It may not be as easy for architecture and engineering firms to qualify for R&D credits, but that doesn’t mean it’s impossible. Now that tax reform may result in lower corporate tax rates, it’s a good time to investigate any R&D activities that occurred for the 2015, 2016 or 2017 tax years. Resulting credits could offset higher federal tax in previous years as well as state franchise or business tax collected in Texas. The first step is an R&D study.
R&D Credit Qualification
Sustainability has been a trend in architecture and engineering for many years. As professional service firms develop new processes and methodologies for making buildings stronger, more environmentally friendly or flexible for users, they may not be thinking about how this innovation could reduce their tax impact.
Once the primary realm of manufacturing or product developers, we know that research and development is happening in service-based industries, too. Due to some changes to federal tax law, options have expanded for more firms to access R&D tax credits. In addition, the digital solutions that companies use to track project costs and processes may make it easier than in the past to collect data and determine eligibility.
A recent case study of one engineering firm that underwent an R&D study found enough quantitative data on R&D costs to support refunding most of the firm’s federal tax liability for the three prior tax years. There was also enough carry-forward remaining to provide the estimated equivalent of an additional four years’ worth of credit. When the firm was audited, according to R&D study expert SourceHOV|Tax, the IRS audit was clean.
The data to support the credit came from the engineering firm’s experience with large government and corporate clients that would request sustainable structures and require new designs to accomplish it. The firm’s historical preservation projects also require new processes and methodologies to strengthen buildings and support longevity without compromising historical integrity.
If you have even the slightest sense that an R&D study could benefit your engineering, design or architectural firm, know that there are different levels of studies that can accomplish your goal. Most importantly, current discussions around tax reform make this 2017 tax year the best time to look into it.
Tax Reform Encourages Closer Look at R&D Credits
Two years ago, federal legislation made the R&D Tax Credit a permanent business credit, which meant that business owners could now plan ahead for future tax years rather than guessing whether or not it would be available and for which types of businesses. The credit was expanded to offset the Alternative Minimum Tax for private, Eligible Small Businesses (ESBs) with gross receipts of less than $50 million. There is also a payroll tax offset up to $250,000 available to Qualified Small Businesses (QSBs) with less than $5 million in gross receipts that were started up to five years ago.
If they qualify, businesses can receive a credit for qualifying R&D expenses that may include the following:
- Salaries and wages – mainly W2 (Box 1)
- Supply costs – used or consumed during research and experimentation
- Contractor costs – up to 65 percent of qualifying costs, including paying for rights and risks of R&D, which means assuming the risks of experimentation without any funding for it and having substantial rights to the research results
In order to quality for the credit, businesses must pass a four-part test related to their research and development activities in a given tax year.
Permitted Purpose – Is the activity intended to improve a business component’s functionality, performance, reliability or quality?
Technological in Nature – The activity performed must not rely on social sciences, but on the principles of physical, biological and computer sciences or engineering
Elimination of Uncertainty – The activity is intended to discover information to eliminate technical uncertainty regarding the capability or method for developing or improving a product or process, or the appropriateness of the business components’ design
Process of Experimentation – With the result being uncertain, the activities involved in trying to achieve the result must be experimental in nature, and include actual experiments and evaluation of one or more alternatives
A few of the qualifying research expenses (QREs) for architectural and engineering firms could happen during the Pre-Design and Bidding process when professionals may experiment with initial design and concepting. But the most significant QREs occur during the Schematic Design and Design Development phases. Professionals may need to evaluate, analyze and test concepts more heavily and also produce mock-ups of innovative or untried processes and methodologies for the client.
Your firm may have already conducted qualifying R&D in previous years and not realized that expenses related to that R&D could make your firm eligible for a tax credit. Fear not. R&D Tax Credit studies can look back three tax years to identify qualifying research expenses. The reason this may be significant for your business now is that tax reform may reduce corporate tax rates going forward. The potential for high tax savings through an R&D tax study won’t get any better than now if corporate tax rates drop for 2018.
The current R&D credit allows firms to offset federal taxation as well as state franchise or business taxes in Texas for tax years 2015, 2016 and 2017. For qualifying businesses, the resulting tax credits often outweigh the costs of an R&D study when you factor in the potential federal and state tax savings.
If your firm provides any of the following services, it is worth considering an R&D Credit Qualification tax study:
- Geotechnical services
- Civil engineering
- Structural engineering
- Mechanical engineering
- Electrical Engineering
There are exceptions to R&D conducted in these disciplines, the main one having to do with funded research. If your firm is under contract and paid to conduct research or if you have received a grant to conduct the research, it may be hard to prove that your expenses qualify for a tax credit. A tax expert experienced with R&D tax credit feasibility like Cornwell Jackson can usually determine this factor early in the discovery process.
Talk to the tax team at Cornwell Jackson about your potential R&D qualifying activities. We can review your data to discover qualifying research expenses and help you decide if an R&D study would be financially valuable for your firm.
Gary Jackson, CPA, is a tax partner at Cornwell Jackson. Gary has built businesses, managed them, developed leadership teams and sold divisions of his business, and he utilizes this real world practical experience in both managing Cornwell Jackson and in providing tax planning to individuals and business leaders across North Texas. Contact him at firstname.lastname@example.org.