Construction Companies May Be Missing a Critical Tax Opportunity (article)
Lower wages in other parts of the world and improved communication technology have made it easier for construction companies to offshore many aspects of a design and build effort. The research and development (R&D) credit is one of the few incentives the government provides to help construction companies reduce the costs associated with paying employees in the U.S. to perform such activities.
Research and development activities may not immediately come to mind with the construction industry, but a number of day-to-day operations may qualify for the credit. The challenges of understanding how the credit functions and what qualifies for its use, however, have resulted in a number of construction industry companies missing out on taking advantage of this powerful tax credit reward.
History of R&D Credits
The R&D tax credit has been a part of the tax code since 1981 and provides an incentive for businesses to further their research and development efforts. Since then, a number of changes have been made to the credit, including which activities qualify, what costs can be included, how it is calculated and the manner in which any credits generated may be used. For example, the removal of the “discovery test” in 2003 expanded the credit to allow efforts that were new only to the company making the claim; efforts did not need to be innovative or new to the industry to qualify. New treasury regulations, IRS proclamations and judicial rulings provided additional guidance for time spent by business owners and executives on development efforts and the contract analysis necessary for inclusion of contractor costs.
In December 2015, Congress significantly enhanced the credit with the passage of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act). Changes in the PATH Act benefit small and mid-sized businesses by allowing business owners with businesses that have an average annual gross receipts amount for the prior three years under $50 million to use the R&D credit against their alternative minimum tax (AMT). The AMT had historically been a significant limitation for small business owners who wanted to use the credit.
The construction industry itself has seen significant changes over the last decade. New technologies, such as BIM modeling software, new material - both internally and on a structure’s façade and LEED certification goals, give rise to opportunities for companies in the industry to benefit from the R&D tax credit.
Costs able to potentially be included within an R&D credit claim include wages, supplies and outside contractors, as long as the costs incurred were for qualifying activities performed here in the United States. Qualifying activities for the credit involve meeting four basic requirements set forth by the tax code.
- The activity must relate to a new or improved product or process that improves the component’s function, performance, reliability and/or quality.
- There must be uncertainty concerning the capability to develop, method of developing or appropriate design of a new or improved product or process at the outset of the project.
- Substantially all of the activities must be elements of a process of experimentation to resolve the technical uncertainty.
- The activity performed must fundamentally rely on principles of physical science, biological science, computer science and/or engineering.
Unfortunately, these requirements are vague, as they were written in a manner that allowed for application to all industries. It is only through regulations, court rulings and the audit process that there has been some level of clarification as to the applicability of the activities of a given industry.
Examples of Qualifying R&D Construction Activities
A number of activities performed every day by construction companies, particularly design and build companies, can meet the R&D tests. The following are examples:
- Determining optimal ventilation for a building design. Research and development activities are frequently involved, such as using dynamic energy modeling to structure airflow routing for increased efficiency and reduced energy consumption or modeling and analyzing wind tunnels to allow for the safe exhaust of vapors generated in a laboratory.
- Designing HVAC systems, in particular when improving efficiency, safety or reliability.
- Overcoming challenges associated with working with specific materials, such as undertaking a trial and error process to devise an optimal method of connecting various bronze railings without welding.
- Developing optimal storm water, wastewater and/or water flow systems. Examples include experimenting with reuse of water and/or minimization of water runoff through the use of site modeling.
- Experimenting with various types of materials in order to reduce energy consumption or related environmental concerns.
- Development efforts associated with means and method processes and/or improving equipment for lifting, transporting and/or installing an item of significant size or fragility.
How Construction Companies Take Advantage of R&D Credits
Just as important as the qualifying nature of the work is the agreement between the company performing the work and the client paying for the work. In order to qualify for the credit, the company making a claim must hold the economic risk of the development effort (i.e., are paid for success) and have substantial rights to the results of the development efforts. Ultimately, the government wants to reward the company who takes the economic risk of a development effort and can use the research results for future efforts.
Although the assessment generally must be made on a case-by-case basis, current case law has provided guidance to construction companies by identifying different types of contracts that have been found to qualify and not qualify. Specifically, fixed-price contracts have generally been found to provide the party performing the work the necessary economic risk of a construction effort to qualify for the credit. Time and Materials and Cost-Plus Agreements have generally been found not to confer upon the party performing the work the necessary economic risk to qualify. Additional language within the contract, such as warranty provisions, can help further clarify which party has the economic risk of successfully completing the effort.
Approach R&D Credits with Care
The IRS has identified the R&D credit as a significant area of improper claims and abuse. It made the credit a Tier 1 audit issue in the late 2000s and included the credit in both its 2016 and 2017 annual “Dirty Dozen” list of tax scams. Such actions by the IRS evidence the need for a proper assessment and documentation effort when supporting a claim. When calculated and documented properly, the credit can be a tremendous reward for the necessary day-to-day activities performed by the construction industry.
For more information about how to take advantage of the R&D claim, call or email Raj Rajan at 949.727.1327 or contact your local CBIZ MHM professional.