by Cord Armstrong, CPA
In light of the recent tax bills released by the House and Senate, this article touches on the areas that should be considered when looking at tax strategies for 2017 and beyond. Both bills call for a 20 percent corporate rate (down from 35 percent), as well as a reduction to the effective tax rate on business income from pass-through entities (down from 39.6 percent) and cuts in the individual rates. Whether a bill passes or not, it’s safe to say that the time-honored approach of deferring income and accelerating deductions before the end of 2017 makes sense. In the worst case scenario if no tax legislation is passed, the rates will be the same and income is just deferred. This approach, however, will turn out to be even more rewarding if Congress succeeds in reducing rates.
Choice of Entity
We generally think of a pass-through entity as the best entity to do business in (i.e. LLCs, Partnerships and S corporations), but in light of the proposed lower corporate rates, C corporations may look more attractive.
Even though pass-throughs may be taxed at a lower effective rate—the House bill calls for a 25 percent rate but generally only on 30 percent of the income while the Senate bill calls for a 23 percent overall deduction—they may not be the automatic fall back choice as they have been in the past. There are too many unknowns. An effective lower pass-through rate is unprecedented and the tax writing committees have some issues to resolve first, including the types of businesses that will be eligible for this new low rate. Both bills allude to the fact that primarily only manufacturing-type businesses will be eligible for this new effective rate as opposed to professional service-type businesses. Presumably, construction will fall into the manufacturing category. However, engineering, architectural and construction management firms may not.
C corporation rates are only one part of the story since there is also another layer of tax to ultimately pay when the corporation either pays a dividend, upon final liquidation or the stockholders sell their stock. The second layer of tax may not need to be considered until several years down the road, while income is currently taxed at a lower rate. With the lower rate, even with this second layer of tax, the overall effective rate may make converting to a C corporation a viable alternative.
Accounting Methods
The House bill would increase the small contractor exemption threshold from $10 million of gross receipts to $25 million. The Senate bill calls for an increase of only $15 million. Currently contractors with gross receipts of more than $10 million are required to account for their construction contracts under the percentage of completion method. Small contractors (those with gross receipts under $10 million) are allowed to use any number of exempt methods (exempt from the percentage of completion method) unless the contract is expected to take more than two years to complete. Exempt methods include the cash, accrual, accrual less retainage or the completed contract method. Under current rules, however, small contractors must still account for their contracts under the percentage of completion method for alternative minimum tax purposes or AMT and must also compute the AMT look-back calculation. Originally both the House and Senate bills called for the AMT to be eliminated but when the Senate bill was passed the restoration of the AMT was one of the last minute changes. Hopefully AMT will be eliminated when both the House and Senate try to resolve their differences during the conference committee. An increase in the small contractor exemption and the elimination of the AMT would both be a huge benefit to these contractors.
There are a few exceptions to the percentage of completion method that large contractors should use to their advantage. For residential contracts, 70 percent of the contract can be accounted for under the percentage of completion method, and the other 30 percent accounted for under the established exempt method. Home construction contracts are also exempt from the percentage of completion method no matter the size of the contractor and are often accounted for under the completed contract method which defers income until the contract is completed.
Large general contractors, who have retainage payables, may still consider electing accrual less retainage as their overall method. This might help reduce their current costs incurred and, in turn, reduce their income under the percentage of completion method. Large subcontractors with retainage receivables can also take advantage of this method and defer that income on their non-long-term contracts.
Expensing and Depreciation
Both the House and Senate bills call for 100 percent expensing of equipment over the next five years. For 2017 the bonus depreciation is still 50 percent of eligible property acquired. Bonus depreciation is required unless you elect out of it by attaching a statement to your tax return. For example, if you have a net operating loss carryover from a prior year, or want to increase the DPAD deduction for 2017 you may consider electing out of bonus depreciation based on your particular set of circumstances. [2017 is likely to be the last year for the generous domestic production activities deduction or (DPAD) since it is currently slated under both bills to be one of the “expenditures” to be eliminated.]
Bonus depreciation does not apply to the purchase of any used equipment. However, any new or used equipment purchased during the year can also be expensed under Section 179 which allows an immediate write-off of purchases totaling up to $510,000 for 2017. This provision generally does not apply to large contractors since the $510,000 ceiling is completely phased out when total purchases exceed $2,540,000. The 179 deduction is also limited by the amount of taxable income. The House bill would increase the 179 amount that can be immediately written off to $5 million with the phase out at $20 million for the next five years. The Senate version would increase the 179 amount to $1 million with the phase out at $2.5 million.
In light of the potential changes for immediate expensing in 2018, contractors who can’t take advantage of the current expensing provisions may consider waiting until 2018. [The five year period under both the House and Senate bills would start for any property acquired after Sept. 27, 2017. This does not give companies a lot of time to plan for 2017 but would be a welcome benefit in case any large purchases need to be made before the end of 2017.]
Repair Expenses vs. Capitalized Costs
Most taxpayers adopted the new tangible property regulations for tax years beginning after 2013, making it easier to deduct repair and maintenance expense, rather than capitalize and depreciate the cost overtime. However, this was not a one-time exercise and the repairs and maintenance costs should be evaluated at the end of each year to make sure you are taking full advantage of the deductions. This not only applies to building repairs and maintenance costs, but to large equipment costs as well. Generally, any repairs or maintenance cost can be currently deducted as long as they are not considered a betterment, restoration, or adaption (to a new or different use). There is also the routine maintenance safe harbor election which allows maintenance costs for equipment to be deducted in the year incurred if at the time the property is placed in service, the contractor reasonably expects to perform the maintenance activities more than once during the property’s depreciable class live. The annual de minimis safe harbor election allows up to $2,500 (per invoice or by item) of any tangible property acquired to be currently deducted, as long as a capitalization policy is in place at the beginning of the year and the same method is used for book purposes. If the contractor has an annual audit done under GAAP, then the amount can be increased up to $5,000.
Research and Experimentation Credit
While many deductions and credits are slated to go away under tax reform, one credit that is expected to be preserved under any of the reform proposals is the Research and Experimentation (R&E) credit which has become increasingly popular in the construction and engineering industry. This credit should be considered any time there is some type of experimentation either in the design, process or materials.
Conclusion
Whether or not a tax reform bill is passed, the best strategy for 2017 for most taxpayers would be to defer income and accelerate deductions. Tax reform may also make C corporations a more favorable choice of entity but that remains to be seen. Be sure you are taking advantage of the optional methods of accounting available, which may also help in deferring taxable income. Additionally, take advantage of the accelerated depreciation methods and new expensing options. If you think the R&E credit may apply to you, now is the time to talk to your tax advisor so they can start gathering the necessary information in time for tax filings.
Cord Armstrong is a managing tax director at CBIZ MHM, LLC, Phoenix, Ariz. He can be reached at (602) 264-6835 or carmstrong@cbiz.com.
##
