It took six years with over 100 Congressional hearings and 10 opinion papers to draft the tax reform legislation now referred to as the “Tax Cuts and Jobs Act.” President Trump signed the legislation into law on December 22, 2017, authorizing a massive piece of legislation that will impact all taxpayers. For the construction industry—whether you are operating as a sole proprietor, Limited Liability Company, “S” corporation, or “C” corporation—the act will change how your tax liability is computed. This article briefly summarizes some of the significant changes to the law. While most of the changes are effective for tax years beginning after December 31, 2017, the changes are generally not permanent and set to expire after 2025.
Tax Rates Reduced
For owners of construction companies operating as pass-through entities and sole proprietorships, the top tax rate is reduced from 39.6% to 37%. Additionally, the rates for most brackets have been lowered and the income range for the bracket has been increased. For contractors operating as C corporations, a 21% flat rate replaces the graduated corporate rate structure that previously had a maximum rate of 35%.
Alternative Minimum Tax
The alternative minimum tax (AMT) system has been eliminated for C corporations. Individuals, including owners of pass-through entities, are still subject to AMT, although the exemption amounts have been increased, along with the phase-out of the exemption amounts. Between the increased exemption and phase-out, many taxpayers who were previously subject to the AMT will no longer be subject to this tax.
Unfortunately, the AMT preference adjustment for small contractors was retained. Small contractors must still calculate their long-term contracts on a percentage-of-completion basis for AMT. For many small contractors this could trigger AMT, despite the increased exemption amounts and phase-outs.
Small Contractor Exemption
The small contractor exemption is increased from $10 million to $25 million in average gross receipts (based on average gross revenue of the three prior years). The exemption allows small contractors to use a method other than percentage-of-completion for accounting for their long-term contracts as long as the contract is expected to be completed within 2 years. Alternative methods available to the small contractor include the completed contract method, accrual less retention, cash, or accrual.
If a contractor is affected by this provision (e.g., had over $10 million but under $25 million in average gross receipts), they could change their accounting method for long-term contracts by use of the cut-off method. The cut-off method would require the contractor to continue to use the percentage-of-completion method for any contracts started prior to 2018. Any new contracts that begin in 2018 would be accounted for under the selected exempt method. For contractors whose average gross receipts are under $10 million, they will be able to continue their exempt method until their average gross receipts exceed the $25 million threshold.
The small taxpayer exception increases the threshold for determining who must use the accrual method of accounting from $10 million to $25 million. This change will benefit many small contractors and subcontractors, particularly those that have inventories that were previously required to use the accrual method of accounting. If a contractor chooses to change their accounting method for long-term contracts, or from the accrual method to the cash method, the contractor will be required to file form 3115, Application for Change in Accounting Method. The form must be filed by the end of the contractor’s fiscal year, and there is a $9,500 fee due to the IRS with the form.
New deduction on Qualified Business Income
The new 20% deduction has been described by many observers as “the new business deduction for pass-through income.” This new deduction does not apply to “C” corporations. However, many other entities with profitable trade or business activity will benefit from the deduction with certain phase-outs. Thus, income from pass-through entities such as partnerships, LLCs, “S” corporations, sole proprietorships (schedule C), and rentals (schedule E) will qualify for the deduction.
Although the deduction is available to all trades or businesses other than “C” Corporations, it has significant limitations on specified service businesses. Note that specifically excluded from the definition of service business are architectural and engineering firms, thus allowing these businesses to take full advantage of this new deduction. Other service businesses are limited with regards to the amount they can deduct once the individual’s taxable income exceeds $315,000.
The bill does include several limitations to the deduction. The first limitation is that the deduction is calculated as the lesser of 20% of Qualified Business Income, or taxable income. Thus, a taxable loss cannot be created with this deduction.
The second limitation is that the deduction is generally limited to the greater of 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of qualified property. These limitations do not apply if the taxpayer’s taxable income is below the threshold of $315,000 (married filing joint) or $157,500 (others) but phase in as taxable income exceeds these amounts.
In summary, this new deduction is a great deduction for qualified businesses and can effectively lower the highest individual tax rate from 37% to 29.6% on trade or business income. However, the deduction is extremely complex and has limitations related to the type of business that is generating the income, the income level of the business owner, the W-2 wages paid by the business, and the amount of assets owned by the business.
The new law makes investing in capital equipment more lucrative from a tax standpoint. The first year depreciation benefit (Section 179) was significantly increased from $500K to $1 million with a phase-out of this amount starting at $2.5 million rather than $2 million. Certain real property improvements will be able to claim Section 179 deductions, including nonresidential building components like roofs, HVAC, fire alarm systems and security systems.
Although this increase is significant, the increase in bonus depreciation or 100% expensing rules are even better for the next several years. Congress increased the bonus depreciation rate from 50% to 100% for most property (other than real property) placed in service after September 27, 2017 through December 31, 2022. After this date, the deductibility is phased down to allow for 20% bonus depreciation after December 31, 2026. Thus, some contractors can actually benefit from this new law in 2017 for purchases made after September 27, 2017, and before their year-end. Another significant change is the expansion of the bonus depreciation, which will now apply to both new and used equipment, rather than just new equipment.
Business Interest Deduction
A new limitation was placed on all taxpayers which may limit the deduction for business interest. The new limit allows a business to deduct interest expense up to 30% of its “adjusted taxable income,” which (for this purpose) is net trade or business income adjusted for interest deductions, depreciation, amortization, depletion, and net operating losses. Any limited or unused interest expense can be carried forward. There is a small business exception where this rule does not apply to most businesses with average annual gross receipts of less than $25 million.
Taxpayers that would otherwise be subject to these new rules can elect out of these new limitation rules by making an irrevocable election to depreciate real property in the trade or business using the alternative depreciation method (ADS), which is generally a slower depreciation method and does not allow for bonus depreciation.
There are several other items in the new law that will affect contractors. A few of the notable items are:
- Deductions for entertainment expenses are disallowed. The 50% limitation for meals was retained with some modifications.
- The deduction for state taxes and personal real estate taxes is limited to $10,000 per year.
- Deductions for employee transportation fringe benefits (e.g., parking, mass transit) are now limited to 50%.
- The 9% domestic production activities deduction (DPAD) is eliminated.
- Net operating losses will no longer be able to be carried back, will have an indefinite carryforward period, and usage will be limited to 80% of taxable income in future years.
- Certain business losses from active trade or business will be limited in their ability to offset other types of income such as interest or dividends if the loss is larger than $500K (married filing joint) or $250K (others). Limited losses can be carried forward.
- The exclusion from tax on lifetime gifts and certain transfer at death was doubled.
- Like kind exchange treatment (1031 exchanges) will be limited to real property exchanges.
As you can see, this is a massive new tax bill that will impact nearly every taxpayer, including contractors. At BFBA, we are prepared to discuss your specific situation and how these changes may impact you and your business.