By Deb Roth on July 25, 2023
Practice Leader/Managing Director
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.
The activity should aim to enhance or create a business component, such as a product, manufacturing process, or software, by focusing on:
The activity must be fundamentally based on principles from any of the following disciplines:
The activity should be focused on gathering information to remove technical uncertainty related to:
The next common inquiry we receive is: "What is the process for gathering the expenses related to the R&D tax credit?"
Your R&D expenses encompass both internal and external costs, such as salaries, wages, supplies, and leases. Salaries and wages have three main components:
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.
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.
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.
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.
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.
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
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:
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.
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.
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:
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.
§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.
§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.
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:
Amid the ongoing challenges posed by COVID-19, numerous small and midsize businesses are grappling with maintaining cash flow, operational capabilities, and their internal research and development initiatives. While the Coronavirus Aid, Relief, and Economic Security (CARES) Act did extend financial aid to these COVID-19-affected enterprises through emergency grants, retention tax credits, and forgivable loans, these solutions offer only temporary cash flow relief, falling short of providing lasting solutions.
The R&D Tax Credit Carryforward Period refers to the duration during which unused portions of research tax credits can be applied to offset future tax liabilities. This provision is often overlooked by many taxpayers who are eligible for R&D Tax Credits. In most cases, companies that have qualified research expenses but lack current income can carry forward these credits to offset taxes on forthcoming profits. The carryforward period allows credits to remain applicable for up to 20 years. Additionally, the option to carry back credits for the previous year is also available.
Navigating the world of R&D Tax Credits often prompts the question: Can these credits be converted into cash refunds? It's a query frequently posed by businesses seeking to maximize their returns on research and development investments. While R&D Tax Credits themselves aren't inherently refundable, they can still yield a financial windfall in the form of cash benefits.