Civil engineering firms can qualify for research and development tax credits.
The research and development (R&D) tax credit is one of the Internal Revenue Service's (IRS) best-kept secrets. Many engineering executives have never even heard of it, and most engineering firm principals and managers likely underestimate—or ignore entirely—the amount of R&D their firms conduct, missing a potentially tremendous cost savings in the form of R&D tax credits.
The Credits for Increasing Research Activities, as the R&D tax credit is more formally known, is, without doubt, one of the most complex and least understood corporate tax credits available. The IRS has a battalion of auditors solely dedicated to it, as do many states. Some accounting firms have entire divisions focused on generating these credits for their clients. American companies amassed more than $5 billion in R&D tax credits last year. So why haven't you heard of it? Probably because you might not think that your company does R&D in the traditional sense.
When most engineering executives think of R&D, they imagine people in white lab coats hovering over Bunsen burners or computer programmers slaving away into all hours of the night. They don't recognize many of their own firm's R&D efforts, such as improvements in specification designs, modeling, and infrastructure investments. Managers frequently view these activities simply as normal and ordinary business operations. In doing so, you are missing the opportunity to recoup as much as 10 percent of related expenditures as R&D tax credits—a dollar-for-dollar credit against your tax liability, in addition to normal tax deductions for R&D expenses.
Congress created the R&D tax credit in 1981 as an incentive for greater private-industry research investments. Recognizing that technological innovation drives economic growth, productivity, and competitiveness, the purpose of the credit was to reverse a decline in U.S. research and development and to encourage U.S. companies to expand their research activities.
The credit is known as a tax recovery or reimbursement amount, intended to offer substantial financial incentives to profitable companies engaged in certain types of product development and process engineering activities. It was meant to be used by businesses of all sizes in a variety of commercial activities, including engineering, manufacturing, processing, food production, and other commercial endeavors.
Unfortunately, the scope and complexity of documentation requirements have historically made many small- and mid-size businesses believe that pursuing the R&D tax credits was not worthwhile. The companies that took advantage of the credits were generally large manufacturing and high-tech concerns that did "traditional" R&D and could afford to hire the Big Four accounting firms. Smaller companies that were less familiar with the credit lacked the expertise to determine how they could benefit, especially within the engineering industry.
However, recently issued IRS Regulations have made it easier to qualify for the R&D credit by broadening the array of activities and industries that qualify and by providing greater flexibility in certain record-keeping requirements.
A technical understanding of potentially qualifying R&D expenditures is the first step toward maximizing tax savings. Qualification is determined by the nature of the activities performed, not by their outcome or the job titles of the personnel performing the activities.
If you qualify, your company can apply for credit for the current year, as well as for as many as three prior calendar years. The amount of R&D tax credits is calculated using a somewhat complex formula, but for most companies, the credit amounts to 10 percent of total qualified R&D expenditures in a given tax year. Governments from 27 states also offer some form of additional R&D tax credit.
Qualified R&D expenditures include salaries and wages for employees who work on or supervise development projects, support staff, contract labor, materials, and supplies. Nearly 70 percent of the R&D tax credit dollars claimed by business are investments in the salaries of researchers.
What qualifies as R&D?
R&D is a documented, systematic, step-by-step process of experimentation that is technological in nature. At its most basic level, research is a planned effort to gain new knowledge that will hopefully be useful in developing a new product, service, process, or technique, or in bringing about a significant improvement to an existing product or process. Development is the translation of your research findings from theory to practice.
A process may be intended to achieve cost reductions or to generate revenue. Also, the need for R&D does not necessarily need to be generated internally; rather, it can come about through having to solve technical problems related to new customer orders or changes in product application.
Engineering activities that typically qualify as R&D include the following:
- experimenting with new materials and integrating the materials to improve products or processes;
- analyzing functional requirements;
- performing engineering to evaluate new or improved specifications/modifications in terms of performance, reliability, quality, and durability;
- conceptual design, testing, and modification of possible product or process alternatives;
- design, construction, and testing of prototypes and models;
- design of tools, jigs, molds, etc. involving new technology;
- engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready to be constructed;
- experimenting with new technologies; and
searching for applications of new research findings or other knowledge.
Documentation is essential for receiving and supporting the credits. Firms must be able to demonstrate to the IRS clearly and completely that the project work was indeed R&D. Documentation needed to present to the IRS includes the following:
- difficulties the company faced trying to achieve its objectives;
- issues encountered during the course of the development work;
- processes the company undertook to resolve any uncertainties; and
- support that the activity is technological in nature, relying upon the principals of the physical or biological sciences, engineering, or computer science.
Providing the IRS with formal project reports will be most effective; although dated notes, drawings, photos, letters/memos, earnings documentation, invoices, and other records will suffice in many cases. A qualified tax advisor can guide you through the regulatory requirements to ensure that you have the documentation needed to present to the IRS.
The process a qualified advisor uses to help a company determine and apply for R&D tax credits involves the following steps:
- Perform an initial analysis to estimate the approximate amount of credit for which a firm may be eligible.
- Scrutinize employees and their job functions to estimate how much of a given employee's time was dedicated to R&D.
- Evaluate similar resource expenses and allocate percentages to R&D, as appropriate.
- Review external expenses to identify additional costs incurred to further R&D efforts.
- Determine exact tax-credit eligibility.
- Compile supporting data and documentation.
- Amend and re-file as many as three prior years of tax returns.
It is a complex process, but one that can be extremely lucrative. A recent engagement that Wiss & Company completed in conjunction with CCR Cost Recovery Services gives a perspective on what the R&D tax credit can mean to engineering firms. We helped a large, New Jersey-based engineering, design, planning, and construction management firm apply for the R&D tax credit for three previous tax years. Like many engineering firms, it had never before pursued an R&D tax credit because it didn't realize that its work was R&D related. Two months after taking the firm through a process similar to the one outlined above, it received a tax credit of more than $1 million.
Implications for the engineering industry
Any firm with cutting-edge technology in its field is likely to have eligible R&D costs. Engineering and construction firms—from civil engineering and nanotechnology to supercomputing and alternative energy—spend a significant amount of time developing new processes that qualify as R&D. There is a constant effort underway to improve existing products, plans, and processes. Uncertainty about a particular issue or design is resolved through a discovery process based on trial and error and experimentation. The costs associated with the time and effort that go into that discovery process amount to R&D expense.
So why haven't engineering firms seen the millions of dollars in R&D tax credits they could potentially benefit from? In part it is because the aforementioned misunderstanding of their eligibility. However, it is also endemic to the highly fragmented nature of the engineering industry, which is made up mostly of small, privately held firms in their first generation of ownership. Many companies that fit this description fall prey to the fallacy that the cost and administrative burden of applying for these credits is impractical.
Fortunately, the application process has become streamlined enough for smaller and mid-sized firms to receive sizeable benefits from pursuing R&D tax credits. Most advisory firms charge a fee equivalent to a percentage of the overall credit, in addition to hourly or project fees, to collect the relevant documentation and amend prior-year tax returns. When you consider that it's not uncommon for an engineering firm to receive credits initially of $200,000 to $500,000 for three previous years of applicable expenses the first time they apply, the potential, overall cost savings is staggering.
The R&D tax credit will likely become a permanent fixture in the American tax code eventually. In the 25 years since its inception, the tax credit has been extended nearly a dozen times, and Congress is likely to heed the call of the American Society of Civil Engineers to make the credit permanent and eliminate uncertainty over its future, thus motivating companies to adopt longer-term views of research projects and the returns on investment they can generate.
Paul Peterson, CPA, is the partner in charge of Engineering Services for Wiss & Company, which provides accounting and tax advisory services. He can be reached at firstname.lastname@example.org .
R&D tax credit example
Anytown puts a contract out for bid for a new bridge, and XYZ Engineering is in the running. Every bridge has its own unique issues, which need to be analyzed. First, the design firm needs to determine what type of bridge (suspension, cantilever, etc.) is best suited for the city. From there, the engineering team needs to evaluate everything from weather patterns and wind effects, to how entry and exit will potentially affect traffic patterns, to the flexibility and durability of materials to be used. XYZ Engineering pulls its team together to brainstorm how to solve the problems, put together a plan, and estimate what the cost would be. This is the beginnings of the R&D process, and many of the costs associated with this work apply to the potential costs savings from an R&D tax credit.
If XYZ Engineering wins the contract to build the bridge, the engineers then need to determine how to best protect the bridge, for example, to ensure that it will survive a sudden, extreme stress, such as an earthquake or plane crash. To fully develop the bridge specification, the engineers need to test different scenarios. They might develop a 3-D computer model of the bridge design, which inevitably reveals problems with the initial design and leads to necessary modifications. Creating this model is the same as producing a prototype for a new ethanol-powered engine, an MP3 player, or a cancer treatment. It answers questions about uncertainties. It is R&D.