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The tax savings available through the Federal Research & Development (R&D) Tax Credit reward businesses that invest in research and innovation. The misconception that only large companies with R&D departments can claim the credit has led many small- and medium-sized businesses to dismiss this opportunity. This assumption is simply untrue. Any business that invests in the identification, evaluation, testing, and improvement of materials, processes, or methods, often qualifies for tax savings. In fact, there are numerous situations in which general contractors, specialty contractors, or sub-contractors (e. g. electrical or plumbing) that have undertaken certain research activities may qualify. Unlike other incentives, comprehensive guidelines must be followed when claiming the R&D Tax Credit. In order to maximize this opportunity, industry companies may want to revisit the immense tax savings program available. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
What is the R&D Tax Credit?
It is a federal tax incentive available to businesses developing new or improved components (e. g. products, processes, techniques, or formulas) that result in improved functionality, performance, or reliability. The incentive is popular because it is a dollar-for-dollar credit that can provide significant tax savings. Additionally, there are similar state-level versions of the credit, including one in California and Texas.
Generally, any project or activity is considered eligible if it satisfies the criteria laid out in the four-part test (Internal Revenue Code §41). This test examines four key areas, including (1) permitted purpose, (2) uncertainty, (3) technological in nature, and (4) the process of experimentation. A detailed explanation of each is outlined below.
- Permitted Purpose – The purpose of the research must be towards creating a new or improved product, process, technique, invention, software, or formulation (or “business component”) resulting in increased performance, quality, or reliability. Concurrently, research activities undertaken for aesthetic reasons (e. g. style, taste, cosmetics) are not eligible. It is important to note that success in a project is not necessary to meet this criterion.
- Uncertainty – The research must eliminate uncertainty about the capability, design, or method of developing a new or improved product, process, or component. Since regulations do not require the taxpayer to successfully eliminate the uncertainty, proof of resolution is not necessary to meet this test. Concurrently, it can be demonstrated that uncertainty existed if the information readily available to the taxpayer did not allow for the development of an improved business component. Finally, it is essential to remember the Patent Safe Harbor rule, which states that the issuance of a patent means information that the research is technological in nature, and the elimination of uncertainty relating to a new business component has occurred.[i]
- Technological in Nature – The research must demonstrate that the process of experimentation relies on the principles of “hard” science. Examples include those found in engineering, physics, chemistry, biology, or computer science.
- Process of Experimentation – The research must eliminate uncertainties through a process of experimentation. This may include an iterative trial-and-error process, the use of the scientific method, simulation, modeling, or any approach involving evaluating alternatives. The process is not required to be completely academic, but documentation on the alternatives considered, testing methodology, and results must be performed and documented to satisfy this requirement.
Which Construction Projects Typically Qualify?
Although any project must pass the aforementioned four-part test to qualify, certain construction projects are usually eligible. The most common include design-build, construction manager at risk, design-assist, and certain plans and specifications. Other projects, such as routine plan and specification projects, simple or routine paving, milling, and grading work, are more difficult to qualify. Finally, repair, maintenance, or warranty projects, labor-only, and projects are undertaken on a time and materials basis are usually ineligible.
Which Construction Activities Typically Qualify?
There are two primary activities that qualify:
- Design-Related – These include activities such as concept development or the recommendation of improvements yielding a new or more efficient construction design process. CAD, BIM, or other drafting activities such as detailing, fabrication, or shop drawings are also included. Finally, site balancing activities related to proposing new elevations or designs and calculations or sketches compiled for proposals may also be included.
- Method-Related – These include activities related to construction means, techniques, and processes. Eligible activities often include evaluation and testing new construction methods to meet project scope, calculations for rigging, wire-pull or cable-pull plans, and evaluating alternative solutions to overcome constructability challenges. In addition, determining electrical layouts, routing configuration, and wiring setup may also be an eligible activity.
Specific expenses can be claimed, including wages, supplies, and third-party expenses.
- Wage Expenses – The wages paid to employees participating in or directly supporting or supervising R&D activities can be claimed. This equates to the ability of companies to capture a portion of the (W-2 Box 1) wages of employees for the time spent performing qualifying activities. There are a few important points to keep in mind:
- If 80% or more of an employee’s time is deemed qualified, then substantially all test is met. This translates into the potential to capture all the W-2 Box 1 wage of said employee towards the R&D Tax Credit calculation.
- Rigid time-tracking is not required as estimation of time spent on performing qualifying activities is permitted but must be made on a reasonable basis.
- Reasonable basis may be demonstrated in many ways, including oral testimony, written summaries from an individual involved in the project, or contemporaneous documentation related to the employee and project.
- Supply Expenses – The supplies used in qualified research not related to land or other depreciable assets can often be claimed. When demonstrating that supply expenses are not depreciable in nature, it may be necessary to show that supplies used are not attached to the land, are not owned by the taxpayer, and have a useful life of less than one year.
- Third-Party Expenses – Certain third-party expenses can also be claimed. For example, tasks completed by a contractor would qualify if those tasks directly support the research. Concurrently, the taxpayer will be required to prove that the tasks completed by the contractor are not funded (and therefore excluded). It is also necessary to show evidence that payment was not contingent on the results or outcomes of activities performed and substantial rights to the research and results have been retained. It is important to note that in most cases, a taxpayer can claim 65% of the cost of an eligible third-party expense.
What Construction Expenses Typically Qualify?
The most captured construction expenses include employee wages and certain subcontractor expenses related to engineering or direct support activities, such as testing and surveying.
Ensuring the proper documentation is available to substantiate expenses claimed is necessary. The typical documentation which may be evaluated includes employee rosters, payroll records, job costing reports, Work in Progress (WIP), and contracts. Information may also be taken from other sources such as bid documents, calculations, change orders, erecting/picking plans, photographs, sketches, and more.
We’re here to help.
The tax savings potential arising from the Federal R&D Tax Credit can be significant for California and Texas construction companies and contractors. Due to the complex regulations governing the credit, it is necessary to consult with a qualified tax advisor to determine eligibility. If you have questions about the information outlined above or need assistance with the R&D Tax Credit, JLK Rosenberger can help. For additional information, please call 949-860-9902 or click here to contact us. We look forward to speaking with you soon.
[i] Treasury Regulation §1.41-4(a)(3)(iii) also establishes the “patent safe harbor” rule.