Research and Development Tax Credit Rewards Innovative Construction Companies
Many people think that research and development tax credits are reserved for scientists, medical researchers, and others wearing white lab coats. In fact, many of the activities performed by contractors and subcontractors in the construction industry qualify, and that can translate into significant tax savings. With a better understanding of this opportunity, construction companies may be able to claim tax credits for research and development activities they may already be doing.
Tax credits reward innovation
The research and development (R&D) tax credit was originally enacted into law in 1981 to prompt companies to increase investments in developing new or improved products, processes, software, techniques, and formulas in the United States. Since its inception, the tax credit has expired several times. However, in 2015, the Protecting Americans From Tax Hikes Act (PATH Act) made the credit a permanent part of the tax code and expanded its benefit for certain small businesses and startups.
When tax reform proposals started moving forward in late 2016 to early 2017, some in the tax community wondered if the R&D tax credit would be affected. When President Trump signed the Tax Cuts and Jobs Act (TCJA), select business tax provisions were modified or repealed, but the Section 41 research credit survived. This was a clear indication that Congress wanted to reward companies that spend money to innovate.
Tax credit eligibility requires qualified research activity
The R&D tax credit incentivizes a company that engages in certain research activities by reducing its after-tax research costs. Eligibility for the credit largely depends on whether the work a company undertakes meets the criteria established by the IRS in its four-part test:
- Qualified purpose (business component 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.
- Technological in nature (discovery test) — The activity undertaken relies on the principles of hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Elimination of uncertainty (Section 174 test) — The activity seeks to eliminate technical uncertainty about the development or improvement of a product or process.
- Process of experimentation — The activity seeks to eliminate or resolve a technical uncertainty, which involves an evaluation of alternative solutions or approaches and is performed through modeling, simulation, systematic trial, and error, or other methods.
If the activity meets all four parts, the company has qualified research activity and is one step closer to claiming the credit. The second step is identifying the costs (qualified research expenses) to compute the credit. The credit is equal to a certain percentage of a company’s qualified research expenses (QRE) in excess of a base amount. Expenses that qualify include wages paid to an employee engaging in qualified research or engaging in the direct supervision or direct support of qualified research activities, supplies used or consumed during qualified activity, and any expenses paid to third-party contractors who assist with the qualifying activity.
Activities that do not qualify for the credit include research conducted outside of the United States (or its possessions), research funded by another party, ordinary product testing, market research, and aesthetic or cosmetic design.
Which construction projects qualify?
Although identifying and documenting qualified research activities in the construction industry is generally more difficult than in traditional research-intensive industries, it can be well worth the effort for contractors that perform certain types of projects. But not all construction projects qualify, so it’s important to understand the qualification criteria to determine whether your company has enough activity to warrant further investigation. Some common research and development questions facing construction firms include:
- What costs qualify for the credit?
- Does the company have design and engineering activities, which may qualify for the credit?
- Does the type of contract make a difference (e.g., cost-plus versus fixed-price)?
- What language in a contract can help qualify a project?
- What is funded research?
- How does one identify the party with the right to the research?
- If the entire project does not qualify for the credit, can a piece of the project qualify?
Unlike industries such as pharmaceuticals or aerospace, where substantially all of the activities in a research and development project are likely to be qualified research, not all construction projects qualify.
Projects likely to contain qualified research
Much of the experimentation in these types of projects involves using advanced modeling software to develop and test mock-up designs. Other qualifying activities could include the testing and experimentation of designs in new or unique environments and the improvement of construction processes or practices for increased efficiency or reliability.
- Green building design and LEED certification
- Energy efficiency design or improvement
- Foundation engineering to mitigate the effect of unstable soil or sand
- HVAC system design for airflow and energy efficiency
- Electrical system design for efficient power usage
- Plumbing system design for efficient water usage
- Lighting system design for energy efficiency
- Drainage or storm water management design
- Structural engineering to withstand earthquakes, hurricanes, fire, and other disasters
- Experimenting with alternative material combinations
- Dew point analysis to determine location and type of vapor barrier for walls, roofs, and floors
- Building information modeling (BIM)
- High-tech equipment installation
- Plant production system design and optimization
Contract analysis: rights and risk for research and development
One of the fundamental R&D tax credit issues associated with engineering and construction projects is identifying the business component, which is one aspect in the four-part test noted above. Construction projects differ from the typical manufacturing company research and development project where the business component is obvious (in most cases, a new product being developed or an existing product being improved). For a construction project, the business component is the design of property that is ultimately built for the customer. The design may relate to an entire building, a building system (e.g., HVAC, plumbing, electrical), or an infrastructure project such as a bridge or highway interchange.
If a construction company employing engineers performs the research and development on behalf of a third-party, one must determine which party can claim the tax credit. Research done on behalf of a third party (e.g., the customer) may still be eligible for the credit, but only if it is not "funded research." To avoid treatment as funded research, the contractor must have both economic risk with respect to the research and substantial rights to the results of the research. An important first step in determining whether a contractor is a good candidate for claiming the R&D credit is to review the contracts.
If the contractor does not have the rights and risk and cannot claim the credit, the customer may (if the customer is a tax-paying entity and not a government or nonprofit entity). Construction companies can leverage the customer’s ability to claim the R&D credit in bid-and-proposal requests or contract negotiations. The determination of which party has the rights and risks usually depends on which party retains ownership over the design schematics, developed processes, and related intellectual property.
Based on established case law, fixed-price contracts are considered to have financial risk to the contractor as long as the contractor is obligated to deliver a successful product or design, regardless of whether the contractor can do so within the fixed price. Cost-plus (cost plus fixed fee, cost plus incentive fee, cost plus additional fee), time, and materials are considered to be funded research contracts, and are thus ineligible for the R&D credit. Certain research and development activities may qualify for the credit if at the conclusion of a cost-plus contract, the company continues research and development at its own expense. This is similar to independent research and development (IRAD), which is common in engineering practices.
Contract analysis is also important if the construction company subcontracts work to third parties. In this situation, it is important for the construction company to retain the rights and risks with respect to the subcontractor's work.
How we can help
Construction companies can qualify for federal or state R&D tax credits. However, it is important to first document how the project meets the IRS's four-part test for qualifying research and development activities. In the process of reviewing the activities that might qualify, firms must determine whether the company retains the economic risks for and substantial rights to the research. This can be assessed through careful contract review. CLA’s construction professionals have broad experience across all construction sectors and have significant experience evaluating contracts and exploring the potential for claiming the R&D tax credit.