2023 Year End Tax Planning for Contractors

With 2023 drawing to a close, now is the time to think through moves that can be made to reduce the annual tax burden. As has seemingly been the case the last year or two, changes on the state side of the tax law could provide the most opportunity for the 2023 tax year.

Massachusetts Act to Improve the Commonwealth's Competitiveness, Affordability, and Equity

As was discussed in this article, on October 4th, 2023, significant state tax legislation was passed. Between increases to the renter’s deduction, the child tax and other credits, reduced short-term capital gains tax rates, and increased estate tax exclusion thresholds (more on this later), there are a number of new ways to keep extra cash in Taxpayers' pockets.

Massachusetts’ decision to change to a single sales factor approach to apportioning multi-state business income beginning 2025 should have Massachusetts companies starting to think through how they can maximize out of state sales with predominantly in state payroll and property resources.

For 2023, for certain taxpayers, one of the most lucrative planning opportunities may result from a loophole that the tax bill actually closed – just not until 2024. First, a call back to, arguably, 2022’s most significant tax change….

Massachusetts Fair Share Amendment – “Millionaire’s Tax”

As part of the 2022 mid-term elections, a constitutional amendment was passed that created a 4% surtax on income in excess of $1 million beginning in 2023. More information about this surtax can be found 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 return 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.

A year ago the planning point of discussion was how to potentially accelerate income into 2022 to avoid the looming surtax. A year later a new strategy has emerged. Analysts who had closely read the guidance noted that the $1 million taxable income hurdle applied on a per return basis. In theory it was thought that, married taxpayers with more than $1 million in taxable income might be able to reap a surtax savings by filing separately in the state of Massachusetts. Married taxpayers filing separately is almost never a tax efficient strategy when paying tax to the federal government. In fact, it’s usually pretty costly. However, prior to the passing of the tax reform bill, nothing prevented married taxpayers from filing jointly with the IRS and separately in Massachusetts. As a result of the bill, Massachusetts now requires filing status consistency between federal and state returns – but not until 2024. Given that the Millionaire’s Tax is in effect for 2023 and the consistency requirement doesn’t go into effect until 2024, an opportunity appears to exist to file separate MA returns in 2023 to subject less income to the surtax.

Construction Accounting Methods & Income Deferral Strategies

With no known income tax increases on the horizon, a somewhat uncertain economy, and higher than typical interest rates, cash savings via income tax deferral is once again a sound planning strategy. As has been well documented, construction contractors have to adhere to the requirements of Internal Revenue Code Section 460 for long-term contract reporting. There are exceptions to every rule and, with respect to construction accounting methods, there are many.

Small Business Taxpayer Exception

A contractor with average gross receipts of $29 million or less over the previous three years is not subject to the 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.

Worth noting is that the aforementioned AMT does not apply to companies structured as C-Corporations. When evaluating accounting method options, a choice of entity analysis may be prudent.

Cash Basis Planning - If utilizing the cash method of accounting for tax purposes, now is the time of year to really start focusing on the company’s cash activity in order to manage the most optimal result. To the extent that it makes business sense, putting greater emphasis on getting those payable or accrual balances down by the close of the year may be wise along with possibly prepaying some expenses that wouldn’t otherwise be deducible until 2024. Paying bonuses in December rather than January should be considered. Recognizing that slowing down billing and collection efforts is almost never a sound business practice, taking the foot off the pedal as the tax year draws to a close can provide tax benefit.

If cash for expense paydown is limited, focus on the non-job accounts payable along with the amounts that are attributable to service or short-term contract work. Payables related to long-term contracts should have the lowest priority as those may be subject to an AMT adjustment.

Be Wary of Lookback Interest

Many contractors that utilize the percentage of completion method for tax accounting purposes have managed their estimated cost to complete figures to reduce profit recognition in part to be more conservative in their GAAP financial statement presentation.

Large contractors utilizing the percentage of completion method recognize that the requirement to pay “lookback” interest during the year in which a contract completes is a cost that they need to deal with on the back end. Essentially, the lookback rules require that, 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.

State Pass-Through Entity Taxes

Now into Year 3 of Massachusetts Pass-Through Entity Tax (“PTET”) regime and with many issues having been worked through, most advisors would agree that paying into the PTET system is a key piece of any annual tax planning strategy and should be maximized to its fullest potential. A Pass-Through Entity Tax 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 has definitely been a win for taxpayers.

Enhanced Tax Incentives of Inflation Reduction Act

The Inflation Reduction Act, which was passed in 2022, 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, now 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 potential 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 $29 million in gross receipts have found it more challenging to deduct their interest expense currently since 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 last year (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 off 100% of the cost of machinery & equipment, most business use vehicles, and even interior tenant improvements. However, 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 ($1,160,000 for 2023).

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 and residential buildings over 27.5 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 and take a retroactive deduction. 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 or disposed.

Other Tax Credits to Consider

The Research & Development Tax Credit has historically provided 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. While the credit still exists and can be lucrative, measures have been taken to make it more difficult and time consuming to claim the credit with the potential for more scrutiny.

Related to the R&D credit, or more specifically, the research & experimentation expenses that are necessary to claim the credit, contractors should be aware of a new requirement that went into effect in 2022 that is relevant regardless of whether a credit is being claimed. Effectively, research and development expenses, including most software development costs, are required to be amortized over five years (15 years if the activities were performed internationally). The more troubling part of this development is that the R&D expenses that are eligible for consideration in the R&D credit calculation represent only a small portion of the research & experimentation expenses defined in Section 174 that must be amortized.

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. While advisors knew that this change was on the horizon, the majority felt very confident that it would be repealed before it ever went into effect. Though discussions did take place, there was no change and, instead, guidance was released during 2023 confirming its place in the law.

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.

All businesses should have the Work Opportunity Tax Credit (“WOTC”) on their radar as part of their hiring strategy through the end of 2025. The WOTC is a credit jointly administered by the Internal Revenue Service (IRS) and the Department of Labor (DOL). It may be claimed by any employer that hires and pays or incurs wages to certain individuals who are certified by a state workforce agency as being a member of one of 10 targeted groups, with certain veterans being among them. In general, the WOTC is equal to 40% of up to $6,000 of wages, which is a maximum of $2,400 per employee.

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.

Utilizing Lower Tax Brackets – It can be tempting to employ a tax strategy in a given year that will eliminate all or most of your tax liability. However, if you typically find yourself in the top income tax paying bracket (currently 37%), not utilizing the lower brackets, particularly the 10%, 12%, 22%, and 24% brackets, along with the permitted standard or itemized deductions may not be tax efficient.
Retirement Contributions - Maximizing retirement contributions will reduce taxable wages which will drive down tax liabilities.
Roth IRA Conversions – With portfolio values somewhat depressed, some may consider this an ideal time to convert traditional IRAs into Roth IRAs to take advantage of future tax-free appreciation. It’s an ideal strategy in a year where you project to be in a lower tax bracket than you are typically accustomed.
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. This is especially the case if the gain will be subject to the MA Millionaire’s Tax.
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.

o 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.

o Donating appreciated stock in lieu of cash allows for a fair market value deduction without first

having to pay tax on the appreciated gain.

o Taxpayers over the age of 70 ½ are permitted to make a qualified charity donation up to $100,000

directly from an IRA to satisfy their required minimum distribution requirement. Contributing to

charity in this manner can be very beneficial for those taxpayers who are utilizing the standard

deduction.

Energy Efficient Tax Credits - The Inflation Reduction Act enhanced the energy efficient home improvement credit. 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 $2 million in assets, should consider whether they want to engage in gifting strategies.

The annual gift tax exemption for 2023 is $17,000 (increasing to $18,000 in 2024). This means that, in 2023, an individual can give away up to $17,000 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.

In addition, MA residents would be wise to revisit their estate plan with their attorneys because, as alluded to in the beginning of this article, the state has doubled the estate exclusion. In addition, the cliff effect has been removed that previously subjected the tax on dollar $1 if the entire estate value eclipsed $1 million. Now, $2 million of assets will be excluded from the tax.

This is clearly a lot to think about and, in a lot of cases, not a lot of time left to do it. We highly encourage you to schedule an appointment with an EJC Partner right away. We, at EJC, would happy to discuss anything contained in this summary with anyone that has questions.

About the Author:

Jeffrey T. Rogers, CPA, MST

Jeff has 18 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.

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