Income taxes play a major role in the key business decisions every privately-held construction company owner needs to make on a daily basis. For many, income taxes have a significant impact on the cash flows of the business, driving decisions from what margins to charge on jobs to what to pay employees. And it will ultimately determine how much they can afford to reinvest in their business for continued success.
We have seen contractors who invest time and effort to manage their income taxes through thoughtful tax planning gain a competitive advantage in the marketplace. With the passage of the Tax Cuts and Jobs Act last December, all contractors have the opportunity to take a fresh look at their business and personal tax situation to maintain or enhance that competitive edge relative to their competitors.
Here are the top three tax planning opportunities that contractors should consider now.
Reevaluate your Tax Accounting Methods
Contractors with less than $25 million in revenue now have the ability to recognize revenue for tax purposes under a more favorable method of accounting than Percentage of Completion.
One method to consider is cash basis, through which the contactor recognizes revenue when receivables are collected and deducts expenses when bills are paid.
Another method to consider is the Completed Contract Method. This provides a greater opportunity to defer the recognition of a contract’s gross profit until it has been completed. For growing contractors, this income deferral translates to a lower income tax burden and more cash to reinvest in the business.
Consider the New 20 Percent Pass-through Deduction
Many privately-held contractors operate their businesses through a pass-through entity (i.e., S corporation or partnership) to take advantage of the single level of tax and the flexibility offered by this structure.
Prior to 2018, income generated by a pass-through business was subject to tax as high as 39.6 percent under the personal individual tax brackets. The Tax Cuts and Jobs Act introduced a new 20 percent deduction that certain qualifying pass-through businesses can deduct against the income reported on their K-1s. This equates to a new effective tax rate of 29.6 percent on this type of income.
Contractors will need to spend time with their tax advisors to model out the potential tax savings from this new deduction. This modeling would also identify opportunities to restructure payment to owners and related parties to maximize the savings that could be achieved by the new deduction.
Examine Your State and Local Tax Deductions
Construction company shareholders often incur large state and local income tax bills as a result of their share of the business income. For some, this amount can be significant. Until 2018, state and local taxes were deductible on the Federal tax return. As a result of the new tax legislation, the total deduction for state and local taxes (including real estate taxes) is now capped at $10,000. This will result in an increase in the overall income tax base for many contractors.
However, a potential solution exists for contractors who reside in Pennsylvania and take advantage of the Employee Improvement Tax Credit (EITC) or the Opportunity Scholarship Tax Credit (OSTC). These credits provide opportunities to redirect a taxpayer’s state tax liability to a qualified school or educational organization in exchange for a state tax credit of up to 90 percent. It is viewed as a charitable contribution on the federal return and is still deductible under the new tax law. There is a process and timeline whereby the taxpayer will need to apply and be approved by the state for these credits, so immediate action should be taken if you would like to benefit from this incentive.
The new tax legislation has created a greater impetus for contractors to evaluate their new tax situation and begin the process of tax planning to take advantage of these changes. Failure to do so could lead to adverse tax consequences and put contractors at a disadvantage versus their competitors.
Carlo R. Ferri can be reached at Email or 215.441.4600.
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