The R&D Tax Credit Aspects of California



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California
        The California economy is an innovative one with at least 25,000 startups at any given time across the state, many of them tech startups.  These brand new companies range from app developers like StyleSeat Inc. in San Francisco which brands itself as a platform for professionals to market beauty, health, and wellness products to DSTLD in Los Angeles, a premium denim manufacturer that blends tech, fashion, and fabric. Innovation in the Golden State touches nearly every industry.  Startups should be particularly encouraged by new legislation effective January 1, 2016 that provides an R&D tax credit that can be used to offset payroll taxes.   


The R&D Tax Credit

        Enacted in 1981, the Federal Research and Development (R&D) Tax Credit allows a credit of up to 13 percent of eligible spending for new and improved products and processes. Qualified research must meet the following four criteria:

  • New or improved products, processes, or software
  • Technological in nature
  • Elimination of uncertainty
  • Process of experimentation

        Eligible costs include employee wages, cost of supplies, cost of testing, contract research expenses, and costs associated with developing a patent.  On December 18, 2015, President Obama signed the bill making the R&D Tax Credit permanent.  Beginning in 2016, the R&D credit can be used to offset Alternative Minimum tax and startup businesses can utilize the credit against payroll taxes.
 

The Added, Large California R&D Tax Credit Benefit

        For over 20 years, companies in California have taken advantage of the state's R&D Tax Credit, one of the most beneficial in the country. The non-refundable credit is equal to 15% of the incremental qualified research expenses incurred in the state over the calculated base amount, plus 24% of the basic research payments over the base amount paid to independent research institutions and universities.  

        Similar to the federal credit, eligible costs include wages, supplies, testing expenses, and contractor research expenses. Unused research credits may be carried forward indefinitely, making it attractive to early stage companies that are not yet profitable.

        Qualified research for purposes of the California R&D Tax Credit must meet the following four tests:
 
  1. Be undertaken to discover information intended to be useful to develop a new or improved business component of the taxpayer.
  2. Qualify as a business under IRC §174.
  3. Be undertaken to discover information that is technological in
  4. Substantially all (at least 80%) of research activities involve a process of experimentation.

        As more informed companies begin to take advantage of the state R&D Tax Credit, claimed California R&D credits have more than doubled from 2009 to 2013. The California Legislative Analyst's Office has projected that the state credit usage will continue to grow and exceed $3 billion in 2020.





Innovation Across the Golden State  

        The new federal R&D Tax Credit legislation allows startups under five years old receive R&D tax credits offsetting payroll taxes -- which is particularly encouraging news for California based companies in virtually any industry.  Silicon Valley is home to world’s highest ranked technology and startup ecosystems. The 1,854 square mile region and has a population of over 3 million people  and is home to the world’s most innovative established companies and continuously breeds the successful startups.  

        The area hosts between 14,000 and 19,000 active startups at any given time; the American metro average of 4,000 pales in comparison.  Over the last two years, the region accounted for 47% of all startup company acquisitions or initial public offerings worldwide.  London came in second at 6%.   The Silicon Valley and San Francisco areas combined account for 53.5% of all California registered patents and 15% of all U.S. registered patents.   

        The Golden State encompasses other innovative regions including San Diego which has a long history in aerospace dating back to the early 1900’s.  Since then, an aerospace cluster has grown to be an integral part of the region’s economy.  More recently, other innovative industries have emerged as well.  Information and communication technology accounts for at least 36% of all employment amongst innovators in the region.  

        In addition, Orange County hosts an innovative economy.  With a population of over 3.1 million, it is home to a number of well known high tech centers and ranks second in the nation in the number of high-tech clusters.   Local universities are also innovating with the number of STEM related degrees increasing at least 25% over the last five years.  


San Francisco

        San Francisco is considered one of the most innovative cities in America.  Known for its artistic creativity, it is home to many of the world’s most promising tech startups. Businesses strive on a top tier network of research clusters and universities. There is no lack of funding as San Francisco and its suburbs were number one in VC funding last year, raising a total of $1.4 billion, the only region worldwide to top a billion dollars.  The region is also number one in lab space with a total of 29.7 million sq. ft.  Business Insider recently compiled a list of the 25 “hottest startups” in the region - among which were a handful of social network apps such as Parenthoods.  The Parenthoods app creates a mobile community for parents; similar to a user friendly and on-the-go version of Mommy Blogs.

        HackerOne, Inc. prides itself on recruiting ex-hackers who know the ins and outs of underground computer hacking.   These friendly hackers continuously surface security holes in order to protect users.  The HackerOne product compiles all vulnerability reports in one place, connects to an issue tracker that constantly searches for bugs, and provides a platform for users to share real time tips about constantly evolving threats.  Many security products are produced in isolation by a multitude of manufacturers and usually don’t communicate well however, the HackerOne technology should address that concern to some degree.

        Shyp Inc. allows users to send packages instantly without going to the post office or even waiting for the mailman.  Users can take a picture of the item they want to send and a driver will come and pick it up.  The service provides couriers within 20 minutes to pick up items, no box necessary.

        App developers aren’t the only innovators in the region. Juicero Inc., recently created a product that has attracted $120 million in venture capital. Referred to as the “freshest juice in the world,” many onlookers think it will completely revolutionize the produce supply and demand change. The product, which has yet to make its debut, involves a countertop machine that delivers a superior juice from pouches of freshly picked produce.  

        Food science is an increasingly sophisticated industry that has been upping the ante on research and development. New health concerns, gluten sensitivity, a desire for non-GMO foods, and overall better nutritional content have challenged food manufacturers to create products with enhanced nutritional contents that still taste the same and also compete with other food products on shelf life length, price, and aesthetic appeal.  Food manufacturers, including small food companies, often have chemists, scientists, and nutritionists constantly seeking solutions to these challenges.  Their salaries and wages are the number one driver of the R&D tax credit and many times 100% of such wages will qualify for the credit.


San Diego

        San Diego has evolved from a military and tourism focused economy to an increasingly high-tech manufacturing and international trade based economy.   In 2013, San Diego added 412 new technology businesses, a 30% increase since 2011.  The sector also added about 1,200 new jobs.   Connect.org, a nationwide incubator hub estimated the county has at least 6,646 high tech businesses that employ more than 143,000 tech workers as of 2013 -- amounting to 11% of total San Diego employment.

        Businesses in the high tech center range from environmental technology, biotechnology, manufacturers, and software companies which employ over 32% of all high tech industry workers in the area. In addition, the United States Patent and Trademark Office (USPTO) ranked San Diego third in the state for total patents granted.

        Despite the bright outlook for tech companies and other innovators in the region, the area is still struggling with one major challenge – water.  On the supply side, groundwater aquifers and freshwater supplies are being withdrawn faster than local utilities can replenish them. On the demand-side, concern is arising from an increasing, regional population and high demand users that are geographically concentrated in regions that cannot sustain such usage.  One solution would be to reduce the demand through conservation.  Water analytics and advanced technologies are being integrated to support this end.  Another alternative, which can be implemented simultaneously, involves increasing the freshwater supply.

        Many communities in the San Diego and Southern California region are beginning to look toward the sea for an answer and in order to make sea water potable, desalination technology is required.

        Although there are at least 26 desalination plants in California that utilize innovative technologies to remove salt from seawater, still, desalination developments have been much slower and more costly than anticipated, especially in the U.S. The challenge for innovators is to lower the costs of desalination technology.  The process involves steep energy usage that is needed to blast water through filters. In order to meet the challenge, investments in R&D must be increased substantially.

        On the demand side, there are solutions as well.  Water can be used significantly more efficiently through use of careful analytics and asset management.  Realizing this, the water industry is undergoing a huge change; from an operation largely dominated by low-tech elements such as earth movers, pipes, and pumps to a modern, streamlined, and highly accurate system using sensors, careful analysis of data, and meticulous planning. .


Orange County

        The Orange County economy is a diverse including various sectors such as business and professional services, construction, healthcare, information technology, logistics and transportation, manufacturing, an emerging bio-technology/nanotechnology cluster, clean energy and green technologies. All of which involve innovation.

        In the business and professional services sector, financial technology (fintech) companies compose the largest market to IT suppliers.  Startups in this sector use big data, advanced analytics, artificial intelligence, social networking, and peer-to-peer solutions to develop products, manage risk, and improve services.   

        In construction, the latest advancements involve everything from inventory management which is used to lower costs and wearable technology, which increases on-the-job safety. GPS fleet tracking applications assist construction companies in managing their fleets by providing useful information to maximize efficiency, reduce costs, and increase quality.  With advanced tagging and tracking of materials and trucks, the Internet of Things (IoT) can vastly reduce costs incurred by construction companies for lost or misrouted items.  

        IT is a smaller segment of the most innovative industry in the world, software/computer science, which typically spends more than any other industry as a percentage of revenue year after year. This likely has something to do with the extremely technical nature of the industry.  In a recent Bloomberg Businessweek article, “What is code?” writer and programmer Paul Ford points to the difficulties in understanding the world of software development. Though essential to our daily lives, coding remains mysterious for most of the population. The article mentions, “there’s no magic, no matter how much it looks like there is. There’s just work to make things look like magic. ” Much of that work is usually R&D credit eligible.
 
        The logistics and transportation industry in the region is innovative as well. The U.S. trucking industry is experiencing major innovations in order to increase fuel efficiency. Most large trucks get less than six miles per gallon and the rate at which they consume fuel has remained stagnant for the past fifty years.  The EPA recently proposed regulations for heavy duty trucks, requiring manufacturers to increase their fuel economy by 40% by 2027.  Innovative efforts to increase fuel efficiency are R&D eligible activities.   

        Manufacturing, of course, is an innovative industry as well. Lean manufacturing process changes, 3D printing, the integration of state-of-the-art production equipment and product developments all provide great opportunities for the R&D tax credit.   

        Orange County is also home to clean energy advancements and electric vehicle fast-charging stations are emerging at various locations scattered throughout the area. ChargePoint Inc., one of the largest charger networks, has 342 ports in Orange County and 781 in Los Angeles County. Based on DMV data, those ports served 7,262 electric vehicles registered in Orange County and 16,304 in Los Angeles. Charging stations such as these are capable of accommodating most e-vehicle types including the Leaf, the Volt and the Tesla models.   


Los Angeles

        The third largest metro economy in the world with a population of 13 million and a GDP of over $700 billion,   Los Angeles has a larger GDP than many foreign nations including Belgium, Saudi Arabia, Norway and Taiwan. About 40% of all containerized goods entering the U.S. pass through L.A., the largest seaport in the Western Hemisphere.  The LA economy is diversified including aerospace, entertainment and fashion, biomedical services, consumer products, and tourism.

        Los Angeles has always been an incubator of new ideas.  The startup investor website AngelList currently has over 6,000 startup member companies in the Los Angeles area and over 14,000 investor members looking to invest in these startups.

        Startups such as Cargomatic Inc., based in Venice, are generating attention lately.   Cargomatic uses an app platform and cloud-based software to streamline the container transportation process and connects shippers and transport companies to customers who need containers shipped.  The company brands the technology as the “Uber style app for trucking” that saves crane operators’ time that would have been spent shuffling through piles for particular containers and also saves drivers’ time that they would have spent waiting for crane operators.  

        Other innovative startups include Club W, Inc. which allows customers to place wine orders, watch taste maker videos, and rate the wine they order. The direct-to-consumer company works with winemakers and vineyards to source the best old-vines, new-vines, bubbles, and vintages for Club W members. Users can generate a “Club W Palate Profile" and Club W will make wine suggestions based on these preferences.  The wine industry is also incorporating new technologies and unique approaches to the cultivation and fermentation of grapes

        The City of Los Angeles’ Innovation Fund, created by Mayor Eric Garcetti, has allotted $1 million in funds designated for city departments to test new ideas that could help the city improve operations.  Candidates should be technologically capable of increasing efficiency, improving the quality of life for people in L.A., and be feasible and measurable.  The Innovation and Performance commission, the organization that administers the funds, also supports innovation by fostering collaboration among innovators and civic leaders.


Inland Empire

        With a population of over 4 million, the Inland Empire region economy is enormous.  From 2010 to 2015, the region added 187,881 people, a gain of 4.4%, representing 12.9% of California’s total population growth.  2015 marks the third year in a row that Inland Empire is expanding by roughly 50,000 jobs, a historical first. Not only has the region reached new records in employment, its job quality is as good as it was before the recession.  
    
        Much of the economic success in the region can be attributed to the warehousing hub. This regional sector handles much of the goods coming in and out of the nearby ports en route to the rest of the country. With the volume of goods expected to double over the next 20 years,  the area should have a strong ripple effect on the rest of the regional economy.

        Although builders in the area have been doubling down on expansion by constructing new warehouses at a steady pace, some of the nearby ports are not yet equipped to handle the workload.  A failure to invest in innovative infrastructure is causing congestion and is disadvantaging U.S. ports.  As ships grow larger, U.S. ports are strained to accommodate their increasingly large loads.  Years of failing to invest in the latest equipment and technology has caused the U.S. to lag behind its foreign port peers, as demonstrated in the chart below.





        The most efficient ports in the U.S. move about 96 containers per hour while our Chinese counterparts move about 130.  Given this discrepancy, the U.S. container shipment industry is poised to lose market share unless it innovates.  Automation, supply-chain analytics, and bigger and faster cranes will drive the industry forward toward efficiency outputs on par with leading worldwide ports.  

        Warehouse development in the Inland Empire is also accelerating at a booming pace.  2015 will likely represent the best year for warehouse construction in Inland Empire history.  Amazon announced in April 2015 that it will be creating 1,000 new jobs at its three Inland Empire fulfillment centers.  In 2013, 23.3 million square feet of new industrial space was absorbed by the industry.  In 2014, it was an additional 22 million square feet.

        Logistics software allows these companies to route orders, track packages, and manage supply chains.   Mobile apps help crane operators stack containers, and new federal legislation puts pressure on truck manufacturers to increase fuel efficiency .  In the warehouse, robots pack boxes and RFID tags track inventory.  This and similar activities provide excellent opportunities for R&D Tax Credits.

        These technologies are increasingly practical as flexible, scalable, and sophisticated software, hardware, and robotic engineering are increasingly adaptable to the frequent changes in product design and operational strategies.


Conclusion

        The California economy is one of the most innovative in the world.  Recent changes to the federal R&D Tax Credit provide great opportunities for startups throughout the state which can now claim R&D tax credits to offset payroll taxes.  The California State R&D tax credit is also beneficial, with more claimed credits than any other state across all fifty states.   Companies should contact a tax professional about the federal and state R&D credits available to support and stimulate innovation efforts.

Article Citation List

   


Authors

Charles R Goulding Attorney/CPA, is the President of R&D Tax Savers.

Andrea Albanese is a Project Manager with R&D Tax Savers.

Michael Wilshere is a Tax Analyst with R&D Tax Savers.


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