State R&D Tax Credits: What You Need to Know

Welcome to SMB Matters, I’m Zach Kitzmiller, Tax Credit Manager at TriNet Clarus R+D. This podcast series takes a close look at the latest news and trends on a variety of topics related to running a successful small or medium sized business.

As an innovative business leader, you may already be aware of federal research and development (R&D) tax credits, but you might not realize that most U.S. states also offer their own R&D tax credits.

With two-thirds of U.S. states offering some sort of state R&D tax credit, there's a good chance your business may be able to take advantage of them if you are also eligible for the federal R&D tax credit. Just like at the federal level, these tax credits are for businesses who spend money on eligible R&D expenses in a state. In general, states follow the same qualification guidelines as the federal R&D tax credit, but details like the calculation method, definition of certain terms and regulations, and carryover periods can vary.

In most states, income tax is imposed on the net taxable income of a business allocated to the state. The state’s taxable income is determined using Federal taxable income as a starting point, then the portion of the business that is attributable to activity in the state or apportionment is calculated.

But how do you know if your business's activities are "connected" to a specific state, or to multiple states? When it comes to determining whether you may be eligible for an R&D tax credit to help offset your tax liability in certain states, there are several things to look at:

• Nexus: the amount of connection a business has to a state. States can use different standards for determining that connection.
• Physical presence standard: an out of state business must have offices, employees, agents, or property in state to establish income tax nexus.
• Economic presence standard: an out of state business must earn income from economic activity in the state to establish income tax nexus.
• Apportionment factor: determined based on the portion of sales, payroll, and property in the state. Also determines the amount of net income that can be subject to net income tax by the state.

As mentioned, state R&D tax credits generally follow the same or similar qualification criteria outlined for the federal R&D tax credit. Section 41 of the U.S. tax code says that qualifying work for the R&D tax credit must meet the requirements in the four-part test, which are Permitted Purpose, Technological in Nature, Elimination of Uncertainty and Process of Experimentation.

Now, let’s take a look at a few states that have unique rules and typically have many companies claiming the state R&D tax credit.

California

When using the regular method of calculation, California’s R&D tax credit closely aligns with the federal R&D tax credit applying a fixed base percentage determined from historical gross receipts and R&D spend. The tax credit amount is determined considering gross receipts and qualified research expenses (QREs) related to R&D work done in California. However, California defines gross receipts as the sale of real, tangible, or intangible property held for sale to customers and delivered to a purchaser within California. This limited definition means receipts related to license payments are generally excluded from the R&D tax credit calculation.

Georgia

Unlike California, Georgia offers only one calculation method. Using this method, the base amount is determined by multiplying a ratio of the past three years of Georgia research expenses and taxable income by taxable net income. The tax credit is generally equal to 10% of QREs that exceed the base amount. Taxpayers can claim the tax credit on GA Form IT-RD with their business return. The tax credit is nonrefundable and is used to reduce up to 50% of a business's income tax liability. Excess tax credits can be used to offset Georgia state payroll withholding tax, which is a great option for businesses with little to no income tax liability that not all other states offer. Claiming the withholding benefit must be done by filing GA Form IT-WH within 30 days after filing a timely Georgia income tax return. Similar to California, unused tax credits can be carried forward, but only for up to 10 years.

Pennsylvania

In Pennsylvania, businesses can submit their applications for the tax credit via the state portal between August 1st and December 1st in the year following the relevant tax credit year. The state R&D tax credit is allowed to be sold for cash if the tax credit exceeds the tax liability for the year, and unused tax credits can be carried forward for up to 15 years.

The calculation method for the Pennsylvania state R&D tax credit uses a base amount of either prior years’ average state R&D expenditures or 50% of the current year’s state R&D expenditures, whichever is greater. Additionally, a business must have at least two years of R&D expenditures. In Pennsylvania, the state R&D tax credit is tentatively calculated as 10% of qualified expenses that exceed the base amount.

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