How Tax Reform Changes Will Impact Your Construction Business
The Tax Cuts and Jobs Act is the most significant tax reform legislation in decades, and contains many provisions that will have a direct and significant impact on the construction industry. Even though we are still awaiting more guidance from the IRS and Treasury Department on certain provisions, it is important to understand what this tax reform means for your construction business now, and what you need to account for in the future.
Here are some of the main provisions in the new tax law that will directly impact your construction business:
Methods of Accounting for Long-term (LT) Contracts
- Certain construction contracts may be eligible to use the cash or the completed contract method of accounting for LT contracts.
- OLD LAW: Contractors with average gross receipts for the prior three years under $10 million are exempt from the requirements to account for LT contracts using the percentage of completion method (POC) for income tax reporting.
- NEW LAW: The $10 million threshold is increased to $25 million for contracts entered into after December 31, 2017. Thus, construction companies with average annual gross receipts under $25 million may be exempt from the requirement to use POC.
- The exemption only applies to contracts expected to be completed within two years of the commencement of the contract.
- Considerations: If eligible, does it make sense to switch to the cash method of accounting for LT contracts? Any deferral of income or acceleration of deductions creates current tax savings by deferring taxable income into future years.
Tax Rates Reduced
- For contractors operating a construction business as a C-corporation – the tax rate has been reduced to a flat rate of 21% for taxable years beginning after December 31, 2017.
- Fiscal year C-corporations have a “blended” 2017-2018 tax rate.
- Considerations: C-Corporations in the lower tax bracket in prior years will experience a tax rate increase. Does it make sense to convert to an S-corporation?
- Considerations: The tax rate differential between C-corporations and pass-through entities warrants a re-examination of entity choice.
- Considerations: For fiscal year corporations, a 2017-2018 blended tax rate will result in a higher tax bracket in 2017-2018 than in future years when the corporation is taxed at 21%. To benefit from the higher tax rate in 2017-2018, fiscal-year corporations should take actions to defer income to a future year and accelerate deductions to the 2017-2018 tax year.
- Known as the Qualified Business Income (QBI) Deduction, this new deduction is available for non-corporate taxpayers.
- Generally, the deduction is 20% of qualified business income from a partnership, S-corporation or sole proprietorship.
- Certain limitations apply to service related businesses. There is also a limitation based on W-2 wages and the adjusted basis in acquired qualified property.
- Considerations: The greater the qualified business income, the greater the QBI deduction. Analyze strategies to increase the bottom line – but keep in mind that you must have a business purpose that falls within IRS guidelines.
Business Interest Expense
- Limitation applies to all corporate and noncorporate taxpayers for tax years beginning after December 31, 2017.
- Annual deduction for business interest incurred is limited to the sum of:
- Business interest income
- 30% of the taxpayer’s adjusted taxable income
- Limitation does not apply to:
- Taxpayers with annual gross receipts of $25 million or less
- Real Estate businesses that elect to exempt themselves. Limitations include:
- Irrevocable election
- Business making the election must use the Alternative Depreciation System (ADS) for certain property (generally real property with recovery period of 10 years or more). ADS depreciates property over longer periods compared to MACRS (Modified Accelerated Cost Recovery System)
- Businesses making this election cannot claim bonus depreciation
- Considerations: Real estate businesses making the election to be exempt from interest expense limitations should weigh the advantage of avoiding the limitation against a longer depreciation period.
- Considerations: Businesses subject to limitation should consider limiting debt exposure by relying more on equity financing for capital.
Meals and Entertainment
- OLD LAW: Business meals and entertainment expenses are only 50% deductible. Employee meal expenses incurred for the benefit of the employer (in-house eating facility, de minimis food and beverages such as coffee & donuts) are 100% deductible.
- NEW LAW:
- Entertainment expenses – 0% deduction
- Business meals with clients and prospects – 50% deduction remains
- Employee expenses incurred for benefit of employer – 50% deduction
- Meals provided at employee recreation events – 100% deduction remains
- Consideration: Businesses will need to account for travel, meal, and entertainment expenses separately.
- Considerations: Consider other benefits to employees that are deductible, such as employer sponsored IRAs and 401(k) plans.
- Bonus Depreciation
- First year additional depreciation is 100% for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023.
- Election can be made to claim 50% bonus depreciation instead of 100% for property acquired and placed in service after September 27, 2017.
- Now allowed on used property.
- Section 179
- Expensing limit increased to $1,000,000 with phase-out threshold increased to $2,500,000 for property placed in service after December 31, 2017.
- Qualified improvement property now includes roofs, HVAC, alarm, fire, and security systems for nonresidential properties.
- Luxury Automobile Deductions
- Applies to a luxury automobile which is any automobile with a minimum cost basis of $50,000.
- Depreciation limits for passenger automobiles over $50,000 that are placed into service after December 31,2017:
- 1st year: $10,000
- 2nd year: $16,000
- 3rd year: $9,600
- 4th year and beyond: $5,760
- Additional first year bonus depreciation: $8,000, which brings the total depreciation for Year 1 to $18,000.
- Like-Kind Exchange – 1031 Exchange
- Beginning in 2018, like-kind exchanges are limited to real property (real estate) that is held for business use or investment purposes.
- There are no more gain or loss deferrals for vehicle trade-ins.
- Qualified Improvement Property (QIP)
- QIP qualifies for 100% (50% if elected) bonus depreciation for property placed in service after December 31, 2017 and before January 1,2024. *
- QIP qualifies for Section 179 Expense.
- QIP eliminates different classes for 15-year qualified leasehold improvement, retail and restaurant property; Eliminates lease requirement.
- Applies to any improvement made to an interior portion of nonresidential real property and placed in service after the date the building was first placed in service by any taxpayer.
- Does not apply to the enlargement of a building, any elevator or escalator, the internal structural framework of a building, or external improvements to a restaurant and restaurant buildings.
- The recovery periods:
- General Depreciation Systems (GDS) – 15 years using the straight-line method
- Alternative Depreciation System (ADS) – 20 years using the straight-line method
- Considerations: Real property trades or businesses (real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage) electing out of the new rules for interest deduction limits must use the ADS recovery period for the following property they hold:
- Nonresidential real property – 40 years
- Residential rental property – 30 years; or
- Qualified improvement property – 20 years *
* Note: Recovery periods were not explicitly included on the final bill. A technical correction will be needed.
Domestic Production Activities Deduction – DPAD – Section 199
- Disallowed for tax years beginning after December 31, 2017 and before January 1, 2026.
- Treated as a net operating loss (NOL) that will be carried over to the next tax year.
- Calculated as follows:
- Taxpayer’s aggregate deductions from taxpayer’s trade or business LESS sum of taxpayer’s aggregate gross income or gain from such trade or business PLUS $250,000 ($500,000 joint return).
- For tax years after December 31, 2017, the NOL may only reduce 80% of taxable income determined without regard to the NOL deduction.
- For tax years after December 31, 2018, the threshold is adjusted for inflation.
- Partnerships and S Corporations: The limit on excess business losses is applied at the partner or shareholder level and not at the entity level.
- The limit is applied after the limit for passive activity losses (PALs).
- Joint Returns – the limit applies to ALL of a couple’s trade or businesses.
- Non-business income (including spouse’s) can be offset only to the threshold of $250,000 ($500,000 joint return).
- Cash Flow Planning – expect to receive refunds from the loss carryforward at least a year after the year the carryforward loss is used to reduce taxable income.
- Further guidance is needed to clarify the interaction between the passive activity rules and the excess business loss rules.
There is always uncertainty with change, especially when there is limited guidance available. A positive, however, is that tax reform opens new doors regarding business and tax planning that can be valuable if you prepare appropriately. It is important to act now to capture beneficial opportunities and eliminate any negative “unforeseen” consequences.
Reach out to Sax’s Construction Practice to help you navigate the complex terrain of tax reform. We can help you evaluate both the short-term and long-term effects that impact future cash flow, analyze your current entity structure, and maximize the 20% QBI deduction, among many other important items to consider.
Gina Perrone, CPA, MST is a Senior Tax Manager at Sax LLP and an integral member of Sax’s rapidly growing Construction Practice, specializing in high-quality tax services and planning opportunities to meet clients’ ultimate goals and objectives. Gina can be reached at [email protected].
Ivonne Rayo, CPA, is a Tax Manager at Sax LLP and member of Sax’s rapidly growing Construction Practice. She specializes in solving the tax challenges of businesses in multiple states. Ivonne can be reached at [email protected].