Contractors need to invest in tax planning throughout the year to gain the maximum impact. While most year-end tax strategies strive to accelerate income in the current tax year and defer expenses to the next year, strategic tax planning takes into consideration many other factors, including how reducing income for tax purposes will affect a contractor’s financial statements, cash position, working capital and financial ratios.
Since sureties rely on the strength of a contractor’s financial statements to determine the company’s character, capacity and capital for a bonding program, it is important to take a holistic approach to tax planning. Following are the top five strategies to consider.
1. Use the right accounting method
Contractors should ensure the tax reporting method for each contract is appropriate by determining which projects are not considered long-term (more than one year) under IRC Code 460. Most contractors use the percentage-of-completion method (PCM) for long-term contracts and report income and expenses during the period incurred instead of deferring it to the end of the project.
Builders, general contractors and specialty contractors qualify to use completed contract method (CCM) if 80 percent or more of the estimated total contract costs for the year the contract was entered into are attributable to the building, construction, reconstruction or rehabilitation of units contained in buildings with four or fewer dwelling units. Improvements to real property that are directly related to such units may qualify as well. The look-back rule will generally apply when the contract is completed.
2. Defer profits or retainage
If a project is due to start close to the end of the year, a contractor can elect to defer the recognition of gross profit on all jobs that are less than 10 percent complete at year-end. The percentage of completion capitalized cost method (PCCM) should be considered for contracts to construct buildings containing more than four dwelling units (such as apartments, prisons, assisted living facilities, dorms and condos).
PCCM allows qualified contractors to defer 30 percent of the profit on contracts until the year projects are completed or they can defer retainage until it’s received. This election is an add-back for the Alternative Minimum Tax (AMT).
3. Take advantage of the DPAD deduction
The domestic production activities deduction (DPAD) provides tax incentives for businesses to increase production and employment in the United States. Contractors can deduct up to 9 percent of qualified production activities income (QPAI) related to constructing or significantly renovating real property. This deduction cannot exceed 50 percent% of W-2 wages, nor be taken on a loss. QPAI and W-2 wages are allocated to each shareholder or partner based on their ownership percentage.
4. Qualify for an R&D tax credit
Contractors may qualify for a research and development (R&D) tax credit if new processes to improve efficiencies or reduce/eliminate uncertainty in the business are developed in the United States. An R&D tax credit is generally taken on a dollar-for-dollar basis on either the entire qualified project or the portion of the project that meets the criteria of the IRS.
If the R&D tax credit is not fully used, it may be carried back to the previous year and carried forward for 20 years. Contractors with less than $50 million in gross receipts can use the R&D tax credit to offset AMT. In addition, qualified start-up and small businesses that may not have an income tax liability can offset payroll taxes with the credit.
5. Assess opportunities for deductions on pass-through entities
Contractors that are owners or invest in pass-through entities (such as sole proprietorships, partnerships, most LLCs and S corporations) can deduct their allocated share of losses to the extent of their basis (debt and equity). Contractors should have a sufficient basis to deduct allocable losses instead of carrying losses to a future year where their income may be lower. In addition, contractors should look for ways to reduce taxable income such as making retirement plan contributions, developing an exit strategy and moving AMT triggers to another tax year. AMT thresholds for 2017 are: $54,300 for single filers, $84,500 for married taxpayers filing jointly, $42,250 for married taxpayers filing separately and $24,100 for trusts and estates.
The above tax planning strategies are meant to provide guidance on how a construction company can reduce its income tax liability. There are numerous other tax elections that contractors may be eligible to take. Business owners should consult with an accountant on which strategies are best to implement for their situation.