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You may not be aware of it, but if you’re a property owner, some changes to current tax laws could put substantial money in your pocket, especially via cost segregation studies. With a little strategic planning, you can drastically reduce your tax liability and generate retroactive refunds for extra cash flow, freeing up capital for future investments and site improvements.
With depreciation, you calculate an asset’s reduction in value as time passes. You allocate the asset over a specific period when it’s expected to be useful. In the IRS’ view, commercial real estate has a useful period of 39 years, while land improvements (such as asphalt, parking, landscape, and security fences) are assigned a useful allocation of 15 years. Land is classified an asset that doesn’t devalue over time.
While straight-line depreciation takes your entire building and depreciates it evenly over 39 years, the modified accelerated cost-recovery systems (MACRS) methodology analyzes different parts of a building as individual assets, such as the roof, concrete, asphalt, carpet, appliances, doors, and signage, which may be depreciated over five, seven, 15, or 39 years.
Cost segregation uses MACRS to accelerate the timetable for property depreciation deductions. To determine depreciation schedules, a cost seg study identifies and reclassifies personal property assets to shorten depreciation time. Engineering and tax professionals can help you identify real property assets and identify which portions of those costs you can treat as real property for accelerated depreciation.
According to MACRS:
Let’s see from the table below how depreciation increases drastically when you apply cost segregation vs. straight-line depreciation. And if your tax bill is lower, you can carry forward any unused depreciation amounts until they’re exhausted.
|California Self-Storage Property||Straight-Line Depreciation||Depreciation With Cost Segregation|
|Total Depreciation in First Year||$14,661||$556,822.68*|
With bonus depreciation, you can take an immediate first-year deduction on a percentage of eligible business property. The 2018 Tax Cuts and Jobs Act, which increased first-year bonus depreciation to 100%, applies it to any long-term assets placed in service after September 27, 2017. The 100% bonus depreciation windfall lasts from September 27, 2017 until January 1, 2023. After that, first-year bonus depreciation will decline as follows:
Post-2027, bonus depreciation vanishes completely.
Think of it: you could get more than $300,000 in first-year deductions on a $1 million purchase!
If you can reduce total annual energy and power costs by 50 percent compared to a sample building from 2007, because of the Energy-Efficient Commercial Buildings Tax Deduction (known as 179D), you can take deductions for new construction and retrofits for assets like HVAC, the building envelope, or lighting for climate-controlled units.
The maximum deduction is $1.80 per square foot. You’re allowed partial deductions of $0.60 per square foot/per system if you reduce energy consumption through the building envelope, HVAC, lighting, or interim lighting.
When Congress passed the CARES act in In March 2020 in response to the pandemic, it delivered tax relief to property owners with these measures:
As you can see, the highly specialized world of real estate taxation can be confusing. The average CPA is probably not conversant with the tax strategies I’m outlining here. As a result, it can beneficial to consult engineering and tax professionals who are familiar with such arcane solutions as cost segregation, bonus depreciation, 179D energy incentives, and NOL carryforwards. However, you might be impressed by your tax savings.
Although taxes are supposed to be one of the only two things that never change in life, tax laws are morphing all the time. As a CPA and an expert on how tax law relates to commercial real estate (including self-storage facilities), I’d like to share some changes to current tax law that could put substantial money in your pocket, especially via cost segregation studies. With a little strategic planning, you can drastically reduce your tax liability and generate retroactive refunds for extra cash flow.
Depreciation calculates an asset’s reduction in value as time passes, owing to wear and tear. The asset is allocated over a specific period when it’s expected to be useful. According to the IRS, commercial real estate, including self-storage, has a useful period of 39 years; land improvements such as asphalt, parking, landscape, and security fences have a useful allocation of 15 years. Land is considered an asset that doesn’t devalue over time.
Here are the two main options for depreciating real estate:
Cost segregation (also known as cost seg) is a federal tax methodology that uses MACRS to accelerate the timetable for property-depreciation deductions. To determine depreciation schedules, a cost seg study identifies and reclassifies personal property assets to shorten depreciation time. Engineering and tax professionals can help you identify real property assets and uncover which portions of those costs can be treated as real property for accelerated depreciation.
Under the MACRS methodology, you can identify and reclassify assets in five-, 15- and 39-year class lives, depending on the IRS determination of their actual useful life. Here are some examples:
By commissioning a cost segregation study, you can retain additional cash flow for capital improvements, repairs, or expansion. Self-storage operators can benefit significantly from using it because of the unique types of construction and exterior improvements found on a storage site. The following table shows how depreciation increases drastically when you apply cost segregation vs. straight-line depreciation. And if your tax bill is lower, you can carry forward any unused depreciation amounts until they’re used up.
|California Self-Storage Property||Straight-Line Depreciation||Depreciation with Cost Segregation|
|Total Depreciation in First Year||$14,661||$556,822.68*|
*To calculate the direct tax savings, take the depreciation amount shown above and multiply it by the effective tax rate you calculated earlier. For example, $556,822.68 x .30 = $167,046.80 in income-tax savings.
Bonus depreciation (a.k.a. cost segregation on steroids) allows an immediate first-year deduction on a percentage of eligible business property. Under the 2018 Tax Cuts and Jobs Act, first-year bonus depreciation was increased to 100%. It applies to any long-term assets placed in service after September 27, 2017. The 100% bonus depreciation amount lasts from September 27, 2017 until January 1, 2023. After that, first-year bonus depreciation will decrease as follows:
After 2027, alas, bonus depreciation vanishes completely. What else qualifies for bonus depreciation under the new law? Tangible personal property with a recovery period of 20 years or less and components of purchased buildings.
A cost seg study will examine the qualified property you can deduct at the 100 percent rate. What components qualify for bonus depreciation (i.e., immediate expensing)? Carpeting, appliances, movable buildings, security fencing, landscape, asphalt, and exterior signage. Think of it: you could get more than $300,000 in first-year deductions on a $1 million purchase!
Don’t overlook the Energy-Efficient Commercial Buildings Tax Deduction (known as 179D), which applies to assets like HVAC, the building envelope, or lighting for climate- controlled units. You can take 179D deductions for new construction and retrofits, but you must be able to reduce total annual energy and power costs by 50 percent compared to a sample building from 2007. And you’re allowed partial deductions.
The maximum deduction is $1.80 per square foot. You’re allowed partial deductions of $0.60 per square foot/per system if you reduce energy consumption through the building envelope, HVAC, or lighting. In addition, you’re permitted a partial deduction for interim lighting.
In March 2020, Congress approved a $2 trillion stimulus package in response to the coronavirus pandemic: the Coronavirus Aid, Relief and Economic Security (CARES) Act, which includes several improvements to cost segregation and other tax changes that benefit tax credits and the treatment of business losses.
On a macro level, there are potential tax changes that could be coming under President Biden: higher tax rates, a lower estate tax limit, higher capital gains rates, and a potential loss of 1031 exchanges. But as of now, these changes haven’t happened, and considering how the winds of politics can blow, they might never be enacted into law.
That said, let’s focus on options to defer taxes that are currently official parts of U.S. tax law and that you can take advantage of now:
A word of advice: the arcane world of taxes can be bewildering. Even most seasoned CPAs are unfamiliar with the tax strategies I’m outlining here, so it can be best to ally yourself with engineering and tax professionals who are conversant with such specialized solutions as cost segregation, bonus depreciation, 179D energy incentives, and NOL carryforwards. But the financial rewards might surprise you.
Many architects are either unaware of the applicability of research and development (R&D) tax credits to their firms, or struggle to understand how the credit applies, if their projects or activities qualify, why they qualify, and how much the credit might be.
The R&D tax credit (formerly the Economic Recovery Act) was adopted in 1981. Since its inception it has been extended 15 times and has been expanded in its definition and application. In 2004 a revision to the code (IRS Code Section 41c) included a “Four-Part Test” to help define qualifying activities, costs, and industries.
The Four-Part Test summarizes qualifications as:
Many Architects struggle to understand how these apply to their daily design and project tasks, or why the IRS allows a tax credit to help fund some of their overhead costs. This credit is an incentive to businesses that invest in innovation and aim to increase technological advancements within the U.S. It also incentivizes businesses that increase these activities each year.
The R&D credit is an income tax offset based on a company’s allowable wage or supply costs (qualifying supply costs are not usually found in typical architectural firms). Eligible wage costs will be hours spent working on activities that fall under the definitions above. These usually occur during the first three to four phases of architectural design: conceptual design, schematic design, design development, and sometimes into the construction document phases.
Examples of qualifying activities include:
What Does Not Qualify?
Activities that do not qualify as research activities include funded research or contracts which guarantee payment for 100% of all time and materials, regardless of the outcome or time incurred. Also, prototype projects with little to no innovation or unique design components have little qualifying time associated with the credit.
The R&D tax credit is a complex calculation of eligible costs averaged out over prior years and calculated as an increase in expenses over those prior year costs. Starting at 20% of increased costs each year, the credit generally averages out as a 5%–6% net federal credit. In 2018, according to the biannual AIA Firm Survey, 28% of architecture firms with over 50 employees applied and received tax credits.
An example of the calculation: A company with $100,000 in qualified research wages might qualify for a $5,000–$6,000 federal credit. A credit will directly offset income tax due, which results in either a refund or reduction in taxes owed. Currently, 42 states recognize R&D activity and provide state credits similar to the federal credits, which can significantly increase the benefit of an R&D credit analysis.
R&D tax credits can be claimed each year. For firms that have never claimed the credit, there may also be credits available for the prior three years . If your company meets the standards outlined above, a discussion with an R&D expert may be worthwhile.
If you are interested in learning more about R&D tax credits, or if your projects qualify, please contact Heidi Henderson of Engineered Tax Services directly at (801) 564-4464 or email@example.com.
This is the first in a series of articles about how research and development (R&D) tax credits are a tax-intelligent strategy that can be applied to a wide variety of industries. In this article, we’ll delve into how the software and gaming industries are prime candidates for taking advantage of R&D tax credits.
The IRS offers R&D tax credits to incentivize technological progress by reimbursing companies that develop new products, inventions, and processes; a percentage of those costs are returned to the company for what are termed Qualified Research Activities and Qualified Research Expenses. You don’t have to be a large company to qualify for the credit. For many years now, Engineered Tax Services has helped companies of all sizes across the United States to identify these expenditures and receive the tax benefits they’ve been missing.
Companies in the software and gaming industries can potentially claim R&D tax credit for:
The IRS treats third-party versus internal-use software a bit differently when evaluating their ability to qualify; the agency requires a higher level of innovation for internal use software, with proof there’s nothing similar already on the market. However, software that will be for sale or license needs to only show that technical coding and development was performed.
What Activities Qualify?
During the seven main phases of the Software Development Lifecycle (SDLC), it’s the fourth — development and coding — where R&D tax credits are the most applicable. This is when the major project deliverables are built, and programmers, network engineers, database developers, and others create code to meet requirements and specifications within the required technical environment. Next comes quality assurance and user acceptance criteria, and finally unit testing is conducted to ensure all user and business needs are met.
Potentially qualifying activities include:
However, the development of user/help documentation during this phase doesn’t qualify.
Keep Clear and Accurate Time-Accounting Documentation
It’s important to keep clear and accurate time-accounting documentation, because 95% of qualifying R&D expenses for software relate to employee wages and U.S.-based contractor fees. To properly claim R&D tax credits, you need to know exactly how much time is spent working on qualifying activities. List each project, all staff involved, and every hour spent on each qualifying activity.
Your documentation must prove:
The Four-Part Test
Take this simple four-part test to determine if you qualify for research and development credits, according to criteria established by the IRS:
Here is an example of how ETS helped one client with R&D tax credits:
|Total Qualified Wage Costs for Development||Net Federal Research Credit|
|December 31, 2018||$326,667||$25,807|
|December 31, 2017||$272,139||$18,311|
|December 31, 2016||$214,042||$15,060|
Because it can be a complex process to obtain R&D tax credits for software development activities, it can be wise to work with a knowledgeable partner like ETS that has many years of experience in this specialized area of tax law. Please feel free to contact us at firstname.lastname@example.org.
If you’re a commercial property owner, rental property manager, or real estate developer, you may be able to earn additional revenue by contracting with wireless carriers to install 5G transmitters on your rooftops.
Fifth-generation (5G) wireless technology is the next phase of cellular telecommunications that’s being rolled out worldwide. It’s become a top priority for deployment for cellular carriers in North America, because 5G can handle over 100 times the data compared to 4G.
However, unlike 3G and 4G, 5G requires transmitters about every five city blocks due to its higher frequency and shorter wavelength. As a result, carriers have been scrambling to find commercial real estate locations to deploy the network as fast as possible. Leases generally range from $2,000 to $20,000 each, and terms can extend for five to 20 years. The best opportunities include rooftops that work well in dense, populated areas where zoning doesn’t permit towers. And there are more than one million cellular sites in the U.S.
Here’s where a savvy technology partner like Engineered Tax Services (ETS) can help.ETS has established relationships with strategic partners to build out 5G networks and provide an end-to-end solution for all carriers nationally. As a result, you can make a considerable amount of money if you’re a building owner who works with ETS. We’ll analyze your building(s) to initially see if they’re suitable for 5G technologies and assess, according to location, if your property is an optimal candidate for carrier consideration.
Making Your Rooftop Work for You
A good 5G partner ensures that you come out on the winning end of the deal. For example, at ETS, we don’t earn anything until you do. Since we align our compensation with you, you’re assured of receiving the best deal possible. Our fee covers everything: property profile, analysis, permitting, tower construction, utilities, taxes, carrier relations, contract negotiation, carrier upselling, cash flow management, and representing you, as the client. You pay nothing until a lease is secured and the first month rent collected. In addition, you get our continued support: once you partner with ETS, we manage the entire rooftop lease process from A-Z.
As a result of the pandemic, commercial real estate is under considerable financial pressure. Could your unused rooftop be a potential cash cow?
In recent years, commercial real estate owners and investors have learned a secret: they can greatly maximize their tax savings if they combine Low-Income Housing Tax Credits with a cost segregation study.
The Low-Income Housing Tax Credit (LIHTC) is the federal government’s major tool for creating affordable housing. As a federal tax credit administered by states, it’s replaced HUD’s direct investment in public housing.
“What most real estate owners and investors don’t realize is that the LIHTC program has created a massive windfall of tax benefits for affordable housing,” said Daryl Petrick, Partner with the CPA firm Bowman & Company, who specializes in tax issues around affordable housing. “And when you combine LIHTC eligibility with a cost segregation study, you can achieve impressive tax savings using bonus depreciation.”
How Does LIHTC Work?
The Low-Income Housing Tax Credit subsidizes the acquisition, construction, and rehabilitation of affordable rental housing for low- and moderate-income tenants. Since it was enacted as part of the 1986 Tax Reform Act, it’s resulted in the creation of over two million new housing units.
After the federal government issues tax credits to state and territorial governments, state housing agencies use a competitive process to award the credits to private developers of affordable rental housing projects. These developers sell the credits to private investors to get funding. Once the housing project is opened to tenants, investors can claim the LIHTC over a 10-year period.
How Does An Investor Qualify for the Credit?
A wide variety of rental properties are eligible for LIHTC, including apartment buildings, townhouses, and duplexes, but project tenants must meet an income test and a gross rent test. They can meet the income test in three ways:
According to the gross rent test, rents must not exceed 30 percent of either 50 or 60 percent of AMI, depending upon the share of project’s tax credit rental units. All LIHTC projects must comply with the income and rent tests for 15 years; otherwise, credits are recaptured. Also, an extended compliance period (30 years in total) is generally imposed.
Cost Segregation: The Bonus Depreciation Bonanza
Low-income housing projects are being developed by public entities or larger C corporations. These include insurance companies, utilities, and especially banks. Under the Community Reinvestment Act, also known as the CRA, banks are obligated by law to help provide housing for low-income people.
“Historically these types of developers haven’t applied cost segregation, thinking it doesn’t create any value,” said Daryl Petrick. “But now they’re aware of the bonus depreciation bonanza, cost segregation makes sense. When you add LIHTC’s low-income credits to accelerated depreciation, it not only creates a windfall of tax savings, but also it expedites return on investment.”
For example, an investor could enjoy $7 million savings in cost segregation depreciation for a $20 million building—and that’s just in the first year. The credit is based on eligible basis. While land is not eligible, the bulk of the building is eligible for credit.
Case Study: $3,648,709 of Depreciation in the First Year
This case study illustrates the virtues of cost segregation. The project had a construction cost of $12,581,756. Thanks to a cost segregation study, the investor was able to claim $3,648,709 of depreciation in the first year. In comparison, without the cost seg study, the depreciation would only be $428,000 in the first year.
Pick The Right Advisor
However, the regulations about cost segregation and Low-Income Housing Tax Credit are complex. For that reason, we recommended selecting a specialty tax advisor like Engineered Tax Services, which has over 20 years’ experience in helping the construction industry to gain tax advantages, specializing in cost segregation studies, R&D tax credits, and 179D tax deductions.
“Now that bonus depreciation has drastically increased the rate of depreciation, it’s helping investors get faster returns on their capital and improving the ROI on these projects,” said Petrick. “There’s no question—cost segregation greatly magnifies the overall tax benefits for LIHTC projects.”
How often should cost segregation be applied to a building? And are annual updates required or necessary?
Property owners ask this question on a regular basis. A good cost segregation study only needs to be applied once to a building and will calculate the annual depreciation for as long as you own it. However, always ensure that your provider is offering a detailed asset listing so that updates can be applied annually, thereby saving you tens of thousands of dollars more each year! And you may want to do a second study after large improvements. (If you’ve just purchased a property, you should do a cost seg study before you undertake any improvements.)
The Advantages Of A Cost Segregation Study
First off, what’s the value of a cost segregation study? The IRS developed the concept of cost segregation so developers could accelerate depreciation of their properties. The IRS’ memorandums define a building as consisting of not only walls, a roof, concrete, and windows, but also land improvements (such as storm sewers, curbs and sidewalks, parking lots, swimming pools, and landscaping) and personal property (such as flooring, interior finishes, decorative lighting, kitchens, interior glass, and electrical wiring for appliances), which should be treated as personal property separate from the structure itself.
Under cost segregation rules, a typical property’s structure is subject to a 39-year recovery period for commercial real estate and 27.5-year recovery period for residential real estate. Land improvements are subject to 15-year recovery period if they qualify for the Qualified Improvement Property (QIP) classification for commercial property only; the improvements are subject to the full depreciation amount if they don’t qualify. Certain other building components qualify as personal property with a five-to-15-year recovery period.
Because land improvements and personal property can now be separately depreciated over the shorter recovery period, the average commercial building owner will realize approximately 25 to 95 percent of their building’s total costs as shorter class-life depreciable assets, depending on the asset type. For canny real estate investors, this translates into major tax savings and increased cash flow.
Because of bonus deprecation, investors no longer have to wait 5, 7, or 15 years for depreciation class lives to become active; they can claim all the reclassified items in year one.
Updating Your Cost Segregation Study
At Engineered Tax Services, we’re experts at cost segregation, with over 20 years of professional experience. And we can tell you that a cost segregation study is a living, breathing document. It needs to be updated and refreshed periodically.
If you’ve already done a cost segregation study but now plan to go ahead with new improvements, we recommend another study to update and reconcile the disposed assets, demo costs, and new items that have been added.
For example, we recommend a refreshed cost seg study when considering installing a lighting retrofit, refurbishing units, or making general improvements.
Here’s the advantage of commissioning a cost seg report pre-rehab: with receipts/invoices to justify the cost of anything new and details on what was replaced, your client can apply bonus depreciation/partial disposition elections/repair rules. After your client proceeds with the improvements, they can revert back to the original cost seg studies and calculate their partial asset disposition (PAD).
The Power of Partial Asset Disposition
As a deduction, PAD allows property owners to recognize a loss on the disposition of a portion of a building when they make significant improvements; this includes replacing, disposing of, or ripping out existing building components. It’s part of the Tangible Property Regulations (TPR) released in 2013 that revised how businesses decide to expense or capitalize property improvements and purchases. Thanks to TPR, you can write off the retired asset and extract and expense the labor costs for demolition immediately.
Cost segregation studies pay off. Because many improvements may qualify for an immediate write-off as qualified improvement property (15-year QIP), they may not have to be capitalized. As an added benefit, bonus depreciation applies to any property classified to a bucket of 20 years or less, which includes QIP.
Make Your Cost Seg Study Evergreen
If you’ve already had ETS undertake your cost segregation study, consider having it updated, possibly on an annual basis, before you implement new building improvements. It will pay off in the long run—especially when you take the bonus depreciation and PAD bonanza into consideration.
There is tremendous value in construction tax planning. If you’re in the construction industry, do you know how many millions of dollars you can save if you plan ahead to take advantage of powerful tax incentives before you build?
At Engineered Tax Services, we have 20 years’ experience specializing in providing specialty tax services to the construction industry. If you consult with us at the blueprint phase before you start construction, we can prescribe guidance to ensure you qualify for energy incentives and optimize your depreciation.
We can enhance your bottom line using the following tax strategies:
How Can We Save You in Taxes?
We’ve helped quite a few clients gain tax savings in unexpected ways.
It pays to bring us in before you build. We can help you pre-qualify for energy efficiency tax credits stemming from 179D and 45L—and 179D’s new regulations make it much more challenging to qualify for. When one client proposed building a large 300-unit Las Vegas multi-family apartment building, we saw the units didn’t qualify. But we pointed out that if our client changed the bathroom exhaust fan from a standard model to a variable speed, continuously running fan for $150, they’d qualify for a $2,000-per-unit energy credit. For 300 rooms, that’s a $600,000 tax credit for a $45,000 expenditure.
A client expressed interest in building a very large apartment complex in Colorado. We realized they’d qualify for 45L tax credits if they installed ceiling fans; 45L takes into consideration tightness of construction and airflow. Because our client was still able to make the change before construction was completed, they were able to claim the entire tax credit.
What Property Components Qualify for Accelerated Depreciation?
We identify accelerated deductions by analyzing costs and documenting design and construction based on federal guidelines. These guidelines define tangible property from all stages of a construction project. We consider:
We also analyze I.R.C. Sec. 174 embedded costs, indirect costs, and professional fees (soft costs) during the planning and design phases of a construction project, allowing for an immediate tax deduction in the year the cost is incurred.
The Nuts and Bolts of Construction Tax Planning
By taking advantage of our pre-construction tax planning services, you can obtain the maximum tax benefits associated with your construction project. We will evaluate your project to ensure that you qualify for:
Backed by our construction tax planning team of architects, general contractors, engineers, and CPAs, you’ll be surprised at the substantial tax savings you’ll enjoy.
Federal research & development (R&D) tax credits have been available for more than three decades to incentivize companies that invest in innovation and technological investments. This is a permanent federal tax incentive meant to stimulate innovation, technical design, and manufacturing within the US. Today, two-thirds of US states also offer tax credits for R&D activities… cont.
Architects often ask if they will face resistance from the IRS if they claim R&D tax credits and get audited, but they can improve their chances by following these guidelines and tips.
Read the IRS guidelines, know the four-part test, and understand how to define phases in project accounting.
According to the IRS audit technique guidelines, three industries are qualified to receive research and development tax credits—manufacturing, software, and the architectural and engineering (A&E) community. But paradoxically, manufacturers and software companies have an easier time passing an audit. Although less than 3% of small businesses are subjected to an R&D audit, it’s the A&E community (particularly the small business community) that’s come under scrutiny in recent months; retaining those credits depends on proper tracking and documentation.
Research, research, research
The problem? Unfortunately, the IRS Small Business unit doesn’t have the resources to have an engineer on staff to clearly judge qualifications for R&D tax credits, and it does delve into hourly time tracking records, so it’s become a purely subjective matter on the part of agency examiners. In fact, one agent is known to demand that “research” be in the project description and denies any application that omits that word, when it’s obvious that many projects missing this word required research and development in order to push innovation. As a result, we recommend featuring the word “research” prominently in each proposal.
It can also help to demonstrate how R&D efforts contributed to innovation. For example, to create a 100% energy-efficient building, you may have installed systems in the building that helped the owner save on operating costs. For the A&E community, energy efficiency reduces carbon footprint. Another designer we know of is contributing to the public good by designing ADA-compliant tiny homes for the disabled and homeless. These projects all contribute directly to our general welfare, and they require innovation.
Another issue: the IRS views architects and engineers solely as service providers and believes they sell nothing but their services, so the “product” being innovated via R&D is less clear than with manufacturing and software companies. The agency doesn’t take into account A&E firms’ intensive scientific expertise and the fact that of course, they have to apply innovation to overcome technical obstacles (such as designing a building in an unusual shape aerodynamically so it doesn’t collapse).
Regularly the IRS refers to “routine engineering activity”—as if any engineering task is routine! Engineering is science, pure and simple. And architecture follows suit. Architecture isn’t merely art (which is how the IRS often views it)—it’s a science, with demanding technical requirements.
How can you increase the chances your project will pass an R&D tax credit audit?
First, we recommend you go to the source and examine the criteria the IRS uses to judge R&D tax credits, the Audit Techniques Guide: Credit for Increasing Research Activities (i.e., Research Tax Credit) IRC § 41* – Qualified Research Activities.
Also, to determine if you qualify for research and development credits under the IRS, consider how your activities meet this simple four-part test:
In addition, documentation is very important. In your application, emphasize time tracking and project accounting. Delineate each phase of each project and exactly who worked on it. What were their hours?
In your task accounting, don’t only mention an employee worked 150 hours on design and development, but also cite that while she undertook design development, she spent them reviewing building systems and site challenges.
Drilling down into detail
Keep notes concise and organized and track exact phases of each project. You may also consider adding or rephrasing some of your project phases to fall in line with the IRS’s terminology. For example:
In your contracts, in many cases, you break out your project phases. For each phase where research is being performed, use the word “research” in the contract to describe the phase (or even say in the contract that you’re performing research as defined in I.R.C. Sec. 41 in phases x, y and z). In your contracts, specify that the xxx is the business component being sold to the client as defined in Sec. 41.
In your timekeeping systems, break the project out by phase. But in your phase names, how you align the name of the phase more closely with the objectives of R&D tax credit criteria? Phases such as admin, bid/proposal, schematic design, and construction aren’t all that helpful. It’s better to employ words that suggest a scientific method or process of experimentation, such as:
You can also place these categories under the overall phase of “develop business component”–even if you only state “business component” at the top of your system.
On the funded research issue, state in the contract that the parties agree that the research is not funded per I.R.C. Sec. 41. You can also state that the parties agree that the taxpayer bears the financial risk of nonpayment and retains substantial rights per I.R.C. Sec. 41. If the taxpayer is the party paying for the research, say the opposite.
Ultimately, the IRS needs to provide greater clarity and guidance in its criteria for R&D tax credit qualification, and lobbying efforts supported by Engineered Tax Services (ETS) are currently underway to encourage that remediation.
Additionally, if you use a specialty tax consulting firm such as ETS, then be sure to discuss these revisions and how you can begin proactive time tracking to build your case and defense under audit.
Again, please understand that less than 3% of all small businesses (like A&E firms) are subjected to audit, so your chances of encountering this eventuality are very slim.
Finally, we’d like to emphasize that we assuredly are not offering tax or legal advice in this article, so before acting on anything discussed here, you should consult your tax or legal professional or contact ETS to assist.
To learn whether your projects qualify for 179D, 45L, or R&D tax incentives, contact Heidi Henderson at Engineered Tax Services.