Understanding the Federal and California R&D Tax Credits

Oct 30

7 min read

Many businesses carry out research and development without necessarily describing the work internally as “R&D.” Developing new products, improving manufacturing processes, writing or enhancing software, testing alternative designs, improving formulations, building prototypes, or solving technical problems can all potentially fall within the scope of the Research and Development (R&D) Tax Credit.

The Federal R&D Tax Credit provides an incentive for businesses undertaking qualified research activities in the United States. California operates a separate Research Credit for qualifying research conducted within California. While the two credits share many underlying principles, there are important differences in how they are calculated and utilized.

How Are R&D Activities Assessed?

Eligibility is determined by examining the activities undertaken rather than simply looking at whether a company has an R&D department or records spending as research and development on its books.

At the Federal level, qualified research generally needs to satisfy four key requirements:

Permitted Purpose: The activity must seek to develop or improve the function, performance, reliability, or quality of a product, process, software, technique, formula, or invention.
Technological in Nature: The work must rely on principles of engineering, physical or biological science, or computer science.
Elimination of Uncertainty: There must be technical uncertainty regarding capability, methodology, or appropriate design.
Process of Experimentation: Substantially all of the activities must form part of a process of experimentation that evaluates alternatives, such as testing, modeling, simulation, prototyping, or systematic trial and error.

These requirements are generally considered separately for each business component being developed or improved.

For many companies, qualifying activities are embedded within ordinary commercial projects. A manufacturer may be improving a production process, a software company may be developing new functionality, or an engineering business may be designing a system for a customer where the appropriate technical solution is not known at the outset.

The fact that the work is commercially driven does not, by itself, prevent it from qualifying. However, where research is performed for a customer, the contract terms matter. The business generally needs to bear the financial risk if the research is unsuccessful and retain substantial rights in the results; otherwise, the work is treated as funded by the customer and excluded from the credit.

What Costs Can Be Claimed?

Once qualifying activities have been identified, the associated Qualified Research Expenses, or QREs, must be determined.

The main categories generally include:

Employee wages for staff performing, directly supervising, or directly supporting qualified research.
Supplies used or consumed during qualified research.
Certain costs associated with the rental or use of computers for qualified research.
Eligible contract research expenses paid to third parties performing qualified research on the company's behalf.

For Federal purposes, generally 65% of qualifying contract research expenses can be included, subject to the relevant requirements. The Federal credit is based on research conducted within the United States, Puerto Rico, or U.S. possessions. California uses broadly similar QRE categories, but only research conducted within California can generate California Research Credit QREs.

Not every cost associated with an R&D project is necessarily eligible. General overhead, routine production costs, depreciable capital equipment, administrative costs, and other nonqualifying expenses need to be separated from the costs directly associated with qualified research. For this reason, a detailed cost analysis is an important part of preparing a robust claim.

How Is the R&D Tax Credit Calculated?

The value of the credit depends on the company's current and historical research spending and the calculation method used.

For the Federal credit, the Regular Credit is generally equal to 20% of QREs above a calculated base amount.

Alternatively, many businesses use the Alternative Simplified Credit, or ASC. Under the Federal ASC, the credit is generally 14% of current-year QREs above 50% of the average QREs for the previous three taxable years. Where the company had no QREs in any one of those three years, the Federal ASC is generally 6% of current-year QREs.

California applies different rates.

The California Regular Credit is generally 15% of QREs above the applicable base amount. For taxable years beginning on or after January 1, 2025, California also permits an Alternative Simplified Credit equal to 3% of QREs above 50% of the prior-three-year average. If there were no QREs in any one of those three years, the California ASC is 1.3% of current-year QREs. The California ASC must be elected on a timely filed original return, not an amended return, and the election is irrevocable once made.

These percentages should not be interpreted as meaning that a company simply receives 14%, 20%, 3%, or 15% of all of its R&D spending. The final credit depends on the applicable base calculation, historical spending, entity type, elections made, and other tax limitations.

Nevertheless, for businesses with substantial qualifying research spending, the resulting Federal and California credits can represent a meaningful reduction in tax liability.

Does a Company Need to Be Profitable?

No. A company does not need to be profitable in order to undertake qualifying research or generate an R&D Tax Credit. For companies that do have income tax liabilities, the credit may be used to reduce those liabilities, subject to the applicable tax rules and limitations.

For certain Qualified Small Businesses, the Federal credit can also be used against payroll taxes. Eligible businesses can elect to apply up to $500,000 of Federal R&D Tax Credit against specified payroll tax liabilities, subject to the Qualified Small Business requirements.

This can make the Federal credit particularly relevant to early-stage technology and engineering companies that are investing heavily in development but have not yet become profitable.

Can the Credit Be Carried Forward or Back?

At the Federal level, unused general business credits, including the R&D Tax Credit, are generally subject to a one-year carryback and a 20-year carryforward. This means that, subject to the applicable limitations, an unused current-year credit may potentially be applied against tax paid in the preceding year or retained for use against tax liabilities arising in future years.

California operates differently. Unused California Research Credits generally carry forward until they are fully utilized. The state does not impose the same 20-year expiration applicable to the Federal general business credit. California does not provide a general carryback for the Research Credit. This means that a California company with little or no current tax liability may still generate a credit and retain it for use when sufficient California tax liability arises in the future.

How Does the R&D Tax Credit Interact With Sections 174 and 174A?

The R&D Tax Credit under IRC §41 and the tax treatment of research and experimental expenditures under §§174 and 174A are related, but they are not the same tax provision.

The R&D Tax Credit provides a credit based on a defined subset of Qualified Research Expenses.

Sections 174 and 174A determine how broader research and experimental expenditures are treated for Federal income tax deduction purposes. For taxable years beginning after December 31, 2024, new IRC §174A generally allows businesses to immediately deduct domestic research and experimental expenditures. Businesses may alternatively elect to capitalize qualifying domestic expenditures and amortize them over a period of at least 60 months.

Foreign research and experimental expenditures continue to fall under §174 and generally must be capitalized and amortized over 15 years.

This represents an important change from the rules applying to 2022 through 2024, when Federal law generally required domestic R&E expenditures to be capitalized and amortized.

The relationship between §174A and the R&D Tax Credit is also affected by IRC §280C.

If a taxpayer claims the Federal R&D Tax Credit without making the reduced-credit election, the domestic R&E deduction or capitalized amount under §174A generally must be reduced by the amount of the research credit. Alternatively, a taxpayer may elect the reduced credit under §280C. For the current Federal credit, this generally means multiplying the otherwise calculated credit by 79%, avoiding the corresponding reduction to the §174A deduction or capitalized amount.

Although the two provisions are connected, expenditures qualifying under §174A are not automatically eligible for the §41 R&D Tax Credit. The credit has a narrower set of requirements, and the qualifying activities and costs must still be separately established.

California treatment also differs from Federal treatment. California has not adopted the Federal §174 or §174A capitalization rules, so both domestic and foreign research and experimental expenditures can still be deducted currently for California purposes. The interaction between the California Research Credit and deductions therefore requires a separate California analysis.

The Importance of Documentation

Identifying qualifying R&D is only one part of the process.

A defensible claim should establish the connection between:

The business component being developed or improved.
The technical uncertainty encountered.
The experimentation undertaken to resolve that uncertainty.
The employees and other resources involved.
The qualifying expenses associated with those activities.

Good documentation therefore combines both technical and financial evidence. For many businesses, the underlying information already exists across project documentation, engineering records, software development systems, payroll information, accounting records, testing documentation, and discussions with technical personnel. The challenge is bringing that information together in a way that clearly supports the credit being claimed.

How Ampirico Can Help

Ampirico specializes in Federal and California R&D Tax Credits.

Our team works directly with engineers, developers, scientists, and other technical personnel to understand the work being carried out and identify potentially qualifying activities across the business.

Our process includes technical interviews, identification and assessment of qualifying activities, detailed cost analysis, calculation of the Federal and California credits, and preparation of supporting technical and financial documentation.

We also support you and your CPA in responding to any questions from the IRS or California Franchise Tax Board about the claim.

If your business is investing in the development or improvement of products, processes, software, technology, or manufacturing capabilities, there may be an opportunity to recover part of that investment through the R&D Tax Credit.

To find out whether your business may qualify, get in touch with our team at www.ampirico.com.

*This article is for general information only and does not constitute tax, legal, or accounting advice. Eligibility for the R&D Tax Credit depends on each company’s specific facts and circumstances.