Contractual Considerations: How Design Firms Can Effectively Manage R&D Expenditures

Navigating the nuances of Internal Revenue Code (IRC) 174 guidance is necessary to properly amortize research and experimental expenditures related to design under IRC 174. Guidance found in Notice 2023-63, released in September 2023, outlines expenses required for amortization in detail. Many architecture and engineering firms designing buildings or structures meet the definition of performing specified research or experimental (SRE) activities. Related IRC 174 expenses must be identified and amortized for domestic and foreign expenditures over the applicable period.

The most common expenses amortized for architecture and engineering service firms are direct labor costs, direct third-party development, and certain operations and management expenses. Direct third-party research expenses can encompass a significant portion of a taxpayer’s 174 costs and can include a variety of specialty design, testing, and engineering companies such as architects, civil engineers, structural engineers, and geotechnical testing.

The contractual relationships between design firms and the outside consultants assisting with research vary in research rights, usage, responsibilities, and fee types. Firms that retain outside contractors must consider who retains research rights and holds economic risk for the design project and closely review contracts to determine if the associated costs constitute 174 expenses. Architecture firms often act as “pass-throughs” for construction and structural engineering costs. In these cases, the architecture firm wouldn’t retain rights to the engineer’s designs and directly pass-through costs to the end client, the building owner.

However, ensuring the contracts reflect this is critical to avoid unnecessary 174 expenses. Engineering firms often contractually retain at least partial research rights to work performed by outside consultants. In these cases, the outside engineering consultants allow engineering service firms to license or utilize their drawings and calculations. Consequently, these types of contracts can result in taxpayers having to amortize considerable amounts of outside consultant expenses.

Because contracts can differ significantly between engineering service firms and architecture firms, it is essential to review each contract thoroughly. This includes examining the scope, fee structures, and the rights and obligations of each party. Doing so will help determine if expenses related to outside consultants need to be amortized under IRC 174.

If you have any questions about this guidance or any other questions regarding the R&D Tax Credit, please do not hesitate to contact our R&D Tax Credit team.