The Tax Cuts and Jobs Act (the Act) was signed into law by the President on December 22, 2017. The comprehensive reforms contained in the Act impact industries and businesses of all sizes. As the main goal of the Act was to promote economic growth and create jobs, the following are important changes to keep in mind for those businesses and individuals in the construction and real estate industry.
Tax Cut for C Corporations – A Lower Tax Rate
- For tax years beginning after December 31, 2017, the corporate tax rate drops to a flat 21%, which is a significant decrease from the previous rate of 35%.
- For taxpayers whose tax year straddles December 31, 2017, a blended tax rate will apply.
Tax Cuts for Pass-Through Businesses – A New Deduction
- A new 20% deduction for “Qualified Business Income” (“QBI”).
- This deduction reduces taxable income for owners (individuals and trusts) of pass-through entities.
The new QBI deduction cannot exceed the greater of:
- 50% of the W-2 wages of the business; or
- 25% of the W-2 wages of the business PLUS 2.5% of the cost of property used in the business.
There are many complexities, exceptions, and limitations that apply with this new 20% QBI deduction. While a complicated calculation, this provision provides tax relief to many small businesses by dropping the top effective tax rate on business income to 29.6%.
Alternative Minimum Tax (AMT) Changes
Corporate AMT Provisions
- Effective for tax years beginning after December 31, 2017, the corporate AMT is repealed.
- Any available AMT credits will be allowed offset regular tax liabilities in tax years after 2017, and will be refundable for tax years beginning after 2018 and before 2023.
Individual AMT Provisions
The AMT exemption amounts are increased under the new law, which should result in less taxpayers being subject to AMT.
- Married filing joint exemption increased to $109,400 beginning in 2018.
- Phase-out of the AMT exemption starts at $1,000,000 for joint filers beginning in 2018.
- Contractors will still need to compute contracts under the percentage-of-completion method for AMT purposes for owners of pass-through entities.
Repeal of the Domestic Production Activities Deduction (DPAD)
- Prior to 2018, contractors could lower their taxable income by up to 9% with the DPAD; however, this deduction was repealed for tax years beginning after December 31, 2017.
Changes in Methods of Accounting Directed at Small Businesses
- Under the new law, the cash method of accounting may be used by businesses if their average annual gross receipts over the prior three taxable years do not exceed $25 million. This applies for tax years beginning after December 31, 2017.
- Effective for tax years beginning after December 31, 2017, the percentage-of-completion method will not apply to small contractors: (1) whose contracts are estimated to be completed within two years; and (2) whose three-year average annual gross receipts do not exceed $25 million. Under prior law, this threshold was $10 million.
- This change will allow many more small contractors to be able to use the cash method or the completed contract method for regular tax purposes for their long-term contracts. This change is an election the contractor could make and a detailed analysis should be conducted before adopting these method changes.
Conversion to C Corporation
The lower C Corporation tax rate, elimination of the Corporate AMT, and expansion of the cash basis method of accounting and percentage-of-completion exceptions may make adopting C Corporation status an attractive option for contractors. This could be accomplished via the revocation of an S Corporation election, or perhaps converting a Partnership/LLC to a C Corporation. Despite the incentive of the lower tax rates to switch to C Corporation status, taxpayers must evaluate many factors and assumptions, including the double taxation of C Corporation dividends and gains on asset sales. In addition, the impact of the new 20% QBI deduction for pass-through entities should be analyzed as part of this comparison (especially now that the proposed regulations for QBI have been issued). Further, the possibility of succession planning and the timeframe for any transfer would become part of this exercise.
- A calendar year taxpayer who wants to be taxed as a C Corporation for 2018 must file a revocation election with the IRS by March 15, 2018. If the revocation is filed after this date, the election is generally effective in the following year, or 2019 in this case.
- If the S Corporation election is revoked, the company cannot re-elect S Corporation status for five years after the revocation.
- Thus, it is essential that the business (likely with the assistance of its tax advisors) evaluate all factors and model out the impact of converting to C Corporation status prior to revoking its S Corporation election and jumping to C Corporation status. It is better to make a well-reasoned decision, even if the business must wait an additional year or so, rather than make a quick move and not fully address all these issues. There can be pluses and minuses with each option.
- In fact, in some situations, it may be advantageous to set up multiple companies to take advantage of both the C Corporation and pass-through entities tax changes.
Increased Depreciation Deductions for “CAPEX”
- The Section 179 expensing deduction was increased from $510,000 to $1,000,000 for qualified property additions effective for tax years beginning after December 31, 2017.
- The Section 179 definition was expanded to cover roofs, HVAC, air conditioning, fire protection, and alarm systems.
- The Section 179 deduction starts to phase out when annual capital expenditures exceed $2,500,000.
- The bonus depreciation factor was increased from 50% to 100% for new or used qualified property acquired and placed in service from September 27, 2017 to December 31, 2022. There is no ceiling or cap on the amount of bonus depreciation that can be claimed.
- Further, bonus depreciation is now available for both new and used property. Previously this only applied to new property. This bonus depreciation feature with used property could be very favorable when evaluating any acquisition of other businesses.
- In addition, bonus depreciation is phased out between 2023 and 2026 (unless it is restored/renewed by Congress).
Changes to Like-Kind Exchange Rules
- The “like-kind exchange” rules allowed for the deferral of gain when old property was traded in for new property. This could apply for machinery and equipment, but most often it occurred with real estate.
- Effective for property disposals after December 31, 2017, only real property not held primarily for sale will qualify for a like-kind exchange. It is no longer allowed for personal property trade-ins.
- Effective January 1, 2018, the base estate and gift tax exclusion has increased from $5 million to $10 million.
- This exclusion is indexed for inflation occurring after 2011, therefore, the basic estate tax exclusion would be $11.2 million for 2018. This dramatic increase will have an impact on estate planning strategies, including many construction and real estate businesses.
The tax reform legislation has other provisions related to tax credits, as well as limitations on business deductions such as interest expense. The interest expense limitation is another complicated provision in the new law, but there is a special exception available to companies involved in real estate, which includes contractors. An election is available, but there are some trade-offs with this decision, so again, input is needed from your tax advisor. There are also curbs on the deduction for meals and entertainment, along with several provisions impacting deductions for individuals.
Therefore, there are many changes and planning opportunities for contractors and real estate businesses and investors to consider. The best course to follow will vary in each situation. If you are interested in evaluating the impact of the new tax law on your business, please consult your local Sikich tax advisor.