As 2022 progresses towards the finish line, it’s time to make some final decisions on year-end tax strategies. While many contractors subscribe to the age-old strategy of deferring income and accelerating deductions (more on this later), for certain contractors, the month of December might be a time to implement the reverse strategy.
Massachusetts Fair Share Amendment – “Millionaire’s Tax”
As part of the mid-term elections, 52% of Massachusetts residents voted their approval for a constitutional amendment that will create a 4% surtax on income in excess of $1 million beginning in 2023. You can read about this surtax here. The majority of construction contractors doing business in Massachusetts are organized as pass-through entities, which means that their net income from operations gets reported on their personal income tax and added to other sources of income to create their taxable income base. As a result, Massachusetts residents or non-residents with Massachusetts source income in excess of $1 million could see a portion of their 2023 income subjected to this tax.
How might a Massachusetts contractor with shareholders that expect to earn greater than $1 million minimize the impact of this surtax?
Cash Basis Planning - If utilizing the cash method of accounting for tax purposes, delay payment of invoices until 2023 and more aggressively seek collection of receivables prior to the close of 2022.
Revenue Recognition Planning - If utilizing the percentage of completion method for tax accounting purposes, consideration could be given to making less conservative (but still realistic) cost estimates to recognize more profit in 2022.
Contractors that previously made the binding election to defer gross profit on all jobs not yet 10% complete might endeavor to have all 2022 completion percentages exceed that threshold.
Deduction Timing Planning - If paying year-end bonuses or profit-sharing contributions, perhaps timing payment such that the deduction is received on the 2023 filing, rather than 2022, is the more prudent measure.
Capital Asset Planning - Contractors looking to make large equipment or vehicle purchases may opt to change those capital purchases in early 2023 in order to take the write-off in 2023.*
*Low inventory availability could make this a moot point as many dealers have significant backlogs.
Be Wary of Lookback Interest
Large contractors utilizing the percentage of completion method need to be cognizant of the requirement to calculate lookback interest during the year in which a contract completes. Effectively, once a long-term project is complete, the contract must be re-evaluated using actual data to determine how far off income recognition was in prior years when it was based on estimates. In a high interest rate environment, such as the one that we are in, profit pick up late in a project could prove costly, especially since it is generally not a deductible business expense.
Construction Accounting Methods
Contractors that do not project to exceed the $1 million income threshold in 2023 or those that just don’t have an appetite for accelerating tax payments would be wise to review their tax methods of accounting.
Small Business Taxpayer Exception
A contractor with average gross receipts of $27 million or less over the previous three years is not subject to IRC § 460 requirement to report long-term contracts using the percentage of completion method. Subject to an adjustment for alternative minimum tax (AMT) purposes, a contractor may report long-term contracts, and all contracts for that matter, under a more tax-efficient method of accounting such as the cash method or completed contract. Contractors that have not been taking advantage of the exception may file Form 3115, Application for Change in Accounting Method to request an automatic change in method.
Other automatic accounting method-related exceptions that a small contractor may be able to pursue:
The requirement to maintain inventories under § 471
Exemption from uniform capitalization provisions under IRC § 263A
A contractor does not need to meet the small contractor exception requirement to potentially defer income. The following opportunities may exist:
<10% Complete Deferral - The election to defer gross profit on contracts less than 10% complete
Home Construction Contracts - The exemption from the percentage of completion requirement for home construction contracts
Residential Construction Contracts - The ability to utilize the Percentage of Completion-Capitalized Cost (PCCM) to defer 30% of the profit on residential contracts
Service & Short-Term Contracts - The ability to utilize the cash method for service contracts and potentially short-term contracts
Retainage Deferral - The ability to take advantage of paid when paid clauses to defer retainage payable and potentially other subcontractor payables
With the exception of the less than 10% complete election, all would be considered accounting method changes and would require advanced consent from the Commissioner. This requires the filing of Form 3115 with a user fee prior to the end of the tax year in which the change would go into effect.
State Pass-Through Entity
Around this time last year, Massachusetts was introducing their variation of the “Pass-Through Entity Tax” following other states that had previously gone the route. A Pass-Through Entity Tax (“PTET”) regime has been a state’s attempt to work around the state tax deduction cap that had been put into place as part of the Tax Cuts and Jobs Act. Effectively, a company organized as a pass-through entity, elects to pay the state income tax that would otherwise be payable by the shareholders or partners directly. In doing so, a deduction is permitted to reduce federal ordinary income in accordance with Notice 2020-75. While nuances exist that slightly erode the economic benefit, in general, it is a win for taxpayers.
Given the timing of Massachusetts’ introduction of their program in late 2021, many taxpayers did not benefit to fullest extent possible. The PTET should be evaluated for all profitable pass-through entities, not just operating companies. In terms of timing, while there is some ambiguity in the Notice, most advisors agree that the safest way to ensure current year deduction is to make the PTET payment by the last day of the tax year.
Enhanced Tax Incentives of Inflation Reduction Act
The Inflation Reduction Act extended the expired §45L New Energy Home Credit, increased its availability to more property types (i.e.; high rise apartments) and made the benefit more lucrative. The credit, which was previously capped at $2,000 per dwelling unit, has increased to $2,500 per unit with the potential to reach $5,000 if Zero Energy Ready Home Program conditions are met. Developers and building owners would be wise to bring their project to the attention of an energy consultant as early in the process as possible.
The §179D Energy Efficient Commercial Buildings deduction is a tax deduction that has historically been available to building owners or designers of government-owned buildings that build or improve energy efficient commercial property. Whereas previously the deduction was worth up to $1.88 per square foot, it could now reach as high as $5.00 per square foot with 50% energy savings if the owner or designer meets the prevailing wage and apprenticeship requirements.
Perhaps the most significant change for design builders is the fact that, beginning in 2023, buildings owned by other tax-exempt entities, beyond government agencies, would be eligible for the deduction. Again, design builders would be well served to connect with an energy consultant that can perform the required study as soon as they perceive potentially eligibility.
Maximizing Section 199A Deduction
The Section 199A deduction, or Qualified Business Income (“QBI”) Deduction, was first introduced as part of the Tax Cuts and Jobs Act and, in general, is a deduction equal to approximately 20% of a pass-through entity’s profits, subject to certain limitations. As construction industry activities clearly qualify for the deduction, attention should be given to owner and partner compensation arrangements to ensure that the QBI deduction is being maximized.
Maximizing Interest Expense Deductions
Heavily leveraged companies that average more than $27 million in gross receipts are going to find it more challenging to deduct their interest expense currently beginning in 2022. The Tax Cuts and Jobs Act significantly expanded the existing limitations on the timing of interest deductions. Companies are only allowed to deduct interest expense up to 30% of Adjusted Taxable Income. Any excess gets carried forward. Prior to 2022, adjusted taxable income was equal to taxable income after adding back the interest expense, depreciation and amortization expense. Beginning in 2022, the adjusted taxable income base is no longer increased by the depreciation and amortization expense addback. Between this changing provision, higher interest rates, and potentially lower profits due to higher costs, a lot of interest expense is set to be trapped and carried forward.
A construction or real estate business that finds themselves subjected to these limitations may wish to consider opting out of the limitations by making an irrevocable Real Property Trade or Business Election in exchange for longer depreciation lives on certain assets, most notable Qualified Improvement Property.
Taking Advantage of Accelerated Depreciation
The government often looks to accelerated depreciation techniques as a means of stimulating the economy. Since the passing of the Tax Cuts and Jobs Act, companies have been able to utilize “Bonus Depreciation” to immediately write of 100% of the cost of machinery & equipment, most business use vehicles, and even interior tenant improvements. Beginning in 2023, the first year write off will decrease to 80% and will continue to decrease in increments of 20% until completely phased out in 2027.
Fortunately, bonus depreciation is not the only mechanism to fully write off assets in the year placed in service. Section 179 expensing will still remain as an option but, unlike bonus depreciation, comes with several limitations including the amount that can be claimed in a given year ($1,080,000 for 2022).
Businesses should not overlook the option to automatically expense the cost of fixed assets below certain thresholds. Referred to as the De Minimis Safe Harbor election, so long as consistent with their book capitalization policy, a company that has audited financial statements prepared may immediately expense any asset costing less than $5,000 ($2,500 if no AFS).
Building owners may want to consider having a Cost Segregation study performed on their property to potentially accelerate depreciation deductions. While non-residential buildings typically must be depreciated over 39 years, a cost segregation study could determine that there are component assets that can be carved out into shorter depreciable lives that might be eligible for bonus depreciation. Even if the property was placed in service in a prior year, it may not be too late to benefit from a study. As an added benefit, having the building broken down into smaller components may make it easier to write off any remaining basis in the future when the component is replaced.
Other Tax Credits to Consider
The Research & Development Tax Credit provides an opportunity for contractors, especially those that do a lot of design build work, to monetize some of the costs that they incur while trying to eliminate areas of uncertainty. The following could potentially be characterized as eligible activities: value engineering, pre-construction planning, efficient energy, power, or water usage designs or improvement, use of BIM modeling, and development of innovate methods and techniques to improve the construction process to create efficiencies. There is a Four-Part test that the IRS requires to be performed to evaluate activity eligibility.
Related to the R&D credit, contractors should be aware of a new requirement that went into effect in 2022 with respect to research and development expenses, regardless of whether a credit is being claimed. Effectively, research and development expenses, including all software development costs, are required to be amortized over five years (15 years if the activities were performed internationally). Prior to this change, which was put into effect as a revenue raiser within the Tax Cuts & Jobs Act, these expenses could be deducted immediately.
The Fuel Tax Credit allows businesses that operate fuel-powered machinery and equipment to recover the excise taxes paid in conjunction with the cost of the fuel. These taxes are only intended to be levied on highway-use vehicles so owners of non-highway vehicles should be aware that there is a means to recover.
By now, most companies are aware of the Employee Retention Credit. While it has definitely come under intense IRS scrutiny for abusive claims, companies that suffered significant revenue losses during 2020 and 2021 or adhered to government shutdown requirements, should not feel deterred from filing amended payroll tax returns to claim the credit if their fact pattern warrants.
Other Tax Planning Considerations
Considering most construction companies and/or real estate developers are structured as pass-through entities, it’s important to consider steps that you can take at the personal tax level to reduce taxes.
Retirement Contributions - Maximizing retirement contributions will reduce taxable wages which will drive down tax liabilities.
Roth IRA Conversions – With portfolio values depressed, some may consider this an ideal time to convert traditional IRAs into Roth IRAs to take advantage of future tax-free appreciation.
Capital Loss Harvesting - Investors with unrealized capital losses inside their portfolio may want to realize some prior to the end of the tax year, especially if they incurred capital gains on the sale of property or a business.
Charitable Contribution Planning - Taxpayers whose itemized deductions closely approximate their standard deduction may wish to bunch up multiple years’ worth of charitable deductions to maximize total deductions.
Contributing into a Community Development Corporation could provide added benefit as a Community Investment Tax Credit (CITC) may be available to go along with the federal deduction.
Donating appreciated stock in lieu of cash allows for a fair market value deduction without first having to pay tax on the appreciated gain.
Taxpayers over the age of 70 ½ are permitted to make a qualified charity donation up to $100,000 directly from an IRA, which can provide advantages over donations from other sources.
Energy Efficient Tax Credits - Consider deferring energy efficient home improvements until 2023 to take advantage of the enhanced credit put into effect by the Inflation Reduction Act. Beginning in 2023, taxpayers will have a $1,200 annual credit that can be used to offset 30% of the cost. Doors, windows, energy equipment and even home energy audits are all eligible but may be subject to their own limitations.
Estate & Gift Tax Planning - Beyond income tax planning, owners of construction companies, especially well-established businesses, would be wise to evaluate their estate and gift tax positions on an annual basis. Individuals that project to have a taxable estate which, for Massachusetts residents, is anyone that owns more than $1 million in assets, should consider whether they want to engage in gifting strategies. The annual gift tax exemption for 2022 is $16,000 (increasing to $17,000 in 2023). This means that, in 2022, an individual can give away up to $16,000 to as many individuals as they choose without it impacting their lifetime estate tax exclusion. A married individual can double that gift if their spouse is willing to split the gift with them.
This is clearly a lot to think about and, in a lot of cases, not a lot of time left to do it. If you haven’t already, we highly encourage you to schedule an appointment with your EJC contact before the end of the year. We would be happy to discuss anything contained in this summary or other tax planning related questions.
About the Author:
Jeffrey T. Rogers, CPA, MST
Jeff has over 16 years of experience specializing in tax planning, tax research & compliance, IRS & State Exam Representation, Mergers & Acquisitions, and Business succession & ownership transitions with a focus in the construction, real estate, non-profit, restaurant, manufacturing & distribution industries. He helps businesses adopt the most tax efficient accounting methods available to them and identifies all tax credit and incentives to which they may be entitled. In recent years, Jeff has developed a deep understanding of the Employee Retention Credit program and has presented on the topic for multiple trade associations, Chambers of Commerce, and at other business events. He was published in the Boston Business Journal and the Cape and Plymouth Times on the subject matter.
Prior to joining E.J. Callahan & Associates, Jeff has served as both a Partner and Director at regional and national CPA firms. He holds a Bachelor of Science Degree in Accounting from Merrimack College and a Master of Science degree in Taxation from Bentley University. Jeff is an active member of the American Institute of Certified Public Accountants (AICPA), the Massachusetts Society of Certified Public Accountants (MSCPA), and the CFMA. Jeff is also on the MSCPA Taxation Committee, a Board Member for the Danvers American Little League and a volunteer coach in several youth sports programs.
Check out Jeff's work:
Boston Business Journal - July 1, 2021
Cape & Plymouth Business Media - December 2021 Issue, pg. 19
"Connecticut Sales Tax for Construction Contractors" Webcast
"Accounting Methods for Contractors" Webcast
"Tax Implications of Distributions from S-Corporations" Webcast
"Massachusetts Sales & Use Tax for the Construction Industry" Webcast
"Tax Planning & Incentives for Contractors" Webcast