Year-End Tax Planning for Contractors
Construction contractors have exceptional tools available to them to reduce or defer taxable income. The procedures described below can assist contractors in lessening their tax burden.
Where to Start
The planning process starts with examining taxable net income from year-to-date operations. Contemplate any possible situations that could impact your financial results. This includes items that are uncertain and, therefore, subject to potential adjustment. Consider various alterative results. Look at documentation from the prior year and see what adjustments were made at year-end. Check contract cost estimates and allocations for any pending changes to contracts that may be “gaining” or “fading” when compared to the initial gross profit estimates.
Tax Implications from Last Year
Many basic tax considerations for 2021 are the same as in 2020. Reserves, allowances, and other non-deductible accruals and deferrals will often roll from year to year. Contract or accounting methods from the prior year typically will impact the results of operations as well. Other potential deductions that carryover from the prior year’s tax return accounting method include net operating losses, limited charitable contributions, AMT credit carryforwards, and similar deductions. When reviewing the current and prior year tax returns and operations, contractors should also perform look-back and gain-fade analyses. The look-back analysis is an “as if” recalculation of a contractor’s taxable income based on the actual performance of completed jobs. There can be tax ramifications in the form of taxable income and interest for projects that perform considerably better than initially projected.
The CARES ACT
CARES Act provisions that are still applicable include:
- The forgiveness status of Paycheck Protection Program (PPP) loans should be known by the end of 2021. Forgiveness is not taxable for federal (and most state) taxable income purposes. However, if the loan needs to be repaid, the interest will be deductible.
- In regards to the Employee Retention Tax Credit (ERTC), the IRS has issued guidance clarifying that employers claiming the credit are required to reduce their deductions for employee wages by the amount and in the year of the credit received. This could have an impact on a company’s qualified business income deduction.
- Food and beverage will be 100% deductible if purchased from a restaurant in 2021 and 2022.
In addition, the CARES Act’s suspension of some of the Tax Cuts & Jobs Act (TCJA) rules will end for tax year 2021, including:
- The limitation on deducting excess business losses for non-corporate taxpayers.
- The limitation of 80% of taxable income applied to all net operating losses (NOLs) for tax years ending after December 31, 2020.
Once you know where you stand currently, know where you’re going next. This might include jobs you are considering or initiating, contracts that might be completed by year-end, possible purchases, and any other significant factors or business decisions.
Use all of the aforementioned information to develop a projection for the rest of the year. Will the remaining months be better, worse, or the same as year-to-date operations? Contemplate prior year projections, the current year’s budget to actual results, budgets on recently completed contracts, and any forecasts for the current year.
New Government Initiatives
Washington is constantly responding to changes in the economic climate. Last year, the COVID-19 pandemic and related impact on the nation’s economy led to a number alterations in the tax code, most notably the passage of the Coronavirus Aid, Relief & Economic Security (CARES) Act in 2020. 2021 is no different, as we’ve seen the Consolidated Appropriations Act and the American Rescue Plan Act pass early in the year. Congress continues to deliberate the passage of a trillion dollar infrastructure bill.
It is imperative to consider any recent, pending, or potential changes in tax law that may impact your current year’s tax plan. There is pending legislation that, if enacted, will have wide-ranging impacts. A few highlights from the outstanding Build Back Better Plan proposal include the following:
- A possible increase in the corporate tax rate (currently, a flat rate of 21%).
- A possible increase in tax rates for individuals, from 37% to 39.6%.
- An additional 3% surcharge on earnings in excess of $5 million (or $2.5 million if married filing separately) for individuals.
- Various changes to deductions and limitations.
ESOPs as an Exit Strategy
Thinking about hanging up your safety helmet? The looming tax changes coupled with strong valuation multiples is creating a compelling case for business owners to consider selling to an Employee Stock Ownership Plan (ESOP). For those not quite ready to exit the business, it is imperative to consider an exit strategy. TCJA introduced a doubling of the lifetime exemption (for gifts and estates) to $11.7 million for 2021 per individual. This is still the current exemption and is set to expire at the end of 2025. However, many proposals in recent legislation seek to reduce this exemption or eliminate it altogether. Consult your Marcum tax advisor about the potential benefits of an ESOP as an ownership exit strategy.
Changing Tax Methods
The Internal Revenue Code allows taxpayers who carry out work on long-term contracts several tax methods to enhance their tax situation. The optimal method depends on the size of the contractor and the type of construction being performed. In general, long-term contracts must be recognized for using the “percentage of completion” method. Nevertheless, there are nuances within the code. Smaller contractors, such as those with average gross receipts from the previous three years of less than $26 million, have additional options; so do service providers engaged in residential and home construction. Contractors should review any variations in contract volum to determine if a discussion with an advisor about method change is necessary. Depending on the method and sales volume, some changes to an accounting method election are automatic, while others require IRS approval. Contractors can use multiple methods to optimize their tax positions.
Common Tax Credits
Maximizing the benefits of tax deferrals and credits can yield substantial savings. Some of the more common credits include:
- Employee Retention Credits
- Research and Development
- Energy Credits and Deductions
- Section 179D “Green” Credits for Governmental Structures
- Work Opportunity Credits
- Certain Investment Credits
- Fuel Tax Credits (for Off-highway Business Use)
Consider revisiting these credits to ensure you are maximizing any opportunities to utilize them. Tax deferrals can be generated by carefully timing certain transactions, such as accruing or paying expenses prior to year-end or capitalizing certain costs associated with future contract completion. Contractors should be aware of the opportunities that are available.
Balancing Owner and Entity Payments
Tax planning is performed to minimize the tax impact to the owners of the company. Utilize opportunities to ensure a suitable balance between entities and owners. If there are interrelated entities or several owners, careful attention should be given to ensure the lowest tax rates available among the contractor, its owner, and any related parties. These tools can include structuring salaries, guaranteed payments, management fees, rental agreements, and owner financing. It is important to factor in the impact of the strategic use of deferrals, deductions, and credits. Once the tax impact is determined, ensure that proper withholdings and estimated payments are made to avoid penalties and interest charges.
Things to Do Today!
Make a detailed list of priorities and goals to achieve before the end of the tax year and the applicable filing deadlines. Review job cost allocation on contracts with higher margins than projected. Review percentage of completion for tax purposes to make sure the recognition of gross profit is correct. Plan accordingly so that all bonuses to the owners, management, and others are made within the proper time frame, with the correct withholdings, to avoid penalties or disallowance of a deduction. Capital equipment should be purchased to maximize depreciation deductions; verify that purchases are executed on time.
Teamwork is a critical part of the tax planning process. Information and insights can come from both internal and external parties to the business. Contact your Marcum tax advisor for assistance with proper planning.