The Colorado research tax credit rewards taxpayers for incurring research expenses in Colorado.
Qualified Research Activities
Most state research tax credits incorporate or are based on the definition of qualified research activities in the federal research tax credit. The federal research tax credit defines qualified research activities using a four-part test. It also includes several limitations. A handful of state research tax credits only adopt some of the federal requirements and very few or none of the exclusions set out in federal law. A few states implement custom definitions. In addition, the research tax credits for most states are limited to research activities that occur within the state. A few state statutes limit their tax credits to activities performed within specific geographic areas within the state.
The Colorado research tax credit only adopts the first of the four requirements provided in the federal definition of qualified research activities, namely, that the expenses meet the definition of research and experimental (“R&E”) expenditures under I.R.C. § 174. Section 174 allows taxpayer’s to elect to currently deduct or amortize R&E expenditures. There are additional requirements that make it more difficult to currently deduct the expenditures. The federal research tax credit requires taxpayers be able to currently deduct their R&E expenditures; the Colorado research tax credit does not. This allows taxpayers to claim credit for research activities that would not qualify for the federal research tax credit or for the research tax credits provided by many other states. In addition, interestingly, the Colorado statute does not limit the credit to research activities conducted in Colorado; instead, the credit is limited by the location where the expenses are made.
Qualified Research Expenses
Most state research tax credits incorporate or are based on the definition of qualified expenses in the federal research tax credit statute. For purposes of the federal research tax credit, qualified research expenses can include wages, contractor, supply, and computer rental expenses. Other states have custom definitions of what expenses are qualified. In addition, the research tax credits may be limited to expenses incurred within the state or certain geographic areas within the state. As mentioned previously, the Colorado research tax credit only requires the expenses qualify as R&E expenditures under I.R.C. § 174. To qualify, the expenses must be made in one of the enterprize zones in Colorado (as identified by the Colorado Office of Economic Development). This peculiar requirement seems to say that the expense can be made in (or sourced to) an enterprize zone even though the research activity is not carried out in the enterprize zone. This may be an oversight that the State of Colorado may rectify in the future.
Definition of Gross Receipts
The research tax credits many states is computed by comparing the taxpayer’s qualified research expenses to their gross receipts for one or more years. For example, the federal research tax credit compares the taxpayer’s qualified research expenses in the current year with its gross receipts for the prior four years. The gross receipts may be limited to receipts or income from property owned or from business conducted in the state or those derived from the sale of property that is sold to customers in the state. The Colorado research tax credit is not based on the taxpayer’s gross receipts.
Research Tax Credit Percentage
Research tax credits are often a percentage of the taxpayer’s qualified research expenses. The percentage varies from state to state; generally ranging from 1 to 20 percent. The Colorado research tax credit equals 3 percent.
Research Tax Credit Dollar Limitation
A number of states impose a dollar limit on the amount of expenses that can qualify for the research tax credit. Other states limit the amount of their research tax credits that taxpayers can claim in any one tax year. The Colorado research tax credit is limited to 25 percent of the amount of the credit. Taxpayers can claim the remaining 75 percent of the credit in 25 percent increments during the next three years.
Incremental or Non-Incremental Research Tax Credit
Most state research tax credits are incremental. This refers to the credit being conditioned on the taxpayer increasing its research spending in the credit tax year and some specific prior tax year or years. The prior tax years are often referred to as the “base period.” Many states adopt the federal base period tax years of 1984 through 1989, or later years if the taxpayer did not exist or began its research activities after 1991. Other states identify a number of years prior to the credit year as the base period tax years. A few states have non-incremental research tax credits which simply reward taxpayers for incurring qualified research expenses. The Colorado research tax credit is incremental; however, unlike the federal research tax credit, the base period tax years Colorado research tax credit are the two years preceding the credit year.
Research Tax Credit Carryback and Carryforward
Most states allow unused research tax credits to be carried back and forward for one or more tax years and forward indefinitely. These credits can then be used to reduce tax liabilities in the other tax years. Other states require research tax credits to be used within a set period of time. Research tax credits not used within this time simply expire. The Colorado research tax credit cannot be carried back; however, unused credit can be carried forward to future tax years.
Refundable Research Tax Credit
A few states have refundable research tax credits. Refundable tax credits can be used to obtain a refund of taxes even if the taxpayer is not obligated to pay any tax to the state. Non-refundable tax credits can only be used to reduce the taxpayer’s state tax liability. The Colorado research tax credit is not refundable.
Some states only allow taxpayers research tax credits if they create and retain specific documents. This may require the taxpayer to develop and retain records that identify the taxpayer’s research expenses and, in some cases, the research activities. Other states expressly or implicitly adopt the general documentation requirement for the federal research tax credit. This general requirement essentially says that the taxpayer is to keep sufficient records to substantiate its research tax credits. It does not identify any specific documents that must be developed or retained. The Colorado research tax credit adopts the general substantiation requirements imposed on the federal research tax credit.