Arizona is one of the only states that offers a true refundable R&D tax credit. Being refundable refers to the taxpayer not needing any state tax liability to monetize the credit. The state simply would send the taxpayer a tax refund reflecting the credit amount.
Under the R&D refundable tax credit program, the Arizona Commerce Authority (ACA) has been given the authority to approve up to $5 million in refunds each year. The refund is allocated on a first-come, first-served basis, with applications available the first business day in January. All submitted applications must be based on actual numbers and not estimates.
Refundable Tax Credit Cap
Beginning in 2019, the ACA began capping its refundable tax credit for R&D activities performed in Arizona at $100,000 per taxpayer. Despite the authorized $5 million in refundable credits, available funds have been known to deplete rapidly after the credit application opens. With companies looking to increase cash flow, this program becomes more competitive each year.
To help navigate the highly competitive and complex refund application process, it’s important to work with essential business advisors who have extensive knowledge and experience with this program.
The Arizona refundable R&D credit is especially beneficial when used in conjunction with the federal R&D credit or the Employee Retention Tax Credit (ERTC, sometimes referred to as the ERC credit).
The federal R&D credit currently allows certain companies to use up to $250,000 of their credit to offset payroll taxes, which was increased by the Inflation Reduction act to $500,000 for tax years beginning after December 31, 2022. While not a true refundable credit, it allows companies with losses to monetize the credit by using it to offset payroll taxes that are incurred regardless of profitability. In addition, companies that don’t meet the qualification criteria for the payroll credit offset may still use R&D credits against income tax liability, with unused credits carrying forward.
Between the federal and Arizona incentives, many eligible companies could see their combined credits amount to upwards of 19% of their qualified development costs for the year.
R&D Credit Overview
Arizona allows companies to elect to treat 75% of the state R&D credit as refundable, forfeiting 25%, or carry forward the credit for up to 15 years until it’s utilized.
Companies that wish to apply for the Arizona Refundable R&D Credit must have fewer than 150 full-time equivalent employees.
For companies to be eligible for the federal R&D credit payroll offset, they need to meet two criteria. They must:
- Not have had any gross receipts prior to five years ago
- Have less than $5 million in gross receipts in the current tax year
Required Development Activities
In addition, the companies must be conducting development activities that meet the following four requirements:
- Technological in nature. Experimentation processes must rely on physical, biological, computer sciences, or engineering.
- Qualified purpose. Research must intend to create a new or improved product or process that increases performance, reliability, or quality.
- Technical uncertainty. Activities must aim to overcome technical uncertainty concerning capability, method, or appropriate design of a new product or process.
- Process of experimentation. Activities must include developing hypotheses, designing and conducting tests, and evaluating alternatives.
Businesses may include several cost categories when applying for the credit including the following:
- Employee wages for those who spend time performing R&D, including supervision or direct support of activities
- Supplies and materials used in the conduct of qualified research
- Contract research for hired consultants, outside testing facilities, equipment designers and manufacturers, and more
- Expenses for cloud services, such as AWS and Azure, used in the performance of R&D
Combining with the ERC Credit
The Coronavirus Aid, Relief, and Economic Security (CARES) Act provided an opportunity for eligible employers to generate a refundable tax credit used to offset their employment taxes and request a refund for any excess credit generated—a substantial benefit for eligible companies.
Eligibility can be acquired by partial suspension of business resulting from government order or gross receipt reductions that meet certain thresholds. For additional information on the eligibility criteria and overall benefit, review eligibility guidelines for the ERC credit.
Filing for the Arizona R&D credit requires multiple steps, as the business must register with the ACA and also file for a certificate of qualification. This requires completing an application for the certificate, providing estimated tax liabilities without the R&D credit, and completing the R&D credit calculation on Arizona application forms.
The credit application process requires a significant amount of complex documentation, so it’s important to make sure all documents are properly accounted for and organized. Applicants often incorrectly complete or omit required documentation, disqualifying their application and allowing credits to be claimed by other applicants before they have the opportunity to make corrections.
Even with opportunity for more companies to claim the credit this year, the application process will remain extremely competitive and the first-come, first-served policy is strictly enforced by submission timestamps.
We’re Here to Help
To learn more about how your business can benefit from the Arizona refundable R&D credit, other cash flow strategies, or information regarding your State & Local Taxes, contact your Moss Adams professional.
Special thanks to Austin Arcala, Manager, R&D Tax Services for their contributions to this article.