Contractors: Maximize Your Research Investment

Many taxpayers have heard of the research tax credit (also known as the R&D credit), which may conjure up images of scientists in an experimental laboratory. However, the research tax credit (research credit) casts a much wider net. There are many other activities that may qualify for the credit, including those commonly performed in the construction industry.

What Is the Research Credit?

The research credit was established to provide an incentive for taxpayers to take risk and make expenditures for new products or processes. The credit is a dollar-for-dollar reduction of tax liability, which helps to mitigate the expenditures undertaken by the taxpayer. To encourage continual growth in R&D, the credit was designed to provide a benefit to taxpayers for increases in research activity and expenditures. Although the calculation of the credit can be complex, the two primary areas of focus for taxpayers are:

1. whether you are engaged in qualifying research activities, and
2. how much you are spending on qualifying activities.

In the construction industry, some activities that may qualify include:

• Performance of design activities during pre-construction,
• Evaluation of the feasibility and constructability of the designs based on field conditions,
• Performance of value engineering,
• Performance of field changes and working with engineers to design and construct the optimal solution, or
• Performance of design and engineering activities on components built in a fabrication shop.

To be considered qualifying research, these activities should also relate to an uncertainty with respect to the construction project (i.e., the proper design of a building component or system). Finally, there should be a process of evaluating different alternatives to determine the best alternative that will eliminate the uncertainty. It is important to note that an activity can still qualify as research even if you know that a solution can be found. The important fact is that you do not know which solution should be used to resolve an uncertainty at the outset.

Defining Qualifying Research Activities

To qualify as research eligible for the research credit, the activity performed must satisfy a four-part test:

1. The activity is intended to discover information that would eliminate uncertainty concerning the development or improvement of a product or process (deductible under §174),
2. The activity must be undertaken for the purpose of discovering information which is technological in nature (i.e., relies on engineering),
3. The application of that information is intended to be useful in your new or improved business product or process, and
4. Substantially all of your activities related to your research effort must constitute elements of a process of experimentation (i.e., evaluating alternatives).

Qualifying Research Expenditures

The research credit is calculated as a function of the qualifying research expenditures incurred by the taxpayer during the taxable year. The qualifying expenditures include:

• Qualified Wages
  • Amounts paid to an employee performing qualified services, which includes employees who:
    • Conduct qualified research
    • Directly supervise qualified research
    • Directly support qualified research
• Qualified Supplies
  • Tangible property used in research activities other than:
    • Land or land improvements
    • Property subject to allowance for depreciation
  • Includes prototypes
  • Does not include meals, entertainment, travel, or overhead
• Qualified Contract Research
  • Amounts paid or incurred to any person other than an employee for performing qualified research
  • Agreements with contractors should provide that you:
    • have the rights to the research results, and
    • agree to bear the expense even if the research is not successful
  • Generally, agreements that determine fees based on a time and materials basis are more likely to meet the requirements as qualified contract expenses

As the list above reflects, the expenses that can be used for the research credit can include not only the wages of your own employees that perform qualifying research activity, but can also include subcontractors that are used for qualifying activities, such as engineering. If you use subcontractors, it will be important to structure your agreements in a manner that allows you to capture these expenditures for purposes of your research credit.

Please contact your KSM advisor to discuss opportunities that may be available to claim these credits.