On December 22, 2017, the President finalized historic federal income tax legislation by signing a bill known as the Tax Cuts and Jobs Acts (the “2017 Tax Act”). The 2017 Tax Act provides a host of tax law changes that significantly benefit the construction industry. This provides a wide range of planning and structural opportunities across the construction industry that will need to be considered beginning with the tax year starting January 1, 2018.
Here is a summary of ten key federal income tax reform changes and planning opportunities of which contractors should be aware.
Pass-Through Deduction – Section 199A
With most construction firms operating in some form of a pass-through structure, one of the greatest benefits in the new law is the Section 199A deduction (the “20% deduction”) on “qualified trade or business” for pass-through entities beginning January 1, 2018. This new deduction applies to construction pass-through ventures – individuals with Schedule C, S corporations, and partnerships/ LLCs. It also applies to trusts, which were initially omitted, but ultimately included in the final bill. One of the most significant last minute additions to the bill was the inclusion of architectural and engineering firms. The 20% deduction excludes “service trades,” where the principal asset of such trade or business is the reputation or skill of one or more employees or owners. Engineering and architectural firms were originally excluded along with those in the fields of accounting, consulting, financial services, health, law, etc., but in the very end, these were carved out of this definition and will qualify for the 20% deduction.
Overall the 20% deduction is calculated on the entity’s income, with some exclusions, limited however to the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of qualified property. The deduction will ultimately be applied at owner level, on an entity by entity basis.
If an individual’s taxable income is less than $315,000 and phases out up to $415,000 (married filing jointly), the wage limit does not apply. In addition, the exclusion of service based businesses from the 20% deduction does not apply if an individual’s taxable income is under these thresholds. It is worth noting that for those contractors outside the definition of a service trade, individual taxable income greater than these thresholds does not limit the applicability of the 20% deduction.
For the contractor, the impact of bonus depreciation and wage limits will require careful attention for planning purposes around the application of Section 199A.
Small Contractor Exemption
After some back and forth between the Senate and House versions of the proposed tax bill, contractors received welcomed news in the final form, with an increase of the small contractor exemption from $10 million to $25 million, beginning January 1, 2018.
Before tax reform, the law defined a small contractor as having average gross receipts from the preceding three years under $10 million. Those contractors that were under this threshold qualified to use a method of accounting for long-term contractors other than percentage-of-completion. (A qualifying contract being one expected to be completed within two years.) This exemption allowed those qualifying small contractors to use other exempt methods to account for their long-term contracts. This provided contractors the ability to defer taxable income from the slowing of revenue recognition, thus improving cash flow.
The $10 million gross receipts threshold had been in existence since 1986, with practically no change. The increase to $25 million opens up a nice opportunity for contractors whom, due to the health of the market, may have found themselves growing over the original $10 million threshold. This provision applies on a cut-off basis, meaning it applies to new contracts that begin in 2018.
Unfortunately, a contractor must still consider the alternative minimum tax (AMT) calculation at an individual level, which requires long-term contracts to continue to be calculated under the percentage of completion. However, while AMT wasn’t eliminated at the individual level, the AMT exemptions and phase-out limits were significantly increased, meaning those contractors that were previously subject to AMT may find themselves no longer impacted.
Cash Method of Accounting
Similar to the gross receipts test under the small contractor exemption, this same threshold approach applies in considering whether an entity can use the overall cash method for accounting. Before tax reform, an entity was required to use the accrual method to account for inventory if production, purchase or sale or merchandise is a significant income producing factor, with possible exceptions if that entity was under $10 million in annual gross receipts depending on industry.
Beginning January 1, 2018, under the new tax law, this level has been raised to $25 million. In addition, if this gross receipts test is met, it no longer matters whether production, purchase or sale of inventory is an income producing factor—an entity may still use the cash method. In the construction industry, this change may have significant benefits to those subcontractors carrying inventories that are under this $25 million threshold.
The tax bill has extended and modified the first year bonus depreciation deduction through 2026. What was a 50% allowance before tax reform, has been increased to 100% expensing for property placed in service after September 27, 2017, and before January 1, 2023. It also expands the definition of qualified property to include used property. The application of this change into the last quarter of 2017 and expansion to include used property was a nice benefit for those in the industry. It will provide some consistency year to year, and may slow the “should I buy a truck” conversations the last few days on each year.
Section 179 deduction (100% expensing), is still alive and well, but muted somewhat now that 100% bonus is in place. However, some expansion of the bill around real improvement property on nonresidential buildings (roofs, HVAC, systems, etc.) may be eligible for Section 179 and not bonus, and therefore may still need to be considered.
Many of the state laws in this area have not been updated to conform to the new federal tax law, therefore modifications and planning should be considered in determining state taxable income.
Domestic Production Deduction (DPAD)
Effective January 1, 2018, the final tax bill repealed the Domestic Production Deduction under Section 199. Many in the industry have qualified in previous years to take a 9% deduction against the lesser of qualified production activities income or taxable income related to qualifying activities. Qualifying activities for the construction industry were typically either the manufacturing or production of tangible property in specific instances, or the construction of real property.
Beginning January 1, 2018, the deduction for entertainment, amusement, recreation, membership dues and related expenses were fully repealed in the new tax bill. A 50% deduction for food and beverage expenses remains, but a 50% limit has been expanded to include employer expenses providing food and beverages to employees through on-premises eating facilities.
Beginning January 1, 2018, a new 30% of EBITDA interest expense limitation applies to contractors. The 30% interest expense limit is determined at the entity level. Entities with less than $25 million in annual sales are exempt from the new 30% interest expense limitation.
Contractors with sales in excess of $25 million can elect ADS depreciation deductions instead, and avoid the new 30% interest expense limitation. However, consideration must be given with regard to the various capital expensing laws, as ADS depreciation will not be able to take bonus depreciation.
Beginning January 1, 2018, the ability for contractors to exchange tangible personal property (equipment) took a hit with the new tax law, by repealing the ability to execute a like-kind exchange and defer gain for tax purposes. Also effective in 2018, like-kind treatment still applies to real property, but contractors should consider this overall change when reviewing capital expenditure decisions over the course of the year.
Net Operating Losses
For those contractors that lived through the late 2000s, the ability to carryback net operating losses from the business to offset taxable income in previous years provided a nice cash influx at a time when many may have needed liquidity to keep the doors open. Unfortunately for the industry, the new tax bill does not do any favors in this area, which now disallows the carryback of net operating losses that previously could be carried-back up to two years. In addition, net operating losses now carried-forward will be limited to 80% of taxable income for losses created in taxable years beginning after December 31, 2017. Finally, on top of everything above, business losses for non-corporate taxpayers are limited to $250,000 per year for single, and $500,000 for married filing jointly. The ability to see any immediate influx of cash from a down year due in this area has been severely limited.
An under the radar change in the tax bill surrounds transportation fringe benefits. The employer deduction for qualified transportation fringe benefits was repealed. In addition, due to the removal of miscellaneous deductions as part of the itemized deduction calculation at the personal level, W-2 employees of contractors may be significantly limited in their ability to write-off out-of-pocket costs for transportation-related expenses associated with the business (mileage & actual expenses). Contractors may want to revisit their policy and consider accountable reimbursement plans to ensure the employee is made whole from a cash perspective, while maintaining deductibility at the entity level.
For more information about how these changes may affect you and your construction business, please reach out to your MCM tax professional or contact Partner Matt Neely, CPA, via email or phone at (812) 670.3434.