Editor: Mark G. Cook, CPA, MBA
Credits Against Tax
Taxpayers in the construction industry looking to minimize their overall tax liability or increase cash flow may want to consider one of the largest business tax incentives available to taxpayers—the Sec. 41 research and experimentation (R&E) credit. However, many taxpayers assume that the R&E credit applies only to high-technology, aerospace, and pharmaceutical industries. In reality, the benefits can apply to many other industries, including construction.
In many instances, activities conducted by construction contractors through their engineering and architectural employees are overlooked as R&E activities. When these employees develop and design new and innovative construction techniques, their activities most likely qualify for the R&E credit. This tax incentive may be available if the activities meet the IRS’s definition of R&E and are supported by contemporaneous documentation.
Overview of the Credit
The R&E credit was introduced in the Economic Recovery Tax Act of 1981, P.L. 97-34. It is designed to reward U.S. companies for increasing spending on research and development. It is also intended to help companies be more competitive with those of other nations in research and development and to be at the forefront of technological advancement. Congress has not made the credit permanent, renewing it 14 times. Its most recent renewal expired on Dec. 31, 2011. There have been numerous discussions about renewing the credit, but it has not been extended as of this writing.
The R&E credit is available to taxpayers who incur incremental expenses for qualified research activities (QRAs) conducted within the United States. Four types of qualified research expenses (QREs) are the catalyst of the credit:
- Wages paid to employees for qualified services;
- Supplies used and consumed in the R&E process;
- Contract research expenses (when someone other than an employee of the taxpayer performs a QRA on behalf of the taxpayer, regardless of the success of the research); and
- Basic research payments made to qualified educational institutions and various scientific research organizations.
R&E Credit Criteria for Construction Projects
For an activity to qualify for the research credit (i.e., it is a QRA), the taxpayer must show that it meets the following four tests:
- Sec. 174 test;
- Business-component test;
- Process-of-experimentation test; and
- Technological-in-nature test.
Once it is established that the QRAs qualify, a thorough analysis must be performed to determine that the taxpayer has assumed the financial risk associated with, and will have substantial rights to, the products and/or processes that are developed through the engineering, architectural, or construction work completed. Since most, if not all, engineering and construction projects are performed pursuant to contracts, engineering and construction companies must analyze each contract entered into to make certain that they assume financial risk and have substantial rights. If the risk and rights are not held by the taxpayer for a particular contract, then the work performed under that contract must be excluded from the R&E credit calculation.
For a contract under which a construction or engineering company retains the rights and risk, an evaluation of the different stages of the contract can determine where qualifying activities may exist. Many activities required to design and construct a new building may be QRAs, e.g., green technology, solar energy, and radical new designs. These new technological advances may be provided by the project’s architects, engineers, and other design services consultants.
To identify potentially qualifying activities in connection with a building construction project, it is necessary to understand the architectural and engineering processes. The delivery of architectural services, along with engineering and certain design consulting services, generally follow a standardized development process that typically involves six discrete stages. Most QRAs, however, are performed in the first three stages of the architectural process. The stages, and the extent to which qualifying research activities may be performed in each stage, can be generally described as follows:
Stage I—Design: This stage typically involves allocation of space (“stacking and blocking”), space planning, and assessment of available and required square footage. There is significant uncertainty at this stage, as the architect is called upon to determine how the proposed site may accommodate the functional and nonfunctional elements required by the client (e.g., placement of personnel and equipment) on an overall basis.
Stage II—Schematics: This stage typically involves exploration of the general concept of the building. In this stage, several schemes will generally be designed, with one selected by the building owner. There is significant uncertainty at this stage, as the architect is called upon to:
- Consider several alternatives for development of the selected space; and
- Determine (on an overall basis) how each alternative may be constructed, given architectural and related principles.
Stage III—Development: This stage typically involves expansion and redesign of the selected design, including assessment of alternative materials and energy sources and the cost of various options. There is significant uncertainty at this stage, as the architect is called upon to resolve major design issues in fitting the selected architectural scheme into a workable overall plan.
Stage IV—Construction documents: This stage typically involves reduction of design concepts to precise drawings. The drawings will be complete enough to allow permitting and final cost estimates. As this stage generally represents indirect construction labor, there would typically be uncertainty at this stage only to the extent that the drawing process reveals the need for reassessment of the design arrived at in the design development stage.
Stage V—Construction: This stage typically involves assistance with the actual construction. As this stage generally represents direct and indirect construction labor, there would typically be uncertainty at this stage only to the extent that rework or change orders necessitate reassessment of the design arrived at in the design development stage.
Stage VI—Commissioning: This stage typically involves certification that the structure has been assembled successfully. As this stage largely represents quality control, there would typically be uncertainty at this stage only to the extent that the testing identifies necessary rework that, in turn, leads to reassessment of the design arrived at in the design development stage.
While there is typically significant uncertainty in the first three stages of the architectural process, not all activities undertaken during the same three stages qualify as research and experimentation.
Examples of some qualifying activities that may be performed during these and the other stages include:
- Experimentation with new material combinations and evaluations of their performance properties;
- Development of innovative green designs;
- Development of innovative assembly or construction methods that accelerate or improve the construction process associated with large infrastructure assets;
- Unique bridge or roadway designs;
- Unique construction or innovative techniques in untested environments;
- Building designs to support unique structures; and
- Design and development of unique energy-efficient buildings and/or features.
Examples of typical nonqualifying activities that may be performed during these and the other stages include:
- Participating in meetings with the city or county to obtain zoning review of plans;
- Producing drawings or promotional materials;
- Participating in marketing efforts;
- Assisting in the review or development of bid packages related to building or component construction; and
- Participating in building construction scheduling or construction oversight services to ensure that the building and its components are constructed according to the design specifications.
To identify qualified activities, each construction project must be evaluated separately through each design stage to determine whether the activities undertaken meet the IRS’s definition of R&E. Given the current examination landscape surrounding the R&E credit, a detailed analysis should be done to properly document the taxpayer’s eligibility for the credit during the tax return preparation process to mitigate risk upon possible examination.
Construction and engineering companies whose activities meet the IRS’s definition of research and experimentation and who can substantiate these activities with contemporaneous documentation can benefit from the R&E credit. Tax credits are a powerful incentive and are available in many industries that one probably would not think of as a potential candidate to take advantage of the credit. As indicated above, the R&E credit for federal purposes expired as of Dec. 31, 2011 (though many states still offer a similar credit). However, if history is any indication, Congress will extend this incentive for another two years (for the 15th time) or possibly make it permanent. As such, planning ahead and building an infrastructure to identify qualified research activities and collect contemporaneous documentation is key to reducing tax liability by taking advantage of the R&E credit.
Mark Cook is a partner at SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or email@example.com.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.