On December 22, 2017, President Trump signed into law “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018.” Commonly referred to as the “Tax Cuts and Jobs Act” (the Act), it consists of sweeping changes for individuals and businesses. The Act will significantly impact tax planning, compliance, financial reporting, auditing, internal controls and more. In fact, these are the biggest changes to United States tax policy since 1986. The factors affecting contractors are highlighted below.
Reduced Corporate Tax Rate
The most significant change for C corporations is moving from a graduated corporate tax rate to a reduced flat rate. Lawmakers reduced the rate to 21 percent, a decrease of 14 percent from the previous top rate of 35 percent. This change is permanent and is effective for tax years beginning after December 31, 2017. Additionally, corporate alternative minimum tax (AMT) was permanently repealed for tax years beginning after December 31, 2017.
Pass-Through Business Income Taxes
For construction firms organized as pass-through entities (sole proprietorships, S corporations or partnerships), a newly created exclusion allows up to 20 percent of qualified business income to be excluded from the owner’s taxable income. If a business qualifies for the full exclusion, it can lower the effective tax rate on pass-through income to 29.6 percent, a decrease from the previous top individual tax rate of 39.6 percent.
This provision has been publicized as a broad boon for most every pass-through entity. However, qualifying for the full 20-percent exclusion may prove to be more complicated than publicized. The provision is intended to prohibit service businesses from receiving benefits and includes a list of specific industries to which the exclusion does not apply: health, law, accounting, consulting. In addition, the law also includes a broad definition of businesses for which the exclusion is unavailable, which states in part: “…any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” While it does not appear that the intent was to exclude contractors from the benefit, one may argue that construction firms could fall under the broad definition. Construction firms should monitor IRS interpretations during the coming months, and make necessary adjustments to qualify for the exclusion.
In addition to the service industry prohibition, the law also includes specific limitations, which could decrease or eliminate the applicability of the exclusion. These limitations primarily relate to the total wages paid by the business and the amount of capital invested in the business, mainly in the form of property and equipment. Many construction firms are structured such that they have separate entities that hold equipment and employ their labor force. These structures could prove problematic for maximizing the exclusion. Construction firms should work with their tax advisers to proactively model their tax situations to determine if any changes are needed to receive maximum benefits from the pass-through exclusion.
Accounting Method Changes
C corporations and partnerships with C corporation partners were previously prevented from using the cash basis method of accounting if their average gross receipts were $5 million or greater. The Act allows for increased availability of the cash method of accounting by raising the average annual gross receipts threshold to $25 million.
The Act also increases the average annual gross receipts threshold from $10 million to $25 million to exempt construction contracts from the requirement to use the percentage-of-completion method of accounting for long-term contracts. Contracts within this exception are those for the construction or improvement of real property if the contract: (1) is expected to be completed within 2 years of contract commencement, and (2) is performed by a taxpayer who meets the $25 million gross receipts test. This change results in increased ability to use the completed contract method, exempt-contract percentage-of-completion method or any other permissible method.
These changes, combined with the repeal of AMT, present a unique opportunity for contractors to take a fresh look at their overall and long-term contract accounting methods.
The Act enhanced bonus depreciation, and taxpayers can now deduct 100 percent of qualified business assets in the year they are placed in service. Additionally, the Act allows both new and used assets to qualify for bonus depreciation. Assets that typically qualify include furniture, computer equipment, tools and construction equipment. This provision applies to qualifying assets placed in service between September 28, 2017, and December 31, 2022.
Section 179 was also permanently enhanced by the Act. Taxpayers may now expense qualified business assets up to $1 million (previously $500,000) per year. This benefit begins to phase out at $2.5 million of asset purchases.
Interest Deductibility Limits
As a trade-off for the enhanced depreciation incentives, the Act includes new limitations on the deductibility of interest expense. Effective January 1, 2018, businesses with gross receipts over $25 million could see a reduction in their interest expense deductions. Business interest expense that exceeds interest income plus 30 percent of adjusted taxable income (ATI) will be disallowed. From 2018–2021, ATI is defined as taxable income computed without regard to interest expense or interest income, depreciation, amortization or depletion. Beginning in 2022, ATI does not provide for the add-back of depreciation, amortization and depletion. Disallowed interest is eligible to be carried forward indefinitely.
Other Changes to Note
- Repeal of Domestic Production Activities Deduction (DPAD)—Construction firms that previously claimed the popular tax incentive would no longer receive this benefit. However, this impact may be offset by the reduction in overall tax rates.
- Disallowance of entertainment expenditures—Firms that have a significant amount of entertainment expenses could be substantially affected by this limitation, as the law further limits the deductibility of certain meals and eliminates the deductibility for most entertainment expenses.
- Accounting for income taxes—C corporations or other construction firms that are required to account for income taxes in their financial statements should be proactive in assessing the impact of the Act on their current and deferred taxes, as firms will generally be required to account for these changes on 2017 financial statements.
- Choice of entity—With reduced corporate tax rates and the repeal of corporate AMT, many businesses that are taxed as pass-through entities are considering the potential advantages of converting to a C corporation. This decision is multifaceted, and thorough consideration should be given to the short-term benefits and the long-term implications of a sale or other liquidity event. Because contractors are required to retain a significant amount of equity in the business, it just may be advantageous to consider this strategy.
The Act’s provisions have created a waiting game as we look to the IRS to provide regulatory guidance and make technical corrections. However, with change comes opportunity, and construction firms should review their overall business structure and create a strategy to minimize their tax burden in this new climate.