Submitted by: David Seibel & Tanner Niehaus, McGuire Sponsel
The R&D Tax Credit is one of the most subjective areas of the tax code and many businesses believe they qualify. With the IRS placing more scrutiny on the R&D Tax Credit, it is important to be aware of common myths of the credit as well as areas of exposure when building a claim. To dispel some of these misconceptions and provide clear guidance for CPA firms and businesses that may qualify for the R&D Credit, this blog explores the construction sector and what activities and business practices are eligible for R&D Credit inclusion.
The construction sector and related industries hold many misconceptions as it relates to the R&D Credit. For firms that are directly or indirectly involved with construction, there are a number of considerations for each individual company to make when evaluating if it is appropriate to pursue a R&D Credit claim.
One early factor to examine is whether the business bears the burden of engineering or design at any point during the project cycle. This can often determine whether a business is likely to be working on projects that satisfy the four-part test. This check does not guarantee a R&D Credit opportunity exists, but the lack of design responsibility typically suggests that a company will not meet §41 requirements. A technical risk assessment for a “typical” project or large specialty project would also be appropriate to determine if there are potentially qualified business components.
For example, within the scope of a new construction project, the party that is responsible for developing the optimal building design including the detailed engineering is very likely to be conducting qualified research activities. This could also extend to contractors who are designing specific systems for the site. Conversely, a contractor or builder that is constructing from prints and is not responsible for the creation of any new design element or construction procedure is typically not conducting qualified research. While qualified employees do not have to be degreed scientists or engineers, a firm that has an engineering and/or design function is a good indicator of qualified research taking place. Market areas that are most likely to be conducting qualifying activities include architectural/engineering firms, specialty and design/build contractors, and manufacturers of new and unique construction products.
Beyond assessing if a business bears the burden of design and if technical risk is present, determining if a taxpayer bears the economic risk of the design is necessary when preparing a R&D Credit claim. This requirement is related to the Funded Research Exclusion as set forth in §41(d)(4)(H). When a company is designing a custom building or solution for a client, the payment structure should generally be fixed-fee, lump-sum, or otherwise structured in a way that the business incurs the costs to resolve any failure to demonstrate the taxpayer is bearing the economic risk. The company must also retain significant rights to use the research without compensation to its client.
In recent years an architectural design firm, Populous Holdings, successfully defended its R&D Credit claims against the Funded Research Exclusion in tax court. The court found that because the contract payment structures were fixed fee and Populous Holdings was paid for a “work product” requiring research to successfully complete, the Funded Research Exclusion did not apply and the claims were valid.
Between determining who bears the technical risk and economic risk of a project, as well as who retains substantial rights to the research, it can often be difficult to determine if a construction company is eligible to claim the R&D Credit for a particular project. An assessment of a taxpayer’s design responsibilities, project contracts, and work performed should be carefully conducted to determine whether a construction firm is able to claim the R&D Credit.