The Research Tax Credit – A Tax Saving Strategy for Architectural and Engineering Firms?
A frequently asked question these days is, “do architectural and engineering/construction firms qualify for the R&D tax credit?” The answer, unfortunately, is not simple. While research tax credits can be a lucrative incentive for any firm, a unique set of facts and circumstances is required for an A&E firm to qualify.
For an activity to qualify, it must meet four criteria:
- The project must discover information relating to a new or improved business component; a business component can be a product, process, technique, formula, invention or software item.
- Research must be technological in nature; it must utilize principles of the hard sciences (engineering, chemistry, biology, physics, computer science, etc.).
- The research must be intended to eliminate uncertainty regarding the development or improvement of a business component; design uncertainty does satisfy this requirement.
- A process of experimentation must be used to eliminate the uncertainties-evaluation of alternatives, such as by calculation, drawing, modeling or simulation.
Architecture and engineering (A&E) firms are generally involved daily in developing new or improved business components that are technological in nature, making it easy to satisfy criteria 1 and 2 above. However, many A&E firms believe there is no technical uncertainty regarding those development activities and that design is just “what they do.” Those firms may overlook the fact there are significant technical uncertainties addressed in schematic or system design of a business component, as well as in detailed designs; both likely satisfy the uncertainty requirement in the tax credit regulations.
Regarding the process of experimentation requirement, projects with technical uncertainties will require designers to develop and evaluate multiple alternatives and innovative solutions to uncontrollable constraints. Evaluation of alternative designs and design changes provides good indications of qualified research.
Examples of activities that may be eligible for R&D tax credits include:
- Development of new plant and process assays.
- Expansion and optimization of existing plant operations.
- Construct-ability reviews intended to identify improvements to asset or process design.
- New production systems or high-tech processes to produce or treat hydrocarbons, hydrogen, ammonia, ethanol, and/or other molecular compounds.
- Process design relating to the integration of key components.
- Development of innovative assembly or construction methods that accelerate or improve the construction process associated with large infrastructure assets.
- Design of temporary structures used in the construction process.
- Development of computer models for analyzing design configurations, performance characteristics and environmental impact.
Although A&E firms are expected to be involved in several activities that meet the qualification requirements, this does not necessarily mean there will be research credits available; there are potential exclusions that could limit eligible expenses. The primary concern for A&E firms is the exclusion related to funded research. Research is deemed to be “funded” if the taxpayer is not financially at risk for the research or if the taxpayer does not own the rights to the intellectual property.
The deciding factor in whether a company is financially at risk for the research is the payment terms of the contract, i.e. whether payment is guaranteed regardless of success or failure. If payment is guaranteed, the company has no financial risk since the risk of failure lies with the customer. However, for most A&E firms, payment is contingent upon success; “If we don’t deliver, we don’t get paid.”
Intellectual property terms, especially ownership rights to the research results, are just as important as determining financial risk. In situations where the contract stipulates ownership of the work product belongs solely or exclusively to the customer rather than the firm, the research is still considered “funded” regardless of the payment terms of the contract. In addition, contracts may consider work product to be “work for hire” under U.S. copyright laws, which would categorize the efforts as “funded” as well. Contracts for technical diagnosis, evaluation, observation, review and study, not new design, often fall into this category. The tax preparer should note that contracts are used to determine financial risk and rights, and are usually requested as documentation during IRS examinations.