Cord Armstrong, CPA, CCIFP, is a managing director in the tax department of CBIZ MHM LLC, with over 25 years of experience in public accounting. Armstrong is also a shareholder of Mayer Hoffman McCann, P.C. He specializes in federal and state tax compliance, planning and consulting for corporations, partnerships and LLCs and their owners with an emphasis in the construction industry. He is a member of the firm’s National Construction Industry Practice Group. Visit cbiz.com.
Before the year is over, it is prudent to review your construction firm’s tax planning, as there are several steps that can be taken to improve your situation before January 1.
What accounting method do you use for your construction contracts? There might be a more advantageous method available. In addition, certain contracts may be required to be accounted for under the percentage of completion method. Generally, under the tax code, large contractors are required to account for their construction contracts under the percentage of completion method. Otherwise, small contractors are allowed to use what is known as an exempt method (exempt from the percentage of completion method), which could be the cash, accrual or completed contract method, to name a few.
Percentage of completion is also required for any contracts that are anticipated to take more than 2 years to complete, regardless of the size of the contractor. Your type of contracts could have also changed. Don’t assume that all construction contracts should be treated the same way for tax purposes. Also, any home construction contracts are exempt from the percentage of completion method, regardless of the size of the contractor.
Domestic Production Activities Deduction
Other tax savings can be attained through the generous domestic production activities deduction, or DPAD. This is a free deduction that is equal to 9 percent of the lessor of your net income from qualifying DPAD activities or net income. Even though the deduction generally applies to manufacturing activities in the United States, it can also apply to architectural, engineering and construction (AEC) activities.
Expensing & Depreciation
Year-end is also a good time to clean up your fixed asset schedule. Any old equipment no longer in use or abandoned should be written off. Even if it fully depreciated for tax purposes, you are more than likely paying personal property tax on equipment you no longer own that is still on your fixed asset schedule. Any new equipment purchased during the year can be expensed under I.R.C. Section 179, which allows an immediate write off in the year purchased up to $500,000. This provision in the law is now permanent. The $500,000 ceiling starts to phase out when total purchases exceed $2 million, and is completely phased out when total purchases exceed $2.5 million, so this generally does not apply to very large contractors.
All taxpayers can also utilize bonus depreciation, which allows a stated percentage of the cost of personal property to be deducted in the year acquired. However, this only applies to equipment when it is first placed in service, so it does not apply to purchases of any used equipment. Bonus depreciation is required, unless you elect out of it by attaching a statement to your tax return. For instance, if you have a net operating loss carryover from a prior year, or want to increase your DPAD deduction, you may consider electing out of the bonus depreciation based on your particular set of circumstances. The bonus depreciation is 50 percent for 2016 and 2017. It phases down to 40 percent in 2018, and 30 percent in 2019, and is scheduled to sunset after that.
Research & Experimentation Credit
The Research and Experimentation credit, or R&E (also known as R&D), has become increasingly popular in the construction and engineering industries. Once thought of as only applying to high-tech businesses, the credit can apply to construction projects that include some type of experimentation either in design, process or materials. The credit is now permanent and, starting in 2016, can also reduce the alternative minimum tax, which restricted most of the benefits in the past. Some R&E activities for the construction industry include:
- New and improved design efforts related to energy efficient goals
- Design efforts associated with overcoming challenges associated with specific site plans
- Use of new or unique materials in the construction effort
- Means and methods engineering
- Developing alternative designs for plumbing, electrical, heating and cooling and lighting systems
- Designing alternative structural designs for a new or improved construction effort
One important caveat to qualifying for this credit is it must not be “funded,” or the contractor cannot pass the costs on to the customer and must be at risk for the investment in the research.
Now may also be a good time to reexamine your employee reimbursement plan. Generally, any employee expenses for travel and meals that are reimbursed dollar-for-dollar by the employer are not taxable to the employee. This is known as an “accountable plan” and should be in writing. Any straight allowances given to employees for automobiles or meals that are not substantiated to the employer by the employee should be included in the employees’ wages. The employees can then deduct their actual expenses on their personal returns, but the deduction likely will be limited and will not produce much benefit to them.
One way to reduce the substantiation burden on employees for out-of-town jobs is through the use of stated, per diem allowances. The employer can issue per diems based on stated daily rates (which can be found at gsa.gov) in the location of the job, or they can use the high/low rates, which is an average for all locations. The per diems are not taxable to the employees. Although this alleviates the burden of having the employees substantiate the actual receipts to the employer, they still have to substantiate the time, place and business purpose of the expenditures.
Section 179D Deduction
Do you design and/or construct energy-efficient government buildings? If so, you most likely are eligible to take the 179D deduction. This deduction is equal to up to $1.80 per square foot of the building, depending on the energy savings. The purpose of the deduction is primarily to benefit the owner of the building, but since the deduction does not benefit governmental entities, the law allows them to pass the deduction on to the primary designer. This deduction is set to expire after 2016, but has been extended in the past.
Be sure you are taking advantage of any look-back interest owed to you. Contractors who account for their contracts under the percentage of completion method are required to compute the look-back interest calculation when the job is completed.
Unfortunately, this calculation may also result in interest owed to the Internal Revenue Service (IRS). In the tax year a contract is completed, the taxpayer must look back to the prior years in which the contract was in process and recalculate the percent complete for each open year, using the final contract price and actual costs rather than the estimated costs. To the extent that a prior year’s gross profit on each completed contract was over or under-estimated, the hypothetical tax must be computed, and interest is then computed on the hypothetical tax. If the prior profits were understated, then interest is owed to the IRS. If the prior profits were overstated, then interest is owed to the contractor.
There is an exception to this calculation for small contracts, if the gross contract price at completion does not exceed the lessor of $1 million, or 1 percent of the average annual gross receipts of the taxpayer for the prior 3 years and the contract is completed within 2 years of the commencement date.
If you think any of the topics mentioned above may apply to you, now is the time to talk to your tax advisor so they can start gathering the necessary information to prepare your 2016 income tax returns.