If your firm provides design-build services or develops innovative construction techniques, you may be eligible for R&D tax credits on your federal and state returns. In years past, these credits were subject to restrictions based on your alternative minimum tax (AMT). However, effective January 1, 2016, firms with three-year average gross receipts below $50 million may take full advantage of all eligible credits, even against AMT!
What expenses are eligible for the R&D tax credit?
For purposes of calculating your R&D tax credit, you may include expenses associated with research, development, design, and engineering. This definition casts the net wide enough to include services performed by architects, engineers, and the design components associated with electrical contracting, HVAC fabrication, and other major building systems. You may also include expenses that advance your firm’s knowledge, skills, and experience – e.g., evaluating new materials or developing new construction techniques. Your “R&D” does not have to be revolutionary for the industry as a whole!
Once you determine that an expense is suitable based on the activity performed, you need to demonstrate that you are “at risk” for the outcome associated with that expense. For example, if you have a Design-Build contract on a Time & Materials (T&M) basis, then the client is “at risk” for the performance of all aspects of the project excluding negligence or misconduct. In that case, you cannot claim tax credits for the design services. However, if your Design-Build contract is on a Fixed Fee basis, then tax credits may apply if you are determined to be “at risk” for the qualifying expenses.
If you work with subcontractors, you may take 65% of the amounts paid to them into your R&D credit calculation if you are “at risk” for those costs. A T&M contract or a cost plus with a maximum price improves the chances of the credit applying to subcontract payments. However, if you negotiated fixed fee contracts with your subcontractors, it’s unlikely that you’ll be considered “at risk” for those expenses and, therefore, won’t be able to include them in the calculation. An R&D tax specialist can help you determine which contracts qualify for credits and which ones do not.
Examples of expenses that fall outside the R&D consideration include designing marketing campaigns, developing promotional materials, meeting with city or county officials regarding zoning, preparing or reviewing bid packages, and drafting specifications for interior design.
How do I earmark expenses eligible for the R&D tax credit?
If you perform the eligible research, development, design, and engineering work using your own employees, then you may include some or all of their wages (as reported in Box 1 of their W-2 forms) based on the percent of their time dedicated to these functions. If they spend 80 percent or more of their time in this capacity, then you can include 100 percent of their wages. You’ll need a credible form of documentation to substantiate your employees’ claims on how they spend their time.
If you use subcontractors to perform qualifying activities, you may use the portion of their invoices that relates to these activities. Again, if that subcontractor is deemed “at risk” for performance, then those expenses do not qualify for your tax credit.
Materials and supplies associated with eligible actives may also be considered for treatment as a tax credit.
When should I evaluate my eligibility for tax credits?
A working knowledge of R&D tax credits as they apply to your circumstances can inform the manner in which you structure contracts. If the potential benefits are substantial, it pays to incorporate language that strengthens the case for your “at risk” standing. For example, a subcontractor agreement based on Cost Plus with a Maximum Price builds a stronger case for eligibility than a Fixed Price contract.
As you incur eligible expenses, your accounting system should have the means to flag them for easy reference by your tax advisor. It is also useful to establish a system through which the affected employees can track their time and provide suitable documentation for cost allocation.
When you prepare your return, your tax expert will make the complex calculations that determine the manner in which this credit should be applied to your circumstances. While the specifics are beyond the scope of this article, your firm’s revenue, tax bracket, eligible credits, and other factors influence the optimal treatment.
The value of expert advice
If the R&D tax credit plays a material role in your tax filings, you should work with an advisor who is well-versed on the applicable and has deep background on relevant case law. While the classification of expenses may be relatively straightforward, the determination of which party is “at risk” can be subject to interpretation. The more aggressive your posture on these expenses, the more likely your need for case law to support your claims. Absent this expert advice, you risk payment of back taxes with penalties and interest should an audit or legal action prove unfavorable.
Meet the Author
Dan Larson, CPA
Aldrich CPAs + Advisors LLP
With over 20 years of public accounting experience, Dan Larson provides construction tax services to contractors and construction companies. He has deep expertise in tax accounting methods and tax credits for contractors. He presents on tax issues affecting contractors for various organizations on a regular basis. Dan has a Master of Science in accountancy with…
- Construction tax
- Certified Public Accountant
- Research and development tax credits
- Strategic tax planning and compliance