R&D Tax Credit Can Boost Cash Flow for Construction Companies

With the COVID-19 pandemic disrupting construction projects across the country for weeks, affecting bottom lines and cash flows, construction and engineering firms should take a closer look at the federal R&D tax credit and how this lucrative tax incentive could potentially mitigate the financial impact of this crisis.

While it’s been long associated with scientists and experimental lab work, the R&D Tax Credit (officially the Credit for Increasing Research Activities per Internal Revenue Code Section 41) is actually captured by businesses in a wide range of sectors, including the construction industry. Contractors, subcontractors, engineering and construction firms involved in the design, development and construction of innovative buildings and infrastructures have the potential to qualify for this valuable tax incentive that could reduce their federal income tax liabilities.

First enacted in 1981 as a temporary measure to incentivize U.S. corporations to increase their investments in new product and process development, the R&D tax credit was later made a permanent part of the tax code and has seen its scope and availability expand to more and more U.S. companies in recent years.

How can businesses claim the R&D tax credit?

Companies can claim the R&D tax credit through a tax return. The credit is calculated annually based on the amount of qualified research expenditures (QRE) paid or incurred by a company. In general, the amount of credit represents between 7% and 10% of the QREs paid or incurred during the year—a significant boost to the bottom line for cash-strapped businesses. QREs include internal wages paid to employees conducting R&D activities, supplies used in R&D activities and amounts paid to third parties hired to perform R&D activities on behalf of the company.

To calculate and capture the R&D tax credit, construction firms will need to assess the eligibility of their projects relating to design, development, and construction of new or improved buildings and infrastructures. The definition and requirements of R&D for tax purposes are lengthy and relatively complex, and the credit calculation can involve several steps. This is why tax professionals, in particular those who specialize in R&D tax, often assist construction and engineering firms with the calculation of their annual R&D credit.

In general, to qualify for the credit, a project will need to satisfy the four-part test set in Section 41 of the Internal Revenue Code:

• The purpose of the R&D activities must be to create a new or improved product, process or technique resulting in an increase in performance, function, reliability or quality;
• The R&D activities must be undertaken to resolve technological uncertainties;
• The R&D activities must rely on the principles of hard sciences such as engineering, physics, chemistry, biology or computer science; and
• The R&D activities must involve a systematic process of experimentation during which different solutions or approaches are evaluated.

What types of construction projects and initiatives qualify for the R&D tax credit?

In general, the following examples of projects and initiatives undertaken in the construction industry are likely to involve activities and expenditures that will satisfy the four-part test and qualify to the R&D tax credit.

• Designing and developing innovative buildings, structures and components.
• Designing and developing new electrical and HVAC systems or sub-systems for energy-efficient buildings.
• Designing and building net-zero homes.
• Experimenting with new combinations of materials, processes and environments.
• Developing new or improved assembly and construction methods to accelerate the construction process of assets.
• Designing and developing buildings and infrastructures incorporating new green technologies.
• Designing and developing unique structural systems in challenging seismic and environmental environments.
• Experimenting with new construction techniques in untested environments.
• Developing new shoring and dewatering processes.
• Developing new value engineering solutions.
• Participating in design-build bidding process for innovative buildings.
• Designing and developing advanced solutions to optimize utilities in atypical environments.
• Experimenting with building information modeling.
• Designing and developing structures and systems to withstand hurricanes, earthquakes and other environmental disasters.
• Designing and developing new or improved storm water management systems.

While many contractors, subcontractors and engineering firms are likely to engage in projects similar to those described in the examples above, one important caveat must be considered before concluding on eligibility for the R&D tax credit. The fact that these projects are often conducted pursuant to a contractual agreement with a third party can render eligibility murky. That is because funded research (either through a contract, grant or other form of compensation) does not qualify for the R&D tax credit.

Therefore, contractual agreements need to be reviewed carefully to determine if the company performing the R&D activities bears the financial risks of failure and retain rights to the results of the R&D work. Based on existing case law, work performed under a fixed-fee contract agreement can qualify for the R&D tax credit while work performed under cost-plus or times and materials agreements is disqualified.

Construction companies looking to learn more about the lucrative R&D tax credit can contact a tax professional who specializes in this area and can help them calculate and claim the credit for qualifying projects and initiatives.