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R&D Tax Credit: Could Your Company Qualify?

Is your company overlooking a potentially lucrative tax credit?

Many contractors don’t realize that some of the work they do might qualify for the federal Credit for Increasing Research Activities, more commonly referred to as the R&D tax credit. In fact, some experts estimate that less than a third of companies that qualify for the credit actually take advantage of it.

The reasons some companies overlook the R&D credit include misconceptions about whether they qualify and the complexity of the documentation that’s required. In addition, for many years the R&D credit was a temporary provision, subject to congressional renewal every few years. This made it difficult for companies to rely on the credit in planning long-term tax strategies.

Recent Developments
This situation changed in late 2015 with passage of the Protecting Americans from Tax Hikes (PATH) Act. The PATH Act made the R&D credit permanent and also modified it to make it more accessible – and potentially more advantageous – to some companies.

In the past, the Alternative Minimum Tax (AMT) made it impractical for many companies to claim the R&D credit since their AMT liability would wipe out any income tax savings they achieved. Now, however, qualifying small businesses (those with less than $50 million in average gross receipts) can apply the R&D credit against their AMT obligation as well.

The PATH Act also added a startup provision that allows certain small businesses to apply the credit against some of their payroll taxes. This provision went into effect just this year. To qualify for this provision, the business must have annual gross receipts of less than $5 million and no gross receipts prior to the most recent five years.

Qualifying Activities and Expenses
R&D Tax CreditAlthough the term “R&D” conjures up images of high-tech laboratories, many of the design, experimentation and problem-solving activities associated with construction projects could meet the R&D credit requirements. To qualify, the activities must meet four criteria:

  1. Permitted purpose – The activity must be done as part of developing or improving a business component, such as project designs or plans. Examples include trying a new material or experimenting with a new construction technique.
  2. Technological in nature – The improvement must rely on principles of science or engineering. This includes construction-related disciplines such as electrical, mechanical and structural engineering.
  3. Uncertainty – The activity must be intended to eliminate some uncertainty regarding the design, method or the company’s capability. Note that this does not have to be groundbreaking industry research. Experimenting with materials or methods that are simply new to your company could qualify under the right circumstances.
  4. Experimentation – The activities must involve some form of experimentation, such as computer modeling, field tests or even systematic trial and error.

Many functions associated with design-build projects could qualify, provided all other conditions are met. Qualifying expenditures include wages, supplies, materials and in some cases the costs of paying for contract research by third parties.

Funding and Risk
There are important exceptions that could make some R&D expenditures ineligible for the credit. The most common exception is for funded research – in other words, research for which the contractor is specifically reimbursed regardless of the outcome.

On a time and materials contract, for example, the customer is actually funding the research. Because the contractor is not at risk of losses if the research is unsuccessful, the R&D credit would not be available. On the other hand, a fixed fee contract shifts the risk back to the contractor, making the contractor eligible for the credit.

Simplified Computation
Another stumbling block that often discouraged contractors from filing for the R&D credit was the complicated calculations the IRS required to compute the credit. This burden was eased several years ago with the introduction of a new Alternative Simplified Credit (ASC).
Unlike the traditional method, which can require financial information dating back to the 1980s, the ASC can be calculated using qualified research expenses for only the current year and the prior three tax years.

What’s at Stake
The size of the R&D credit can vary significantly, but it typically ranges from 4 percent to 10 percent of the qualifying research expenditures. According to the IRS, 341 construction companies filed for the R&D credit in 2013. Their average credit was almost $83,000.

The qualifying criteria are fairly stringent and the calculations are not simple, even under the ASC. Nevertheless, a potential tax credit of that size is probably worth investigating.

To learn more about qualifying for the R&D credit, please call us at 401-331-0500 to schedule a consultation with one of our tax professionals.