R&D Tax Credit Opportunities for Construction Companies

Contractors: Don't blame yourself if you've been running on the assumption that your company is ineligible for the federal research and development (R&D) tax credit. Many people believe the potentially lucrative tax break is available only to organizations in industries commonly associated with experimentation and innovation, such as technology and life sciences. But construction businesses may indeed qualify for the credit — sometimes without knowing it, and even if they don't report profits in a given tax year.

How Does It Reduce Taxes?

Under Section 41 of the tax code, the R&D credit generally equals 20% of the excess of a company's domestic qualified research expenses (QREs) for the tax year over a base amount. The base amount is usually calculated in part based on the taxpayer's average gross receipts for the four most recent years. QREs include:

• Wages for employees involved with the research,
• Supplies to conduct the research,
• Amounts paid to rent or lease computers for research purposes (including many cloud-computing arrangements), and
• 65% of amounts paid or incurred for contractors involved with the research.

Notably, for some taxpayers, the credit isn't applicable only to offset income taxes. Qualified small businesses (QSBs) can also apply up to $500,000 annually for five years against payroll taxes. That means you can benefit even if you have a loss for the year.

QSBs are corporations (including S corporations) or partnerships with 1) gross receipts of less than $5 million for the tax year, and 2) no gross receipts for any tax year in the preceding five-year period ending with the tax year. Note that the payroll credit first reduces an employer's Social Security tax for the quarter, then it reduces the employer's Medicare tax for the quarter. Any remaining excess carries over to the next quarter.

Corporations without publicly traded stock, partnerships and sole proprietorships whose average annual gross receipts for the preceding three-year period don't exceed $50 million also have the option to offset the alternative minimum tax. Members of controlled groups, businesses under common control and affiliated groups are treated as employed by a single employer for purposes of this gross receipts test.

Which Activities Qualify?

To claim the R&D credit, your construction business must generally satisfy the following four factors:

1. It must perform research to eliminate technical uncertainty about the development or improvement of a "business component." This is generally defined as a product, process, technique, formula, invention or type of software.
2. It needs to undertake the research to discover information that's technological in nature. In other words, your efforts must be based on physical, biological, engineering or computer science principles.
3. It must intend to apply the research to develop a new or improved business product or process.
4. Its research activities must substantially be elements of an experimentation process related to a new or improved function, performance, reliability or quality.

While these requirements may seem daunting, you'd be surprised how many of your company's activities might satisfy them — especially in today's innovative construction environment. Qualified research activities could include:

• Exploring alternative project delivery means and methods (before work begins),
• Testing constructed systems throughout a job,
• Improving building components (for example, to withstand natural disasters or improve sustainability), and
• Developing construction models.

If your business engages in such activities, or has in the recent past, you could qualify for the credit or a refund that trims your tax bill and reduces your effective tax rate and estimated tax payments.

What Documentation Is Needed?

The IRS has heightened the information requirements for refund claims. So, comprehensive documentation is essential. Claimants must identify all business components to which the refund claim relates for the relevant year. Also, for each component, you need to:

• Identify all research activities performed,
• Name the individuals who performed each activity (or provide their titles or positions),
• Describe the information each individual sought to discover, and
• Provide the total qualified employee wage expenses, total qualified supply expenses and total qualified contract research expenses for the tax year.

In addition, you'll have to keep contemporaneous records to fulfill those requirements, including payroll and hours (divided between qualifying and nonqualifying activities), third-party contracts and invoices, and detailed documentation of the research process.

Who Can Help?

Although potentially beneficial, the R&D credit is far from simple. We can help you determine whether your construction company qualifies for the tax break. If it does, we'd be happy to assist you in documenting your research activities and claiming the credit come tax time.