Now more than ever, construction contractors face complex tax issues that strain resources and drain what may be already-shrinking profits.
Especially during a recessionary period, contractors need to minimize spending though effectively managing their tax burden and protecting themselves against tax increases and assessments. This is particularly important now, when nearly every tax authority, from the federal government down through state and local jurisdictions, is seeking additional sources of revenue in response to strained budgets.
Between now and 2009, construction contractors should keep in mind the following tax tips to minimize their tax liabilities:
1. Nail down depreciation and expensing deductions.
All contractors should be aware by now that in early February 2008, bonus depreciation deductions were revived for the 2008 calendar year. As an incentive to purchase new equipment during 2008, taxpayers are allowed to deduct half of the cost of qualifying property in the first year of use and then depreciate the remaining half of the asset over the equipment's normal useful life. For five-year equipment, this results in a deduction of 60 percent of the asset's cost.
What is not as well known are the specific rules that must be satisfied in order to claim the bonus deduction. Generally speaking, the asset must fit into specific categories, it must be used for the first time (i.e., it is a new asset), and it must be placed into service in 2008. In addition, it must not have been the subject of a contract that precedes 2008.
Contractors need to work closely with their tax advisers to make sure they are taking full advantage of this deduction. For example, the requirement that an asset be placed into service during 2008 generally means it must be in the contractor's possession and be available for its intended use at that point. This may require you to work with your equipment suppliers to make sure deliveries of ordered equipment occur in 2008.
In addition, the expensing limits under Section 179 are significantly increased for tax years beginning in 2008. Originally designed for small contractors, these rules now allow expensing of up to $250,000 of the acquisition price of new or used assets. A phase-out of this expensing amount begins when more than $800,000 of assets are placed in service during the year.
2. Look out for the expanded "kiddie tax."
Most contractors are family-owned businesses and many have used a variety of tax planning techniques to shift income from one family member to another. The "kiddie tax" has been expanded to require excess unearned income of full-time students under age twenty-four to be taxed at their parents' marginal rate, unless the student's earned income equals one-half of his or her support.
This calls for a thorough review of estate planning and gifting strategies to avoid higher income taxes on dependent children over age eighteen. For example, gifts of portfolio assets yielding current income may no longer be appropriate. Instead, gifts of assets producing tax-exempt income should produce the desired result.
3. Revisit the tax rebate.
As part of the same legislation that revived bonus depreciation for 2008, Congress and the president passed a law that called for tax rebate checks to be mailed to taxpayers beginning in May of this year. As a general rule, taxpayers who qualified for a rebate should have already received a check. However, there are situations in which taxpayers may claim an additional credit, even though they have already received a check.
What is not widely known about the tax stimulus rebate is that it is actually an advance rebate on 2008 tax liabilities. The rebate checks that the government already issued are based on the facts contained in 2007 tax returns in order to allow the Treasury Department to expedite checks. If income or dependency changes from 2007 to 2008, taxpayers may be able to claim additional credits with their 2008 income tax returns.
For example, the basic credit, which entitles a married couple to receive up to a $1,200 rebate, begins to phase out at income levels of $150,000. Therefore, if a married couple's 2007 adjusted gross income exceeded that amount, they would have received a check smaller than the maximum allowed or perhaps no check at all. Because, however, the actual rebate is based on 2008 tax facts, if that same married couple's income declined, they may be eligible to claim a credit with their 2008 income tax return.
In addition, taxpayers who extended their income tax returns did not, in most instances, receive an advance rebate check at all. In this case, they may claim credits for which they are eligible with their 2008 income tax returns.
Therefore, during the year-end planning process, take into account rebates that have not been received.
4. Review transfer pricing agreements.
Foreign jurisdictions typically review intercompany transactions for adequate documentation and consistency of pricing applications. States are increasingly reviewing these types of arrangements as well to ensure that income reported by a particular taxpayer is properly reflected. Contractors need to review all intercompany charges in place for appropriateness (especially where management companies are involved) and make sure the proper supporting documentation is maintained.
5. Determine whether the company can lower property taxes.
A property tax review would ensure that all real and intangible property is excluded from the personal property tax base. In addition, there may be opportunities to lower the property tax valuations on real property. The review would not only generate savings in the first year but in future years as well.
6. Examine capital asset depreciation methods and lives.
Depreciating fixed assets is one of the most complex aspects of tax law. Understanding and properly applying these rules can accelerate income tax deductions, and often those deductions add significantly to current tax flow. For those contractors who have underreported prior depreciation, recent IRS guidance allows "catch-up" deductions by filing an automatic change in accounting method.
7. Review deferred compensation plans.
Between now and the end of 2008, if you have not already done so, work closely with your tax advisers to make sure that any arrangement calling for compensation earned in one year and paid in another year has been modified to conform with complex new rules. These rules, originally enacted in 2005, have been delayed time and time again, however they become final at the end of this year.
These rules extend to compensation arrangements far beyond traditional deferred compensation plans. If these rules are violated, there are dramatic consequences, including the acceleration of taxation to recipients, plus the payment of interest and penalties.
Plans affected include deferred compensation plans, phantom stock and stock option plans, as well as some severance agreements and offers of employment. In addition, many bonus plans are affected, even those in which employers intend to pay all bonuses by March 15 of the following year. All compensation arrangements need to be examined (even if there are no current additions) to avoid running afoul of these new requirements.
8. Consider future capital gains and dividend tax rate increases.
Under current law, capital gains and qualified dividends are taxed at a favorable 15 percent federal income tax rate. This preferential treatment is scheduled to expire at the end of 2010, however, the pending change election has the potential to significantly change the taxation landscape. No tax break is safe from post-election changes.
Taxpayers who have significant pending capital gain transactions, or those who have the ability to influence the payment of qualified dividends, need to work with their tax advisers to closely watch the election results and then determine if the tax positions of the new president and Congress merit acceleration of these items into 2008.
9. Analyze the business structure.
A business's organization can have a major impact on the amount of taxes paid, especially in the areas of state, local and employment taxation. The benefits of restructuring the business (for example, by establishing a partnership to provide intercompany services) may not only include reducing taxes but may also provide other benefits, such as reducing liability risk and more properly aligning the profit drivers in a contractor's business.
10. Consider establishing a separate entity to own and lease fixed assets used in the business.
Often referred to as leasing companies or procurement companies, these entities help manage assets and may significantly reduce sales and use tax-a tax collected and remitted regardless of whether the company is profitable.
Construction Business Owners, November 2008