The passage of a new tax law in December was intriguing, if not downright exciting, news for most construction company owners. Now that the dust has settled, this article takes a look at some highlights, including reduced tax rates and boosted depreciation deductions. A sidebar points out that some valuable tax breaks have been eliminated or limited.
For starters let’s take a look at some of the highlights of the Tax Cuts and Jobs Act ("TCJA").
Tax rates reduced
Most construction companies will see their tax rates go down in 2018. The TCJA reduces the C corporation income tax to a flat 21% rate. Previously, corporations were subject to graduated tax rates ranging from 15% (for taxable income up to $50,000) to 35% (for taxable income over $10,000,000), with rates as high as 39% at certain income levels in between.
Construction companies organized as pass-through entities — such as S corporations, partnerships, limited liability companies and sole proprietorships — are still taxed at their owners’ individual rates. But the TCJA benefits these owners in two ways. First, it lowers individual income tax rates, with the top rate dropping from 39.6% to 37% (through 2025). Second, the law allows pass-through owners to deduct 20% of their qualified business income, which translates into an effective top marginal rate of 29.6% on business income.
A reduced deduction is available to owners whose taxable income exceeds a specified threshold ($157,500 for individuals; $315,000 for joint filers). For these owners, the deduction is limited to the greater of 50% of the company’s W-2 wages, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property (generally, depreciable tangible property used in the business).
This provision doesn’t change the requirement to pay reasonable compensation to owners; rather, it’s designed to prevent owners from abusing the new deduction by recharacterizing wage income as business profits.
Depreciation breaks increased
The TCJA allows 100% bonus depreciation (up from 50% in 2017 and 40% in 2018) for equipment, certain building improvements and other qualifying assets placed into service after September 27, 2017 and before 2023. After that, the tax break will phase out by the end of 2026. For the first time, bonus depreciation is available for both new and used assets.
Additionally, the act permanently increases the Section 179 expensing limit, allowing you to deduct, rather than depreciate, up to an inflation-indexed $1 million (previously, $500,000) in new and used equipment and other qualifying assets. The new threshold applies to property placed in service in tax years beginning after December 31, 2017. Eligible assets now include certain depreciable personal property used to furnish lodging, as well as roofs, HVAC systems, fire protection and alarm systems, and security systems added as improvements to nonresidential buildings.
The deduction is phased out once a company’s total purchases for a year exceed an inflation-indexed $2.5 million (up from $2 million).
Estate tax exemption doubled
For the estates of persons dying and gifts made after December 31, 2017, the TCJA doubles the estate, gift and generation-skipping transfer tax exemption amounts to an inflation-adjusted $11.18 million ($22.36 million for married couples). The exemptions are scheduled to revert to their previous levels (adjusted for inflation) on January 1, 2026.
This change will ease the cost of succession for some family-owned construction businesses. It also creates opportunities to take advantage of temporarily increased exemptions by making large lifetime gifts or establishing “dynasty” trusts.
Accounting relief expanded
Generally, construction companies are required to account for long-term contracts using the percentage-of-completion (PCM) method, which recognizes revenues and expenses as a job progresses. There’s an exception, however, that allows certain companies with average annual gross receipts of $10 million or less in the preceding three years to use the completed contract method (or another permissible alternative). The completed contract method allows you to defer taxable income until a job is substantially complete.
The TCJA increases the gross receipts threshold to $25 million. It also allows companies whose gross receipts are below that threshold to use the cash method of accounting for tax purposes and to avoid certain inventory and capitalization requirements.
Sidebar: And now some bad news …
Not all of the news regarding the new tax law is good for construction companies. Some valuable tax breaks have been eliminated or scaled back:
State and local tax deductions. The new tax law limits the itemized deduction for state and local income taxes and real estate/property taxes to $10,000 per year. This provision could impact contractors who have larger state and local taxes paid at the individual level because of “pass through” income and/or W-2 income.
Section 199 deduction. This tax break has been eliminated. It allowed many construction companies a deduction for certain qualified domestic production activities.
Net operating loss (NOL) usage. NOLs can be used for only 80% of taxable income for tax years beginning after 2017, and NOL carrybacks are eliminated. The new law does, however, allow you to carry NOLs forward until they’re used. The elimination of the NOL carryback could significantly affect the construction industry because the loss carrybacks available under previous law provided tax refunds that eased cash flow concerns during economic downturns.
Interest expense deductions. Tax deductions for business interest expense are curtailed to business interest income plus 30% of “adjusted taxable income.” There are several exceptions, including a small business exception for companies with average gross receipts of less than $25 million. This restriction offsets the new law’s enhanced accelerated depreciation opportunities.
Now that the New Year is underway, it’s important to dig deep into the TCJA’s provisions and identify tax-planning opportunities for 2018 and the years ahead in order to make the transition into the new law as smooth as possible.
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