From designing sustainable buildings to developing plans that incorporate more cost-efficient materials or construction methods, architects and engineers often pursue innovative new techniques in their day-to-day work. However, many architecture and engineering firms miss out on the opportunity to significantly reduce their tax burdens with a commonly overlooked incentive: the Research and Development (R&D) Tax Credit.
Each year, large corporations save billions of dollars through the federal R&D Credit, while many smaller and mid-sized businesses mistakenly assume that they are not eligible. One of the most common misconceptions preventing taxpayers from claiming the R&D Credit is that it is reserved for those engaged in high-tech or scientific research. In reality, this incentive is available to businesses in several different industries—including architecture and engineering—and is now more available than ever to smaller and newer businesses. Here is a brief overview to help demystify this lucrative incentive for architecture and engineering firms:
What is the Research and Development (R&D) Tax Credit?
Also called the Research and Experimentation (R&E) Tax Credit, the federal R&D Credit was adopted in 1981 as a way to encourage growth and progress in the U.S. by rewarding businesses that pursued innovative solutions. For decades, the credit was not a permanent part of the tax code and was subject to renewal by Congress almost annually. However, this hindered the purpose of the credit; without certainty that tax savings would be available to help offset the costs of research activities, some businesses were hesitant to pursue them. Fortunately, the Protecting Americans from Tax Hikes (PATH) Act of 2015 made the R&D Credit a permanent part of the federal tax code.
Changes to the R&D Credit under the PATH Act
In addition to permanently adding the R&D Credit to the tax code, the PATH Act included two significant changes that made it easier for small and mid-sized businesses to capture tax savings:
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- Businesses with an average of $50 million or less in gross receipts over the past three years may now use the R&D Credit to offset their alternative minimum tax (AMT) liabilities. Previously, the credit could only be used against income tax, which reduced its utility for some smaller businesses.
- Businesses that have been in operation for less than six years, had no gross receipts for the five preceding tax years, and have gross receipts of $5 million or less in the current year may now apply the R&D Credit to their FICA payroll tax liabilities. However, the credit amount is limited to $250,000 and cannot exceed the company’s payroll tax liability during a given quarter.
Which architecture and engineering activities may qualify for the R&D Credit?
A wide variety of activities may constitute qualified research for purposes of the R&D Credit. Businesses claiming the credit must demonstrate that their activities satisfied each prong of the following four-part test:
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- Permitted purpose. The purpose of the activity must be to create or improve a product, process, or software. For architects and engineers, this prong may be met with activities such as creating designs that include energy efficiency measures or accommodate unique site conditions or client requirements.
- Elimination of uncertainty. The business must seek to eliminate some uncertainty in capability, design, or method that exists at the beginning of the project. For example, architects and engineers may attempt to find the optimal solution for variables such as which building materials should be used.
- Process of experimentation. The activity must involve a process of experimentation designed to evaluate one or more alternatives. For example, architects and engineers often use modeling, computational analysis, engineering calculations, or an informal trial and error process to test alternative design concepts.
- Technological in nature. The process of experimentation must be technological in nature and must rely on principles of the physical or biological sciences, engineering, or computer science.
Examples of activities that do not qualify for the R&D Credit include those performed outside the U.S., conducted solely for the purpose of improving aesthetic appeal, and the routine testing of materials or products for quality control purposes.
What are qualified research expenses (QREs)?
Qualified research expenses (QREs) are costs that a business incurs while conducting qualified research. For instance, QREs may include wages paid to employees who perform qualified research or their supervisors, amounts paid for supplies, and amounts paid to third parties who are contracted to perform R&D activities. Businesses may begin accruing QREs at the conception of an idea through the phase just prior to commercial production.
Claiming the R&D Credit
Claiming the credit requires thorough documentation of qualified research activities. For example, a business may need to provide payroll records, employee time sheets, project lists, project cost summaries, and tax returns.
Do states offer R&D Credits?
Yes! In addition to the federal R&D Credits, several states offer their own credits that reward qualified research. These credits may be even more substantial than at the federal level, and claiming them typically does not require much more effort once documentation is prepared for the federal credit.
R&D Tax Incentive Consultants
At Capital Review Group (CRG), our team of tax experts has helped countless businesses, including architecture and engineering firms, save hundreds of thousands of dollars through state and federal R&D Credits. For example, we helped a mid-sized engineering firm based in Phoenix save approximately $152,000 per year in federal R&D Tax Credits and $234,000 per year in Arizona R&D Credits based on activities such as developing environmentally friendly designs and testing different design concepts.
Wondering if your firm qualifies for the R&D Tax Credit? Contact CRG today to schedule a consultation!