The Construction Contractor’s Guide to the R&D Tax Credit
If a construction business includes an engineering or architectural component, it may be eligible for the Research and Experimentation Tax Credit, also known as the federal R&D tax credit.
The R&D tax credit is a dollar-for-dollar tax credit designed to incentivize U.S. companies to stay ahead of the curve in technology and research, and help the nation maintain a competitive advantage in an increasingly global economy.
This credit is not one that typically comes to mind for a construction contractor; however, design-build services, as well as certain innovative construction practices that improve the reliability, functionality or performance of an existing product or trade process, can qualify for the credit. One of the key components in determining whether or not an activity qualifies is uncertainty–there must be a technical uncertainty involved in the service. If at the outset of a project, there is certainty that the construction can be completed in a specific way, or if the project is relying upon mature and proven construction methods, then it doesn’t qualify for the credit.
Typically, expenses incurred in the first three phases of the design and engineering process (conceptual design, schematic design, and design development) contain significant amounts of uncertainty. Therefore, these expenses can often qualify for the credit. However, it is ultimately the contract terms and language that will determine whether a project qualifies, as the contract outlines who bears the financial risk as well as who ultimately has substantial rights. In terms of the R&D tax credit, the IRS looks unfavorably on cost-plus contracts, milestone payments that are contingent on progress, and payment upon acceptance in a fixed fee pricing arrangement, among others.
There are two ways to calculate the credit; each is based on company-incurred qualified research expenses, which fall into four primary categories:
- W-2 Wages: amounts paid to employees for research activities
- Materials & Supplies Expense: amounts paid for tangible items going into research activities
- Contractor Research Expense: amounts paid to subcontractors (Note: contractors must have substantially all of the rights to the research being performed in order for the expense to qualify.)
- Research Payments: any amount paid to a qualified educational institution for research (this category is unlikely to apply to a contractor)
According to John Colwell, CPA, and Brian J. Shin, CPA, of Crowe Horwath, LLP, the following construction activities qualify for the credit:
- Experimentation with new material combinations and evaluation of their performance properties.
- Development of innovative assembly or construction methods that accelerate or improve the construction process associated with large infrastructure assets.
- Unique bridge or roadway designs.
- Unique construction or innovation techniques in untested environments.
- Building designs to support unique structures.
Calculating the R&D tax credit can be complicated; there are specific documentation criteria, which can open up the risk of an audit if not met properly, that are required from the outset of a project. Therefore, it is strongly recommended that contractors consult with a tax advisor early on to determine both whether they qualify for the credit and the calculation method most suitable to their situations.