How the R&D Tax Credit Carryforward (Unused Credits) Works for Businesses
Originally published on October 14, 2024
What Does “Carryforward” Mean for R&D Tax Credits?
Research & development (R&D) tax credits are among the most valuable federal and state incentives to spur innovation. But in many years—especially for start-ups or rapidly scaling firms—businesses may not have enough tax liability to use the full amount of those credits. That’s where the carryforward provision becomes critical: it lets companies carry forward unused R&D tax credits into future years so those credits retain value.
The Federal Carryforward Rule for R&D Credits
Under Internal Revenue Code §39, unused business credits (including R&D credits) may be carried back one year and carried forward up to 20 years.
- First, businesses can carry the credit back one year (if they had tax liability).
- Then they can carry it forward for up to 20 years.
- After 20 years, any remaining unused credits expire.
Example: A company earns $200,000 in R&D credit in 2024 but has only $100,000 of tax liability. It applies $100,000 now and carries forward $100,000 to future years.
Note: Certain limitations apply, including the IRC §38(c) and 25/25 rule for corporations with higher tax liabilities.
State-Level Carryforward Rules Vary
States vary widely in how they handle R&D tax credit carryforwards. Some match the federal 20-year rule; others are more or less generous.
Examples:
- California: Indefinite carryforward period
- Texas: 20-year carryforward
- New York: 10-year carryforward
- Massachusetts: 15-year carryforward
Companies with multi-state operations should consult a tax advisor to manage state-by-state credit utilization efficiently.
Who Qualifies for R&D Tax Credit Carryforward?
To claim the R&D credit and carryforward benefits, companies must meet the IRS’s four-part test:
- Permitted Purpose: Intent to improve functionality, reliability or quality of a product or process.
- Technological in Nature: Must rely on hard sciences (e.g., engineering, physics or computer science).
- Elimination of Uncertainty: Research aims to resolve technical uncertainty.
- Process of Experimentation: Involves testing, modeling or systematic trial-and-error.
Audit & Statute of Limitations for Carryforward Credits
Audits on R&D tax credits generally begin in the year the credits are used, not earned. If you carry forward 2024 credits to 2027, the IRS has the right to audit them beginning in 2027 (within a typical three-year statute of limitations). If fraud is suspected, the window may extend to six years.
This means technical and financial documentation must be retained for all years involved, even for credits applied years after they were earned.
Using Carryforward R&D Credits for Capital Gains Tax
Unused R&D credits can also reduce tax liability on capital gains. For companies that sell assets or ownership stakes, these credits can help reduce tax on gains from the sale.
Example: A tech startup with unused R&D credits sells the business in 2026. Those credits can offset capital gains taxes from the sale.
This adds another layer of strategic value to carrying forward R&D credits.
Why Carryforward Provisions Matter
The ability to carry forward unused credits can:
- Preserve cash flow
- Maximize long-term tax efficiency
- Encourage continued R&D investment
- Improve planning in years of uneven profitability
Startups, growing firms and companies with high R&D costs but inconsistent profits especially benefit.
Best Practices for Managing Carryforward Credits
- File IRS Form 6765 and Form 3800 properly.
- Track credit utilization over multiple years.
- Retain documentation for both R&D activities and expenses.
- Work with a tax expert to navigate federal and state rules.
Work With a Trusted Advisor
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. 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.
