Tax Planning Considerations for Competitive Construction Companies
By Brian Marron, Director, Tax & Business Services
As construction companies enter Q4, this is a great time to look at performance and take advantage of potential tax savings opportunities. As a contractor, there are various items to consider that can help defer income and minimize taxes in the current year. Given that cash flow management is paramount to most contractors, taking advantage of the multiple opportunities to preserve cash flow and adequately manage tax burden is vital. Here are some opportunities that contractors should consider exploring to gain every tax advantage available:
Proper Tax Treatment of Certain Contracts
Most construction contractors must file under IRC 460, which addresses long-term contracts and primarily reports on the Percent of Completion (POC) accounting method. However, several types of contracts should be looked at individually to determine if other beneficial reporting methods exist for tax purposes, and IRC 460 has multiple exceptions. It is imperative to address this sooner rather than later as many exceptions require filing a request for accounting method change with the IRS, which needs to be completed by December 31. Each contract a contractor has could provide a different exception, so you must address each contract, or you could miss out on opportunities to defer revenue to future years.
What are some of those exceptions?
- Home construction contracts (four or fewer dwelling units)
- Residential construction contracts (more than four dwelling units)
- Unit-price contracts
- Guaranteed maximum price (GMP) contracts
- Contracts with a “pay when paid” clause
- Maintenance contracts
Upon reviewing your contracts, if any of these apply, an assessment should be done to determine the applicability of IRC 460, calculate the tax benefits, and, ultimately, file the appropriate change of accounting method with the IRS.
In one recent case, Marcum worked with a larger contractor filing their taxes on a percent complete basis. Upon reviewing their contracts, we were able to file a method change with the IRS and defer $13 million of income, which equated to reducing current federal income tax by $4.5 million. To take that one step further, in this rising interest rate environment, the contractor has more liquid cash available and has estimated the interest saved for one year alone on this money is another $250,000. This is one example, but it shows the importance of reviewing contracts to determine tax applicability.
179D is a deduction for energy-efficient construction or building improvements to commercial buildings. What used to be a maximum deduction of $1.8 per square foot can now be a maximum of $5 per square foot as of January 1, 2023, if prevailing wage and apprenticeship requirements are met. This is a significant opportunity for many contractors. For example, a 100,000-square-foot project may yield a contractor an additional $500,000 deduction.
Understanding this and knowing how to obtain this credit is critical. For contractors that can address energy efficiency on their projects, 179D likely represents a significant advantage.
R&D Tax Credit
Construction companies may be eligible for research and development-related credits if they perform design-build contracts or continuously experiment to improve processes and techniques. Under current law, the IRS requires the capitalization of R&D expenses over five years, but if the Build It in America Act passes, those R&D expenses will no longer need to be capitalized through December 31, 2025. This is a tax credit on items the contractor already paid for, and provided the contractor qualifies, the contractor can use this credit to apply to taxes owed on the company’s profit.
45L Tax credit
45L tax credits are a per unit tax credit for home builders and developers of energy-efficient residential properties. Effective January 1, 2023, credits have increased to $2,500 (Energy Start Certified) or $5,000 (Zero Ready Energy Certified) per unit if prevailing wage requirements are met. Again, given this is a tax credit on items the contractor already paid for, and provided the contractor qualifies, the contractor can use this credit to apply to taxes owed on the company’s profit.
Therefore, it is essential to address and assess the applicability of these and other tax credits to reduce the contractor’s overall tax burden.
Cost Segregation Study
A cost segregation study is an immediate acceleration of depreciation expense and is ideal for any real estate that a construction company or shareholders own. Instead of depreciating commercial property over 39 years, this study will break down the building into sub-components, reclassing 39-year property into property classes with depreciable lives of 15 years or less. Once these are classified into lower-class lives, they are eligible for bonus depreciation. This should be considered for 2023 as the 80% allowable bonus depreciation in 2023 will drop to 60% come January 2024. Given the opportunities under the Internal Revenue Code, contractors likely qualify as real estate professionals and can offset the losses against other income.
In summary, a contractor operates in a highly competitive environment with tight margins, rigid job schedules, and a lot of uncertainty. Understanding the options afforded to contractors under the IRS code can and does provide them with some relief and puts them in a more competitive position.
Maximum Deductions Based on Building Size
|BUILDING EXAMPLES||BUILDING SIZE IN SQUARE FEET||PRE-IRA DEDUCTION MAXIMUM (JAN 1, 2006 – DEC 31, 2022)||POST-IRA DEDUCTION MAXIMUM* (JAN 1, 2023 – ONGOING)||WITHOUT PREVAILING WAGE|
|OFFICE / ELEMENTARY SCHOOL||50,000||$90,000||$250,000||$25,000 – $50,000|
|HIGH SCHOOL / MULTISTORY RESIDENTIAL||100,000||$180,000||$500,000||$50,000 – $100,000|
|HOSPITAL / WAREHOUSE||500,000||$900,000||$2,500,000||$250,000 – $500,000|