Construction contractors are planners by nature. From imagining and designing a project to reviewing the blueprints to getting “shovels in the ground,” the contractor is planning every step of the way. And the planning isn’t limited to just building. The best of the best construction contractor takes that planning discipline into the office, most notably on the financial management side of the business.
In a “cash is king” industry, planning for future financial stability depends on being able to identify the peaks and valleys of operations. But when uncertainty looms, even the best laid plans are in danger of disruption.
Additional Layer of Uncertainty in 2020
Uncertainty can mean several things as we enter the fourth quarter 2020, a year already riddled with challenges. But perhaps the biggest uncertainty is the upcoming presidential election and the potential changes to the United States’ tax structure if former Vice President Joe Biden wins – as well as how these changes would impact the construction contractor’s approach to tax planning.
A proactive income tax deferral plan is an effective way for a construction company to finance itself. The deferral enables the contractor to conserve capital that can be deployed into projects while requisitions are being funded, to avoid a lengthy dip into any credit facilities or looking to ownership to infuse additional liquidity.
This strategy can only be realized by understanding the highly specialized tax rules that govern how a construction company reports the results of their operations. For example, long-term contracts are required to be reported under the percentage of completion method but anything that is short-term, started and completed in one tax year, could be reported under a different, more advantageous method such as cash basis. Traditionally speaking, a contractor would plan to keep a long-term contract’s percent complete lower and attempt to defer cash receipts while accelerating disbursements on the short-term project, thereby lowering the current period’s tax liability by deferring it into a future year.
However, the proposed changes under Biden’s tax position could render a strategy like this obsolete for 2020 tax planning. In other words, if Biden is elected and proposed tax changes are approved, the construction contractor’s approach to tax planning must change as well.
The following is a summary of what I believe are the most pertinent changes and the potential impact on the construction industry.
Tax Deferral Strategies
Under current tax law, ordinary income, which includes wages and the entity’s flow-through income, is subject to seven brackets with a top rate of 37%. Biden’s tax position would raise the top rate to 39.6% for those making over $400,000 annually.
Most middle market construction companies are set up as flow-through entities because this structure allows corporate income to be taxed at lower personal income tax rates. This helps the contractor to avoid double taxation (once at the corporate level and again at the personal level if a dividend is issued). While Biden’s plan may be deemed a minor rate increase, it is still an impending rate increase, which by its very nature would negate the benefits of deferring income into the future.
As mentioned earlier, how a construction concern reports taxable income is quite unique. An increase in personal tax rates should have the contractor revisiting their deferral strategy with an emphasis on unwinding traditional deferrals to accelerate income into the current year. Similarly, it would be wise to conduct an analysis of the different reporting methods available to the industry and consider a voluntary change.
Another popular income tax deferral strategy relates to capital expenditures. While there is currently no proposal in Biden’s plan to reduce or eliminate the benefits of Section 179 and bonus depreciation provisions, contractors may want to postpone any fixed asset additions into the subsequent years to reduce taxable income into the year when any proposed tax increases would become effective.
Section 199A Deduction
The Section 199A deduction for pass-through entities is a 20% deduction for qualifying trade or business income if certain criteria surrounding wages and assets are met. If there is a change in the White House, it appears the 199A deduction would phase out for taxpayers with income over $400,000.
The construction industry was a beneficiary of the 199A deduction, since many construction firms are structured as flow-through entities and the credit is driven by wages, one of the contractor’s largest costs. It is also important to keep in mind that the 199A deduction is applicable to all ordinary income. If repealed, like the changes in personal income tax rates, the impact to the construction contractor could be seismic, and tax planning should shift to a strategy in which expenses over time offset future earnings.
Wages paid are currently subject to the Social Security tax of 6.2% (capped at $137,700 for 2020); Medicare tax of 1.45% has no cap and there is currently a surtax of 0.9% on wages above $200,000 (single)-$250,000 (couples). Biden’s tax proposal would continue Social Security and Medicare taxes at the current rates but assess the tax for wages paid over $400,000. (As an employer is often times an employee, the tax of 6.2% is paid for each or shared which equates to 12.4%).
To clear this up, consider an owner of a construction company who is being paid $1,000,000 for 2020. The first $137,700 is subject to both taxes. Under Biden’s plan, Social Security tax would still freeze from $137,701 to $400,000, but the wages in excess of $400,000 would be subject to Social Security taxes with Medicare continuing throughout the pay cycle. Summarized, the owner would remit Medicare tax of $29,000 (employee and employer share at 12.4%) and Social Security of $91,474 ($137,700 and the excess over $400,000 at employee and employer share at 12.4%) for a total $120,474 compared to the current law of $30,600, an increase of $89,874.
Based on this, in an industry where it is a common strategy to bonus owners at year end to fund their income tax liabilities, this plan would need to change. Assuming the construction executive is maintaining a reasonable compensation level, an increase in distributions to fund income tax obligations should be considered.
Biden’s plan would also change how C corporations would be taxed. The current law has C corporations taxed at 21%, with the proposed plan seeing these rates raised to 28%.
As noted above, most middle market contractors are structured as some type of pass-through entity. However, with all of the aforementioned potential changes looming, it begs the question: Should the construction contractor consider revoking their current S election or forming a new operating entity as a C corporation? After all, in light of the proposed rate increase and elimination of the 199A deduction, C corporations would bear the preferable tax rate.
While not an all-inclusive list of the potential tax changes that may await us if Biden wins, these are the ones I believe to be most relevant to the construction industry. As the year draws to a close, the construction contractor’s tax plan has to be developed, implemented and continuously refined. While some tax uncertainty will loom for the next few weeks, one thing is certain: failing to plan is a plan to fail – a plan most contractors would not want to implement.
To discuss your current and future tax planning strategies, please reach out to Carl Oliveri, Partner and Construction Practice Leader, at COliveri@grassicpas.com or 212.223.5046.