The IRS has reported that millions of businesses are likely eligible for the research credit, yet a far fewer number actually claim it. (This tax break is also referred to as the “research and development,” “R&D” or “research and experimentation” credit.)
Construction companies may not view themselves as “cutting-edge innovators” in the vein of software developers or medical researchers, but contractors can qualify for the research credit and potentially reap a substantial reward in lower tax liability.
Four-part test
The research credit was originally created under the Economic Recovery Tax Act of 1981 and has been revised by various regulations and legislation since. Essentially, the tax break allows a business to reduce its federal and state income taxes by a percentage of the eligible expenses incurred for qualified activities.
Such activities are qualified by a four-part test. First, you need to spend time and money developing a new tool, process or technique for your business and/or industry. A product might be a new tool, whereas a process or technique could be a methodology for improving the performance, efficacy or efficiency of your construction activities.
The improvement by this new tool, process or technique must be evolutionary or advanced in nature. In other words, you can’t claim the credit for a personal taste item like the mixing of a new shade or color of paint. The new tool, process or technique needs to be a novel design element or a new approach for construction. Fortunately, 2003 U.S. Treasury regulations lowered the standard from “revolutionary development” in the industry to “evolutionary development,” easing access to the credit while retaining some stringency.
The second test stipulates there must be uncertainty before the research is performed. Innovation, by definition, can’t be a slam dunk. The new tool, process or technique must spring from questions such as, “How could we redesign this tool to perform better and yield improved results?” or “Could our construction company actually perform this technique on our projects and see appreciable benefits?”
The third test dictates that an activity must evaluate different alternatives by experimentation of some sort. The experimentation should try to eliminate the uncertainty of whether a tool, process or technique will work by either building models of a product, simulating a process or technique on a computer, or conducting trial-and-error tests of a process or technique to find the best way.
The fourth test states that the activity must be technological or scientific in nature. For example, you might synthesize chemicals to develop a new construction product or implement physical science or engineering principles to come up with a new building process or technique. (To be clear, you don’t need to have invented or discovered the chemistry, physical science or engineering principles applied.)
Qualified expenses
If your research activities meet the four tests in the eyes of the IRS, you can include many of the associated costs as qualified expenses when claiming the credit. Specifically, expenses eligible for the credit must be direct costs incurred while performing, supervising or supporting your research. Examples include costs:
- Associated with laboratory-style experiments (performing),
- Incurred so project managers or others can supervise research (supervising), and
- Of fabricating tools or components while doing research (supporting).
Direct costs of materials and supplies will typically qualify as long as they’re clearly associated with the research. Administrative costs are usually ineligible because they’re considered overhead. Travel, telephone costs and rent expense are also ineligible for the same reason. However, Internet costs generally are includable.
A contractor’s eligible expenses can also include 100% of wages paid to employees working on the qualified activities and supplies or materials costs incurred directly for those qualified activities. These must be payroll wages (including bonuses) but not pretax benefits such as a retirement plan or health care insurance.
Qualified research expenses may also include hiring subcontractors to work on the research project. However, eligible subcontractor expenses include a lesser 65% of the amount paid to them for qualified activities.
Powerful stuff
The research credit is powerful because, like all credits, it reduces tax liability dollar for dollar. Also, if you realize you’ve already been conducting research of one kind or another, you can amend your tax returns three years back and request refunds. Or you can carry forward the unused tax credits for 20 years.
However, be forewarned: The calculations and administrative burden associated with the credit can be difficult. Ask your CPA for help determining whether you’re eligible and, if so, claiming this valuable tax break.
Employee Retention Credit still available
While you’re looking into the research credit for your construction company (see main article), don’t overlook the Employee Retention Credit. When originally introduced under the CARES Act, it equaled 50% of up to $10,000 in compensation — including health care benefits — paid to an eligible, retained employee from March 13, 2020, through December 31, 2020.
However, the Consolidated Appropriations Act, signed into law in late 2020, boosted the credit from 50% of qualified wages to 70%. It also expanded eligibility by reducing the requisite year-over-year gross receipt reduction from 50% to only 20% and raised the limit on per-employee creditable wages from $10,000 for the year to $10,000 per quarter. In addition, the threshold for a business to be deemed a “large employer” — and subject to a tighter standard when determining the qualified wage base — has gone up from 100 to 500 employees.
Finally, the American Rescue Plan Act, signed into law in March 2021, extended the availability of the credit for eligible employers that continue to pay wages during COVID-19-related closures or reduced revenue through December 31, 2021.
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