A Tax Blueprint for Contractors

By Kelli Franco
Partner

Katie Burton
Senior Manager
Moss Adams LLP

In the construction industry, no one likes surprises. First you plan, then you build—not the other way around. But when it comes to taxes, many contractors forget this core principle, failing to adequately plan and ending up losing out on key money-saving opportunities. Sadly, it’s the financial equivalent of measuring once and cutting twice.

To help you avoid this fate, let’s take a brief look at tax rates and a few construction-specific financial opportunities in 2013 while there’s still time to put together a plan with your CPA and other advisors.

The American Taxpayer Relief Act of 2012 extended many of the 2001 and 2003 tax cuts. However, beginning in 2013, individuals are subjected to a top rate of 39.6 percent. These tax rates aren’t currently set to expire, which allows you to defer income and accelerate deductions to help reduce your current-year tax burden.

TOP TAX RATES 

	2013*	2012	Increase
Ordinary earned income	39.6%	35%	13%
Net investment income and passive income**	43.4%	35%	24%
Long-term capital gains	23.8%	15%	59%
Qualified dividends	23.8%	15%	59%
Estate and gift tax	40%	35%	14%
* Includes 3.8 percent surtax on net investment income and certain items of passive income with adjusted gross income over $200,000 (single filers) or $250,000 (joint filers) ** Includes interest, dividends, royalties, net rental income, and other passive income

Favorable deductions for equipment purchases continue to be available for 2013. These include:

This portion of the Internal Revenue Code allows a 100 percent first-year write-off of qualifying purchases (equipment, computers, nonpassenger vehicles) of up to $500,000. This is phased out if you have purchases of over $2 million during the year. You can purchase new or used equipment to take advantage of this provision. However, you must have taxable income in your company to use the deduction.

You can immediately deduct 50 percent of the cost of qualifying new (not used) equipment purchased and placed into service before Jan. 1, 2014. If you rent or lease a new piece of equipment and purchase the equipment within 90 days, you’re deemed to be the original user and the purchase qualifies for bonus depreciation. You don’t need to be profitable to take 50 percent bonus depreciation; as a result, you can also use this opportunity to increase a net operating loss, if you have one, to help offset taxes owed.

Two additional things to note: 

• For contractors recognizing revenue under the percentage-of-completion method, bonus depreciation is now generally decoupled from the allocation of contract costs.
• Many states don’t conform to federal rules on Section 179 and bonus depreciation, so taking the deduction can complicate multistate tax filing.

Bonus depreciation and the increased amount for the Section 179 deduction are set to expire at the end of 2013, which may impact your year-end buying decisions. Although these provisions have historically been extended, there’s no guarantee what Congress will do. 

	2014	2013
Maximum Section 179 deduction	$25,000	$500,000
Bonus depreciation	0%	50%

For many years, contractors and their accountants have been discussing the notion of deferring income, but they generally opted not to do so out of a fear of rising tax rates. After all, who wants to push income from a 35 percent bracket to a 39.6 percent bracket? However, now that the uncertainty of rising tax rates is over, it’s time to take a second look at deferral strategies.

There are a variety of tax accounting methods you can opt for depending on whether you’re a small contractor (under $10 million in revenue) or a large contractor (over $10 million in revenue). These can vary depending on the type of contractor you are and the type of projects you perform. Your tax advisor should be able to examine your job schedules and determine which tax-deferral and cash-saving strategies to use. 

Small contractors can choose among multiple methods for revenue recognition, which can defer income into later years. These include:

• Cash method. Income is recognized as cash is received. Conversely, deductions are allowed as cash is paid.
• Completed contract method. All income and costs for a specific contract are deferred until the contract is completed.
• Percentage-of-completion method. Percent complete is usually determined by comparing costs incurred to date with total estimated costs.
• Accrual method. Income is recognized once the contractor is entitled to receive the billing, regardless of cash collection. Contract costs are deductible when incurred, generally.
• Accrual method excluding retention. Follows the same rules as the straight accrual method, but retention is excluded from consideration of billings.

Large contractors are more limited in their deferral options. The key takeaway for large contractors is to dissect your job schedules. You must follow the percentage-of-completion method for tax purposes. However, there may be a few methods available to large contractors to defer income into future years. These include:

• Percentage-of-completion method excluding retention payable. Retention payable is excluded from the cost-to-cost percentage of completion formula, allowing for less income recognition in the current year. If available, this is a good method for large general contractors that often use subcontractors. 
• Ten percent deferral. All contracts are deferred (both income and costs) until they’re greater than 10 percent complete.
• Percentage of capitalized cost method. Available for contractors with residential contracts (apartments, condominiums, prisons, assisted living facilities, dormitories and barracks, etc). Under this method, 30 percent of income and costs are deferred until the contracts are complete. 
• Exclusion for home construction contracts. Depending on land ownership and the type of home (spec home versus custom home), contractors may be able to use the completed contract method for home construction contracts. 
• Other methods. Other methods available to small contractors may also be available to large contractors for short-term and service contracts. Again, the key here is to dissect your job schedules.

A note of caution: For alternative minimum tax purposes, income from long-term contracts must be reported using only the percentage-of-completion method.

When many people think of research and development (R&D), they don’t typically imagine it applies to contractors. However, many contractors have expenses that qualify as R&D expenses under IRS criteria. You could be eligible for research tax credits if you:

• Devote time and resources to creating new or innovative products
• Improve existing products
• Develop processes
• Hire designers or engineers

The R&D tax credit is a dollar-for-dollar credit you can use against taxes owed or paid. Each year contractors with qualifying R&D activities successfully claim the R&D credit. Current law for the R&D credit expires at the end of 2013, but the credit can be retroactive. Depending on when your tax return was filed, you may be able to claim the credit for three prior open tax years.

As you can see, there are a number of things you can still do in 2013 to keep more of your business (and personal) income and give less of it to the IRS. However, the longer you wait to plan means the less time you and your advisors will have to properly think through all your options and choose the strategies right for your business.

In the few months that remain this year, now is a good time to review the provisions in this article that apply to you and your business and begin sketching out a financial blueprint that will help you build a successful 2014 and beyond.

Associated General Contractors of America
2300 Wilson Blvd, Suite 300
Arlington, VA, USA
Ph: 703-548-3118 Fax: 703-837-5402