Industry Insights

One of this year’s hot topics in the architecture and engineering industry has been the ability of some firms to benefit from federal and state research and development (R&D) tax credits. While R&D credits can be a lucrative incentive for any firm, a unique set of facts and circumstances is required for an architecture or engineering firm to qualify. Much of the information provided to firms in this industry has been incomplete or inaccurate—in some cases, encouraging aggressive tax positions. This article provides some facts about how these credits may apply to your firm.  

Background

The federal R&D credit has been extended through the end of 2011. It has been extended 14 times since its creation in 1981 and is expected to be extended again—either temporarily, as in previous years, or permanently. Currently under consideration, the Greater Research Opportunities With Tax Help Act is a bipartisan bill designed to strengthen the federal R&D credit and make it permanent.  

The following states also offer an R&D credit:

While this article focuses on the federal credit, taxpayers who qualify at the federal level likely also qualify at the state level if the research activity is taking place in one of the aforementioned states. 

Research credits can be a powerful tax savings opportunity. They are driven by wage, supply and contract research expenses related to qualified research activities. For an activity to qualify, it must meet four criteria:

• The project must discover information related to a new or improved business component; a business component can be a product, process, technique, formula, invention or software item.
• Research must be technological in nature; it must utilize principles of the hard sciences (engineering, chemistry, biology, physics, computer science, etc.).
• The research must be intended to eliminate uncertainty regarding the development or improvement of a business component; design uncertainty does satisfy this requirement.
• A process of experimentation must be used to eliminate the uncertainties—evaluation of alternatives, such as by calculation, drawing, modeling or simulation.

Architecture and engineering (A&E) firms are generally involved daily in developing new or improved business components that are technological in nature, making it easy to satisfy criteria 1 and 2. However, many A&E firms feel there is no technical uncertainty regarding those development activities and that design is just “what they do.” Those firms may overlook the fact there are significant technical uncertainties addressed in schematic or system design of a business component, as well as in detailed designs. Both will likely satisfy the uncertainty requirement in the tax code and regulations. Regarding the process of experimentation requirement, projects with technical uncertainties will require designers to develop and evaluate multiple alternatives and innovative solutions to uncontrollable constraints. Evaluation of alternative designs and design changes provides good indications of qualified research.

Although A&E firms are expected to be involved in several activities that meet the qualification requirements, this does not necessarily mean there will be research credits available; there are potential exclusions that could limit eligible expenses. The primary concern for A&E firms is the exclusion related to funded research. Research is deemed to be “funded” if the taxpayer is not financially at risk for the research or if the taxpayer does not own rights to the research results.

The deciding factor in whether a company is financially at risk for the research is the payment terms of the contract, i.e., whether payment is guaranteed regardless of success or failure. If payment is guaranteed, the company has no financial risk since the risk of failure lies with the customer. However, most companies argue that payment is contingent upon success, i.e., “If we don’t deliver, we don’t get paid.”

Intellectual property terms, especially ownership rights to the research results, are just as important as determining financial risk. In situations where the contract stipulates ownership of the work product belongs solely or exclusively to the customer rather than the firm, the research is still considered “funded” regardless of the payment terms of the contract. Contracts also may consider work product to be “work for hire” under U.S. copyright laws, which would put efforts under the “funded” exclusion as well. Contracts for technical diagnosis, evaluation, observation, review and study, i.e., not new design, fall in this category. Contracts ultimately are used to determine financial risk and rights and usually are requested as documentation during IRS examinations. 

Conclusion
A&E firms have the opportunity to take advantage of R&D credits. However, not all projects will qualify. Any firm considering taking this credit should seek upfront consultation with an R&D credit advisor to evaluate the potential benefits and risks.

If you have questions about how the R&D credits might apply to your firm, contact your BKD advisor.