With all these new provisions created by tax reform, the time is now for construction businesses to start a conversation on how to plan for and adjust to these changes. Learn more.
Daniel J. Mauriello
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act, the biggest piece of tax legislation enacted since the Tax Reform Act of 1986. The goal of the act was to provide tax relief to American companies; the theory was that by lowering corporate tax rates, companies that once held operations in the United States, but fled to countries with more favorable tax rates, would now return to America. The return of these corporations to the U.S. would in turn create more jobs here at home.
Many companies in the construction industry are not structured as C corporations, so in order to avoid slighting these non-C corporation business owners, a new pass-through entity deduction was created with the new tax law. This deduction acts as a decrease in the overall effective tax rate a business owner will pay on his or her share of pass-through trade or business income. Under this new methodology, the effective tax rate on trade or business income is reduced from the top individual rate of 37% to approximately 29%. While this does not equal the rate of C corporations, it does close the gap from 16% to 8%.
Tax law requires any company with construction contracts spanning a single tax year to recognize revenue from such contract on the percentage of completion method. This means revenue must be recognized and subjected to tax in relation to the progress on that contract, regardless of what has been billed to the customer.
This can create cash-flow issues for many businesses. For smaller companies, there was some relief in the form of alternative methods for recognizing revenue. A company whose average annual gross receipts for the prior three years was less than $10 million, and is estimated to be completed within two years of commencement, is exempt from using the percentage of completion method.
Congress recognized that the $10 million average annual gross receipts test excluded many taxpayers from being able to take advantage of this exception. To afford more taxpayers the opportunity to utilize this exemption, Congress included in the Tax Cuts and Jobs Act a provision to increase the average annual gross receipts test from $10 million to $25 million. With this expanded gross receipts threshold, more companies can now utilize any allowable method of recognizing revenue from each contract. The completed contract method will be much desired, as it allows a taxpayer to defer all revenue from a contract until its completion. The ability to defer revenue recognition until the contract is completed provides the taxpayer ample time to collect billings from the customer, which in turn provides the necessary cash flow to pay the taxes on that income.
Contractors require large investments in machinery and equipment, and huge amounts of capital must be contributed to the purchase of new M&E every year, which can cause a strain on cash flow. The Tax Cuts and Jobs Act provides a new provision that allows taxpayers to take a deduction for the full cost of capital purchases made each year. This is referred to as 100% bonus depreciation—under the old laws, a taxpayer could immediately expense 50% of the cost of new fixed assets and was required to depreciate the remaining cost over the asset’s useful life (which was roughly five years). The new law not only increases the immediate expense limitation from 50% to 100%, but also allows both new and used property. In order to be considered qualified property for the purposes of 100% bonus depreciation, the asset must have a tax depreciable life of 20 years or less. This includes computers, furniture, vehicles, construction equipment, parking lots, land improvements and certain real property improvements. The only downside to this new provision is that it is only available until 2023, and will begin to phase down until it is full eliminated after 2026.
An alternative to the 100% bonus depreciation is what is called Section 179 expensing. Similar to bonus depreciation, it allows businesses to expense the full cost of both used and newly acquired qualified property. The difference between 179 expensing and 100% bonus is the former is capped, while the 100% is not. Prior to the Tax Cuts and Jobs Act, the cap on 179 expensing was $500,000, but the new legislation increased that cap to $1 million.
An additional limitation that applies to 179 expensing, but not 100% bonus, is businesses are only allowed to place into service $2 million worth of fixed assets in a tax year before the $1 million cap begins to phase down. Once the value of fixed assets reaches $2.5 million, the deduction is phased out. 179 expensing and 100% bonus can be used together; this does not have to be a “one or the other” scenario.
With all these new provisions, the time is now for construction businesses to start a conversation on how to plan for and adjust to these changes.