With the high demand in housing and multi-use properties currently increasing in sometimes record amounts across the country, it may be a surprise to companies within the Design-Build industries, including Architecture, Engineering, and Construction, which provide the engineering, design and manufacturing processes related to new housing and real estate development that some of these activities can be qualified and claimed as part of the Research and Development Tax Credit. The difficulty with these types of activities – and which is commonly the case related to other manufacturing industries and activities – is the determination of where the design process ends, and production begins. For the Research and Development Tax Credit, the important activities to focus on are those that occur up to the point of when a product, business component or design is considered as “in production”.

For an example – some companies provide the engineering design necessary for the components of a home or other structure – i.e., the walls, the trusses and roof, and floors. The time spent by the engineers to design each component, as well as the time spent combining those components into overall building designs can likely be considered as qualified activities, as long as the four tests – technical uncertainty; process of experimentation; new or improved performance, function, quality or reliability; and based on “hard sciences” such as engineering – are met. In this example, these four tests might be met in the following manner:

  • Technical uncertainty – the overall design for a wall is unknown – what the framing design will be; what the materials will entail and what impact those materials will have upon the structural integrity of the wall; what will be the ultimate load bearing capability of the wall and will it meet all necessary specifications?

  • Process of experimentation – many design firms utilize advanced software such as CAD to analyze the overall structures of engineered items. Computer simulation is an allowable form of process of experimentation – a systematic, recordable, or observable manner in which to eliminate uncertainty from a design. Additional activities that might fall under process of experimentation in this example might include the fabrication of a prototype wall for actual physical testing of load bearing, or in finding the point of failure; or in analyzing the impact that moisture has on the performance of the wall.

  • New or improved performance, function, quality or reliability – even though walls are common and have been around for centuries, the specific application and design needs of walls in new construction can be considered as a new design, especially if the whole of the design (the house or structure) is a new design. It may be perfectly suitable and successful to import a wall design used in other instances, but it is still unknown whether that wall will function as necessary according to specifications.

  • Based on “hard sciences” – this test is to ensure that the activity being claimed is not related to sectors of activity considered as explicitly non-qualified – ie., accounting, marketing, human resources, etc. The majority of companies performing these design activities will be basing their work upon engineering and physics principles and knowledge, which are considered “hard sciences.” For example – the physics behind the development of a load bearing wall – evaluating the impact of wind and other natural forces on the structural integrity of a wall design, and what impact utilizing different materials might have on these forces.

Some items of concern other than identifying when the design process ends, and the production process begins including how companies performing these activities structure their agreements with clients and customers. The main items of concern in this area are who retains the rights to the design, and who inherits the risk of performing the activity?

Staying within the example of designing the components of a home or structure, if the company performing these design activities has an arrangement with a real estate development firm to provide designs, and will receive payment regardless of whether the designs are used or if the designs meet the specifications provided by the developer, then these design activities, no matter how complex, would be considered funded research – because the development firm has paid for the rights to the designs, and also inherits the financial risk regardless of the final design.

However, another agreement structure might entail the design firm receiving a portion or “good faith” deposit from the developer, the remaining amount being contingent upon the delivery of an acceptable final design. In this case, any costs for the design efforts that occur outside of the initial good faith deposit would be a risk of the design firm. And the contingency aspect of the acceptable final design also puts the risk inherently with the designer, and not the developer. Regardless of the structure of the agreement, it is very important that when claiming these types of activities for the Research and Development Tax Credit that the agreements be collected as part of the contemporaneous documentation required to successfully defend a claimed credit.

These are just a few ways that Design-Build industries can participate in and benefit from the Research and Development Tax Credit. The main issues to consider are:

  • When does design end and production begin?
  • If there was a design agreement with a third party, what is the structure of that agreement?
    • Who holds the rights to the design and the risk of the design activity?
  • What documentation has been collected to support the claim?
    • Design documents – showing iterations, computer modeling, testing, test reports, photos of prototype testing, etc.
    • Agreements between the Design Build firm and their client/customer

IRS Circular 230 Required Notice‐‐IRS regulations require that we inform you that to the extent this communication contains any statement regarding federal taxes, that statement was not written or intended to be used, and it cannot be used, by any person (i) for the purpose of avoiding federal tax penalties that may be imposed on that person, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein

Covid-19 Issues with Research Credit, June 2021

The research Credit and Covid-19

Covid-19 has impacted almost every part of people’s lives.  This includes the business world where organizations have had to limit operations and, in some cases, either let people go or furlough employees.  These measures that businesses and organizations had to make will have a significant impact on the Research Credit. 

In order to combat some of the hardships businesses and employees were experiencing, the federal government passed the Paycheck Protection Program (PPP) as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act.  This program was designed to provide an incentive to keep employees on the payroll.  The PPP were low interest rate loans that had the potential to be completely forgiven if certain criteria were met and were structured as having either two- or five-year maturity period.  If the funds were used for payroll costs, interest on mortgages, rent, and utilities, and at least 75% of the amount had gone to payroll then the loan would be forgiven. 

Deductibility of PP expenses

If the loan is forgiven, then the expenses used came from PPP funds should still be included in the Research Credit calculation. Initially based on the April 30, 2020 IRS issued Notice 2020-32 to provide guidance regarding the deductibility for federal income tax purposes it was thought the PPP funds would include some risk to the R&D credit.  The notice stated that no deduction was allowed under IRC for an expense that is otherwise deductible if the payment of the expense results in forgiveness of a PPP loan, because the income associated with the forgiveness is excluded from gross income.  It goes on to reference Sec. 265 as the specific disallowance provision and notes that case law would disallow the deduction because the taxpayer has reasonable expectation of reimbursement for the expenses. Since this initial determination Congress passed the Consolidate Appropriations Act[1] which allowed the full deductibility of ordinary and necessary business expenses that were paid and forgiven with a PPP loan.

Planning for employee expenses

Some foresight and planning to determine what potential qualified expenses were funded by a forgiven PPP loan would be a beneficial exercise.  One Covid-19 issue that will take extra investigation is how employees were categorized during any office or business closures.  The way businesses and organizations handled employees during this difficult time varied but for the most part fell into one of a few categories.  Those categories would be: employee was laid off or furloughed with no pay or work duties; employee was paid to work from home; employee was paid but not required to fulfill normal job duties or only limited duties; and finally employee was considered essential and had normal work throughout the pandemic. 

The biggest items to review are if an employee is qualified for the Research Credit and how that employee’s pay and job duties were affected by Covid-19. Some employees who typically would be considered to have qualified activities in a normal year may still have been paid to work at home, but not able to do the same types of work as a typical business year.  This scenario would result in the employee’s qualified percentage being lower for the year and result in lower wage QREs.  Another scenario could be an employee was laid off or furloughed for part of the year.  With no pay the employee would not count that time as part of the work year, so there is potential to keep a stable qualified percentage of time.  The IRS has not come out with guidance for these various issues but based on the current regulations and how paid time off is treated it is safe to assume the same would apply to breaks in work for Covid-19 related issues.

The 2020 tax year will be a more difficult year to understand and develop a tax plan.  These issues will need to be accounted for as taxes are filed. Proper planning and expert help can allow for the best tax position for each business. If you have more questions related to Research Credit, please contact CFO Services.

CFO Services Can Help With Your Research Credit & Tax Incentive Needs

The R&D Credit provides an opportunity to reduce tax liability. In order to maximize the R&D Credit impact to don’t forget to capture all the expenses that should qualified, especially wages that are direct support.  To learn if you’re eligible for the R&D Credit or have more questions related to qualified direct support, please contact CFO Services.

Through knowledge and perspectives gained working with virtually every industry and type of client (Fortune 500, medium-size and small companies), CFO Services has committed to a strategy of providing a depth of knowledge in a narrow field of focus: business incentives and credits. Providing tried and tested methodologies, our professionals can help almost any business research, identify and comply:

  • Research and Development Credits
  • Multi-State Tax Incentives and Credits
  • State Sales and Use Tax
  • Strategic Alliances
  • Workforce Training

IRS Circular 230 Required Notice‐‐IRS regulations require that we inform you that to the extent this communication contains any statement regarding federal taxes, that statement was not written or intended to be used, and it cannot be used, by any person (i) for the purpose of avoiding federal tax penalties that may be imposed on that person, or (ii) to promote, market or recommend to another party any transaction or matter addressed herein.

[1] P.L. 116-260 Consolidated Appropriations Act, 2021 [12/21/2020] 276(a)(1)(i) ‘(1) no amount shall be included in the gross income of the eligible recipient by reason of forgiveness of indebtedness described in subsection (b),

(2) no deduction shall be denied, no tax attribute shall be reduced, and no basis increase shall be denied, by reason of the exclusion from gross income provided by paragraph (1), and”