With builders facing the prospect of an economic slowdown, rampant inflation, and persistent capacity challenges that cut into profit margins, construction companies need to look closely for every tax savings opportunity available to them now. Here are several often-overlooked tax strategies that can offer substantial benefits for those in the construction industry.
Construction-specific income deferrals
The Internal Revenue Code (IRC) contains several pro-construction provisions that allow a company to defer taxable income to later years, which is usually preferred in an environment of stable tax rates. Here are the most widely applicable:
- Gross profit on contracts < 10% complete
- Large contractors using the percentage-of-completion (POC) method to recognize revenue can defer the gross profit on contracts that are less than 10% complete.
- Gross profit on multi-family contracts – 30% deferral
- Large contractors using the POC method and who work on multi-family contracts (defined as a contract to build a residential building with more than 4 dwelling units) can defer 30% of the gross profit they recognize on those contracts.
- Gross profit on home contracts – 100% deferral
- Large contractors using the POC method who work on small-scale residential contracts (4 units or fewer per contract) can defer 100% of the gross profit recognized on the contract until the year completed.
- Cash basis and completed contract method for small contractors
- Small contractors (generally, those with average annual gross receipts for the three prior years of $26 million or less, and $29 million starting in 2023) can choose to use the cash basis for tax purposes, which ensures that tax is assessed only after the taxpayer has received the cash that generated the tax liability. Also available to small contractors is the completed contract method, which allows them to include in taxable income only the gross profits on contracts that they completed during the year. However, there are alternative minimum tax considerations that go along with using this method, so it’s important to discuss with your tax adviser ahead of time.
Tax law changes for 2022 and 2023
Bonus depreciation allows taxpayers to accelerate deductions of capital investments in assets such as equipment and vehicles. Whereas a deduction of 100% of an asset’s cost can be deducted through 2022, the available deduction will decrease to 80% of an asset’s cost for assets placed in service starting January 1, 2023. Companies should consider whether they should shift capital expenditures to take advantage of the 100% deduction before it phases out.
The business interest expense limitation impacts companies with average annual gross receipts in excess of $26 million and limits deductible interest to 30% of “adjusted taxable income” (ATI).
Effective in 2022, taxpayers are no longer be able to add back deductions for tax depreciation and amortization in calculating ATI, which will decrease a taxpayer’s allowable deduction for interest expense and increase taxable income. Companies with higher levels of debt will be impacted most acutely, especially those that employ bonus depreciation and Section 179 expensing to accelerate deprecation for tax purposes.
R&D tax credits
If your company provides design services, uses new or alternative materials or construction methods, you may be able to claim a tax credit for research and development (R&D) costs. Starting in 2022, R&D expenses must be capitalized and amortized over five years, which will limit the expenses available to be considered when calculating this tax credit.
Additionally, it’s important to note that claiming an R&D tax credit without the proper support to back up the credit amount can be risky, and the IRS has identified these credits as a focus of increased enforcement activities, so be sure to have a proper R&D study performed before taking advantage of this credit.
Sec 179D deduction – energy efficient commercial building property gets a boost
Through 2022, certain improvements made to a commercial building that increase its energy efficiency may result in a deduction of up to $1.88 per square foot of the entire building. Interior lighting, HVAC, and hot water systems, or building envelope systems that reduce energy consumption by 50% or more compared to a theoretical baseline model building are needed to qualify.
Beginning in 2023, the threshold for increased efficiency drops to 25% and the maximum deduction more than doubles to more than $5.00 per square foot, provided that prevailing wage requirements are met. Property owners tend to be the main beneficiaries of this deduction, but starting in 2023, tax-exempt owners such as government entities and other tax-exempt organizations may transfer the deduction to the building designers.
New Energy Efficient Home Credit for builders of single- and multi-family homes
Builders of single- and multi-family homes that satisfy a tiered set of requirements for energy efficiency may claim tax credits ranging from $500 to $5,000 per unit, depending upon the energy savings achieved by the housing unit and satisfaction of prevailing wage requirements. There is no maximum number of housing units that can be considered in calculating the credit, so a substantial credit could be available to builders with large-scale operations.
State and Local Tax considerations
Although federal tax considerations are important and impactful, state, and local tax issues merit the same care and consideration as you examine opportunities for tax planning. While each state should be approached individually, here are some trending issues at the state and local level:
- Election to be taxed at the entity level for pass-through entities
- In response to the $10,000 federal cap on deducting state and local taxes as an itemized deduction, many states are allowing pass-through entities to elect to have their income taxed at the entity level. By paying tax at the entity level, business owners receive a deduction for the full amount of tax instead of the tax being subject to limitation. States have different requirements for electing this entity-level tax treatment, making it important to be well-informed of the requirements in the jurisdictions in which the company operates.
- Job credits at the state and local level
- Several states offer tax credits to employers who increase the size of their workforce or who employ apprentices. Ask your tax adviser about opportunities in the states in which you operate.
Employee Retention Credit (ERC)
Companies that held on to their employees despite lower revenues in 2020 and 2021 could be eligible for thousands of dollars in tax credits per employee. The credit is available up to $5,000 per employee for 2020 and up to $7,000 per employee per quarter for the first three quarters of 2021. This credit can add up quickly and provide much-needed cash to fund continued operations.
Companies have three years to claim the credit if they are eligible, so it’s not too late to determine if your business may qualify. Also, ERC as it was enacted initially excluded companies that received Paycheck Protection Program (PPP) loans from claiming the credit; however, subsequent legislation eliminated that requirement retroactively, increasing the number of companies potentially eligible for the benefit.
But a word of caution: this credit is a favorite of so-called tax credit “mills” that perform low quality services for a percentage of the credit calculated. Businesses like these have attracted much scrutiny from the IRS, so we strongly recommend that you engage a reputable professional for advice on the appropriate qualifications and filings to claim the ERC.
Many contractors are owned and operated by a small group of stakeholders, some of whom are family. In such situations, an unexpected illness or death can leave a void within a company from which it is difficult to recover.
Devising and executing a plan to install the next generation of owners and leaders is vital. Whether it’s a planned purchase of stock, gifting, the formation of a new company that will eventually absorb the old one, creation of an employee stock ownership plan (ESOP), or installing a new management team, various strategies exist to ensure that the company continues to deliver the services its customers expect for generations to come. Because a successful succession strategy may take anywhere from five to ten years to execute, advanced planning is crucial.
We Can Help
If you would like help in understanding how these tax strategies may affect your business, please contact our team.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.