Jan 21 Construction Industry Tax Update
There are many changes, rising challenges, and emerging trends facing the construction industry as it continues to evolve. As we kick off the new year and decade, consider the following tax update relating to the construction industry when planning for success. Topics include tax accounting-method opportunities, the Qualified Business Income Deduction for contractors, the business interest expense limitation, and notable IRS compliance campaigns affecting businesses with over $10M of assets.
Tax Accounting-Method Opportunities
For tax-year 2019, contractors with average gross receipts under $26M for the prior 3 years may use the cash method of accounting. Such contractors are also exempt from the percentage-of-completion method of accounting for long-term contracts expected to be completed within 2 years.
New Jersey does not prohibit “pay-if-paid” clauses in contracts. On a contract-by-contract basis, taxable income may be adjusted when the sub-contractor has not yet been paid. If sub-contracts contain the appropriate “pay-if-paid” provision, advance consent from the IRS is needed by filing Form 3115 “Application for Change in Accounting Method.” However, if sub-contracts don’t include this provision, and their wording is changed, this constitutes a change in facts — no Form 3115 is needed, and there is no $10,800 user fee. Note that the change should not impact normal business practices.
The Qualified Business Income Deduction for Contractors
This provision, created in December 2017, allows a 20% deduction of Qualified Business Income (QBI). Under current law, this provision will sunset in 2026. QBI is qualified income, gain, deduction, and loss from a partnership, S-Corp, or sole proprietorship. QBI does not include reasonable compensation paid to a partner or shareholder.
Income from “specified service trades or businesses” (SSTB’s) is excluded. SSTB’s are law, health, consulting, financial services, or any trade/business where the principal asset is the reputation/skill of one or more of the owners/employees. Engineers and architects are specifically excluded from SSTB’s. If your 2019 married-filing-jointly income is under $321,400, your 2019 married-filing-separately income is under $160,725, or your single/head-of-household income is under $160,700, you can still benefit from the QBI deduction even if you work in an SSTB. The benefit phases out to $0 once income reaches $100,000 more than the stated thresholds.
The AICPA reports that most contractors took advantage of the full QBI deduction for tax-year 2018. Profits were healthy and the W-2 limit had little or no impact. There are planning issues related to owners’ reasonable compensation. Aggregation with real estate entities is available for self-rentals and for businesses under common control.
The Business Interest Expense Limitation for Contractors
This provision, known as Section 163(j), also created in December 2017, limits the business interest expense deduction to 30% of adjusted taxable income (ATI). ATI is calculated as taxable income without regard to non-business income/expense, business interest income/expense, the net-operating-loss deduction, the QBI deduction, and for years before 2022, deductions for depreciation, amortization, and depletion.
Any limited interest expense deduction is carried forward and used in a subsequent year when the business generates enough ATI to take the deduction. Businesses with average gross receipts under $26M for the prior 3 years are exempt.
Real-property trades or businesses may elect out of Section 163(j) but must then use the slower Alternative Depreciation System (ADS). Note that construction activities qualify as real-property trades or businesses.
Active IRS Large-Business Audit Campaigns
The IRS continues to pursue audit campaigns to improve return selection, identify potential non-compliance issues, and make the best use of limited resources. Here are the top 8 active audit campaigns impacting the construction industry:
- S-Corp distributions
- S-Corp losses claimed in excess of basis
- S-Corp Built-in Gains tax, as it applies to assets sold by the S-Corp within 5 years of converting from a C-Corp.
- Sale of partnership interests
- Related-party transactions
- Interest capitalization of self-constructed assets
- Offshore private banking
- Virtual Currency
Reach out to Sax’s Construction Practice to discuss planning opportunities related to the topics above. We can help you evaluate the short- and long-term effects of accounting-method changes, QBI, and Section 163(j), and many other important items to consider.
Gina Perrone, CPA, MST is a Senior Tax Manager at Sax LLP, and a member of Sax’s Construction Practice. She specializes in high-quality tax services and planning opportunities to meet clients’ ultimate goals and objectives. Gina can be reached at [email protected].
Adam Nelson, CPA, MST is a Senior Tax Associate at Sax LLP, and a member of Sax’s Construction Practice. He specializes in addressing the compliance challenges of multi-state businesses. Adam can be reached at [email protected].