Five Commonly Missed Construction Tax Strategies
Numerous advantageous tax strategies are available to construction contractors. However, these strategies are only beneficial if properly planned and used. Unfortunately, many of the strategies discussed below are commonly missed, which means contractors could be leaving money on the table each year. In consultation with your tax advisor, construction contractors can take advantage of these strategies to keep more money in their businesses and give less to Uncle Sam.
1. EXEMPT CONTRACTS
There are several types of exempt contracts that will give taxpayers the advantage of using a method other than percentage of completion method, which is required under the Internal Revenue Code. For example, certain exceptions allow a taxpayer to use the completed contract method, which enables income for that contract to be deferred until it is considered complete. Home construction and residential construction contracts are two examples of such exceptions.
- Home Construction Contracts
- Home construction contracts are contracts where it is estimated that at least 80 percent of the contract costs (including land, materials, and services) will be attributed to the construction of dwelling units or improvements to real property directly related to, and located at the site of, the dwelling unit.
- Dwelling units for the purposes of home construction contracts are defined as buildings that contain four or fewer dwelling units.
- The allocable share of common improvements is allowed to be included in the cost of the dwelling, provided the common improvements benefit the dwelling, and the taxpayer is required by contract or law to build the common improvements.
- Contracts that qualify under the home construction contract rules qualify for the completed contract method, which means the income from these contracts will not be recognized for tax purposes until the contract is considered complete.
- Residential Construction Contracts
- Residential construction contracts are similar to home construction contracts, except these contracts appertain to buildings that contains more than four dwelling units.
- These contracts are eligible to use percentage of completion method or percentage of completion capitalized cost method.
- Percentage of completion method recognizes income for tax purposes based on the completion percentage of the contract in each taxable year.
- Percentage of completion capitalized cost method treats 70 percent of the contract under the percentage of completion method, above.
- The remaining 30 percent of the contract is calculated under an exempt contract method, such as the completed contract method.
- This benefits the taxpayer because it allows the taxpayer to defer at least 30 percent of the income from the contract until the contract is completed, provided the completed contract method is used as the exempt contract method.
It is also worth noting that construction contract accounting within the Internal Revenue Code (IRC §460) does not apply to contracts that are not long-term contracts or to construction management contracts. Contracts not covered under this section of the code should be accounted for using the taxpayer’s “normal” method of accounting, whether it be cash or accrual. Lastly, the code allows contracts that would otherwise be required to use percentage of completion to be excluded from revenue if the contracts are less than10 percent complete.
AMT PREFERENCE ITEM ONLY APPLIES TO CERTAIN LONG- TERM CONTRACTS
The Alternative Minimum Tax (AMT) is a reality for many contractors due to the preferential tax methods allowed to them. The following contracts are exempt from AMT:
- Short-term contracts, meaning the contract was started and completed within the same taxable year.
- Home construction contracts, described above under “Exempt Contracts.”
- Contracts that are less than 10 percent complete.
The following are also exempted from the Alternative Minimum Tax:
- C corporations with less than $5 million in average annual gross receipts.
- The 50% bonus depreciation deduction (described below).
- The Section 179 depreciation deduction (described below).
However, the differences between the percentage of completion method and the methods used for long-term contracts could render the contractor to be subject to AMT. Lastly, it is important to note that AMT for flow-through entities will be calculated at the owner level, not the entity level.
3. LOOK-BACK TAX RETURNS ARE NOT PREPARED
Taxpayers that use the percentage of completion method or the percentage of completion capitalized cost method are subject to look-back calculations. The look-back provisions provide for a recalculation of the income from a contract over the life of the contract once it has been completed. The look-back is calculated as follows:
- Allocate the income for the contract over the taxable years before the contract was completed, based on the actual contract price and costs.
- Next, calculate the amount of tax that should have been paid based on the figures calculated in (1), above.
- If the taxpayer has overpaid the tax for the applicable years, then the taxpayer is entitled to receive interest calculated on the amount of overpayment. If the taxpayer has underpaid the tax over the applicable years, then the taxpayer must pay interest on the amount of tax calculated.
An exemption to the look-back calculation exists for contracts that:
- Do not exceed the lesser of $1 million or 1 percent of the average annual gross receipts over the three taxable years preceding the taxable year in which the tax was completed, and
- Which are completed within two years of the contract start date.
4. FAILURE TO MAXIMIZE TAX DEPRECIATION DEDUCTIONS
Contractors have several advantages available when it comes to depreciation.
- Construction equipment is allowed a tax useful life of five years, which can be substantially less than the financial statement useful life for many types of construction equipment. This allows the taxpayer to deduct the full cost of the asset for tax purposes well before the financial statement useful life is over.
- Contractors are also allowed to deduct repairs and maintenance expenses on their equipment, provided the repairs do not improve the performance or extend the useful life of the asset. Generally, construction equipment is costly to repair, and the ability to expense repairs gives the contractor a substantial tax advantage.
- Section 179 of the Internal Revenue Code allows the full cost of new and used equipment to be expensed in the same year it is purchased.
- For tax years beginning on or after January 1, 2017, the deduction is limited to $510,000 with a phase-out beginning after total assets purchased for the year exceed $2,030,000.
- The Section 179 deduction may not be taken if the deduction creates or increases a net loss for the taxable year.
- Limits exists for certain types of property; for example, sport utility vehicles are only allowed $25,000 of Section 179 deductions.
- Bonus depreciation is still applicable for the 2017 tax year. Bonus depreciation allows taxpayers to deduct 50% of the cost of certain new depreciable
property purchased during the tax year.
- Bonus depreciation is calculated after Section 179 deductions have been applied.
- Bonus depreciation will be decreased to 40% in the 2018 tax year and 30% in the 2019 tax year.
5. FAILURE TO UTILIZE CREDITS OR DEDUCTIONS
Contractors have several credits available to them. A few of the most common credits are the Research and Development Credit, Energy Credits, Fuel Credits and the Work Opportunity Tax Credit.
- The Research and Development Tax Credit allows taxpayers a credit for a percentage of their qualified research expenses.
- Qualified research expenses consist of in-house research expenses (wages and supplies) or contract research expenses (amounts paid for qualified research) incurred within the taxable year.
- To be eligible for the credit, research and development activities must be performed on U.S. soil.
- Section 179D is an example of an energy efficiency deduction. The Section 179D deduction is available to taxpayers who place in service energy efficient
commercial building property in the taxable year.
- Governmental agencies have no use for the Section 179D deduction, which means government agencies can assign this deduction to the engineers who designed the property or the contractors who built the property.
- Section 179D allows for a maximum deduction of $1.80 per square foot of the building, decreased by the aggregate amount of Section 179D deductions taken for the building in all prior tax years.
- Note: As of this writing, Section 179D has expired. There are presently lobbies in Congress pressing for its extension. In the meantime, there may be amended return and refund opportunities pertaining to earlier years.
- The Biodiesel Fuel Credit is an example of a fuel tax credit. This credit rewards taxpayers for using more environmentally friendly fuels, such as
- The Biodiesel Fuel Credit allows the taxpayer a credit of up to $1.00 per gallon of biodiesel, not mixed with diesel, used in a trade or business.
- The Work Opportunity Tax Credit (WOTC) allows for a credit equal to 40% of qualified first-year wages for members of certain targeted hiring groups.
- Examples of targeted groups include qualified veterans, qualified ex-felons, qualified summer youth employees, and qualified long-term unemployment recipients.
- The amount of qualified first-year wages is limited to $6,000 per employee, meaning a credit of $2,400 per employee. However, certain qualified veterans can have first-year wage limitations as high as $24,000, or a credit of $9,600.
These commonly missed tax strategies can provide construction contractors with significant tax savings. Due to the amount and complexity of these tax strategies, it is imperative to plan ahead and review the operations of the company prior to the end of the taxable year. With proper planning and consultation with a tax advisor, construction contractors can benefit from the above-mentioned tax strategies and, in many cases, use these strategies to reduce their tax liability.