For years now, the architectural, engineering, and construction community has been receiving the research and development tax credits it deserves for fostering innovation in its creation of America’s vital infrastructure.[1]
But recently the architectural, engineering, and construction community has begun seeing an increase in unfair denials of these credits by the Internal Revenue Services, breaking with the long-standing application of the research and development tax credit for businesses that provide these important services.
When my company, Engineered Tax Services[2], which represents members within the architectural, engineering, and construction community, brought up this fact in meetings with members of the U.S. House Ways and Means and U.S. Senate Finance Committees last year, they were concerned that inadvertent IRS actions could stifle innovation at a time when it’s crucial for America’s future.
Here’s the imperative situation: The U.S. is losing high-paying jobs tied to manufacturing and innovation to competitive overseas markets.[3] The R&D tax credit is one of our country’s best defenses to try to stem this loss.
This is because the R&D tax credit is, in reality, a jobs credit — a wage credit — that incentivizes businesses to create and keep high-paying and strategically important jobs in the U.S. that help us maintain our competitive edge in next-generation design, manufacturing, technology, and medical breakthroughs.
Architects and engineers are a vital part of this R&D industry and our economy overall — they comprise the middle class that earns $100,000 to $150,000 a year[4] and are critical to the success of our country’s goals to achieve climate-conscious building and infrastructure advancements for the future.
The fair and consistent application of the R&D credit for architectural, engineering, and construction service businesses is essential to keeping this workforce in the U.S.
This is particularly important as the U.S. faces steep competition for this field of experts. As a 2020 Ernst & Young study shows,[5] many other countries have better, more lucrative R&D tax incentives than the U.S.
Several countries have gone so far as to introduce what is known as a patent box, a special very low corporate tax system that incentivizes research and development by taxing patent revenues differently from other commercial revenues.[6]
America’s strong economy depends on two primary factors: access to capital markets and a strong workforce. That’s why we have such a high standard of living.
But capital markets are under stress now, particularly if the U.S. dollar isn’t backed by high-paying jobs generating income tax. And if you drive away strategic jobs in the $100,000 to $150,000 wage range, our economy will suffer.
On top of this, the architectural, engineering, and construction community delivers notable design innovation that directly benefits the public good. Here are some examples:
- Every day, architects and engineers bake energy efficiency into their buildings to reduce carbon footprint. Their buildings will be with us for hundreds of years, and the resulting savings will be realized for hundreds of years as well.[7]
- Architects and engineers are reinforcing aging hydroelectric dams to prevent them from flooding large populations,[8] building bridges that will not collapse,[9] widening and innovating new road designs to stop motorists from veering off-road,[10] and developing every other structure or component that handles, treats, processes, and keeps harmful chemicals and compounds at bay.[11]
- Recently an architectural firm spent its own money to design communities of tiny homes for the disabled and homeless.[12]
- Architectural, engineering, and construction companies are constantly faced with building code changes and requirements that require them to research new and improved components and design.
- The industry also creates highly technical designs based on hard science required by at least one component of the IRS’s four-part test.[13]
Why has the IRS been denying R&D tax credits to the architectural, engineering, and construction community more often lately? It’s not really the agency’s fault.
You see, with few exceptions, the architectural, engineering, and construction community falls into the IRS’ small business category. Unfortunately, while the IRS unit that audits large businesses has ready access to full-time engineers equipped to scientifically analyze R&D tax credit submissions, the small business unit typically does not have access to the same level of resources. As a result, the analysis is often left to examiners who are unfamiliar with the mechanics of innovation.
According to Kreig Mitchell, a Texas-based attorney who specializes in federal and state issues, “In addition, some cases are larger in scope, and it is not uncommon for one audit to experience multiple agent turnovers, further complicating the consistency of the audit.”
Another issue is that despite the fact that architectural, engineering, and construction businesses have qualified for the tax credit since its inception in 1981 and, by the IRS’s own statistics, account for approximately one-third of the R&D credits approved each year,[14] recently some in the IRS appear to be viewing architects and engineers solely as service providers, believing they sell nothing but their services, so the “product” being innovated via R&D is less clear than with manufacturing and software companies.
“Recent credit denials make it clear that current agency staff are not taking into account A&E firms’ intensive scientific expertise,” Mitchell said, “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 to prevent it from collapsing.”
This and other examples reflect the regrettable fact that there’s a gray area in the tax code. The criteria used to judge whether a business qualifies for R&D tax credits requires projects to pass a complicated four-part test that is open to interpretation, and that’s where the architectural, engineering and construction community is running into trouble.
When we take into account the fact that the IRS has even pressed novel theories for the research tax credit that have not been accepted by the courts,[15] it underscores the need for clarity for this important industry. Unfortunately, those of us in the small business community don’t have the resources to constantly counter the IRS’s costly audits that typically play out over several years for contested R&D tax credits.
As it stands now, companies seeking R&D tax credit approval should carefully review the IRS ruling that lays out the criteria under which their credits will be judged,[16] and they should understand the four-point test they must pass.
Companies should undertake careful time tracking, project accounting, and concise, organized note-taking so the IRS can clearly see where research efforts have been directed. They must discuss the research they’ve undertaken and describe in detail their funded research.
Taken together, these guidelines can greatly enhance a company’s likelihood of having its R&D tax credits approved.
Given the recent inconsistencies in IRS assessments of the R&D tax credit for this industry, it’s clear that clarifying guidance in the form of a revenue ruling or other guidance from the IRS is both merited and needed to ensure small businesses in our critical architectural, engineering and construction community have a fair playing field and an opportunity to continue to innovate here in the U.S.
In the past, the IRS has demonstrated its willingness to amend, clarify or revise its interpretation, as we saw last year in its decision to allow the deduction of Paycheck Protection Program loans and its November 2020 ruling to apply bonus regulations retroactively.[17]
More directly, the IRS issued similar guidance clarifying how the R&D tax credit applies to the pharmaceutical industry in its 2012 memorandum “Guidance for Computing and Substantiating the Credit for Increasing Research Activities under Section 41 of the Internal Revenue Code for Activities involved in Developing New Pharmaceutical Drugs and Therapeutic Biologics.[18]
This type of clear, clarifying guidance for the architectural, engineering and construction industry would benefit the government and taxpayers by ensuring this important element of the tax code continues to yield a strong and direct benefit to America’s economy and to the critical small businesses we will rely on for our next generation of innovation in the U.S.
Disclosure: ETS has raised this issue with members of Congress on the House Ways and Means and Senate Finance Committees.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] https://engineeredtaxs.wpengine.com/research-development-tax-credit/. [2] https://engineeredtaxs.wpengine.com/. [3] https://www.oecd.org/unitedstates/us-manufacturing-decline-and-the-rise-of-new-production-innovation-paradigms.htm; https://hbr.org/2020/04/bringing-manufacturing-back-to-the-u-s-is-easier-said-than-done. [4] https://en.wikipedia.org/wiki/Upper_middle_class_in_the_United_States. [5] https://www.ey.com/en_gl/tax-guides/worldwide-r-and-d-incentives-reference-guide-2020. [6] https://en.wikipedia.org/wiki/Patent_box. [7] https://www.gensler.com/uploads/document/434/file/gensler-climate-change-2016.pdf. [8] https://damsafety.org/sites/default/files/Cost%20of%20Rehab%20Report-2016%20Update_1.pdf. [9] https://www.fhwa.dot.gov/bridge/abc/. [10] https://nacto.org/docs/usdg/flexibility_in_highway_design.pdf. [11] https://www.epa.gov/sites/production/files/2015-07/documents/con-bld05_0.pdf. [12] https://www.news-leader.com/story/news/local/ozarks/2020/05/28/springfield-homeless-tiny-home-eden-village-ii-home-builders/5259847002/. [13] https://engineeredtaxs.wpengine.com/research-development-tax-credit/. [14] https://www.irs.gov/pub/irs-soi/14co01rsrchcr.xlsx. [15] Examples include Poplous Holdings v. Commissioner, Docket No. 405-17, arguing that an architect firm only sells drawings; Siemen Miller, cite, arguing that no credit for a project that spans several years; Trinity Industries Inc. v. U.S., 691 F. Supp. 2d 688 (N.D. Tex. 2010), arguing that a project incorporating components from third parties does not qualify; and Suder v. Commissioner (T.C. Memo. 2014-201), arguing that taxpayer with engineering know-how knows engineering and therefore cannot qualify for credit. [16] https://www.irs.gov/businesses/audit-techniques-guide-credit-for-increasing-research-activities-i-e-research-tax-credit-irc-41-qualified-research-activities. [17] https://nhlnk.co/api/v1/track/link/click/5a1f77ddcba395a9bd857e4e/1614184609595/?link=https%3A%2F%2Fwww.irs.gov%2Fnewsroom%2Feligible-paycheck-protection-program-expenses-now-deductible. [18] https://www.irs.gov/businesses/guidanceforcomputingsubstantiatingpharmaceuticaldrugstherapeuticbiologics
