California R&D tax credit: How your business can benefit

If your business conducts research and development activities in California, you may be eligible for the state’s R&D tax credit. This can help reduce your state tax liability and improve cash flow.

In this article, we’ll explain what exactly the R&D tax credit is, who is eligible for it, and what you need to do to claim it. So let’s jump straight in.

What is the California R&D tax credit?

The California R&D tax credit is a state incentive designed to encourage businesses to invest in research and development activities within the state. It allows eligible businesses to claim a credit of 15% of the increase in California-based qualified research expenses (QREs) over a base amount.

Qualified nonprofit organizations (such as universities and nonprofit science groups) can also claim a 24% credit for basic research.

What’s the difference between the California R&D tax credit and the federal R&D tax credit?

The main difference is that the federal credit applies to research conducted anywhere in the US, while the California credit is limited to expenses incurred within the state.

Other key differences include:

• Credit rate. California offers a 15% credit, compared to the federal rate of up to 20% (regular method) or 14% (alternative simplified method).

• Base calculation. California only uses a fixed-base percentage method, while the federal credit offers both a fixed-base and an alternative simplified method.

• Eligible expenses. California only allows 65% of contract research expenses to be counted, compared to 75% under federal rules.

• Payroll tax offset. Unlike the federal credit, California does not allow small businesses to offset payroll taxes.

• Carrying forward. California allows unused credits to be carried forward indefinitely, while the federal credit has a 20-year carryforward limit.

What are the benefits of the California R&D tax credit?

Claiming the California R&D tax credit offers your business several advantages, including:

• Reduced tax liability. The credit directly offsets your company’s corporate income tax in California, allowing you to lower your overall tax burden.

• Indefinite carryforward. If the credit cannot be used in the current tax year, it can be applied in future years without expiration.

• More innovation. By reducing the cost of R&D, your business can reinvest in product improvements, new technologies, and market expansion.

• Improved cash flow. Tax savings free up funds that can be allocated toward growth, hiring, or additional R&D efforts.

If your business is engaged in a research-driven industry — such as technology, software, or manufacturing — the credit provides a tangible financial benefit that rewards innovation.

Who is eligible for the California R&D tax credit?

To qualify, your company must:

• Engage in activities that meet the IRS Section 41 definition of qualified research.

• Conduct research within California.

• Perform research that is technological in nature and seeks to develop new or improved products, processes, or software.

• Use a process of experimentation to resolve technological uncertainties.

• Incur qualified research expenses (QREs) such as wages for R&D employees, supplies used in research, and a portion of contract research costs.

How do you apply for the California R&D tax credit?

To apply for the California R&D tax credit, your business must follow these steps:

1. Identify your qualified research activities (QRAs)

First, review your internal projects and expenses to ensure they meet the eligibility criteria listed above.

2. Calculate the credit amount

To calculate the credit amount, you first need to establish a fixed-base percentage. For first-time claimants, this percentage is fixed by default at 3%. However, after three years of claiming, your fixed-base percentage is likely to change.

You will then need to calculate the base amount, which is based on your company’s historical gross receipts, using the following formula:

Base amount = Average gross receipts x fixed-base percentage

For instance, let’s say:

• Your average gross receipts in California over the past 3 years were $50 million

• Your current year QREs are $2.2 million

Using the formula, your base amount would be:

$50m x 3% = $1.5m

You would then need to calculate the incremental QREs by subtracting the base amount from your current-year QREs, as follows:

$2.2m - $1.5m = $700k

Finally, to calculate the credit, you would then apply the 15% rate:

15% x $700k = $105k

3. File Form FTB 3523

Include this form with your California corporate or personal income tax return.

4. Apply any unused credits

If the income tax liability is insufficient, your business can carry forward your unused credits indefinitely.

5. Maintain proper documentation

Ensure that you keep detailed records of your R&D activities, expenses, and employee roles in case of an audit. Specifically, you should aim to:

• Maintain organized records. Keep thorough documentation of your projects, expenses, employee activities, and research methodologies.

• Track R&D expenses separately. If possible, maintain a separate ledger for R&D costs, making it easier to verify during an audit.

• Use time-tracking systems. If wages are part of your claim, ensure employees log the time spent on R&D projects.

• Retain supporting documents. To help validate your claim, keep supporting records such as contracts, invoices, prototypes, test results, and meeting notes.

Can you claim the federal R&D tax credit and the California R&D tax credit together?

Yes, your business can claim both the federal and California R&D tax credits. However, you must ensure that expenses claimed for the federal credit are adjusted appropriately when calculating the California credit.

It’s also important to note that, since California does not conform to the federal alternative simplified method, businesses using ASC at the federal level will need to calculate their California credit separately using the fixed-base method.

To learn more about claiming the federal R&D tax credit, check out our in-depth guide below:

Tax and Compliance —

6 min

How to claim the R&D tax credit in the US

The research and development (R&D) tax credit is a highly useful relief for many US businesses. Learn how to claim it in our in-depth guide.

Is the California R&D tax credit worth it?

If your business engages in any kind of innovative research, the California R&D tax credit can potentially provide a major financial advantage. However, to make the process efficient and simple, you need to keep full track of the compensation you’re paying to the employees who are contributing to your QRAs.

As a fully automated payroll system, Remote Payroll can provide you with this information quickly and accurately, making it more simple to calculate your eligible costs. Our system also enables your people to track their hours, improving the accuracy and validity of your claims.

To learn more about how we can help — and how we can simplify your entire payroll management system — speak to one of our friendly experts today.

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