Many construction company owners might assume that a tax credit related to research and development is out of their reach. Au contraire — contractors can and have claimed the research credit for improving construction techniques or developing industry-related software. Here’s a refresher on this potentially valuable tax break.
Making the grade
Essentially, the research credit allows a business to reduce its federal and state income taxes by a percentage of the eligible expenses incurred for qualified activities. Such activities are qualified by a four-part test.
First, you need to spend time and money developing a new tool, process or technique for your business and/or industry. A product might be a new tool, whereas a process or technique could be a methodology for improving the performance, efficacy or efficiency of your construction activities.
The improvement by this new tool, process or technique must be evolutionary or advanced in nature. In other words, you can’t claim the credit for a personal taste item like the mixing of a new color of paint. The new tool, process or technique needs to be a novel design element or a new approach for construction. Fortunately, 2003 U.S. Treasury regulations lowered the standard from “revolutionary development” in the industry to “evolutionary development,” easing access to the credit while retaining some stringency.
The second test stipulates there must be uncertainty before the research is performed. Innovation, by definition, can’t be a slam dunk. The new tool, process or technique must spring from questions such as, “How could we redesign this tool to perform better and yield improved results?” or “Could our construction company actually perform this technique on our projects and see appreciable benefits?”
The third test dictates that an activity must evaluate different alternatives by experimentation of some sort. The experimentation should try to eliminate the uncertainty of whether a tool, process or technique will work by either building models of a product, simulating a process or technique on a computer, or conducting trial-and-error tests of a process or technique to find the best way.
The fourth test states that the activity must be technological or scientific in nature. In other words, it must use the physical, biological or computer sciences.
For example, you might synthesize chemicals to develop a new construction product or implement physical science or engineering principles to come up with a new building process or technique. (To be clear, you don’t need to have invented or discovered the chemistry, physical science or engineering principles applied.)
Identifying your costs
If your research activities meet the four tests in the eyes of the IRS, you can include many of the associated costs as qualified expenses when claiming the credit. Specifically, expenses eligible for the credit must be direct costs incurred while performing, supervising or supporting your research.
Examples include costs associated with laboratory-style experiments (performing), and expenses incurred so project managers or others can supervise research (supervising). A third example is the cost of fabricating tools or components while doing research (supporting).
Direct costs of materials and supplies will typically qualify as long as they’re clearly associated with the research. Administrative costs are usually ineligible because they’re considered overhead. Travel, telephone costs and rent expense are also ineligible for the same reason.
A contractor’s eligible expenses can also include 100% of wages paid to employees working on the qualified activities and supplies or materials costs incurred directly for those qualified activities. These must be payroll wages (including bonuses) but not pretax benefits such as a retirement plan or health care insurance.
Qualified research expenses may also include hiring subcontractors to work on the research project. However, eligible subcontractor expenses include a lesser 65% of the amount paid to them for qualified activities.
Getting credit for your work
Here’s another possible surprise: You may have already done the work to qualify for this tax break. If so, now it’s time to get credit — literally! Ask your CPA for more information.
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