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Tax Strategies to Reduce Income Tax Liability
MCC Construction Zone
Tax Strategies to Reduce Income Tax Liability
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Martin C. McCarthy, CPA, CCIFP
Contractors need to invest in tax planning throughout the year to gain the maximum impact. While most tax strategies strive to accelerate income in the current tax year and defer expenses to the next year, strategic tax planning takes into consideration many other factors such as how reducing income for tax purposes will affect a contractor's financial statements, cash position, working capital, and financial ratios. Lenders and sureties rely on the strength of a contractor’s financial statements along withthe company’s character, capacity, and capital when deciding on a lending and bonding program. Customers also review these metrics to ensure that the contractor is financially strong and able to meet their performance obligations. Therefore, it is important to take a holistic approach to tax planning. Here are strategies to consider:
Take advantage of COVID-related tax credits. Many tax provisions were implemented under legislation aimed to help businesses and individuals deal with the COVID-19 pandemic and its ongoing economic disruption. These include the Employer Retention Credit (ERC) and numerous other tax credits for businesses and individuals. We will address ERC in a separate article.
Qualify for a R&D tax credit.Contractors may qualify for a research and development (R&D) tax credit if new processes to improve efficiencies or reduce/eliminate uncertainty in the business are developed in the U.S. A R&D tax credit is generally taken on a dollar-for-dollar basis on either the entire qualified project or the portion of the project that meets the criteria of the IRS. If the R&D tax
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credit is not fully utilized, it may be carried back to the previous year, and carried forward for 20 years. Qualified start-up and small businesses that may not have an income tax liability can offset payroll taxes with the credit.
Assess NOL carryback vs. carryforward.Recent legislation permits net operating losses (NOLs) to be carried back to obtain refunds of prior year taxes. While this may sound appealing, contractors should assess the implications of this tax provision before deciding totake a NOL carryback or carryforward. President Biden has stated that he intends to raise income taxes. Therefore, it is important to determine if it is more advantageous to take a carryback and refund in a year with a lower tax rate or have the NOL available for future years when income tax rates are expected to be higher. Evaluate current working capital needs along with the company’s long term financial stability before making a decision.
Use the right accounting method.Contractors should ensure that the tax reporting method for each contract is appropriate by determining which projects are not considered long-term (more than one year). Most contractors use the percentage-of-completion method (PCM) for long-term contracts. However, many exceptions exist. Residential builders (homebuilders and contractors who build apartments, dormitories, assisted living facilities and prisons) generally qualify to use a different tax reporting method. Other elections should be considered for having paid if paid language in contracts, unit price contracts, Guaranteed Maximum Price (GMP) contractsand retainage receivable. Under the Tax Cuts & Jobs Act of 2017 (TCJA), tax accounting methods previously available only to smaller contractors can generally be used by contractors with average annual gross receipts of up to $26 million (as adjusted for inflation). Choosing the appropriate method for each contract to reduce taxes is an overlooked tool.
Assess opportunities for deductions on pass-through entities. Contractors that own or invest in pass-through entities (sole proprietorships, partnerships, most LLCs, and S corporations), can deduct their allocated share of losses to the extent of their basis (debt and equity). Contractors should have a sufficient basis to deduct allocable losses instead of carrying losses to a future year when their income may be lower. In addition, contractors should look for ways to reduce taxable income such as making retirement plan contributions and developing an exit strategy. There are several factors that affect basis and knowing those items could reduce your tax obligation or change the entity structure.
Take advantage of bonus depreciation changes.The CARES Act includes a technical correction to TCJA that permits 100% bonus depreciation for eligible Qualified Improvement Property (QIP) placed in service after December 31, 2017, and before January 1, 2023. Taxpayers whoplaced eligible QIP in service during 2018 and 2019 may be eligible to claim 100% bonus depreciation. REITs, manufacturers, and other businesses that own certain types of nonresidential real estate improvements on leased land may also be eligible. This can help businesses, especially in the retail, restaurant, and hospitality industries, improve cash flow.
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Conduct a Cost Segregation Study. Contractors and real estate investors that acquired, renovated, or built a building should consider conducting a cost segregation study to determine if the property qualifies for accelerated depreciation. Qualified assets are reclassified from real property to personal property for federal income tax purposes and therefore have a shorter depreciable tax life. A 39-year or 27.5-year property could qualify as a 5-, 7-or 15-year property. Generally, 20% to 40% of the property can be reclassified as personal property. Flooring, signage, landscaping, and parking lots areexamples of building components that can be reclassified. Typically, the building should have been placed in service within the last five years, and the cost of the building, remodel, expansion, or build-out needs to be at least several hundred thousand dollars. A good threshold is $750,000.
Qualify as a real estate professional. Rental activities and income are generally considered passive income unless the investor qualifies as real estate professional for tax purposes. Then it is treated as non-passive income. Losses can be deducted if the real estate professional materially participates in the rental activity. More than 50% of the person’s time and 750 hoursmust be spent on real estate activities. Holding a real estate license is not required. Other rules apply. However, generally contractors qualify for this provision under the Internal Revenue Code. It is important to assess this as it becomes a valuabletax planning tool.
Take the Section 179 election. Section 179 allows businesses to deduct the full cost of qualifying equipment in the year of purchase rather than depreciating the cost over time. Eligible property may be new or used and leased or purchased. To utilize a deduction under Section 179 an eligible property must be: tangible (physical property like computers, software, equipment, furniture, machinery, and vehicles), placed into service in the year the deduction is claimed, cannot be purchasedfrom a relative or related organization, and must be used more than 50% of the time for business purposes. There are caps to the total amount written off ($1,040,000 for 2020), and limits to the total amount of the equipment purchased ($2,590,000 in 2020). The deduction begins to phase out on a dollar-for-dollar basis after $2,590,000 is spent by a given business. The entire deduction goes away once $3,630,000 in purchases is reached.
Take the Energy Efficient Building Deduction. The Consolidated Appropriations Act (CAA) of 2021 made the Energy Efficient Building Deduction (Section 179D) permanent. Business owners and government contractors can take a deduction for energy-efficient improvements to commercial and government buildings.A tax deduction of $1.80 per square foot is available to owners of new or existing buildings who install interior lighting, building envelope, or heating, cooling, ventilation, or hot water systems that reduce the energy and power costs by 50% or more. Any accrued tax deductions from these buildings can be carried-back two tax years or can be carried-forward for up to 20 years. Eligible designers and builders (such as architects, engineers, contractors, environmental consultants, and energy service providers) can also qualify for 179D under a special rule for public property.
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Invest in a Qualified Opportunity Zone. Another TCJA provision established Qualified Opportunity Zones to provide a tax incentive for private, long-term investment in economically distressed communities. Investors in these programs generally can defer and potentially reduce tax on recognized capital gains. If a capital gain is invested in a Qualified Opportunity Fund within 180 days of realizing the gain, the gain is not included in income until the investment is sold, or on December 31, 2026, whichever is sooner. Potential tax benefits can come from a temporarydeferral,permanentexclusionofeither10%or15%,orpermanentexclusionofpostacquisition appreciation.
Other Simple, Yet Effective Planning Strategies to Consider Change your corporate structure. Contractors that retain earnings in the company instead of distributing profits to shareholders may benefit from changing their corporate structure to a C corporation. Under TCJA the highest effective tax rates of C corporation net income is 21% (plus 15% or 23.8%on dividend distributions). For S-Corp, the highest rate 37% (29.6% with full section 199A deduction). Contractors electing to make this change must remain a C corporation for five years.
Defer taxes with a like-kind-exchange. Section 1031 allows investors to defer paying taxes on the gain from the sale of a property if the proceeds are reinvested in a similar property. There is no limit on the number of times or frequency of doing a 1031 exchange. Business or investment properties generally qualify.
Hold properties for more than a year. Real estate investors who own properties for more than a year are taxed at the capital gains rate instead of their ordinary income tax rate. The capital gain tax rate is 0%, 15%, or 20%, depending on the investors’ tax bracket. If the investor lives in the property for at least two years, the first $250,000 of capital gains is tax-free for singles and $500,000 for married couples. Holding property for more than a year reduces the chance that the IRS will classify the investor as a “dealer.” Earnings for dealers are generally subject to double FICA taxes because they are considered self-employed. The investor would pay 15.3% towards social security and Medicare taxes instead of 7.25%.
Take the Qualified Business Income Deduction. The Qualified Business Income (QBI) Deduction (Section 199A) allows noncorporate taxpayers to deduct up to 20% of QBI, plus 20% of qualified real estate investment trust (REIT) dividends and qualified publiclytraded partnership (PTP) income. QBI is the net amount of qualified income, gains, deductions, and losses included in taxable income from any qualified U.S. trade or business. Individuals, including owners of sole proprietorships, partnerships, and S corporations,may qualify, as well as certain trusts and estates. Income earned through a C corporation or by providing services as an employee is not eligible for the deduction. Items such as capital gains and losses, certain dividends, and interest income are excluded. W-2 income, amounts received as reasonable compensation from an S corporation,
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amounts received as guaranteed payments from a partnership, and payments received by a partner for services under section 707(a) are also not QBI. The deduction is available for taxable years beginning after December 31, 2017, and ending before December 31, 2025.
Take the 20% pass-through deduction. A TCJA provision allows small business owners to deduct 20% of domestic qualified business income (QBI) from a pass-through entity. The deduction is taken on the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. The deduction cannot exceed taxable income. Rules apply.
Establish a self-directed IRA account. Holders of a self-directed IRA may fund real estate purchases from their IRA. There is no penalty for being under age 65. The non-financed portion of the purchase is sheltered from taxes by the IRA. A custodian or trust company must administer the selfdirected IRA. Other rules apply.
There are many other opportunities to discuss as year-end approaches to complete your Tax Blueprint. Taking a strategic yet holistic approach to tax planning can provide many benefits. There is a fine balance in what makes sense for any company. Implementing one strategy may offset the benefits of another. Contractors should weigh the costs versus the benefits before implementing any tax planning strategy.
About the Author Marty McCarthy, CPA, CCIFP, is the managing partner of McCarthy & Company. He is well respected by sureties and bankers for the high quality of his work and profound understanding of the construction industry. Marty helps clients by providing them with theinsight needed to grow their business. He can be contacted at 610.828.1900 or Marty.McCarthy@McCarthy.CPA.
A version of this article was originally in Construction Today (5 Tax Strategies Contractors Should Consider to Reduce Their Income Tax Liability. Marty McCarthy, CPA, CCIFP. Issue 2. 2021) published by the General Building Contractors Association.
Disclaimer: This article is for informational purposes only and does not constitute professional advice. We strongly advise you to seek professional assistance with respect to your specific issue(s).
Marty McCarthy, CPA, CCIFP
Call us to design your tax blueprint. 610.828.1900
