As a hardware startup in the R&D phase, how can I save money?

Kruze Consulting Startup Q&A Author
Vanessa Kruze Founder, CPA

If you are a hardware startup that’s in R&D mode and purchasing physical goods in CA, you should absolutely be taking advantage of the California Manufacturing and R&D Partial Exemption. These exemptions were put into place in 2014 by the CA Board of Equalization and can save you hundreds of thousands of dollars.

When were talking about R&D Tax Credits, a lot of founders just consider the payroll tax credit. The Sales Tax Exemption is something much different, and can have a major impact on hardware and manufacturing startups.

First, a quick primer on Sales Tax and Payroll Taxes - two taxes even cash-burning startup pay! All companies pay payroll taxes every pay cycle, and companies also pay sales taxes when the purchase goods. So if a biotech startup is paying employees, it is paying payroll taxes. If a biotech startup purchase equipment, it pays sales taxes. R&D Payroll Tax Credits are filed on your annual tax return and get you refunds on your payroll taxes, whereas R&D Sales Tax Partial Exemptions get you a bargain rate on your R&D equipment purchases. Think refunds (R&D payroll tax credit) vs discounts (R&D sales tax partial exemption).

Here’s a quick comparison the R&D Payroll Tax Credit vs R&D Partial Sales Tax Exemption

R&D Payroll Tax Credit vs R&D Partial Sales Tax Exemption

I’ve compiled a few FAQ from our founders which I’ve shared here.

How much can my startup save with the California Manufacturing and R&D Partial Exemption?

The savings are significant and you should definitely work with your startup CPA to capture the exemptions. The key thing to remember here is that this is a partial exemption - not a full one.

The current Partial Exemption Rate is 3.3125% plus any district tax, and most CA based startups would otherwise be paying a ~8.5% sales tax rate. In other words, you can save 50% on your startup taxes :)

Let’s break it down: if you are a San Francisco based hardware startup, you are subject to an 8.5% sales tax rate. That’s comprised of:

  • California = 6%
  • SF County 0.25%
  • SF City (Special) = 2.25%
  • = 8.5% Total SF Sales Tax Rate

Now let’s say you purchased $5,000,000 worth of R&D materials in 2018.

With R&D Tax Exemption:

  • You purchased $5,000,000 worth of R&D materials in 2018, shipped to your SF HQ.
  • SF imposes an 8.5% sales tax rate
  • You paid $425,000 in sales tax
  • Total purchase price $5,425,000

Without R&D Tax Exemption:

  • You purchased $5,000,000 worth of R&D materials in 2018, shipped to your SF HQ.
  • SF imposes an 8.5% sales tax rate, but you got yourself an R&D Exemption. Hence, your effective rate is 3.3125% + 2.5% = 5.8125%
  • You paid $290,625 in sales tax
  • Total purchase price $5,290,625
  • YOU SAVED $134,375!!! ($425K-$290K) Take your startup CPA to a steak dinner!!!

Is there an annual maximum for the R&D Partial Sales Tax Exemption?

Yes, there is a $200 Million annual limitation. Considering that this could save you ~4% in sales tax, that equates to an estimated $8M annual savings.

When does this exemption apply or take effect?

Jul 1 2014 - June 30 - 2022

Is my startup eligible for the California Manufacturing and R&D Partial Exemption?

You do have to meet certain criteria to apply. Here are the 3 main criteria:

  1. You Must Be a “Qualified Startup”: Your startup is primarily (+50% of time) engaged in R&D activities and usually covers that companies in the manufacturing, biotech, and engineering industries. More specifically, they’ve classified themselves with the North American Industry Classification System (NAICS) in these codes:
    1. Manufacturing Codes 3111 to 3399
    2. NAICS Code 541711: R&D in BioTech
    3. NAICS Code 541712: R&D in the Physical, Engineering, of Life Sciences
  2. Purchase Qualified Property: up to $200M. This includes:
    1. Machinery, Equipment, Tools
    2. Computers, Software, Parts
    3. Note that this “Qualified tangible personal property” does not include: equipment with a useful life of less than one year or property used primarily for General & Administrative purposes.
  3. Use that Property in a Qualified Manner
    1. Within the R&D process
    2. Within the manufacturing process
    3. To maintain or repair the above equipment

Where can I find my NAICS code? Who filed that for me?

Your tax CPA would have listed your NAICS code on you annual tax return, Form 1120. Got to Page 4, Sch K, 2a.

My NAICS code

My NAICS code is not in that range… am I now ineligible? What to do?

You are fine. There is no need to amend tax returns or contact tax agencies. As long as an “establishment” of your business is engaged in true R&D activities and is eligible, you are good to go as is.

OH NO! My startup is eligible but I didn’t take the R&D credit/refund and I paid the full sales tax rate! What to do??

If you paid tax at the full rate, you can obtain a full refund credit from the vendor or obtain a credit with the BOE. First things first, work with your startup CPA. A retroactive credit or refund is still possible.

How do I document a California Manufacturing and R&D Partial Exemption? How do I make this happen?

Fill out this form. Does it have to be this exact form? No. Technically, it just has to have these items, per the CA BOE: Any document may be regarded as a partial exemption certificate as long as it contains the following:

  1. the signature of the purchaser, the purchaser’s agent, or the purchaser’s employee;
  2. the name address, and telephone number of the purchaser;
  3. the purchaser’s seller’s permit number, or if the purchaser is not required to hold a seller’s permit, a notation to that effect and the reason;
  4. A statement that the property purchased is:
    1. to be used primarily for a qualifying activity, or
    2. for use by a contractor performing a construction contract for a qualified person
  5. A statement that the purchaser is:
    1. a qualified person primarily engaged in a qualifying line of business, or
    2. a contractor performing a construction contract for a qualified person.
  6. A statement that the property purchased is qualified tangible personal property
  7. A description of the property purchased
  8. The date of execution of the document
CPA Disclaimer:
References:
https://www.cdtfa.ca.gov/industry/manufacturing-exemptions.htm

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