers have claimed.
- While most states follow the federal definition of qualified expenses, some states offer incentives for other items, such as equipment used in R&D activities.
- Some states limit the amount of tax that a taxpayer can offset by the credit in a particular year (e.g., limiting it to 50% of tax otherwise owed).
- Certain states put a cap on the total amount of credit awarded in a given year.
- Some states limit the types of entities that can claim R&D credits.
- States without refundable credits have different carryforward windows for unused credits.
- Some states require the credit amount to be added back to income (or offer a reduced credit), while others do not.
- Certain states have a broader definition for qualified activities, while other states limit the credit to certain industries (or offer increased incentives to specific industries).
As an example, consider a C corporation that incurs $1 million in qualified R&D expenses for a 2011 project involving the development of a new product (and assume the corporation’s base amount is $500,000 for incremental credit computation purposes). Following is a snapshot of several state R&D incentives that could be available, depending on where the corporation incurs the R&D expenses:
- If the corporation undertakes the R&D project in California, its net state credit benefit could be as much as $68,000 (assuming the corporation has elected to take the reduced credit under Sec. 280C(c) for California tax purposes). If the corporation owes no tax, it can carry forward the credit indefinitely. The value of the credit could be increased significantly for certain taxpayers with taxable income in 2011 because the use of California NOL carryforwards is suspended for 2011. However, California R&D credits often are audited aggressively by the state’s Franchise Tax Board—potentially diluting the credit’s value.
- If the corporation undertakes the R&D project in Utah, the state credit benefit could be as much as $117,000 ($25,000 of incremental credit and $92,000 of nonincremental credit). However, the value of the credit can be significantly limited if no tax is owed in 2011, as the $92,000 of nonincremental credit will be lost if not used in 2011.
- If the corporation undertakes the R&D project in Minnesota, the credit benefit could be as much as $50,000. In this example, the Minnesota credit is lower than both California and Utah but may be the most attractive option for companies operating at a loss as the 2011 credits are refundable, providing immediate cash refunds instead of credit carryforwards.
Many other factors could affect the amount of credit received from the various states under this scenario (e.g., the individual base amount computations for the incremental credits).
When evaluating the potential tax effect of R&D investments, taxpayers should be aware of the generous tax incentives offered by many states that can add to the benefit received for the federal R&D credit. As many states have recently enhanced their credits and since the state incentives differ significantly in design, consultation with your tax adviser can help you determine the actual value of state incentives and the most tax-favorable states for new R&D investment.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.