Carryforward Tax Credits: Unused R&D Tax Credits and Their Lifespan

Research and development (R&D) tax credits are among the most valuable incentives provided by the federal government and many state governments to encourage innovation and technological advancement in businesses. For companies investing heavily in R&D activities, these credits can significantly reduce tax liabilities, freeing up capital for further innovation and growth.

However, it’s not uncommon for businesses — especially startups and companies in high-growth phases — to not have enough tax liability each year to fully utilize their earned R&D credits. In such cases, the ability to carry forward unused research tax credits becomes crucial, offering businesses future tax relief and enhanced financial planning.

What Is the R&D Tax Credit?

The R&D tax credit is a federal incentive designed to encourage companies to engage in research and development that leads to innovation. It is a dollar-for-dollar reduction in tax liability and applies to qualifying expenses related to R&D activities. Initially established by the Economic Recovery Tax Act of 1981, the credit has become a permanent provision under the Protecting Americans from Tax Hikes (PATH) Act of 2015.

The R&D tax credit applies to a wide range of industries, including manufacturing, technology, pharmaceuticals and software development. By offsetting federal and state taxes, this research credit incentivizes companies to reinvest in qualified research and development of new or improved products, processes, software or technology.

Understanding the R&D Tax Credit Carryforward

When a company earns R&D tax credits but is unable to use them in the year they are earned, they can carry forward these unused credits to future years. The IRS allows businesses to carry forward unused R&D tax credits for up to 20 years at the federal level. After the 20-year period, any remaining credits that haven’t been used will expire.

Let’s say that in a given year, a company earns $200,000 in R&D tax credits for costs and expenditures in 2024. However, it has only $100,000 of taxable income that year. It can apply $100,000 of the credit to offset its current tax liability and carry forward the remaining $100,000 into future years to offset tax liabilities on future tax returns.

By carrying forward unused credits, companies can maximize the benefit of the R&D tax credit, especially in periods of uneven profitability or high R&D investment.

State-Level Carryforward Provisions

While the federal government provides a clear guideline for the 20-year carryforward of unused R&D tax credits, state regulations vary widely. Many states offer R&D tax credits in addition to the federal research credit, but the rules for carrying forward unused credits differ. Some states mirror the federal 20-year carryforward period, while others offer shorter or longer periods. A few states also allow indefinite carryforward of unused credits, enabling businesses to use them whenever they become profitable enough to do so.

Here are a few examples of carryforward periods for R&D tax credits at the state level:

• California: Unused R&D tax credits can be carried forward indefinitely.
• Texas: The state allows a 20-year carryforward period, similar to the federal rule.
• New York: R&D tax credits can be carried forward for up to 10 years.
• Massachusetts: Unused credits may be carried forward for 15 years.

It’s important to consult a tax advisor who is familiar with both federal and state tax laws to ensure you maximize the value of your R&D tax credits across jurisdictions.

R&D Tax Credit: The Four-Part Test

Not all activities qualify for the R&D tax credit. To determine eligibility, companies must meet a four-part test outlined by the IRS:

1. Permitted Purpose:

The activity must be intended to create a new or improved product, process, software or invention. The goal must be to improve functionality, performance, reliability or quality.

2. Technological in Nature:

The activity must rely on principles of hard sciences such as engineering, physics, chemistry, biology or computer science. In other words, it should be based on technical expertise and innovation rather than common knowledge or business intuition.

3. Elimination of Uncertainty:

The research must aim to eliminate technical uncertainty about the development or improvement of a product or process. This means the company is working to determine how to achieve the desired result or whether achieving it is even possible.

4. Process of Experimentation:

The activity must involve a process of experimentation. This can include testing, modeling, simulation or systematic trial and error to resolve uncertainties.

If your company’s R&D activities meet these four criteria, you may qualify to claim the credit (subject to applicable federal and state laws). If the qualification criteria seem complex, it’s advisable to consult a tax professional to ensure compliance and avoid missed opportunities.

Audit Period and Statute of Limitations

It’s essential for companies to understand the audit period and statute of limitations when claiming R&D tax credits, as this impacts when and how credits are scrutinized by tax authorities. The audit period begins in the year the credits are used to offset tax liability, not when the credits are earned. For example, if a company carries forward unused credits from 2024 and applies them in 2027, the IRS has the ability to audit the credits starting in 2027, with a typical statute of limitations of three years from the time the return is filed.

However, if the IRS or state authorities suspect fraudulent activity or significant underreporting of income, the statute of limitations could extend up to six years. As such, maintaining accurate records and detailed documentation for all qualifying research and development activities is critical, even if credits are carried forward to be used in later tax years.

Using R&D Tax Credits to Offset Capital Gains

Another advantage of R&D tax credits is their flexibility in offsetting not only ordinary income tax but also capital gains. If a business experiences significant capital gains, such as from the sale of assets, investments, or other property, unused R&D tax credits can be applied to reduce the associated tax liability. This adds a layer of financial flexibility for companies, particularly those involved in asset-heavy industries or those realizing gains from strategic investments.

What makes this option particularly valuable is that the same R&D credits generated by the business can be applied to offset capital gains taxes from the sale of that business or its assets. For example, if a company engages in substantial R&D over several years (thereby earning R&D tax credits) and eventually sells the business or related assets, those unused R&D credits can be used to reduce the capital gains taxes owed on the sale.

Here’s an example: Suppose a tech startup has earned significant R&D tax credits over several years’ worth of research and development costs. When the owner decides to sell the business, the sale results in substantial capital gains. The unused R&D tax credits generated by the business’s research activities can now be applied to offset the capital gains tax liability from the sale, reducing the overall tax burden.

By allowing businesses to offset capital gains tax, the R&D credit serves as an additional tool in tax planning, helping companies manage both operational and investment-related tax burdens. This capability can be particularly useful for startups, high-growth companies or firms that frequently engage in mergers, acquisitions or asset sales as part of their business model.

Why Carryforward is Important

For companies in their early stages of growth or those investing significantly in R&D but not yet realizing significant profits, the ability to carry forward unused R&D tax credits provides flexibility and financial relief. The carryforward mechanism allows these businesses to “bank” the credits until future tax years, when they have enough taxable income to offset — ensuring the long-term value of the credits is not lost.

Moreover, the financial benefit of carrying forward credits provides companies with several advantages:

Cash Flow Preservation

By carrying forward R&D credits to offset future tax liabilities, companies can conserve cash, which is particularly valuable for businesses still in growth or scaling phases.

Increased Financial Planning

Knowing that unused R&D credits can be carried forward allows companies to plan their tax liabilities strategically and optimize cash flow management over time.

Increased Competitiveness

As businesses grow and innovate, utilizing carryforward credits ensures they can reinvest in further R&D, ultimately keeping them competitive in their industries.

Maximizing R&D Tax Credits: Consult an Expert

Navigating the intricacies of the R&D tax credit, including the four-part test, carryforward provisions and the application of credits to capital gains, requires careful attention to detail. It’s essential to properly document qualifying activities and expenditures to ensure compliance with IRS regulations. Additionally, with different states applying varied rules for credit utilization and carryforward periods, having a comprehensive understanding of both federal and state laws is crucial.

For companies looking to fully capitalize on the R&D tax credit — whether to reduce their current tax year liability or to carry forward unused credits — consulting a tax expert is advisable. An experienced tax advisor can assist in determining eligibility, ensuring accurate filing and developing a long-term strategy to maximize the value of both federal and state R&D tax credits.

James Moore & Co.: Your R&D Tax Credit Experts

If you’re unsure whether your company qualifies for the R&D tax credit or how to handle unused credits, consult the experts at James Moore & Co., a Florida-based full-service CPA firm. Our R&D tax credit expert, Lucia Valenzuela, and her specialized team specialize in guiding businesses through complex tax matters, including R&D tax credits and their carryforward provisions.

Reach out to James Moore for personalized advice on maximizing your R&D tax credit potential, and let our team help you turn your innovations into tangible savings — for this tax year and in the future!

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.