Construction businesses are often surprised to learn that they may be eligible for the research tax credit, often referred to as the “research and development,” “R&D” or “research and experimentation” credit. Too often, they assume that this tax break is for only large pharmaceutical, biotechnology, software and aerospace companies, so they don’t bother to investigate whether any of their activities qualify.
But if your company commits resources to developing new construction techniques, improving processes, experimenting with alternative materials or devising other innovations, it pays to explore the potential tax benefits. And even if you’ve looked into the research credit before, now is an ideal time to revisit the subject. Late last year, Congress made the credit permanent and enhanced its benefits for smaller businesses. (See “New and improved research credit benefits smaller companies.”)
The tax benefits of the research credit are significant: a dollar-for-dollar, nonrefundable credit of up to 6.5% of qualified research expenditures (QREs). QREs include wages and supplies related to qualified research activities, computing costs and 65% of research fees paid to certain contractors.
“Nonrefundable” means the credit can’t exceed your tax liability for the year. So you can’t use it to generate a loss and claim a refund. But unused credits may be carried back one year or forward up to 20 years to offset your tax liability in those years.
It’s important to understand that simply conducting research isn’t enough to qualify for the credit. Rather, it’s designed as an incentive for companies to increase their research activities. Calculating the credit is complex, and there are several methods for doing so, but, essentially, it’s equal to a percentage of the amount by which your current-year QREs exceed a base amount.
Generally, to qualify for the research credit, a research activity must: 1) be related to development or improvement of a “business component,” such as a product, process, technique or software program, 2) strive to eliminate uncertainty over how (and whether) the business component can be developed or improved, 3) involve a “process of experimentation,” using techniques such as modeling, simulation or systematic trial and error, and 4) be technological in nature — that is, it must rely on “hard science,” such as engineering, computer science, physics, chemistry or biology.
An inherently uncertain business, construction often requires architects, engineers and contractors to use innovation and experimentation to meet the technical challenges associated with a project. Here are a few examples of activities that may qualify for the research credit:
- Developing more efficient, more effective, and safer construction techniques and methods,
- Evaluating alternative materials or combinations of materials,
- Developing new or improved construction equipment,
- Designing more efficient HVAC, electrical, plumbing or lighting systems,
- Developing innovative foundation designs to accommodate unusual site conditions,
- Developing innovative mechanical or electrical systems to accommodate unusual structures,
- Creating new or improved estimating software or building information modeling systems, and
- Designing buildings, features or systems that improve energy efficiency or help achieve LEED certification.
Generally, firms that perform engineering, architecture or design work in-house — such as design-build or engineer-procure-construct firms — have the most significant research credit opportunities. But any construction company that invests in these types of technological innovations may be eligible.
Review your contracts
To determine whether otherwise qualified research is eligible for the research credit, it’s important to review your contracts carefully. To claim the credit, you must bear the financial risk associated with the research and enjoy substantial rights to the results. Otherwise, it will be considered “funded research,” which is ineligible for the credit.
Generally, research performed pursuant to a fixed-price contract is eligible for the credit because the contractor bears the financial risk (provided the contractor also retains the rights to the results of the research). But research performed under a cost-plus or time and materials contract will likely be considered funded (and therefore ineligible) because the financial risk lies with the customer.
Don’t leave money on the table
If your business invests time and money into developing or improving construction processes, techniques, products or designs, talk to your tax advisor about whether these activities qualify for the research credit. Too often, contractors leave money on the table by failing to take advantage of this valuable tax break.
New and improved research credit benefits smaller companies
The Protecting Americans from Tax Hikes Act of 2015 made the research credit permanent after decades of short-term renewals. It also made two important changes that expand the benefits of the credit for smaller businesses.
First, beginning in 2016, the act allows businesses with average gross receipts for the previous three years of $50 million or less to claim the credit against the alternative minimum tax (AMT). This is good news for taxpayers, particularly owners of partnerships and S corporations, whose ability to use the credit is limited or eliminated by the AMT.
Second, also beginning in 2016, start-ups — generally, companies in operation for less than five years with less than $5 million in gross receipts — may use the research credit to offset up to $250,000 in employer-paid FICA taxes. This is a big advantage for companies that incur substantial research expenditures but can’t otherwise use the credit because they’re not yet generating any taxable income.