A court weighs in on non-qualifying activities and expenditures.
Are you considering taking advantage of a research and development (R&D) tax credit for your general construction (GC), or mechanical, electrical, and plumbing (MEP) company? Determining what qualifies can be challenging. A recent U.S. District Court summary judgment against a construction industry taxpayer illustrates the complicated and strict rules for which activities and expenditures do and do not qualify for the credit.
R&D tax credits are designed to incentivize spending in the U. S. on research and development activities. They are available to taxpayers in many industries, including for GCs and MEPs, as long as the business is seeking to develop new products or improve existing products and processes, and the related projects or activities involve a sufficient level of technical uncertainty.
To benefit, the taxpayer must have both qualifying research activities and qualifying research expenditures. For taxpayers in the construction industry, qualifying activities often involve the engineering and design of a project. But many other activities related to the construction, renovation, and expansion of a building can also qualify, including design reviews and experimentation with raw materials. Qualifying expenditures can include internal labor costs, including wages, as well as the cost of outside consulting.
Qualified research activities
As they relate to general construction, activities that typically qualify for an R&D tax credit include:
- Development of estimates based on designs provided by architects or engineers
- LEED and green initiatives
- Evaluation of engineering and construction methods for improvement in build time or overall performance and reliability
- Development of unique material transfer systems on project sites (e.g. crane design)
- Development of temporary support structures for active construction
- Testing and validation of new mechanical systems to solve technical uncertainties
For MEP companies, qualifying activities include:
- Design and development of HVAC systems for new or existing structures
- Development of unique heat exchange, humidity control, and air filtration solutions
- Improvement of energy efficiency via system design
- Design and development of electrical systems
- Architectural lighting design
- Design and development of plumbing systems
- Development of coolant delivery systems for refrigeration
- Development of pressurized air, water, and other substance distribution systems
- Design and development of sprinkler and fire protection systems
The court case: two factors
While there are many R&D qualifying activities and expenditures for contractors, a recent U.S. District Court ruling in United States v. Grigsby highlights two critical factors, “funded research” and “business component,” where related activities and expenditures were disallowed, resulting in a summary judgment against the taxpayer:
- Funded research, any research funded by a grant, contract, or otherwise by an individual or governmental entity, does not qualify for an R&D tax credit. That seems to imply that if you are paid to do the work, it will not qualify. However, there are two contractual requirements that determine whether the work is “funded”:
- Funded projects do not include amounts paid based on the success of the research. If you bear the economic risk of getting it right—if the project is unsuccessful, you will not get paid—then the work is not funded. For contractors, that often means that fixed-price or lump-sum contracts will qualify, but cost-plus or time-and-expense contracts will not.
- A taxpayer is eligible for the R&D tax credit only if it retains the rights to the research; if the contractor is eligible to reuse the results of the project without paying someone else, they have retained the rights.
Key concerns for contractors
United States v. Grigsby reveals some key concerns for contractors taking or considering taking an R&D tax credit. First, many GCs will find it difficult to meet the business component test related to qualifying research activities. However, MEP subcontractors, especially those doing design work, can often establish their business component as a product they are developing and evaluating with alternatives. Second, the terms of a contract are critical to determining whether the research is funded and therefore ineligible for the credit.
Given the high level of complexity associated with applying for the R&D tax credit, contractors should work with a qualified expert to identify their eligibility for, and calculation of, an R&D tax credit. HBK works with clients in many industries, including construction, to help them claim R&D credits. We can help you too. For more information, or to schedule a meeting with a Construction Industry tax specialist, call us at 330-758-8613, or email me at email@example.com.