The pursuit of the R&D tax credit has become a common inquiry among construction and real estate companies. They often wonder, 'Do we qualify for this valuable credit?' Our response is simple yet essential: Let's examine the 4-part test together. By doing so, we can identify the qualification markers that encompass the activities you undertake to innovate and enhance your products or processes.
Permitted Purpose
The activity should aim to enhance or create a business component, such as a product, manufacturing process, or software, by focusing on:
- Functionality improvement
- Enhancing performance
- Ensuring reliability
- Enhancing quality
Technological in Nature
The activity must be fundamentally based on principles from any of the following disciplines:
- Physical sciences
- Biological sciences
- Computer sciences
- Engineering
Elimination of Uncertainty
The activity should be focused on gathering information to remove technical uncertainty related to:
- Developing or improving a product or process.
- Assessing the suitability of the business component design.
Qualified Research Expenses (QREs) include
- Wages, which encompass direct support and direct supervision.
- Supplies required for the research.
- Contract Research Expenses, where the rights and risks to the research performed must be retained.
- QREs are limited to 65% of the total costs.
- Computer Rental and Cloud expenses may also be considered as QREs.
Process of Experimentation
- Most of the activities involved in the research should be part of a systematic process of experimentation, which includes:
- Formulating one or more hypotheses or design alternatives.
- Conducting experiments to test and analyze the hypotheses.
- Refining or discarding hypotheses based on results to develop the business component.
- Utilizing modeling, simulation, and trial-and-error testing for further experimentation.
The next common inquiry we receive is: "What is the process for gathering the expenses related to the R&D tax credit?"
1. SALARIES & WAGES
Your R&D expenses encompass both internal and external costs, such as salaries, wages, supplies, and leases. Salaries and wages have three main components:
- Core Research: This covers individuals directly involved in research activities, like researchers, engineers, CAD associates, and project managers, forming the essential basis for the credit.
- Supervisory Roles: This category includes supervisors overseeing employees engaged in direct development.
- Direct Research Support: If a researcher has an assistant who takes notes and collects data, the assistant's time supporting the researcher's work is also considered part of the R&D expenses.
2. SUPPLY COSTS
When engaging in prototyping and material testing, it's essential to consider the incorporation of supply costs. For instance, within the construction and A&E sectors, there are intriguing possibilities for utilizing innovative materials, such as a novel concrete formulation or other advanced building materials. These expenses play a pivotal role in the development and potential breakthroughs in these industries.
3. COMPUTER RENTAL OR LEASE
While not as widely recognized, the concept of renting or leasing computers for research purposes is gaining momentum, particularly in the realm of software development where complex research algorithms and testing techniques demand substantial computational power. This trend encompasses leasing robust computers tailored for research activities and exploring dedicated cloud storage spaces exclusively designed to cater to research needs.
4. CONTRACT RESEARCH
Contract research can be a valuable component of your research activities, allowing you to engage specialized outside resources directly associated with your projects. For example, if you require the expertise of an electrical engineering specialist, you can allocate 65% of the related expenditures as part of your research activities.
Throughout a typical construction project, different stages involve various levels of qualification. During the early phases, such as estimating, bidding, design, development, and documentation, expenses may be eligible for research and development (R&D) funding. However, as the project progresses into the construction and completion phases, R&D qualifying activities tend to phase out. This is because uncertainties are progressively addressed, and the focus shifts to activities where high degrees of certainty have been attained.
GENERAL CONSTRUCTION
- Crafting accurate estimates through the skillful interpretation of architect and engineer designs.
- Emphasizing LEED and green initiatives to promote environmentally friendly construction practices.
- Evaluating and enhancing engineering and construction methods to optimize build time, performance, and reliability.
- Pioneering the development of efficient prefabrication processes for faster and more cost-effective construction.
- Devising unique material transfer systems, such as innovative crane designs, to improve efficiency on project sites.
- Creating specialized support structures for active construction to ensure safety and smooth progress.
- Conducting rigorous testing and validation of novel mechanical systems to overcome uncertainties and achieve technical excellence.
- Utilizing cutting-edge tools like Building Information Modeling (BIM), AutoCAD, and Revit for precise project planning and visualization.
- Designing and developing construction management software to enhance project coordination and efficiency.
In the realm of construction projects, clients often face uncertainties regarding the success of their proposed methodologies, plans, or designs. Despite using CAD modeling, they cannot be certain of success until implementation during the construction phase and subsequent onsite testing to meet required benchmarks. The development-of-estimate phase offers a fertile ground for initial feasibility planning, where multiple hypotheses or methods for building or component design are explored. This serves as an excellent starting point for Research and Development (R&D) endeavors, especially for projects pursuing qualifications like LEED or green initiatives, which can qualify for R&D tax credits. Additionally, the growing popularity of modular and spatial design in optimizing building space usage presents significant qualification potential. Ultimately, the construction industry continually strives to enhance efficiency and reliability by embracing innovative design approaches for faster and more efficient construction methods.
Clients often inquire about efficiently allocating time on their building projects between qualifying and non-qualifying aspects. To address this, we primarily rely on accounting and time data, which enables us to track employee activities and project progress effectively. By breaking down the time into specific activities, we can determine if those activities align with qualifying stages during the construction process. This evaluation involves checking if the tasks occur at stages that typically qualify for certain benefits. Once we establish these benchmarks, we can allocate a reasonable percentage of an employee's time toward qualifying projects. This systematic approach is referred to as Project Accounting Data (PAD) analysis. PAD analysis enables us to optimize the allocation of time and resources, ensuring that a significant portion is dedicated to qualifying projects, leading to overall project success.
REAL-WORLD EXAMPLE
We collaborated with a reputable construction client generating $115 million in annual revenue, showcasing an impressive average of over $5 million in qualified expenditures yearly. Their primary operations encompassed new building design, LEED development, and electrical and plumbing systems. Consequently, they received a commendable annual credit of approximately $450,000. Our thorough PAD analysis offered invaluable insights into their ongoing projects and the responsible parties involved.
In the architecture and engineering domain, it was essential to consider fee types as they significantly impacted project qualification. A time and material fee was deemed low-risk, as work could continue without monetary loss, regardless of the duration. Conversely, the fixed fee model induced pressure to meet timelines, budgets, and design specifications, elevating risks and potentially jeopardizing qualification eligibility.
ARCHITECTURE
- Development of schematic design, design development, and final construction documents
- Design modification for resolving conflicts between multiple trades' drawings
- Designing unique buildings and structures
- Development of custom structural support solutions
- Evaluation of multiple design solutions for technical problems
- Considering structural integrity and custom architectural elements
- Design activities Including estimating and programming
- Reviewing and modifying designs for cost reduction and energy efficiency
- Exploring alternative materials for specific design requirements (e.g., sound absorption, energy efficiency)
- Developing comprehensive architectural master plans
- Development of curtain walls, facade, and other building envelope systems
TYPICAL EXAMPLES OF QUALIFYING A&E ACTIVITIES:
When undertaking a project that involves extensive design work and encompasses uncertainties related to abilities, methodologies, and materials to be employed, numerous opportunities for Research and Development (R&D) applicability arise. On the other hand, if a project employs a repetitive design without uncertainties, it may not be eligible for R&D qualifying activities. Having accurate project time accounting data proves to be highly beneficial in this context, enabling the testing of projects and determining qualifying expenditures for R&D purposes.
Impact of recently signed Inflation Reduction Act (IRA) on Commercial and Residential Tax Incentives
ENGINEERING
- Providing comprehensive foundation design solutions informed by geotechnical findings
- Innovative development of design alternatives to address unique challenges at project sites
- Implementing seismic retrofitting strategies for structurally sound buildings
- Designing and optimizing industrial processes for efficient production facilities
- Expertly conducting environmental remediation activities to restore ecological balance
- Utilizing CAD & BIM modeling to meticulously plan and visualize 30 building projects
- Performing computer modeling and simulation to ensure optimal design and site conditions
- Proficiently utilizing software tools like AutoCAD, REVIT, BIM, HEC·RAS, STAAD, and ANSYS
- Adapting designs and making modifications to meet rigorous regulatory compliance standards.
COMMERCIAL
The Commercial Energy Efficient Deduction (EPAct §179D) is a tax incentive in the United States aimed at encouraging energy efficiency in commercial buildings. This deduction allows commercial building owners and design firms to claim tax benefits if they have made eligible energy-efficient improvements to their properties.
To qualify for the §179D deduction, there are three main components that need to be met:
- Interior Lighting System
- HVAC and Domestic Hot Water System
- Building Envelope
Starting in 2023, the Improved Retrofit Act (IRA) will bring significant changes to energy-saving tax deductions. Architecture and engineering firms will now benefit from increased deductions ranging between $2.50/sf and $5.00/sf, granted they achieve 25% to 50% energy savings while complying with new prevailing wage and apprenticeship standards. Failing to meet these requirements will still secure a reduced deduction of $2.50/sf to $5.00/sf.
The most notable shift lies in the allocation of deductions. Formerly exclusive to government projects, starting in 2023, tax-exempt entities, such as Indian tribal governments and private colleges and universities, can also enjoy designer allocation.
For retrofit projects until the end of 2022, ASHRAE 90.1 building comparison is the norm for qualification. However, in 2023, an alternative tax deduction is introduced. The new approach demands a comprehensive evaluation of proposed buildings and their energy-efficient measures (lighting, HVAC, building envelope) against existing building energy use intensity. This assessment necessitates gathering 12 months of utility data pre-construction to establish a baseline, followed by a comparison to utility data post-construction. The resulting post-construction savings will determine the tax deduction amount, ranging from $0.50 to $5.00 per square foot.
Before commencing renovations on existing buildings, it is vital to develop a retrofit plan, pre-approved by a registered architect or engineer, ensuring a minimum of 25% savings compared to the current structure. A proactive approach to energy-efficient improvements ensures success in the construction process.
RESIDENTIAL
The IRC §45L New Energy Efficient Home Credit is designed to incentivize developers to build energy-efficient dwelling units, such as single-family homes, multifamily buildings, and mobile homes. As of December 31, 2022, this credit is available for dwelling units acquired by sale or lease to be used as residences. However, starting January 1, 2023, significant modifications have been made to the credit rate and eligibility criteria for units acquired from that date onwards.
For single-family homes:
- To qualify for the tax break, projects must meet the government-backed "ENERGY STAR" qualification, which certifies energy efficiency.
- Meeting the new standard allows for a tax credit increase to $2,500 per unit, up from the current $2,000.
- Achieving the higher "Zero Energy Ready Home" (ZERH) standard grants an even more substantial credit of $5,000 per unit.
- No prevailing wage requirement applies in either case.
For multi-family homes:
- In order to be eligible for the tax break, projects must also meet the "ENERGY STAR" standard, ensuring energy efficiency.
- Meeting the ENERGY STAR certification results in a tax credit of $2,500 per unit, or $5,000 per unit if the ZERH program requirements are met (assuming prevailing wage requirements are fulfilled).
- Failure to meet the prevailing wage requirements reduces the credit to $500 for ENERGY STAR certification and $1,000 for the ZERH program.
TCJA CHANGES THAT COULD IMPACT R&D
The 2017 Tax Cuts & Jobs Act (TCJA) introduced certain changes that may have implications for Research & Development (R&D) in Architecture & Engineering (A&E) and construction firms. Although these changes are yet to be confirmed until after the mid-term election, it is prudent to be prepared. One significant amendment brought about by the TCJA is the requirement to amortize research expenditures. Additionally, the TCJA now considers all software development as an R&D expenditure. It's essential to note that the research credit itself remains unaffected, but these changes do influence the economics of research in three primary ways:
- Instead of focusing solely on expenses, the new approach involves considering capitalized and amortized costs as the primary financial perspective.
- The §280C election offers the option to claim a reduced credit. However, if taxpayers choose not to elect the reduced credit under §280C, the excess research credit over the current year's R&E (Research and Experimentation) amortization deduction will reduce the amount of R&E capitalized for that year. For example, in 2022, the research credit percentage must exceed 10% for taxpayers to experience any deduction. Opting for the reduced credit may no longer be advantageous for many taxpayers.
- The elimination of the reasonableness requirement under §174 is positive news for research-oriented firms. This change in compliance issues allows more flexibility in claiming research-related benefits.
COMPLIANCE ISSUES
Be cautious with taking the §45L energy efficiency credit for residential dwellings if you are also conducting a cost segregation study on the property. The order in which you handle these matters is crucial. If you have already taken the credit, it will no longer be a 3115 process. To make a method change, you must pay an $11,500 IRS user fee and file by the end of the year. This can lead to significant added expenses. If possible, file the 3115, wait for it to be effective, and then file amended returns.
For building owners
§179D is available on timely filed, original returns subject to normal 9100 late election relief. However, bonus depreciation (QIP) or 179 expensing (QRP) may eliminate federal benefits.
For designers
§179D is available on timely filed, original returns and is also available on amended returns for open tax years. However, no Form 3115 late election relief is available in this case.
CONCLUSION
If your clients or organization seek more guidance and resources on maximizing the benefits of these credits and provisions, feel free to reach out to the authors:
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