The R&D Tax Aspects of Los Angeles Innovation



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Los-Angeles-Innovation
        The hottest industry in Los Angeles may no longer be entertainment, as in recent years the city's tech scene has emerged and grown at a rapid pace.  Attracted by the city's weather, nightlife, abundant transportation choices, and quantity of talent, tech firms (both large and small) are choosing L.A. as an operating base. From a tax standpoint, the more time developing new products and technical services, the greater the likelihood that companies will qualify for both federal and California R&D tax credits.

 

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 19, 2014, President Obama signed the bill extending the R&D Tax Credit for the 2014 tax year.  

        Companies in a wide variety of industries may be eligible for R&D tax credits. Such industries may include (but are not limited to): manufacturing, software and information technology, biotech, food processing, pharmaceutical, and logistics.


Recent L.A. Tech Trends

        The tech industry in Los Angeles has rapidly grown in recent years, as the area has seen a surge in both the number of startups and tech financing deals. The startup investor website AngelList current has over 6,000 startup member companies in the Los Angeles area and over 14,000 investors members looking to invest in these startups.

        According to the venture capital database CB Insights, more than $4.5 billion has been invested into L.A. tech companies since 2009 across a variety of sectors, the largest of which has been internet-based companies.
The number of investment deals for L.A. tech firms has increased every year in recent history, with more than 300 deals taking place in 2013.



Source: CBInsights.com


Los Angeles Now a Major Tech Hub

        Despite being relatively a new tech scene, the Los Angeles area's strong growth has now made it a major tech hub. In a recent study from Upfront Ventures, the Los Angeles area has the third highest share of early-stage startups in the country, and is currently the fastest growing.

        Because of this recent growth, 9% of the Los Angeles work force now works in high-tech. This 9% accounts for 17% of the area's total wages, with L.A. high-tech workers earning 67% more on average than those employed in other industries. Since the  end of the recession, numerous high tech industries in the L.A. area have seen significant growth in employment.


L.A. Growth in Employment: Select Tech Industries

Category
2009-2013 Growth
Internet Publishing, Broadcasting, Web Search 27.0%
Pharmaceutical & Medicine 14.7%
Data Processing, Hosting & Related 8.4%
Computer Systems Design & Related 7.0%
Aerospace Product & Parts 5.8%



        Since 2012, more than 250 companies based in the Los Angeles area have raised more than $1 million in funding, with some of the most notable being Snapchat, The Honest Company, SpaceX and TrueCar. The amount of activity in the region has caught the attention of venture capitalists, entrepreneurs, and job-seekers looking to reap the benefits of the Los Angeles tech environment.


Contributing Factors and Future Growth

        The recent growth in the Los Angeles tech scene can largely be attributed to the prolific entrepreneurial spirit of its residents and abundance of local talent available.

        A 2014 study by the Kauffman Index of Entrepreneurial Activity listed the Los Angeles-Long Beach-Santa Ana area as having the second highest entrepreneurship rate in the country, with 490 entrepreneurs per 100,000 individuals. This is approximately 14% higher than the third highest amount (Miami), and 19% more than that of the New York City area. The entrepreneurial spirit that has long been prevalent within the Los Angeles arts and service industries has now spread to its emerging tech industries.
 
        When it comes to the sustaining the recent trends experienced within the Los Angeles tech scene, the area is ripe with talent to fuel future growth. The L.A. metropolitan area has the highest total amount of engineers of any U.S. metropolitan area, with approximately 70,000.  

        Additionally, local colleges and specialized schools are expected to be key factors in future growth. With highly ranked engineering programs that include Harvey Mudd College, Caltech, UCLA and USC, technical talent is available in the Los Angeles area to fill and create future tech jobs.

        In recent years, the Los Angeles Unified School District (LAUSD) has seen a sharp increase in applications to the district’s 150+ magnet programs, many of which are focused in sciences and applied mathematics. Currently, over 50,000 students are enrolled in LAUSD public magnet schools, with thousands more in specialized private schools throughout the area.  

        Many of these schools provide an interactive and collaborative learning environment, showing a shift from 20th century textbook passive learning to research-driven, active learning emphasized by 21st century educators. With these specialized schools potentially serving as feeder schools to the abovementioned colleges and universities, the quantity of homegrown talent in technological fields will likely see a significant increase in the next decade.


The Added California Benefit

        For over 20 years, companies in California have taken advantage of the state's Research and Development 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, contractor research expenses, and patent related 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 Credit must meet the following tests:

  1. Qualify as a business under IRC §174.
  2. Be undertaken to discover information that is technological in nature.
  3. Be undertaken to discover information intended to be useful to develop a new or improved business component of the taxpayer.
  4. Substantially all (at least 80%) of research activities involve a process of experimentation.

        Claimed California R&D credits 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.



 

Incubators and Accelerators

        Coinciding with the growth in startup activity, a rise in the formation of local accelerators and incubators has taken place in recent years to provide the necessary funding and expertise to help these startup firms grow.

Several notable organizations in the area providing support to startup firms include:

  • Amplify: four month program that provides free workspace and professional services to member companies, in addition to mentorships and educational workshops
  • Idealab: provides capital and a full range of resources to selected companies; 40 of its member companies have been acquired or successfully filed for IPOs
  • TYLTLab: provides capital and business planning, marketing and consulting services to early-stage startups
  • Media Camp: three month program that provides weekly workshops and networking events for companies with a focus in media technology

        Additionally, numerous colleges in the area have launched incubator programs to offer services and resources for companies founded by alumni and current students.  These programs (along with many others not listed) provide invaluable opportunities for founders and employees of Los Angeles startups to learn business skills, meet key people, and hone their technological crafts.


Conclusion

        Los Angeles tech industries are innovating at a rapid pace. Companies in the area are spending billions on a wide array of research and development activities, making both the federal and California R&D tax credits lucrative to pursue. These companies that are creating highly innovative products and processes should consider these tax credit opportunities not only as a way to provide a tax benefit to shareholders, but also to fund future activities.

Article Citation List

   


Authors

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

Raymond Kumar is a CPA and Tax Manager with R&D Tax Savers.

Melissa Chin is a Tax Analyst with R&D Tax Savers.


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