While many associate the research and development (R&D) tax credit with the technology, aerospace/defense and pharmaceutical industries, the engineering and construction industries are often overlooked as areas for potential R&D credits. While identifying and documenting qualified research activities taking place in these industries is generally more difficult than in traditional R&D-intensive industries, it can be well worth the effort for contractors that perform certain types of projects, as discussed below. Because not all construction projects qualify, it is important to understand the R&D credit qualification criteria sufficiently to determine whether your company has enough potential R&D activity to warrant further investigation. Some questions facing construction and engineering firms related to R&D include:
- What types of design and engineering activities may qualify for the credit?
- What costs qualify for the credit?
- Does the type of customer make a difference (i.e., public versus government)?
- Does the type of contract make a difference (i.e., cost-plus versus fixed-price, etc.)?
- Is there language in a contract that can help qualify a project?
- Does subcontracted work qualify for the credit?
- 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?
- If the contractor is not eligible for the credit, is the customer then eligible, and can this influence contract negotiations?
This article addresses these questions and many more about the research tax credit in the context of the construction and engineering industries.
The R&D credit has expired and been extended 15 times in its history, making it difficult for many businesses to plan R&D investments. Despite the uncertainty, businesses should still consider capturing credit-qualifying activity as part of their regular business operations so that the credit can be documented and claimed if and when it is extended again. Many states have R&D credits and other incentives that may provide additional cash tax savings, freeing up more capital to be reinvested in the business or distributed to owners.
The IRS R&D credit qualification tests
The IRS defines R&D as not only new product development, but also improvements to existing products, designs and processes. In order to qualify as research for purposes of the credit, the design or development activities must meet a four-part test:1
- Uncertainty – The activity must be intended to discover information to eliminate technical uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.
- Permitted purpose – The activity must relate to a new or improved function, performance, reliability or quality of a business component (i.e., product, process, computer software, technique, formula, or invention) that is to be held for sale, lease, or license or used in a trade or business.
- Technological in nature – The research activities must fundamentally rely on principles of physical science, biological science, computer science or engineering.
- Process of experimentation – Substantially all2 of the activities must be elements of a process of experimentation to resolve the technical uncertainty and be supported by documentation explaining:
- The alternatives considered and attempted
- Testing performed on the alternatives
- Test results and analysis
If a project is considered qualified, the portion of the Form W-2 wages of individuals directly performing, supervising or supporting the research is a major component of the tax credit computation. Additionally, materials used or consumed in the R&D process, 65 percent of the amounts paid to third-party contractors for qualified research, and the rental or lease cost of computers (e.g., cloud computing) used for qualified research are factored into the credit computation.
R&D in the engineering and construction industry
Unlike an R&D-intensive industry like pharmaceuticals or aerospace where substantially all of the activities in an R&D project are likely to be qualified research, not all construction projects qualify. Of the ones that do, only a portion of the activities rise to the level of qualified research, requiring application of the shrink-back rule in most cases.3 However, many types of firms employ professionals, including architects, engineers, general contractors and sub-contractors, to perform qualified research as part of their project activities. Qualified research is most often found in projects that present one or more technical challenges that must be overcome. The firms that provide the best credit opportunity are the ones that perform engineering and design work in-house (e.g., design-build firms).
Some examples of the types of projects most likely to contain qualified research include the following:
- Green building design/LEED certification
- Energy efficiency design or improvement
- 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
- 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/storm water management design
- Unique infrastructure design
- Building information modeling (BIM)
- High-tech equipment installation
- Plant production system design and optimization
Much of the experimentation in these types of projects involves using advanced modeling software to develop and test virtual mock-up designs. Other potential 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. Conversely, research conducted outside of the United States (or its possessions), ordinary product testing, market research, and aesthetic or cosmetic design activities do not qualify for the credit.
The type of contract matters
One of the fundamental R&D credit issues associated with engineering and construction projects is identifying the business component. Construction project R&D is not like the typical manufacturing company R&D 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 or plumbing), or an infrastructure project like a bridge or highway interchange.
Research done on behalf of a third party (e.g., the customer) may still be eligible for the R&D 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 significant contracts.
If the contractor does not have the rights and risk and cannot claim the credit, the ultimate customer may have the rights and risk and be eligible to claim the credit (if the customer is a tax-paying entity and not a government or non-profit entity). The potential ability for the customer to claim the R&D credit can be leveraged by construction companies in bid-and-proposal requests or contract negotiations. The determination of which party has the rights and risks is facts and circumstances based and likely dependent on which party ultimately retains ownership over the design schematics, developed processes, and related intellectual property.
Based on settled case law, fixed-price contracts are considered to have financial risk to the contractor as long as the contractor is obligated to deliver a 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, and indefinite delivery/indefinite quantity (IDIQ) contracts are considered to be funded research contracts and are thus ineligible for the R&D credit. Certain R&D activities may qualify if at the conclusion of a cost-plus contract, the company continues R&D at its own expense. This is similar to independent R&D (IRAD), which is common in engineering practices. Also, it is possible to perform a contract line item number, or CLIN, analysis to determine if certain specified tasks of a project are funded while others are not.
This contract analysis for rights and risk will also apply if the construction company further 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, as opposed to the subcontractor or customer retaining rights and risks with respect to the design.
Technological in nature requirement
The technological in nature requirement also warrants further discussion in the context of construction projects. In examinations, the IRS often looks at the technical credentials of the individuals who are claimed as performing qualified research. Since the research activities must fundamentally rely on principles of a hard science, persons who do not have the proper educational or professional certifications may be excluded from qualification. For example, a construction laborer who is not a professional engineer is likely to be excluded by the IRS even though the person may be performing testing under an engineer's supervision. It should be noted that the time spent by individuals directly supervising or directly supporting the R&D activity may be included as qualified wages in computing the credit.
It is not uncommon for a construction or engineering firm to perform R&D that qualifies for federal or state R&D tax credits. However, it is important to first review the nature of the work to determine whether it is disqualified funded research or whether the company retains the economic risks for and substantial rights to the research. A thorough contract analysis should be performed by an experienced R&D specialist to make this determination. It is also essential to document how the project meets the IRS's four-part test for qualifying R&D activities, as well as to identify the different costs associated with the contract work (labor, materials and subcontractors).
1 Pursuant to section 41(d) and the regulations thereunder.
2 See Reg. section 1.41-4(a)(6) which defines "substantially all" as 80 percent or more. To the extent less than 80 percent of the activities represent qualified research, there is a requirement to shrink back the related costs to the percentage associated with the time spent on qualified activities. See Reg. section 1.41-4(b)(2) and footnote 3, below.
3 The shrink-back rule allows a taxpayer to determine whether any activity related to a project component qualifies for the credit even though the overall project would otherwise be disqualified. Think of this as peeling the layers (components) of an onion (project/business component) back until a qualified activity is discovered.