In a world of ever-evolving regulations and best practices, construction business owners need every tool possible to stay ahead of the competition and maintain a thriving business. Generally, while much commonsense business savings can be recognized in budgeting and revenue goals, there are other opportunities that are not paid as much attention, like the research and development (R&D) tax credit available to many construction firms.
For more advice on this credit, Construction Business Owner (CBO) spoke with Cole Marr, director of research tax credit services at California-based accounting firm Sensiba San Filippo LLP. Marr has focused exclusively on the R&D tax credit for 14 years, working with businesses of all sizes to identify, substantiate and validate their research tax credits. Read on for Marr’s insight on how construction businesses can take advantage of the opportunity.
CBO: What is the R&D tax credit?
Marr: The federal research and development (R&D) tax credit, also known as the research and experimentation (R&E) tax credit, provides a general business credit for qualifying project expenditures.
In addition, many states offer R&D credits that are very similar in nature to the federal credit. It is important to note that this is a general business credit, not a deduction or write-off.
Many construction companies are performing R&D that qualifies for a credit in the eyes of the IRS but don’t even realize it due to a lack of awareness and common misconceptions. But it can help you stay ahead of the competition and provide valuable savings, enabling reinvestment.
CBO: How much can it save business owners, if their business qualifies?
Marr: Thanks to the complexity of the formulas used to calculate the federal R&D credit, the benefit can range from approximately 6% to 10% of qualifying expenditures. In addition, state R&D tax credits can potentially double the overall benefit.
So, a company can expect to see anywhere from 6% to 20% of their R&D expenses returned to them via tax credit depending on geographic location and individual business characteristics.
CBO: How can contractors assess what types of projects or expenses can qualify?
Marr: To determine if a project (or portion of a project) is eligible to generate an R&D credit, the business component (the R&D credit term for “project”) and associated activities must satisfy four general requirements. The test consists of four separate qualifiers that the project must meet in order to qualify for the R&D credit. Here’s an overview of the four tests:
- Permitted purpose—The activity must be intended to develop or improve the functionality, performance, reliability or quality of a business component (a product, process, technique, formula, invention or software).
- Elimination of 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 business component’s design.
- Technical in nature—The activity must be one of the “hard sciences” to qualify, which in the case of construction, almost exclusively means engineering.
- Process of experimentation—Substantially all of the activities must be elements of a process of experimentation. These must involve the evaluation of one or more alternatives to achieve the desired end result.
When activities are determined to meet the above four criteria, the associated expenses for that project can be quantified and used to generate the R&D tax credit. Qualified research expenses consist of three basic expense categories:
- Wages—Consist of the taxable compensation paid to employees who spent a portion of time working on R&D. Their time spent working directly on a project, overseeing multiple projects, or assisting in a small component of one can all be included.
- Supplies—Consist of materials used up to build or test a new product or improvement. For example, if the R&D project is a new processing technique, the expenses associated with testing that technique may be includable.
- Contract research—Any outside vendor paid to provide assistance with an R&D project. Often these are individuals or companies that are paid to perform detailed engineering work, test and certify new product formulations, or calibrate and maintain equipment used for R&D.
CBO: What types of construction activities might qualify?
Marr: There are a number of possible activities in the industry that can be leading indicators of potential opportunity:
- Developing prototypes and modeling
- Development of new, improved or more reliable products or processes
- Design improvements for Leadership in Energy and Environmental Design (LEED) or energy efficient projects
- Development of a unique assembly or construction methods and processes
- Experimentation with new materials
- Complex systems integration design
- Developing or improving equipment
- Any project requiring an extra level of testing or certification upon completion
The above activities are meant as simplified examples to help construction companies identify if they may be performing activates that qualify for the R&D credit.
CBO: Are there any exclusions to what activities can qualify?
Marr: There are several exclusions you must keep in mind when considering what activities qualify. Examples of activities that do not qualify include:
- Efforts that would be considered “routine” engineering
- Research to improve style, taste, cosmetic or seasonal design factors
- Efficiency, management or consumer surveys
- Research in the social sciences, arts or humanities
- Research conducted outside the United States
- Projects funded by another entity
CBO: Why isn’t this credit more widely used?
Marr: The R&D credit is an often overlooked and misunderstood tax incentive. Because the guidelines for what can be rewarded with the credit are broad, the requirements for demonstrating eligibility and quantifying the credit amounts are substantial.
Frequently, when a business does not have R&D in a traditional sense, accountants overlook the pockets of potential opportunity within a client. This doesn’t make them a bad accountant or even signal any particular cause for concern.
Identifying R&D tax credit opportunities requires such a specific expertise it takes someone with highly specialized knowledge and experience to identify eligible activities. If a company has overlooked the R&D credit in the past, the potential exists to look back to prior years to recoup the missed credit amounts.
Typically, the available look back period is 3 tax years. So, for example, if a company claims a credit for 2020, they may be able to go back and claim the missed credits for 2017, 2018 and 2019.
CBO: What are some next steps for contractors with work that qualifies?
Marr: The best course of action is to reach out to your tax advisor or an R&D tax credit specialist to discuss the opportunity. Typically, a short conversation with someone knowledgeable about the credit and the process of claiming it, will make clear the potential opportunity.
If the R&D tax credit is something that makes sense for your business, it can become a valuable tax planning tool to factor into your annual analysis. The process of analyzing projects and the associated activities that may qualify for the R&D tax credit is a difficult task but can be navigated efficiently and effectively with guidance from an expert.