What does the new tax reform act mean for construction companies?
Editor's Note: This piece was written by Michael DeSiato, a certified public accountant and certified financial planner who is a tax partner in the Fort Lauderdale, Florida, office of Cherry Bekaert LLP. He provides tax planning to the construction industry, and specializes in helping business owners exit their firms. The opinions represented in this piece are independent of Construction Dive's views.
The Tax Cuts and Jobs Act was passed by Congress on Dec. 20 and signed by President Donald Trump Dec. 22. Major tax reform has been 31 years in the making as the last major tax reform bill was passed in 1986. The act contains many provisions that will have a direct and significant impact on those in the construction industry. The major of these provisions are summarized as follows:
New tax rates
For contractors that are C corporations, the tax rate decreased to a flat 21%, down from the top rate of 35%, for taxable years beginning after Jan. 1 of this year. For those companies that are pass-through entities, the top individual rate was decreased from 39.6% to 37% beginning in 2018.
The act left a number of individual tax brackets unchanged at seven with rates of 10%, 12%, 22%, 24%, 32%, 35% and 37%. These individual tax rate changes are set to expire after 2025.
Domestic production activities deduction
Under old law, almost all contractors were allowed to take this deduction for construction activities conducted in the U.S. The deduction was, in simple terms, equal to 9% of their construction net income. The act repeals the deduction starting in 2018.
Our advice to contractors is to sharpen their pencils when calculating this deduction for the last time for 2017.
Deduction for pass-through income
For tax years beginning after 2017 and before Jan. 1, 2026, the act adds a new deduction for non-corporate taxpayers (including trusts) for qualified business income. The deduction is generally 20% of the taxpayer’s qualified business income from a partnership, S corporation or sole proprietorship.
Qualified business income includes income from construction activities, as well as income from both architectural and engineering services. The deduction is generally limited to the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of qualified property. There is final overall limit of 20% of the taxpayer’s taxable income.
It is important to note that the W-2 wage limitations do not apply if the owner’s taxable income is less than $157,500 (single) and $315,000 (married filing jointly). There is also a range over which relief from these limits will be phased out with the limits being fully applicable for taxpayers whose taxable income exceeds $207,500 (single) and $415,000 (married filing jointly).
In cases where the pass-through owner is in the maximum tax bracket of 37% and is not limited by the W-2 wage limitation, the maximum effective tax rate on qualified business income will be 29.6% (.80 amount taxable x .37 tax rate) as compared to the maximum rate under old law of 39.6%. This is close to 25% reduction in overall taxation and represents a significant benefit to those in the construction industry.
Completed contract method/cash method of accounting
Under old law, small contractors (average annual gross receipts of $10 million or less in the three prior years) were able to postpone taxation on income from long term contracts (those that are started and completed in different tax years but are expected to be completed within two years) until they were completed or when cash was collected. Larger contractors had to use the percentage of completion method of accounting which requires them to recognize income as the job progresses.
Effective Jan. 1, the act increased the $10 million gross receipts threshold to $25 million. Small contractors affected by this provision can change from percentage of completion to either the completed contract or the cash basis for contacts started after Dec. 31, 2017. Any contracts started before 2018 would continue to be accounted for under the percentage of completion method.
Keep in mind that for non-corporate small contractors the percentage of completion method must be used for Alternative Minimum Tax (ATM) purposes. This often minimizes the benefit of the deferral using either the completed contract or cash methods of accounting.
However, beginning in 2018 the Act increases the AMT exemption amounts which will help offset the AMT tax bite. The AMT exemption amounts have been raised from $123,100 (single) and $164,100 (married filing jointly), to $500,000 (single) and $1 million (married filing jointly). The AMT was repealed for C corporations.
The accrual method of accounting was available to contractors with average annual gross receipts of $10 million or less or $5 million or less if a C corporation. The act raises the threshold to $25 million for all taxpayers. Under the act, affected contractors with inventories can now switch to the cash method of accounting beginning in 2018.
Expensing of property, plant and equipment
Under old law, contactors had two provisions to take faster depreciation when it comes to their property and equipment purchases. One provision is section 179 immediate expensing, and the other is bonus depreciation. Under section 179, up to $510,000 of property and equipment (new or used) can be immediately expensed so long as total acquisitions do not exceed $2,030,000.
In addition, contractors could take first year 50% bonus depreciation on new equipment purchases in 2017. Bonus depreciation was scheduled to start phasing out after 2017.
Under the act, there will be 100% immediate expensing allowed for the cost of new or used qualified property (office and field equipment, heavy trucks, earth movers and cranes) acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023.
Additionally, the section 179 limit/phase-out will be increased to $1 million/$2.5 million for property placed in service after Dec. 31, 2017. While it may appear as if section 179 is superfluous due to the 100% expensing provision, there are some items of property that are eligible for section 179 and not for immediate expensing. These are items as roofs, HVAC, firm alarm systems and security systems.
Business interest deduction
For tax years beginning after Dec. 31, 2017, every business is generally subject to a disallowance of a deduction for interest expense in excess of 30% of the business’s adjusted taxable income. Adjusted taxable income is computed without regard to deductions for interest, depreciation, amortization, depletion and net operating losses.
Businesses with average annual gross receipts for the prior three years of $25 million or less are exempt for this limitation. Any unused interest expense is carried forward indefinitely.
Those businesses in the construction industry otherwise affected by this provision can make an irrevocable election out of this limitation if they depreciate any of their real property and qualified improvement property used in their trade or business under the alternative depreciation system (ADS).
Under the ADS system, the cost recovery period for non-residential real property is 40 years as opposed to the regular cost recovery period of 39 years. The ADS cost recovery period for qualified improvement property is 20 years versus the 15 year regular cost recovery period. However, Section 179 depreciation does apply for ADS.
Business entity selection
Most contractors are organized as pass-through entities where their owners pay tax on the entity’s income at their personal tax rate. As stated above, the maximum pass through tax rate for business income will be 29.6% versus the old maximum tax rate of 39.6%.
The major benefit of a pass-through entity is the fact that, unlike with a C corporation, there is no double taxation on business income, including gain on the sale of the business. Additionally, with the pass-through entity structure, most of the gain on the sale of the business will be taxed at the preferential capital gains tax rate of 20%, while this will not be the case for a C corporation as all income is taxed at 35%.
With the C corporation tax rate being reduced from 35% to 21%, the use of C corporations in the construction industry needs further examination. Not only will current business income be taxed at a lower rate (21% versus 29.6%), which could have positive effect on cash flow and bonding capacity, but double taxation may be avoidable in certain circumstances.
For example, if the C corporation qualifies under section 1202 as a “Qualified Small Business” and other conditions are met, and assuming that all business profits are re-invested into the business, then double taxation may be avoided as each shareholder can exclude up to a minimum of $10 million of gain on the disposition of their shares. This disposition can occur in liquidation of the company after a sale of its assets (taxed at 21%).
New construction business entities need to take a harder look at the C corporation structure as well as existing entities.
On balance the new tax bill provides significant benefits to those in the construction industry. There are still many unanswered questions and ambiguities in the new law which should be addressed in upcoming technical corrections bills and IRS regulations.