Accounting Corner

r & d tax credit - can construction & engineering companies really qualify?

By: louis sandor iii, cpa, ccifp, partner & peter sullivan, CPA

You may not be aware that your company may qualify for federal and state research and development (R&D) tax credits. We are not talking about the white lab coat drug research programs that can cost millions of dollars with no definitive ability to recoup costs until an approved drug is developed. Instead, we are talking about your everyday activities to construct something or being involved in constructing something. But beware, claiming credits requires a thorough contract review to determine experimental risk and rights of research.

Originally introduced in the Economic Recovery Act of 1981, the R&D credit covers expenses paid or incurred for qualified research. The research must be undertaken to discover technological information and must be intended to develop a new or improved business component for the taxpayer. All activities of the research must be substantive elements of a process of experimentation to improve function, performance, reliability, or quality.

The R&D credit can be utilized by mainly two means: a payroll tax offset for small business taxpayers or a dollar-for-dollar income tax reduction. Taxpayers may be eligible for the Qualified Small Business Tax Credit if their gross receipts are less than $5 million in the year the credit is taken and they incurred gross receipts for five or fewer years. The payroll tax credit offset cannot exceed $250,000 and may be used against the employer portion of social security liability. Those not eligible for the Qualified Small Business Tax Credit may be eligible for the regular R&D credit, but it is important to note that these taxpayers must incur federal or state income taxes in order to monetize the credit. In the first year of taking a credit, the taxpayer may be able to look back to the three prior years to claim the credit. Any unused credit carries over for twenty years.

In recent years, The Internal Revenue Service (IRS) created a four-part test to define what qualifies as research activities for the credit:

1) Technological in Nature Test – The process of experimentation used to discover information must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement.

2) Permitted Purpose Test – The purpose of the research must be to create a new or improved product or process resulting in increased performance, function, reliability, or quality.

3) Technical Uncertainty Test – The activities are intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.

4) The Process of Experimentation Test – The activity seeks to eliminate or resolve a technical uncertainty which involves an evaluation or alternative solutions or approaches and is performed through modeling, simulation, systematic trial and error, or other methods.

Once the four-part test has been met, one must identify the cost of qualified activities to compute the credit. Expenses that qualify include wages paid to an employee engaging in qualified research activities, supplies used or consumed during qualified activities, and any expenses paid to third party contractors who assist with the qualifying activity. Research expenses conducted outside of the United States or its territories, research funded by another party, ordinary product testing, market research, and aesthetic cosmetic design do not qualify. Construction activities that are novel and innovative in nature that may qualify for the R&D credit include the following:

• Preparing structure and facility design for constructability

• Developing and improving construction equipment development

• Designing LEED/green initiatives

• Designing HVAC systems

• Designing electrical system design

• Utilizing Building Information Modeling (BIM) for sub-system coordination

• Analyzing the functions of a design directed at improving performance, reliability, quality, safety, and/or life cycle costs

• Performing Request for Information Process (RFIs)

• Improving mechanical equipment sizing

By now you are saying “yeah we do that, so why haven’t we taken this credit?” Well hold on, the devil is in the details of the contract review. The IRS or state taxing authorities will not grant you tax credits for simply doing your job according to the contract. There must be an element of trial and error, design or redesign, uncertainty, experimentation, or problem solving. There must also be risk, such as incurring the above with the uncertainty of reimbursement. Be on the lookout for costs incurred on out-ofscope work, job margin fades, cost overruns, and change orders. Contract language that clearly allows for the contractor’s reim-

Construction and engineering firms should be cognizant of the potential risks and issues in claiming R&D credits. Identifying the business component can be challenging for construction companies. For instance, if the construction company employs engineers to perform R&D on behalf of a third party, the contractor must have both economic risk with respect to the research and substantial rights to the results of the research. As such, contract analysis is essential when determining R&D. The determination of which party has the rights and risks usually depends upon which party retains ownership over the design schematics, developed processes, and related intellectual property. This can be leveraged and discussed during contract negotiations between construction companies and their customers.

Lastly, one of the most critical aspects of the R&D credit is ensuring proper contemporaneous documentation. A taxpayer must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. The taxpayer must also clearly establish full compliance with all relevant statutory and regulatory requirements. Failure to maintain records in accordance with these rules is a basis to disallow the credit and incur potential penalties.

For additional information regarding the next steps of determining if the R&D credit may apply to your projects, please contact Louis Sandor III, CPA, CCIFP (lsandor@withum.com).