Many construction contractors may not be aware of significant changes that could impact their tax and financial planning—some negative, but mostly very positive—provided under the Tax Cuts and Jobs Act (TCJA). For example, with regards to Domestic Production Activities Deduction (DPAD), under the previous laws, taxpayers were entitled to a DPAD equal to 9 percent of their qualified production activities income. Under the new law, it has been eliminated.
While this may seem like bad news, eligible contractors can benefit from a new 20-percent pass-through deduction, which can create significant tax savings. However, to qualify for this deduction, contractors must have salaried employees on staff. This change is likely to motivate some business owners to reconsider how their entity is structured.
The Qualified Business Income Deduction
Up until 2017, under Section 199 of the United States Jobs Creation Act of 2004, the DPAD was basically earned by being a U.S. company and doing business with U.S. customers. As of Dec. 22, 2017, the TCJA of 2017 was signed into law, and the 20-percent deduction came into being, with all of its complexity. It represents the Qualified Business Income Deduction (QBID) to adjusted gross income and is governed by Section 199A.
The QBID, known as a pass-through deduction, has two particular benefits for business owners:
- The new 20-percent deduction is larger than the 9-percent of the DPAD, so it has the potential to make those tax refunds bigger.
- It’s designed to help sole proprietorships, partnerships and S companies operate on a more level playing field with their C-company competitors, who just saw their income tax rates drop. In many cases, the rates dropped as much as 14 percent (from 35 percent to 21 percent) because of the same tax legislation.
It’s All in the Details
The details are critical for understanding QBID and how Section 199A was written. Rather than listing businesses that the law governed, it highlighted those that did not qualify for the deduction. Fortunately, the construction industry was not on the list.
Where you once automatically received the 9-percent DPAD, now you must qualify for the 20-percent QBID, and that can require a completely new approach to the way construction contractors do business. This new approach is driven by the deduction limitation to 50 percent of W-2 wages paid, or 25 percent of those wages plus 2.5 percent of the value of acquired property used in the business, before depreciation.
For example, if a sole proprietor has a taxable income of $200,000 and pays out $100,000 to subcontractors in 1099 wages rather than salary, the QBID is zero dollars. If the construction contractor paid his or her subcontractors in W-2 wages, the QBID would be $40,000.
There are some considerations and caveats to paying W-2 wages. They will bring extra expenses, such as payroll taxes, Social Security payments, contributions to local and state unemployment insurance, and even potential benefit costs, including life and health insurance and pensions. There are also the pressures of keeping W-2 employees on the payroll when business can often be volatile; whereas, it’s much easier to manage subcontractors who receive a 1099.
The Future of the Tax Cuts & Jobs Act
The authors of the TCJA aimed to help the construction industry by helping company owners to have more funds to invest in themselves and their employees. Whether this happens or not, the impact on the generally conservative construction industry will likely run behind the impact on the economy.
This lag will be due to project authorization, funding in the face of rising interest rates and bidding processes, which all take time. However, this affords the construction industry more time to take advantage of new benefits like the QBID and other aspects of economic change.
The IRS has received many queries from accountants seeking insights on how to apply the QBID to their clients. In reaction, the IRS issued proposed regulations to govern the QBID on Aug. 8, 2018. The agency created a frequently asked questions about the deduction webpage, which is constantly updated.
With the right accounting support, it’s possible to work through these complexities and achieve significant tax savings, helping the construction industry better invest in its businesses, owners and employees.