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:
- Permitted Purpose: The activities must relate to new or improved business components, function, performance, reliability, and quality.
- Technological in Nature: The activity performed must fundamentally rely on principles of physical or biological science, engineering, or computer science.
- Elimination of Uncertainty: The activity must be intended to discover information to eliminate uncertainty concerning the capability, method, or design for developing or improving a product or process.
- Process of Experimentation: The taxpayer must engage in an evaluative process that can identify and evaluate more than one alternative to achieve a result. This may include modeling, simulation, or a systematic trial-and-error methodology.
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:
- bid/proposal and hypothesis
- admin and concept development
- schematic design and testing alternatives
- iterate—and terms of that nature
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.