Claiming R&D Tax Credits in Architecture, Engineering & Construction: Risks and Rewards

Summary: R&D tax credits can help businesses in the Architecture, Engineering, and Construction (AEC) industries boost cashflow and fund innovation, but taxpayers in these industries must be diligent around determining, documenting, and supporting qualified activities.

Businesses in the architecture, engineering, and construction (AEC) industries are often tasked with devising unique and innovative solutions, whether dictated by unique client demands or technical project challenges. Either way, if the process of finding the perfect solution requires experimentation or trial-and-error (as is often the case), then these businesses may be eligible for the research and development (R&D) tax credit. However, these businesses must also be aware of certain pitfalls that could jeopardize their eligibility and increase the risks associated with claiming the R&D tax credit.

R&D Credit Eligibility may be Broader Than You Think

R&D tax credits are available at both the federal and state levels and provide a lucrative incentive to eligible companies. The general purpose of R&D credits is to incentivize innovation by U.S. businesses, so the eligibility criteria are broad and can encompass any company engaging in a process of experimentation to develop or improve a product, process, or software. Since the eligibility is so broad, there are grey areas around which specific industries can qualify, and some industries may carry a higher risk of audit. Businesses in the AEC industries often fall into this grey area since their work can vary between highly innovative and more routine.

Claiming an R&D credit for an AEC business will require more due diligence to prevent future headaches. Heightened audit risk and additional scrutiny of eligible activities mean these businesses will need to pay close attention to which activities and expenditures are included in the calculation and should prepare highly detailed documentation proving eligibility for each year the credit is claimed.

What R&D Activities may Qualify?

To improve the strength of an R&D claim, AEC firms should be clear about which R&D activities are likely to hold up to IRS scrutiny in the case of an audit. As defined by the Internal Revenue Code (IRC), firms must ground their claim in the 4-part test: activities must have a permitted purpose, be technological in nature, involve the elimination of uncertainty, and proceed by a process of experimentation. That process is similar to the scientific method, in which researchers generate a hypothesis and then test at least two alternate theories. In AEC, technical uncertainties can be related to how to achieve structural soundness, overcoming electrical concerns, architecting a structure within specific spatial constraints, and so on.

Research activities that are innovative typically qualify, even if they are not innovative to the industry as a whole. For example, methodologies or techniques that are new to the company may qualify, even if others in the profession have “discovered” or used those methods, so long as all four parts of the 4-part test are satisfied.

Additionally, the company’s engagement in a process of experimentation does not have to be successful in overcoming the technical uncertainties; many R&D activities qualify even if the experimentation yields inconclusive or unsatisfactory results.

Some examples of activities that typically qualify include:

• Developing, modeling, and testing unique structural solutions, control systems, and building materials;
• Creating novel techniques and solutions for atypical conditions, such as HVAC or lighting control systems, energy efficiency improvements, resource conservation and recycling, or advanced plumbing systems;
• Using simulation tools and modeling techniques to improve performance of design aspects related to building systems, renewable energy, load-bearing systems, geotechnical conditions, etc.;
• Projects that required multiple design drawings and/or the modelling of alternate schematics to minimize errors and complications.

A team of professional R&D credit specialists can parse the difference between unqualified and qualified activities and explain the nuances between the two.

What Activities are not Qualified?

Several activities within the AEC industry may seem, at first glance, to qualify for R&D treatment, and taxpayers may be tempted to operate with their own definition of “research and development.” However, if any part of the 4-part test is not met, then neither the activities nor the associated costs will qualify for the credit. The following efforts, though not a comprehensive list, are examples that do not qualify as R&D:

• Activities conducted to resolve questions around zoning. Zoning and permitting are bureaucratic concerns, not scientific (technological).
• Routine design work. Reproducing existing designs without significant improvement does not qualify, even if the original effort was innovative and technical in nature, as there is no elimination of technological uncertainty.
• Activities conducted overseas (not in the United States).
• Work to create systems built as final products adapted to specific customer needs (as opposed to pilot models constructed to address and eliminate technical uncertainty).
• Efforts to improve aesthetics. While uncertainty may abound, it is not technical/scientific and thus unqualified.
• Contracted work in which the firm does not retain the economic risk of development (typically time and materials contracts) nor the IP rights.
• Contracted work in which contracts lack provisions such as quality assurance procedures and specific barometers for success; such contracted activities can be deemed “funded,” interfering with the company’s research credit claim.

“Business Components” and Documentation

Any R&D tax credit requires the definition of one or more “business components” as well as the retention of supporting documentation. The Internal Revenue Code defines a business component as any product, process, computer software, technique, formula, or invention that is intended to be held for sale, lease, or license, or used by the taxpayer in its trade or business. In AEC, this could be a novel technique for improving a structure’s resistance to earthquake damage, or a process for overcoming geological challenges.

However, some court cases such as Phoenix Design Group, Inc. v. Commissioner, Leonard v. Grigsby,and Geosyntec Consultants Inc. v. United States suggest controversy around the validity of business component claims in the AEC industry. Cases such as these point to several key elements, including the need for the taxpayer to bear the financial risk of failure, and the requirement that research be aimed at resolving uncertainty rather than producing final products for specific customer needs.

AEC companies need to think critically about whether their qualified activities and business component(s) would be considered a product, process, software, technique, formula, or invention. A new form will require companies to select one of those options. If your AEC firm is developing plans or innovative design drawings, does that constitute a physical product? If so, does the firm have the supporting documentation to prove this? Perhaps your firm is developing new or improved techniques. Regardless, the company must retain the IP rights to what they develop.

Supporting documentation is crucial in the defense of an R&D credit, should an audit ever arise; indeed, contemporaneous documentation proving the 4-part test is the only evidence that will sustain a credit under audit. AEC companies claiming the credit should keep documentation on-hand and well organized. Good documentation examples include iterative technical drawings that demonstrate change from version to version and the scientific reasons why change was required; communications such as emails discussing technical uncertainties and proposed solutions; and slide decks outlining a process of experimentation in which the team evaluated alternative methods or approaches.

Final Thoughts: Call on an Experienced R&D Credit Advisor for Guidance

Despite some blunders from the AEC industry in calculating and claiming R&D credits, many companies have legitimate claims that can put cash back into the business. To avoid a time-consuming and costly experience, businesses should connect with reputable R&D specialists for guidance. These professionals will have deep knowledge of the credit eligibility requirements and the audit defense process to help you optimize your credit claim.