By Justin DiLauro, Partner, BRAYN Consulting LLC
Since the elimination of the “discovery test” in the early 2000s, Architecture and Engineering (A&E) design service firms have been and continue to be excellent candidates for R&D Tax Credits. It took almost a decade for the application of R&D Tax Credits to A&E firms to be tested through taxing authority examinations, appeals, and public court orders and opinions. In the decade since, countless A&E service firms have successfully claimed significant benefits from Federal and State R&D Tax Credits for many of their design activities that are most often under contract with clients and are what many architects and engineers would consider “routine” design activities.
As A&E firms sharpened their R&D positions over the last decade, the IRS has shifted its exam focus on different issues than in years past. This has caused some unprepared or under-represented A&E firms claiming R&D Tax Credits to achieve unfavorable results in an IRS Audit or even complete disallowances. This has unfortunately caused some accounting and tax professionals to prematurely raise alarms that the IRS has completely changed its position on the qualification of A&E design activities and that A&E firms would have a more challenging time at audit than in years past.
However, from the collective experience of the author and his colleagues, the IRS is not changing its treatment or general stance on A&E design firms’ R&D Tax Credit claims. The Service has been focusing on different R&D issues than in years past, including an issue that has been taken for granted for years and often relatively glossed over – the “business component for a permitted purpose” requirement of the “Four-Part Test”. This has exposed some unprepared R&D service providers and given the IRS another reason to disallow a claim.
IRS Historical Focus –> Process of Experimentation
The “discovery test” was officially eliminated with the 2003 Final Treasury Regulations, leading job shop manufacturers to be one of the first industries to take full advantage of the new broadened definition of R&D. Often small or mid-sized privately held businesses, these manufacturers could now claim R&D Tax Credits for product or process developments and improvements.
The manufacturer’s advantage in an R&D analysis is an easier to explain “business component”. They have tangible products (e.g. metal or plastic parts) and processes that could be seen on a shop floor and more easily understood. Manufacturers found it easier to explain how they passed the “business component” requirement, which requires a taxpayer to be developing any product, process, computer software, technique, formula, or invention for new or improved function, performance, quality, or reliability. The “business component” must also be developed to be held for sale, lease, or license or used by the taxpayer in its business.
The manufacturer’s challenge then, was not the “business component” requirement of the “Four-Part Test”, but with the “process of experimentation” test. The “process of experimentation” requirement requires that the development of the business component be undertaken through a process designed to evaluate one or more design alternatives, and the Treasury Regulations cite modeling, simulation, and systematic trial and error methodologies as examples of a process of experimentation. While this is a broad definition, manufacturers had to focus attention on the “process of experimentation” because it was not as easily explained or documented as the other parts of the “Four-Part Test”.
Consequently, R&D Tax Credit service providers focused much of their attention on the “process of experimentation” requirement, and for any CPA, tax, or accounting professional that have seen R&D Study Reports over the years, they likely recall the lengthy process of experimentation write-ups where the business component (and other) sections were often much smaller.
IRS Recent Focus –> Business Component
As A&E firms started to claim R&D Tax Credits with more success, they and their CPAs and R&D providers focused their analysis on the “process of experimentation” as that had been the IRS’ focus with other industries. Unlike manufacturers, A&E design firms found themselves uniquely situated to better explain their design evaluation process (i.e. their “process of experimentation”). By the nature of their work, A&E firms found themselves with a voluminous amount of process of experimentation documentation – design studies, engineering reports, engineering calculations, design models, and extensive meeting notes discussing design options.
Furthermore, various court cases over the last decade or so, including Geosyntec Consultants, Inc., Populous Holdings Inc., Trinity Industries, Inc., and the 5th Circuit Court of Appeals Decision in United States v. McFerrin, have supported that architectural and engineering design activities can (and have) constituted a process of experimentation within the meaning Internal Revenue Code Section 41(d). Some may know of one such example where the Court in Trinity Industries, Inc. agreed that the design activities for a marine vessel to meet passenger/occupant egress requirements and compliance with the American Disability Act (ADA) required a process of experimentation.
On the contrary, A&E firms’ “business components”, which are the designs and design packages for buildings, structures, and systems that they develop for their clients, are harder to explain, whether you define them as “products” or “techniques” or another enumerated business component. However, continuing with the approach that stemmed from manufacturing, many R&D business components analyses were want of much substance and were often conclusory (e.g., “Taxpayer developed a product and therefore it meets this requirement”).
Whether a result of this common deficiency or pure coincidence, the IRS has focused increasing attention, particularly with A&E firms, on the “business component” where follow up Information Document Requests (IDRs) on this one issue are common in recent years. As such, if an A&E design firm or their provider are not prepared to provide a legal and factual explanation of a “business component,” the IRS may very well use it as a reason for an R&D credit denial because the burden of proof is still in the taxpayer’s hands.
In sum, simply making generalized statements that an A&E firm develops “blueprints” or “design drawings” and those are “techniques” with little to no further explanation would likely be viewed as conclusory and self-serving statements and would give the IRS an opportunity to deny the claim in full in its own advocacy for its client, the Federal Treasury. It would give them an avenue to argue that the taxpayer has not explained the “business component”, and therefore, does not have a “business component” or “qualified purpose.”
Path Forward for A&E Firms
While some advocate for the IRS to issue guidance to clarify the R&D Tax Credit’s application to A&E and other service firms, the prudent A&E firm and their tax advisors will recognize the lengthy and unlikely event of this occurring, and that they can take measures into their own hands to mitigate their exposure right now.
A&E firms should seek to retain an A&E industry expert to prepare their R&D Tax Credit Studies. The expert should have extensive in-house experience with R&D Tax Credit analyses, claims, and IRS audits, both generally and within the A&E industry. Additionally, it is incredibly important to have in-house engineers, accountants, attorneys, and an active audit defense group.
Regardless of expert provider used, A&E firms need to ensure that all requirements of IRC Section 41 are appropriately addressed and prepared for an audit and not just focused on the “business component” and “process of experimentation” requirements. The IRS can shift its attention as the industry adjusts, and firms may be audited for a claim that was prepared 2-3 years earlier in some cases.
For the “business component,” talk with your provider about how it is addressed and defined, as it would be case-by-case. However, as an example of a much-improved analysis, an architecture firm recently argued that the Construction Documentation package they were designing and developing for a new 100,000 square foot commercial office building was a “product” developed to be “held for license” with its client. It proved this position out with much more detail, but it included specific citations and quotes from the contract between the taxpayer in its client and explained how that was within the meaning of “product” and that the firm owned the documents and were effectively licensing them to their client for their construction project. The explanation further developed the “qualified purpose” of the “business component” through an explanation of the final construction documentation package, focusing on how this “product” was providing for “new or improved” “function, performance, quality, or reliability.”
Furthermore, R&D providers should include full and unlimited audit defense support, including full representation through IRS Appeals and ability to be power of attorney. Providers should take an active approach to tax audits by carefully drafting answers to the questions posed to them by the IRS, as opposed to passive participants simply sending information.
In conclusion, the R&D Tax Credit was and continues to be an excellent opportunity for A&E service firms, and the IRS has not changed its treatment or position on this application so much as it is shifting focus to another issue in its efforts to represent the government.
Justin DiLauro is a Partner of BRAYN Consulting LLC, and as a degreed engineer and licensed attorney, is in his second decade of supporting A&E firms and their CPAs to maximize and defend Federal and State R&D Tax Credits.
BRAYN is a niche consulting firm that guides businesses to greater value through tax credits and incentives. BRAYN Consulting LLC is not a CPA firm, finance, tax, law, or engineering firm, and nothing contained herein can be construed as legal, financial, accounting, tax, or engineering advice.
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