Tax Planning for Construction Contractors: What to Do While You Still Have Time!
More than almost any other industry, construction contractors need to spend time and resources planning for their income taxes before the end of their fiscal year. Contractors must be sure to retain their financial statement strength and ratios while considering possible tax methods of accounting, projected taxable income for remaining months, tax vs. book depreciation, and the calculation of alternative minimum taxes and available tax credits for both the entity and the pass-through owners. It is important that all these variables be considered to ensure that the most favorable financial and tax objective is achieved.
Tax Methods of Accounting for Construction Contractors
Most industries have the choice of only one method of accounting, cash or accrual, depending on their revenue volume and nature of business. Due to the code sections and revenue rulings related to the construction industry, contractors have up to seven different methods available, depending on their volume and the length and nature of their contracts. It is not unusual to find a contractor using up to four different tax methods on a single tax return. IRS Revenue Ruling 92-28 actually instructs agents to expect at least two methods on every construction company’s tax return.
- Overall Methods of Accounting Available to Contractors
- The cash method is available to C corporations with less than $5 million in average annual gross receipts, and partnerships and S corporations with up to $10 million in average annual gross receipts over their prior three years. Certain contracts exempt from long-term contract methods can remain on the cash method, regardless of the entity’s size.
- The Accrual Method is available to construction contractors, although is not generally a good selection. Many contractors will be “overbilled” on their jobs, which can cause them to be taxed on amounts that have been billed but not earned, for financial statement purposes.
- The Accrual Excluding Retainage Method is allowed to taxpayers with contracts that include retainage. Revenue Ruling 69-314 directs taxpayers to remove retainage receivable from taxable income until jobs are completed and accepted. Most contractors that have not elected cash as their overall method of accounting elect the Accrual Excluding Retainage Method. It can apply to any contracts that are not subject to long-term methods of accounting.
- Tax Methods for Long-Term Contracts
- Percentage of Completion Method (POC) is required for all long-term contracts per Code Section 460, unless exempted. “Long-Term” is defined as any contract which starts in one fiscal year and is finished in another. The percent complete is determined as a ratio of cost incurred to date compared to total estimated cost to complete.
- Tax Percentage of Completion includes adjustments to percentage of completion required by Code Section 460, including adding many indirect and general and administrative costs to jobs, which also results in changes to estimated total costs, and adjusting for loss contracts (GAAP requires 100% of contract losses to be reported for financial statements, regardless of actual percentage of completion). In addition, contracts that are less than 10% complete can be omitted for tax purposes.
- Completed Contract Method is allowed for contracts that are exempt from the Percentage of Completion Method. These include contracts performed
by “small” contractors (average annual gross receipts of less than $10 million per year) or home construction contracts.
- Home construction contracts are defined as any of those performed by contractors (or subcontractors) with four or fewer dwelling units per structure, and also include common improvements such as sewers, roads and clubhouses contractually obligated or required by law.
- Percentage of Completed Capitalized Cost Method (PCCCM) is allowed for residential contracts. Residential contracts are defined as the same as home contracts but include those with more than four dwelling units per structure, with an average stay of more than 30 days. These include most multi-family projects as well as college dormitories, assisted living facilities, military barracks and prisons. A contract that qualifies for PCCCM is accounted for 70% Percentage of Completion and 30% under the Elected Tax Method of Accounting (e.g., cash, completed contract, etc.).
Projected Taxable Income for Remaining Months
After determining, or electing, the appropriate or allowable tax methods, it is important to project the taxable income for the year.
- Obtain management and internal accounting assistance in producing reasonable and supportable estimates.
- Compare projections to prior year actual results. Consider why the current year will be better or worse than the prior year (weather, government budgets, etc.).
- Review taxable income or losses at related companies. Most contractors have related entities involving equipment or real estate rentals, or additional construction trades. It is essential that losses or lower tax brackets not be wasted due to ownership, basis or participation rules.
Tax Depreciation Methods for Contractors
Contractors are allowed several favorable methods related to depreciation and capitalization of expenses for tax purposes.
- Construction equipment is depreciated over five years for tax purposes, even though the GAAP useful life might be much longer.
- Contractors are eligible for beneficial tax depreciation methods, such as Section 179 (deduction equal to $500,000 if total purchases do not exceed $2 million) and 50% bonus depreciation on purchases of new equipment.
- Due to the high cost and long GAAP useful lives of construction equipment, many repairs are currently deductible for contractors vs. required capitalization. Expenditures that do not enhance performance or do not extend the useful life generally do not have to be capitalized.
Alternative Minimum Taxes for Contractors (AMT)
Due to the preferential tax methods available to contractors, alternative minimum taxes are a consideration. Pre-year-end planning should include the possibility of AMT in the calculations.
- Differences between the Tax Percentage of Completion Method and the methods used in the tax return for long-term contracts can create AMT. Home contracts, less than 10% contracts, and non-long-term contracts are exempt from alternative minimum tax.
- Accelerated tax depreciation can create AMT. However, bonus depreciation and section 179 are not treated as preference items.
Tax Credits and Deductions Available to Contractors
Contractors are eligible for several tax credits or deductions that should be reviewed as a part of pre-year-end planning.
- A 9% manufacturing deduction is available to contractors. Construction activities are included in the definition of manufacturing for purposes of qualifying for the deduction. The deduction is based on the lower of gross profit from construction, or net income for the company. Architects and engineers also qualify for the deduction.
- Section 179 D deduction is available to the parties involved in energy efficient construction. As an incentive to governmental agencies to use “green” construction, the contractor, engineer or architect can be awarded deductions of up to $1.80 per square foot on projects that achieve certain energy savings.
- Research and development credits.
- Energy credits.
- Work Opportunity credits.
Review Pass-Through Entities and Owner’s Tax Situations
It is essential that all tax planning take into account any tax liability at the company level, while also considering the tax burden of the pass-through owners.
- Maximize the use of lower tax brackets and deductions between companies and owners.
- Calculate alternative minimum tax at the owner level if applicable.
- Consider the timing and deductibility of payments between related parties. Bonuses and other payments must generally be made prior to year-end to be deductible.
Create a Detailed “To Do” List
A detailed list of what needs to be done prior to year-end should be prepared and reviewed.
- Bonuses and withholding prior to year-end.
- Tax estimates or deposits required after planning (remember that proper tax planning can reduce both the current year tax liability and the estimated taxes for the following year).
- Gifting or transfers related to estate and continuity planning.
- Invoicing, documentation and payments between related parties.
As discussed, there are many planning opportunities available to construction contractors. It is essential that the Company’s operations be reviewed prior to year-end while considering the savings available from tax methods, depreciation, related party payments, and other tax deductions and credits.