Tax law changes with the biggest impact on the construction industry
The 2018 tax year was the first full year that was impacted by the comprehensive tax legislation, the Tax Cuts and Jobs Act (TCJA), enacted in late 2017. However, taxpayers are still trying to understand how to maximize their tax savings under the new law. Here are some of the tax law changes with the biggest impact on the construction industry.
S Corporation vs. C Corporation - Which Status is Right for You?
As the corporate tax rate decreased to a flat 21 percent, many companies are evaluating whether to remain an S Corporation or partnership—or convert to a C Corporation. Despite the new qualified business income deduction (QBI), which results in a maximum rate of 29.6 percent for pass through entity business income, there is a significant gap of over eight percent between the C Corporation and individual rates.
The repeal of the corporate alternative minimum tax (AMT) is an additional change that impacts the decision of filing as a C Corporation or S Corporation. C Corporations are no longer subject to corporate AMT after 2017, and can use AMT credits generated prior to 2018 to offset regular tax liabilities and receive refunds of these AMT credits in 2018 through 2021.
While individual taxpayers received AMT relief under tax reform (with increased exemptions and the phase-out of the exemption starting at a higher level), they are still subject to AMT. Additionally, unlike C Corporations, long-term contracts (contracts spanning more than one calendar year) of pass through entities are still subject to the percentage of completion method for AMT, regardless of the method of accounting used for regular tax purposes (see changes to income recognition below).
Taxpayers, who plan on retaining earnings in their company rather than paying it out to owners through wages or distributions, will want to seriously consider holding C Corporation status. This status would likely also make sense for start-up companies with heavy capital needs.
S Corporations are preferable when owners are taking cash distributions out of the company, since compensation is subject to payroll taxes and distributions out of a C Corporation are subject to double taxation. S Corporation shareholders must be paid reasonable compensation, which is not eligible for the QBI deduction. However, other income passing through to the owner from the S Corporation should qualify for the lower QBI tax rate. Owners considering selling their businesses in the near term should also consider maintaining S Corporation status to build-up basis and avoid double taxation on the sale of their company.
Changes to Income Recognition and What it Means for You
A major change under tax reform impacted taxpayers with average annual gross receipts under $25 million over the prior three taxable years. Before 2018, all contractors whose average annual gross receipts were over $10 million were required to use the percentage of completion method for their long-term contracts. Additionally, C Corporations whose average gross receipts were over $5 million were required to use the overall accrual method of accounting for regular tax purposes.
Starting in 2018, these “small” taxpayers could use the cash, accrual, completed contract or percentage of completion method of accounting for regular tax purposes. Changing from your current method to a new method allowed under the law is an automatic change requiring the filing of Form 3115. Taxpayers need to carefully analyze which method makes sense for their business, considering the type of contracts and growth expectations. This can be a detailed analysis but can yield significant tax savings for a construction business and its owners.
Conversion to C Corporation
Many of these components could make revoking an S Corporation election or converting a partnership to a C Corporation appealing to construction companies. Despite the incentives to convert to a C Corporation, taxpayers must evaluate the double taxation of C Corporation dividends and gains on stock sales vs. the impact of new business deduction for pass through entities to determine which selection is best for their business.
Several other important considerations include:
- Calendar year taxpayers, who want to be taxed as a C Corporation for 2020, must file an S Corporation revocation election by March 15, 2020; and this revocation must be consented to by over 50% of the shareholders of the S Corporation
- S Corporation status cannot be reelected for five years after the revocation
- It could be beneficial to set up multiple companies to take advantage of the specific benefits of a C Corporation and pass through entity status
Increased Depreciation Deductions
Capital intensive businesses, like many contractors, have benefited from increased depreciation deductions in recent years. In 2018, the section 179 deduction increased to $1 million for qualified property and the deduction did not start to phase out until capital expenditures exceeded $2 million. The increased section 179 deduction is still available for 2019 and is slightly higher, as these amounts are indexed for inflation.
More significantly, 100 percent bonus depreciation is allowed for new and used qualified property until December 31, 2022, with bonus depreciation being phased out between 2023 and 2026. These favorable depreciation provisions will allow contractors to expense most of their asset acquisitions in 2019.
Other provisions in the Tax Cuts and Jobs Act that impacted contractors and their owners in 2018 include the new deduction limitations on (1) interest expense; (2) meals and entertainment; (3) and even employee parking costs. There were also several changes in itemized deductions for individuals.
Tax planning opportunities for contractors continue in 2019, so please consult your Sikich tax advisor before the end of the year to determine what steps you can take to minimize your taxes.