Editor: Marcy Lantz, CPA
During this past year, most income tax professionals were focused on meeting filing deadlines, assisting clients with questions regarding Paycheck Protection Program loans, navigating the tax law changes in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, and keeping their businesses moving forward despite significant challenges created by the COVID-19 pandemic.
Amid all that, it is important to not overlook several tax-saving opportunities that have been around for a while and may not be current headline news. For CPAs who specialize in serving the housing and construction industries, advising clients to take advantage of the Sec. 45L credit, the Sec. 179D deduction, and the research and development (R&D) credit may be second nature. However, for those who have a more general client base, it may be helpful to have a refresher, or perhaps an introduction, on how businesses can qualify for these incentives and how tax preparers can assist them in claiming these tax benefits.
Explanation of the incentives
R&D credit: The R&D credit is an often misunderstood and overlooked tax benefit. The name brings to mind images of white lab coats, working in clean rooms, and products that are new to the world. Perhaps a more apt name for this credit would be "the new or improved product or process credit." This is because Sec. 41 defines the activities that can qualify as those having a purpose of creating new or improved business components, i.e., products, processes, techniques, formulas, inventions, or software. The key phrase here is "new or improved," and the application is to the taxpayer and not necessarily "new or improved" to the world. This means a wide variety of industries and taxpayer projects might contain qualified research activities. The Code also requires that the activities be for the purpose of discovering information that is technological in nature. To meet this standard, qualified research activities must rely on principles of the physical or biological sciences (e.g., physics, chemistry, biology, and/or material sciences), engineering, or computer science.
In addition to developing a new or improved business component and being technological in nature, the activities undertaken for a qualified research project must also meet a third requirement regarding the elimination of uncertainty. This uncertainty requirement is often where confusion about qualified research activities comes in. Qualified research activities will eliminate uncertainty if the information available to the taxpayer before the activities are undertaken does not establish the capability or methodology involved for the development, improvement, and/or appropriate design of the business component.
Finally, because of the uncertainty, the qualified research activities will require a process of experimentation. Experimentation that meets this last requirement can include systematic trial and error, prototype creation and testing, computer-aided modeling, and/or simulation.
An example of an R&D credit application within the housing and construction industry is for a builder that is developing prefabricated homes. Undertaking modular design and determining how best to construct the prefabricated home in terms of materials used and cost-effectiveness are exercises in qualified new or improved business components for the builder. The technical aspects of modular construction involve principles of engineering, physics, and material sciences. The technical challenges associated with designing modules and the construction process create methodology uncertainty in the project for the homebuilder. The experimentation involved with modular design includes the evaluation of materials that improve affordability, sustainability, and performance. The construction process with prefabricated elements might also require experimentation in terms of methodology for highest efficiency.
Sec. 179D deduction: Sec. 179D provides a deduction for a commercial building that meets certain energy-efficiency requirements and was constructed or had improvements placed in service after Dec. 31, 2005. For this purpose, a multifamily residential rental property qualifies as a commercial building if it has four or more stories above grade. The benefit can be up to $1.80 in tax deductions per square foot. This is done by computer-modeling the energy efficiency of new construction or remodeling of a building in comparison to historic energy standards. The areas that are modeled are lighting systems; building envelope; and heating, ventilation, air conditioning (HVAC), and hot water systems. The deduction is generally taken by the owner of the building, but in the case of a government building where the owner would receive no tax benefit, the owner may allocate the deduction to the building's designer.
Sec. 45L credit: Sec. 45L provides a credit to contractors constructing new energy-efficient homes. To secure the $2,000-per-dwelling-unit credit, a unit must be at least 50% more energy-efficient than a similar unit constructed in accordance with the 2006 International Energy Conservation Code, with 10% being derived from building envelope construction or improvements, and have minimum heating and cooling equipment efficiencies under certain U.S. Department of Energy regulations. The credit is allowed for both single-family and multifamily dwelling units, as long as the building is no taller than three stories. The credit is allowed in the year the property is leased or sold.
Details and trade-offs for tax preparers to be aware of
R&D credit: There are multiple components to the R&D credit calculation, but, generally, a taxpayer will receive a credit for approximately 6% to 10% of qualifying costs. If a taxpayer does not make the reduced credit election under Sec. 280C on Form 6765, Credit for Increasing Research Activities, included in an original timely filed tax return, then it must reduce its otherwise deductible expenses by the amount of the credit. The reduced credit election is generally tax-neutral from a federal income tax perspective for corporate taxpayers, and it can simplify multistate filings. Beginning with the 2018 tax year, with the corporate federal tax rate lower than the individual federal tax rate being paid by most passthrough owners, it is generally preferable to make the reduced credit election when possible for passthrough businesses. However, tax preparers should consider all relevant facts for a specific client before deciding whether to make this election.
As part of the Protecting Americans From Tax Hikes (PATH) Act of 2015, P.L. 114-113, the R&D credit was expanded to include additional tax benefits and opportunities for smaller and early-stage businesses. Qualifying startup companies may elect to take part or all of their R&D credit as a payroll tax offset, and eligible small businesses may use the R&D credit to offset the alternative minimum tax. The details of the expanded benefits are beyond the scope of this discussion, but tax preparers should research these rules when evaluating the tax benefits of the R&D credit for clients that are in their first five years of generating revenue or that have an average of $50 million or less in gross receipts over the prior three years.
Sec. 179D deduction: The Sec. 179D deduction is based upon the cost of qualifying energy-efficiency property placed in service, up to a maximum of $1.80 multiplied by the building's square footage. When claiming the deduction, the building owner must reduce the property's depreciable basis by the amount of the deduction. Therefore, for a building owner, the Sec. 179D deduction is effectively a timing difference, albeit a powerful one, considering a depreciable life of 39 or 27.5 years. Deductions claimed under Sec. 179D are subject to recapture under the Sec. 1245 rules, so tax preparers should maintain a basis schedule that takes Sec. 179D deductions into account so that preparers can properly calculate potential recapture amounts in the event of a future sale of the building.
When a government building owner allocates the Sec. 179D deduction to the building designer, the designer claims the ordinary deduction in the year the building was placed in service. Because the designer does not own the building, there is no depreciable basis reduction to the building. If the designer is a passthrough entity, the noncash tax deduction will eventually reverse for the entity's owners, since it will lower its tax basis in the entity. Upon receiving a distribution in excess of basis or having a sale event, that prior noncash deduction will mean the owners have more gain on distribution or sale. In that case, the Sec. 179D deduction ultimately provides a favorable timing difference for the owners of the building designer and likely some permanent tax savings based upon the difference between the ordinary and capital gains tax rates.
Sec. 45L credit: When claiming the Sec. 45L credit, the taxpayer must take a dollar-for-dollar reduction in the basis of the dwelling unit sold or leased. This means that a homebuilder that sells a dwelling unit will reduce its cost-of-goods-sold deduction by the amount of the Sec. 45L credit claimed in a tax year, and one that leases a dwelling unit will reduce its depreciable basis in the leased dwelling unit.
It is important for tax preparers to be aware of both the benefits and trade-offs so they can help set realistic expectations for their clients of the true cash benefit to be obtained from claiming these various incentives.
Logistical issues related to claiming these tax incentives
The R&D credit was made permanent with the PATH Act, but as of this writing, the Sec. 179D deduction and the Sec. 45L credit are only effective through Dec. 31, 2020. Taxpayers still have time to claim these tax benefits for 2020 and for previous tax years for which the statute remains open (generally, 2017 and later tax years, as of this writing) through a combination of originally filed and amended tax returns. Practically speaking, most tax professionals expect that their clients may face a higher level of IRS scrutiny when claiming substantial tax benefits on amended returns versus on original returns. However, with the appropriate documentation and support in place, many taxpayers will decide that the cash savings are worth the potential increased exposure.
To claim these incentives for tax years for which the filing date has passed and the tax return has already been filed, the most common approach is to file amended tax returns. However, the Sec. 179D deduction may be claimed by a building owner via an accounting method change if the building owner previously placed in service qualifying property that would entitle it to the deduction but instead has been depreciating the full cost of the property. Section 8.01 of Rev. Proc. 2019-43 provides for an automatic change for this scenario, so a property owner may claim the Sec. 179D deduction (net of prior depreciation) via a Sec. 481(a) adjustment rather than an amended return. For a designer of a government building, the deduction must be taken in the year the property is placed in service, which will require an amended tax return for a previously filed year.
Many companies in the homebuilding and construction industries operate as tax partnerships, and many of them are now subject to the centralized partnership audit regime. Those partnerships that are subject to a centralized audit will generally not be able to file an amended Form 1065, U.S. Return of Partnership Income, for tax years beginning with 2018. Instead, they will be required to file an administrative adjustment request (AAR) to claim additional tax benefits, which will result in the tax savings being claimed by the partners when they file their individual tax returns for the year in which the AAR is filed. While this may delay the receipt of the cash tax benefits, it should not negate the opportunity to consider claiming additional credits.
Both the Sec. 45L credit and the Sec. 179D deduction require specific professional certifications that the property meets certain energy-efficiency requirements to claim the credit or deduction. Most CPA firms that provide core tax compliance services are not specialized in providing such certifications for clients, so they should refer clients to a third-party service provider that specializes in those certifications. While the R&D credit does not require any specific certifications, it does require substantial documentation to support the qualifying projects and expenditures, so any taxpayer claiming a substantial R&D credit is well advised to enlist the help of a specialist consultant to maximize and support its credit. Clients need to be made aware of the additional professional fees they will incur for both the specialty providers and their own tax preparer's time to prepare and file the relevant forms and returns so the clients may fully consider the expected net cash benefit to be obtained.
Tax professionals serving clients in the homebuilding and construction industries should familiarize themselves with the details of these tax credits and deductions and keep up to date with their clients' business activities so that they are well positioned to provide timely and proactive advice to help their clients maximize available tax incentives and save much-needed cash.
Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore. Ms. Lantz would like to thank the following practitioners for their help editing the December Tax Clinic: Michael T. Odom, CPA, CVA, partner at Fouts & Morgan CPAs PC in Memphis, Tenn.; Carolyn Quill, CPA, J.D., LL.M., principal at Thompson Greenspon CPAs & Advisors in Fairfax, Va.; Kristine Boerboom, CPA, CMA, MBA, partner at Wegner CPAs in Madison, Wis.; and Todd Miller, CPA, partner at Maxwell Locke & Ritter in Austin, Texas.
For additional information about these items, contact Ms. Lantz at 503-620-4489 or firstname.lastname@example.org.
Contributors are members of or associated with CPAmerica, Inc.