The R&D Tax Credit Aspects of California
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:
- Be undertaken to discover
information intended to be useful to develop a new or
improved business component of the taxpayer.
- Qualify as a business under IRC
§174.
- Be undertaken to discover
information that is technological in
- 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.