Tax Planning for Contractors
Authored by Dana Houston : Professionals : CLA (CliftonLarsonAllen) (claconnect.com)
As the year comes to a close, exploring tax strategies with your CPA is a way to uncover potential tax savings opportunities. Whether you’re an individual looking to minimize your tax liability, or a business owner seeking to maximize your after-tax income, this article will provide you with the information needed to develop a plan with your tax professional.
Accounting Methods
As part of the Tax Cuts and Jobs Act, small contractor accounting methods are available to contractors with average annual gross receipts under $29 million for tax year 2023. While these alternative methods only provide tax deferral opportunities (and not permanent tax savings), it may be worth revisiting given that interest rates have risen significantly.
Completed Contract Method: Contract related revenue and costs are deferred until the job is complete. The income, however, is subject to the Alternative Minimum Tax for non-c corporation entities and requires careful planning and cash flow management.
Accrual with Deferral of Retentions: Popular among subcontractors, retainages receivable are not considered income for tax purposes until the retainage is payable.
Cash Method: Income is recognized when cash is received, and expenses are deducted once paid. The cash method of accounting generally defers recognition of income relative to the accrual method because most taxpayers have more receivables than payables.
Prepaid expenses: Accrual-method taxpayers can generally deduct prepaid payment liabilities, such as insurance, taxes, and warranty or maintenance service contracts, if the term covered by the prepayment does not extend beyond the earlier of 12 months after the first date on which the taxpayer realizes the right or the end of the tax year following the year of payment.
10% Method: Contract related revenues and costs are deferred until the job is at least 10% complete.
30% Residential Contract Deferral: 30% of contract related revenues and costs on residential contracts (contract for a dwelling containing more than 4 units) are deferred until contract completion.
Capitalization of Research Expenses
Beginning in 2022, taxpayers are required to capitalize and amortize their Section 174 research and experimental expenditures over a 5-year period for domestic expenditures. The new capitalization rules created a conflict between Sections 174 and 460 in regards to research costs allocable to a long-term contract accounted for using the percentage of completion method.
On September 8, 2023, Notice 2023-63 was issued, providing interim guidance whereby nondeductible Section 174 costs are no longer included in the numerator of the percent complete calculation. While this wasn’t the most taxpayer-friendly solution, the proposed rule by the IRS does allow taxpayers utilizing the percentage of completion for long-term contracts to defer some income recognition for at least one year (i.e., only 10% of the allocable 2022 Section 174 R&E expenditures are included in the 2022 PCM calculation rather than 100%). The IRS is planning to issue proposed regulations consistent with the rules in the Notice to be effective for tax years ending after September 8, 2023.
On this topic, there is some support in the house for a year-end tax bill reinstating the “Big 3” business tax provisions covering immediate expensing for research and development (R&D), 100% bonus depreciation, and earnings before interest, taxes, depreciation, and amortization (EBITDA) interest deductibility. However, current thinking is that the bill doesn’t have a serious chance of passing until February or March of next year.
Fixed Asset Purchases
The bonus depreciation percentage for assets placed in service in 2023 is 80% and the percentage is scheduled to drop to 60% for 2024. Although not commonly used while 100% bonus was in effect, many taxpayers will qualify for immediate expensing under Sec. 179 and thus are not impacted by the change in the bonus depreciation percentage. For 2023, the Sec. 179 limit is $1.16 million with a phase out beginning when purchases exceed $2.89 million. The additional bonus depreciation available in 2023 provides an extra incentive for taxpayers subject to a Sec. 179 limit to place assets in service before year end.
It may be advisable to elect Sec. 179 on property to generate a Sec. 179 carryover as opposed to electing bonus depreciation. Additional bonus depreciation would generate an NOL which is limited to 80% of taxable income whereas a Sec. 179 carryover can reduce taxable income dollar for dollar.
Section 179D
The Internal Revenue Code Section 179D deduction allows the owner of a commercial building to receive a tax deduction for a building that is constructed or renovated in an energy-efficient manner. Owners of commercial buildings can take advantage of this incentive through an accelerated deduction of energy efficient systems. Because government and not-for-profit entities do not pay federal taxes, they can assign tax benefits to taxpaying commercial businesses involved in designing these buildings, such as architects, engineers, contractors, and energy service providers. The deduction is intended to encourage the designers to create buildings that consume less energy.
This incentive provides an immediate first year tax deduction for specific energy-efficient portions of a new or remodeled commercial building. To claim the deduction, these building components must be tested and certified as attaining specific energy savings compared to the American Society of Heating, Refrigerating and Air-Conditioning Engineers (ASHRAE) energy standards. Three systems are reviewed when modeling buildings for the Section 179D Deduction. The interior lighting systems, the heating, cooling, ventilation, and hot water system, and the building envelope system.
To take advantage of this incentive, the entity may allocate the deduction to the designer of the energy efficient commercial building. This is completed through an Allocation Letter which must be signed by both the designer and the building owner. Prior to 2023, only governmental entities could allocate the deduction to the designer but this has since been expanded to those entities identifying as tax-exempt.
Business Interest Limitation
The Tax Cuts and Jobs Act limits the deduction for business interest to the sum of:
- The taxpayer’s business interest income for the tax year.
- 30% of the taxpayer’s ATI for the tax year; and
- Floor plan financing interest expense.
Any interest that is disallowed can be carried forward.
It is important to note that some taxpayers are exempt from the Sec. 163(j) limitations. Small businesses (defined as those with average annual gross receipts of less than $29 million for 2023) and electing real property trades or businesses are not subject to these limitations. Construction contractors typically qualify as a real property business that can choose not to apply the limits. An electing real property trade or business is required to use ADS depreciation for real property and qualified improvement property with extended depreciable lives and the inability to claim bonus depreciation. This applies to assets that are not fully depreciated at the date the election is made, and any assets placed in service thereafter. If the contracting business doesn’t directly own any real property, the limits on depreciation may be negligible.
Pass-through Entity Tax
Many states have enacted some form of pass-through entity tax as a workaround for the $10,000 SALT cap limitation. These regimes impose the state income taxes on the pass-through entity directly and allow for a deduction against federal income. While the rules vary from state to state, the nuances of cash vs. accrual basis taxpayers are important to consider during year-end planning.
Employee Retention Credit
The Employee Retention Credit (ERC) was initially created through the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in 2020. ERC now applies more broadly due to changes made by the Consolidated Appropriations Act of 2021. The ERC is a fully refundable payroll tax credit for qualified wages (including allocable qualified health plan expenses) that eligible employers pay their employees.
The ERC has been a valuable opportunity for employers impacted by COVID-19. To qualify, an employer must have either experienced a significant decline in gross receipts or had its operations fully or partially suspended by a government order. For this purpose, gross receipts are measured on a tax basis. Consequently, it is possible your business qualifies even if it did not have a meaningful decline in gross receipts for book purposes. Employers have three years to amend payroll tax returns for refunds of up to $7,000 per employee per quarter in each of the first three quarters of 2021 and up to $5,000 per employee in 2020.
The 2020 filing expiration is April 15, 2024. The 2021 filing expiration is April 15, 2025.
It is imperative to explore this opportunity with your Tax Advisor, even if only to provide comfort in the fact that you are not leaving money on the table!
Year-end planning starts with a discussion with your advisor, so they understand your current year activity and your long-term objectives. Careful and strategic tax planning can result in significant savings and provide opportunities to further grow your business. We are here to help.
Mary Jo is a principal with over 15 years of experience serving the construction industry. A member of CLA's construction tax leadership, she is an advisor providing tax and consulting services to the construction industry. She helps construction companies and their owners navigate industry challenges, succession planning, and complex tax legislation.
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