We are not talking about the white lab coat drug research programs where a company can spend millions of dollars with no definitive ability to recoup these costs until an approved drug is developed. Instead, we are talking about your everyday activities in constructing something or being involved in constructing something. But beware, the credits are in the details of a thorough contract review and not in an off-the-cuff sales call.
Originally introduced in the Economic Recovery Act of 1981, the R&D credit is generally allowed for expenses paid or incurred for qualified research. This research must be undertaken for discovering information that is technological in nature, and its application must be intended for use in developing a new or improved business component for the taxpayer. Substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved 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 its gross receipts are less than $5 million in the year the credit is taken and they incurred gross receipts for five years or less. 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, yet 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 have the potential 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 qualified research activities for the credit:
Once the four-part test has been met, one must look to identify the costs associated with qualified activities in order 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. Construction activities that do not qualify are research expenses conducted outside of the United States or its territories, research funded by another party, ordinary product testing, market research or aesthetic cosmetic design. Construction activities that are novel and innovative in nature that may qualify for the R&D credit include the following:
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 are not going to 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, problem-solving, etc. Also, there must be a risk, such as incurring the above with the uncertainty of being reimbursed. Be on the lookout for costs incurred on out-of-scope work, job margin fades, cost overruns, change orders, etc. Contract language that clearly allows for the contractors’ reimbursement of the above costs or limits its risk will most likely not be eligible activities.
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 risks 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 a 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 of the relevant statutory and regulatory requirements. Failure to maintain records in accordance with these rules is a basis for disallowing the credit and incurring potential penalties.