This article is the third in a series looking at what public and private construction firms pay in federal taxes and the techniques some of them use to minimize their tax burden. Click here for the entire package.
Much of the debate around raising taxes to pay for President Joe Biden's proposed infrastructure, social and environmental programs has focused on how much corporations and wealthy individuals actually pay.
For instance, a Construction Dive analysis revealed that publicly traded construction companies employ numerous tax strategies to pay far less than the statutory 21% corporate tax rate passed by Congress.
But while those large, public contractors get the lion's share of attention in the industry, they are in the minority from the standpoint of how they are taxed.
According to the U.S. Census Bureau, just 16% of nonresidential construction businesses in the U.S. are registered as C corporations, and thus subject to corporate tax rates. Most of the remaining 84% is comprised of S corporations, sole proprietorships and partnerships that are treated as so-called "pass-through entities," because profits from the business pass through to their owners, where they are taxed at individual income rates.
Currently, those rates range from 10% for individuals making up to $9,950 per year to 37% for individuals with income of $523,601 or more.
"For corporations, you can do an analysis on the 21% rate," said Todd Simmens, national managing partner of tax risk management at consultancy BDO, who previously served as legislation counsel to the Joint Committee on Taxation in Congress. "But for individuals, it's an entirely different rate system."
Personal income tax brackets and income cut offs, 2021
|Tax Rate||Individuals||Married filing jointly|
|37%||$523,601 or more||$628,301 or more|
|Proposed Top Tax Rate|
|39.6%||$452,700 or more||$509,300 or more|
SOURCE: IRS, U.S. Treasury
That distinction is becoming increasingly important for the majority of construction companies that are classified as pass-through entities and pay taxes at the individual level as the debate over how to fund the administration's proposals continues.
Big C corps seem to have avoided a corporate tax rate hike for now, with the bipartisan, $1.2 trillion infrastructure deal in the Senate being paid for via untapped COVID-19 relief funds, leftover federal unemployment dollars and more stringent tax collection, among other measures, according to the Associated Press.
But owners of pass-through companies may still face the prospect of paying more to Uncle Sam at the individual level to help pay for the $3.5 trillion in social and environmental programs that Democrats are hoping to pass without Republican support through the budget reconciliation process.
The reason why comes down to a lesser-known provision in the tax code known as Section 199A, which allows pass-through company owners to deduct 20% of net income from their taxes.
"If you take away the QBI deduction for people making over $400,000, and you increase the top rate, somebody who effectively pays 29.6% now will be looking at 39.6% instead."
The provision, also known as the qualified business income deduction, was enacted as part of former President Donald Trump's 2017 Tax Cut and Jobs Act and was put in place to try to level the playing field between what C corps and pass-through companies pay.
Before the law took effect, C corps were paying a 28.4% marginal effective tax rate, compared to 25% for pass throughs, a difference of 3.4 percentage points, according to an analysis by the Tax Foundation, a right-leaning think tank.
When the TCJA cut the statutory corporate rate from 35% to 21%, though, it also gave pass throughs the 20% QBI deduction to try to even out the effective tax rate each type of company pays.
So far, it seems to have done that, with pass throughs now facing a marginal effective rate of 20.3%, and C corps paying 19.9%, according to Garrett Watson, senior policy analyst at the Tax Foundation. "It narrowed the gap between what the two entity types were paying," Watson said.
The result of the QBI deduction theoretically means that pass-through business owners are subject to a maximum effective rate of 29.6%, instead of the current 37% tax rate if they're in the top income bracket.
A quick exit for QBI?
While that was a win for pass-through business owners, its ultimate fate has been brought into question ever since Biden announced his American Jobs Plan in March. The original proposal to pay for the plan was to raise the corporate tax rate from 21% to 28% — an option that didn't happen under the current, bipartisan infrastructure plan — while raising the top individual tax rate from 37% to 39.6%.
It would also reduce the amount of income needed to hit that threshold from the current $523,601 to $452,700 per year, according to a breakdown of possible 2022 tax rates released in May by the Treasury Department.
That's where construction accountants start to worry.
"There are a lot of very successful construction companies making well over $450,000 a year," said Andrew Kahn, a certified public accountant who specializes in construction finances at Bethlehem, Pennsylvania-based advisory firm Concannon Miller. "Not only would you be facing a rate increase, you would be getting that rate increase at a lower income level."
In July, Senator Ron Wyden (D-OR), who heads the Senate Finance Committee, introduced a bill that would begin phasing out the current 20% QBI deduction for individuals making $400,000 or more, a move he intends to include in the $3.5 trillion follow-on bill Democrats have waiting in the wings.
If that happens, it would change the calculus for who's impacted most by any potential tax hikes, with Republicans accusing Democrats of raising taxes on small businesses.
"The tax burden of those companies would obviously go up," Kahn said.
Of course, pass-through owners would still be able to chip away at what they pay through the same tax strategies employed by their C corp cousins, such as writing off expenses for equipment and deferring what they owe to a future year. Indeed, a change in rate would make engaging in those strategies that much more important.
"There would be a greater benefit to the accelerated depreciation methods, the R&D tax credits and things like the work opportunity tax credit," Kahn said. "All those credits and deductions would have a higher value because the benefit would be at a higher rate."
A different prospect than expected
When the Biden administration pivoted to a focus on raising the corporate tax rate to pay for the American Jobs Plan in April and seemingly backed away from raising the individual rate, owners of pass-through businesses rejoiced.
"There was this huge sigh of relief," said Erin Roberts, head of the global construction and engineering practice at consultancy Ernst & Young. "If that individual rate was going to go back up, it would be very burdensome and costly for those pass-through businesses to be competitive."
But should the $1.2 trillion bipartisan infrastructure proposal now being debated in the Senate pass, that would clear the way for Democrats to move forward with their follow-on $3.5 trillion proposal that focuses on social and environmental programs, including free community college, clean energy mandates for utilities, lower prescription drug prices and expanded Medicare benefits, among other items.
Democrats have indicated they will try to push that package through the evenly divided Senate using the budget reconciliation method, which wouldn't require any Republican votes. Senate Majority Leader Chuck Schumer (D-N.Y.) has pledged to pass both bills before the August recess, which is currently slated to begin Aug. 9.
While Schumer has said he has the votes for the budget reconciliation bill, Sen. Joe Manchin (D-W.Va.), a moderate and key swing vote, said this week he “can't really guarantee” it will pass, citing concerns over how it will be paid for.
But if it does, raising both the corporate rate — perhaps to 25% — and the top individual rate to 39.6%, could be back on the table, in addition to phasing out the QBI deduction above $400,000.
That scenario would have a huge impact on the owners of pass-through construction companies.
"If you take away the QBI deduction for people making over $400,000, and you increase the top rate, somebody who effectively pays 29.6% now will be looking at 39.6% instead," Kahn said. "You're increasing their taxes, in essence, by one-third. That's fewer after-tax dollars in the pockets of the owners of these companies."
A corporate tax rate of 25%, on the other hand, would amount to an increase of just one-fifth of the current rate.
To S corp or not to S corp?
With that proposed top rate 18.6 percentage points higher than the current 21% corporate rate, should owners of S corps reclassify their businesses as C corps? Probably not, Kahn said. The reason why comes back, again, to the unique mechanics of how C corps and pass throughs are taxed.
While paying a 39.6% rate at the individual level might seem unfair compared to corporations' 21%, pass throughs don't actually pay any federal taxes at the company level; that's why their owners pay individually.
C corps, on the other hand, pay the 21% rate at the company level, and then their employees — including CEOs and presidents — still have to pay individual income tax on their salaries. Kahn, who refers to this mechanism as "double taxation," argues that switching to a C corp structure wouldn't necessarily benefit an S corp owner who's currently paying at the individual rate, even if the 20% QBI deduction goes away.
"Because you're paying a second tax as a C corp, I think that brings your overall tax to a larger number than you'd pay as a pass through," Kahn said. "I think you would want to retain S corp status."
Higher taxes, but also higher profits, ahead
In the end, however the infrastructure and follow-on social and environmental packages are paid for, others make the case that the amount of stimulus going into the overall economy will still leave owners of construction companies — both C corps and pass throughs — with bigger profits overall.
Indeed, during a recent Ernst & Young webinar, two-thirds of the 1,600 participants responded to a polling question that they were open to some additional tax burden in order to get an infrastructure deal passed.
"I think everybody is starting to see how the administration's initiatives can benefit contractors via long-term, meaningful investments," Roberts said. "People are looking at that and coming to the conclusion that some level of increased taxes to fund it may be worth it."