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Confusion and gray area have surrounded the research and development (R&D) tax credit (technically called Research and Experimentation tax credit IRS Code Section 41) for years. Both CPAs and business owners struggle to understand the complex nature of the credit, and the definition of “qualified research activity.” But a recent win in the U.S. Tax Court is one giant step in clearly defining this valuable credit for architects in a more robust way.
Congress originally passed the R&D tax credit for research and development in 1981, while consistently implementing expansion and clarifying guidance to the original bill. R&D credits were made permanent in the PATH Act passed in December 2015, along with a provision for start-up companies to offset FICA payroll taxes and qualifying small businesses to offset their AMT (alternate minimum tax) limitations.
The biggest impact for architects was the adoption of the four-part test in place of the Discovery Test in 2004, which changed the qualifying activity from a requirement of “new to the industry,” to “new to the company.”
This designation opened the door for architects to apply the four-part test to their projects in determining the time involved on innovative projects and overcoming technical challenges. The four-part test is defined as: a permitted purpose, technological in nature (engineering), the elimination of uncertainty, and a process of experimentation.
The technical nature of R&D tax credits causes most CPAs and businesses to seek subject matter experts to assist with a formal analysis of qualified activity, time, and complex calculations. At Engineered Tax Services, these experts are tax attorneys who have years of experience and education in the field.
However, IRS auditors are not always as educated or knowledgeable in the specific code requirements or interpretations, which has caused differing opinions between the IRS and taxpayers. Some of these arguments revolve around the term “funded research,” and the assumption of risk rule, which involves contractual agreements between architects and their clients.
What is Funded Research?
The tax code specifically outlines a definition to determine which party to a contract is entitled to the credit: “qualified research does not include “funded research,” as defined as “Any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).” No credit is allowable to the contractor for funded research. IRS Sec 41(d)(4)(H).
Research is considered funded research unless two conditions are met: (1) payment is contingent on the success of the research, and (2) the contractor retains substantial rights in the research. (Sec 1.41-4A(d), Income Tax Regs.)
This leads taxpayers and IRS auditors to the contracts between an architect and their client to determine eligibility. In a few cases, the IRS has taken the position that architects are performing funded research. However, the February 2020 court case Populous Holdings, Inc. v. Commissioner of Internal Revenue upheld the Petitioner’s position that in a fixed fee or fixed price contract, it is considered unfunded research, and therefore the architect qualifies for the tax credit!
What this means is that architects now have a solid case to uphold their position in support of R&D tax credit claims. The court docket says that fixed-price contracts are inherently risky to the designer if the research or design is unsuccessful. And under fixed-fee pricing, the designer would have to fix any failed concepts at their own expense, thereby placing economic risk on the designer rather than the client.
The second point of contention with the IRS is the determination of who owns the rights or knowledge to the research. Because many clients gain ownership of the blueprints and building design, it has been argued that the client owns the rights. Many clients own copyrights on their construction documents, models, renderings, and other work product. And the IRS claimed that the architect did not retain rights and thereby is not entitled to the credit.
However, the court decided that “ownership of documents does not dictate the right to use technology-related research results or mean that the clients had exclusive right to the petitioner’s research” (Populous Holdings, Inc. v. Commissioner of Internal Revenue). There was no provision prohibiting an architect from using related research technology in their business, which therefore makes them eligible to their original R&D tax credit claim.
Engineered Tax Services has invested years on Capitol Hill speaking with legislators and the Oversight Committee to discuss the need for clarity from the IRS on R&D tax credits for services industries including architects and engineers, but progress has been slow.
This court case offers supporting case law to defend an architect’s right to claim R&D tax credits for their work on innovative and unique projects, and areas that require overcoming technical challenges in their designs!
Claiming R&D tax credits requires a fair amount of documentation required by the IRS. That’s why it’s important to seek professional help from a consultant with a strong expertise in helping architects successfully claim these valuable tax credits. Our R&D experts dig much deeper into the fundamentals of your business activities—incorporating operations, engineering, financial, and tax expertise that results in more credits and meticulous documentation that is necessary to support your activities, costs, and credit. There is a direct correlation between the amount of your defensible credit and the expertise of the advisor performing the tax credit study.
Learn More About R&D Tax Credits for Architects
The R&D tax experts at Engineered Tax Services have helped companies of all sizes across the U.S. identify and qualify these expenditures and receive the tax benefits they have been missing. Our process begins with an R&D Tax Credit Qualification Analysis to make sure your company qualifies for the R&D tax credit.
If you own or invest in multifamily properties such as rental units, you are focused on increasing the property’s value over time. One of the most effective ways to accomplish this is to decrease your tax liability through federally approved tools like cost segregation. While cost segregation is well-known among other commercial property owners, it is sometimes overlooked in the multifamily property space. While the fundamentals of cost segregation are the same for all commercial properties, there are differences in IRS rules and strategies for attaining maximum tax benefits with multifamily units.
Through cost segregation, multifamily property owners can separate property components so that items such as land improvements and personal property can be separately depreciated over shorter recovery periods for cost savings. The process of identifying assets and determining which costs qualify for accelerated depreciation is a critical tax-savings tool that also increases your cash flow.
The Tax Cuts and Jobs Act (TCJA) of 2017 made cost segregation even more lucrative. Since 2001, property owners have been able to take a depreciation deduction of 50% for certain portions of eligible assets in the year they acquired it. This bonus was limited to new property and other assets with a shorter lifespan. Bonus depreciation enacted as part of the latest tax reform allows for 100% first-year bonus depreciation on certain depreciable business assets with a life of 20 years or less.
See related blog: Tax Reform Changes Regarding Cost Segregation.
While other commercial property typically has an IRS depreciation period of 39 years, multifamily property generally has a depreciation period of 27.5 years. Cost segregation allows you to take deductions over 5, 7 or 15 years. If you are able to reclassify portions of your building to take tax deductions at 5 or 7 years, the accelerated tax deductions could mean thousands of dollars per year in tax savings. What’s more, if you are making immediate improvements upon acquiring a property, these cost savings can offset investments that can’t be recouped through rent increases. And, since multifamily property investors often hold properties for up to 10 years before selling at a profit, the accelerated depreciation timetable is an especially valuable asset for their investment.
Cost Segregation Studies: Identifying Property Assets for Accelerated Depreciation
The way to determine how quickly you can accelerate depreciation schedules is through a cost segregation study. Engineering and tax professionals are needed to conduct the study to determine which aspects of your buildings(s) can be reclassified. A qualified engineer will use blueprints and cost reports to determine whether property can be reclassified for tax benefits. This physical inspection will sort relevant assets into property classes and justify why each asset has been assigned to a particular class. The study will also state and explain the cost basis for every asset.
To learn more about the information that needs to be collected for a cost segregation study, read our related blog: What Information Needs To Be Collected For A Cost Segregation Study?
If you have not had a cost segregation study performed in the past, you can still benefit through retroactive studies. As long as the property was acquired, remodeled or expanded since 1987, you have an opportunity for savings through reduced income taxes. You don’t even have to wait to take the depreciation—you can take the unrecognized depreciation deduction the year the cost segregation study is performed.
Depreciation Recapture—a Balancing Act
Cost segregation offers multifamily property owners and investors a tremendous opportunity for cost savings. However, it is important to note that the IRS considers any capital gains from the sale of depreciated property as personal income that must be taxed at your ordinary income tax rate, also known as depreciation recapture. Most investors will find they can still benefit from cost depreciation. By working with your tax professional, you can determine whether the ability to invest in additional properties today outweighs what you must pay the IRS when you sell.
The engineering and tax professionals on the cost segregation team at Engineered Tax Services have helped real estate owners and investors significantly increase their cash flow by identifying and reclassifying assets of their building for faster depreciation. Request a Free Benefit Analysis to identify an estimated benefit and ensure a cost segregation study makes sense for your property.
To learn more about cost segregation studies for real estate owners and investors, call Engineered Tax Services at (800) 236-6519 or visit cost segregation page for more information.