The Research and Development Tax Credit: Federal and California

California Is a Different Calculation

California’s conformity date is January 1, 2025 under SB 711 — before OBBBA — so the state does not adopt Section 174A. But the practical result is the opposite of the usual California disadvantage.

California retains Section 174 as it stood in 2015, meaning it never adopted the TCJA amortization requirement in the first place. Both domestic and foreign research costs remain fully deductible for California purposes. On this issue, California is more favorable than federal law, and the domestic/foreign distinction that now governs the federal return simply does not exist on the state one.

SB 711 Rewrote the State Credit Methods

For tax years beginning on or after January 1, 2025, the California credit works like this:

• Regular credit — 15% of California QREs above the base amount, plus 24% of basic research payments
• Alternative Simplified Credit — newly available, at a California rate of 3% against the federal 14%; a reduced 1.3% rate applies where there were no QREs in one of the three prior years
• Alternative Incremental Research Credit — repealed and no longer available

Three consequences follow, and they are time-sensitive:

Taxpayers who used the AIRC must actively choose a new method. The repealed election does not roll into anything by default.

The election is binding and must be made on a timely filed original return. This is not a position that can be optimized later on an amended return, which is a departure from how many businesses have historically approached the credit.

The ASC opens the credit to businesses previously shut out. Companies with large gross receipts or an unfavorable base period frequently generated no California credit under the regular method. The 3% ASC can produce a credit where none existed before — worth modeling even for businesses that concluded years ago that California was not available to them.

Other California specifics: the credit is claimed on FTB Form 3523, is nonrefundable, and carries forward indefinitely. Research must be conducted in California to count. A $5 million annual credit usage cap applies for 2024 through 2026, with an irrevocable election on Form FTB 3870 to convert disallowed amounts into a refundable stream. And California does not conform to the federal Section 41(h) payroll tax offset, so a pre-revenue startup electing to apply the federal credit against payroll taxes gets no equivalent state benefit.

Documentation and Audit Exposure

The credit is examined often, and claims fail on records rather than on the merits of the science.

What holds up: contemporaneous project documentation identifying the business component and the uncertainty at the outset; time tracking allocating wages to specific qualified projects; design records, test protocols, and failure logs showing the process of experimentation; and contracts establishing who bore financial risk and who holds rights to the results.

What does not: a percentage of payroll estimated after year-end, a promoter’s questionnaire completed retroactively, or a narrative written to describe work no one documented while it was happening.

Two recurring examination themes. First, funded research — the government reads contracts closely for who bore the risk. Second, the Section 280C election, which reduces the credit in exchange for preserving the full deduction; the interaction with Section 174A expensing should be modeled deliberately rather than defaulted.

Federal credit examinations also carry state consequence. Because you must report federal adjustments to the Franchise Tax Board within six months under R&TC 18622 — and failing to report leaves the California assessment window open indefinitely — a federal R&D adjustment left unreported becomes a state assessment years later. Our business tax audit page covers examination defense.

Who Actually Qualifies in Southern California

The credit is not limited to laboratories. Regional businesses that routinely qualify include software and firmware developers, medical device and biotech companies across the San Diego corridor, aerospace and defense subcontractors, contract manufacturers developing new tooling or processes, food and beverage producers reformulating products, and engineering firms solving design problems where the method was not known at the outset.

Construction and architecture firms sit in a harder position. Work performed to a customer’s specification under a contract where the customer bears the risk is generally funded research. The analysis turns on contract language, which means it is worth reviewing before the contract is signed rather than at filing.

Frequently Asked Questions

Can I still amend 2022–2024 returns for retroactive R&D expensing?

For most filers, no. The small business election under Rev. Proc. 2025-28 was due by the earlier of July 6, 2026 or the Section 6511 refund window. Going-forward expensing under Section 174A remains available for 2025 and later.

Does California follow the federal R&D expensing rules?

No — and here that favors the taxpayer. California retains pre-TCJA Section 174, so both domestic and foreign research costs remain fully deductible for state purposes.

What happened to the California AIRC method?

SB 711 repealed it for tax years beginning on or after January 1, 2025. Taxpayers who used it must affirmatively elect the regular credit or the new 3% ASC on a timely filed original return.

Can I claim the California credit without claiming the federal one?

Yes. The state credit is independent, though the research must be performed in California.

Does my company need a laboratory to qualify?

No. The test is technological uncertainty resolved through experimentation. Software development, process engineering, and product design routinely qualify; the constraint is documentation, not setting.

What is funded research and why does it disqualify claims?

Research paid for by a customer who bears the risk of failure and holds rights to the results. The contractor generally cannot claim the credit on it, which is why contract terms should be reviewed before signing.

What is the $5 million California cap?

For 2024 through 2026, California limits annual business credit usage to $5 million. Disallowed credits carry forward indefinitely, and an irrevocable Form 3870 election can convert them into a refundable stream.

Model Both Regimes Before You File

The federal and California credits now diverge on method, rate, expensing treatment, and the geography of qualifying research — and the California election is binding once the original return is filed. That makes the credit a planning item with a hard deadline rather than a filing-season computation.

Pietro Canestrelli holds an LL.M. in Taxation and advises businesses on credit qualification, documentation standards, and federal and state examination defense. Schedule a consultation, or read more about our corporate tax and Section 179 planning work.