Each year, many small businesses leave dollars on the table by neglecting to claim tax incentives for which they are eligible. Architecture firms are not immune to this oversight. In fact, the tax code provides a few incentives for which the activities of architecture and engineering firms are uniquely suited. Understanding the requirements imposed by these incentives is the first step for businesses seeking to maximize their tax savings.
Since the requirements for the Research and Experimentation (R&E) Tax Credit were changed in 2003, it has represented a lucrative savings opportunity for many businesses, including architecture and engineering firms that routinely conduct research activities. To claim the R&E Credit, taxpayers must demonstrate that they engaged in activities that satisfy a basic four-part test:
- The purpose of the activity must be to create new or improve the existing functionality of a business component.
- The taxpayer must intend to eliminate uncertainty about the project they are undertaking.
- The taxpayer must engage in a systematic process of experimentation, ranging from informal trial and error to modeling and computational analysis, with the goal of evaluating one or more alternatives.
- The process of experimentation must be technological in nature and must fundamentally rely upon principles of the physical or biological sciences, engineering, or computer science.
For architects, various routine activities may fulfill this test. Examples include developing designs that incorporate new techniques, performing engineering calculations or construction planning, evaluating and testing designs, and creating designs that take into account clients’ requirements, municipal codes relating to structure or energy usage, climate, and site conditions.
The R&E Credit is calculated based on the qualified research expenses (QREs) the taxpayer incurred. QREs include wages paid to employees and amounts paid for supplies used in the conduct of eligible activities, as well as other specified costs. These expenses may be captured using either the project accounting or the hybrid method. With project accounting, the method preferred by the IRS, the taxpayer will ideally track information contemporaneously with time sheets. The hybrid method, on the other hand, captures portions of qualified expenses incurred by different cost centers without considering work done on specific projects. Although the hybrid method is used by most tax service providers, it has been repeatedly attacked by the IRS and state auditors. Consequently, Capital Review Group (CRG) recommends the project accounting method.
When claiming the R&E Credit, businesses should maintain and share with their tax advisors several forms of documentation from the previous four years, such as a payroll report, trial balances, federal and state tax returns for the business and its shareholders, a project list with cost summary, and a fixed asset addition schedule. CRG offers research studies to guide clients interested in claiming the R&E Credit. However, CRG only proceeds with a study if a careful analysis of the client’s documentation reveals that it is worthwhile to pursue. If a research study would be useful, CRG discusses the potential benefits and estimated costs involved with the client and his or her CPA firm. Once the client signs an agreement granting CRG permission to conduct the study, CRG obtains and analyzes more detailed information and prepares a report based on its findings. The client then uses this report when filing for the R&E Credit.
Designed to encourage sustainability in commercial buildings, §179D of the tax code allows a deduction for energy-efficient upgrades to a building’s envelope, lighting, or HVAC systems. The deduction may amount to $1.80 per square foot, or $.60 per square foot for each of the three subsystems. Section 179D applies to new and existing buildings that are used primarily for commercial or industrial purposes, as well as multifamily housing of four or more stories. All upgrades must satisfy the standards enumerated in ASHRAE 90.1-2001. Projects must be certified by a third party with an engineering analysis that uses Department of Energy-approved software.
When the owner of a building eligible for §179D is a tax-exempt government entity, the deduction may be allocated to the primary designer of the energy efficiency measures. Primary designers include architecture firms, mechanical engineers, and lighting designers. These taxpayers may look back and claim the deduction for open years, which are generally within three years of the date of filing.
Different information must be provided when taxpayers are claiming the deduction for lighting than when they are claiming it for HVAC, the building envelope, or the whole building. However, all claims require information such as the square footage covered by the project, the cost of the project, and the date that it entered service. When assisting primary designers of energy-efficient upgrades, CRG reviews documentation and confers with the client and his or her tax advisors to ensure that the client may take and use the §179D deduction and that the government agency that owns the building will allocate the deduction.
Unfortunately, both the R&E Credit and the §179D deduction expired at the end of 2014. However, these incentives and other so-called tax extenders have a long history of being retroactively renewed each year after lapsing. In July 2015, the Senate Finance Committee passed a bipartisan bill with strong support to extend these provisions through the end of next year. The bill would modify the R&E Credit to allow certain small businesses to claim the credit against their Alternative Minimum Tax (AMT) or payroll tax liabilities. It would also allow tribal governments and non-profit organizations to allocate their §179D deductions to primary designers, while updating the eligibility requirements to align with the more recent ASHRAE Standard 90.1-2007. Although Congress is not likely to take further action on the Senate Finance Committee’s bill until later in the year, businesses should continue to consider these incentives in their tax-planning strategies in anticipation of their retroactive renewal.
By understanding the requirements of the R&E Credit and the §179D deduction and collaborating with tax professionals as needed, architecture firms may enjoy a significantly reduced tax burden. Contact CRG to learn more about the process involved in capturing the benefits of these incentives.