How tax reform will affect contractors
INSIGHT ARTICLE |
Tax reform, commonly referred to as The Tax Cuts and Jobs Act (TCJA), was officially passed by Congress on Dec. 20, 2017 and signed into law by President Donald Trump shortly thereafter. The TCJA is a major overhaul of the country’s tax code, and the stated overall goal is straightforward: cut taxes on individuals and businesses, thereby stimulating the economy and creating jobs. Studies have forecast that the new tax codes will cause federal revenues to decrease by $205 billion in 2018 and $323 billion in 2019. But the nation’s GDP is expected to increase over the next few years by 0.25 to 1.5 percentage points.1
The TCJA’s sweeping changes are now officially in effect. These changes can affect how contractors do business, so contractors should be proactive when it comes to understanding and planning for these changes. How will this new legislation affect contractors? Following are a few areas in which tax reform could have the greatest impact:
Capital expenditures and accelerated depreciation
The TCJA expanded the ability to expense capital expenditures. Previously, taxpayers were allowed to expense 50 percent of qualifying assets when placed in service. The TCJA increased bonus depreciation amounts to 100 percent. In addition, the TCJA expanded the definition of qualifying assets to include certain used assets, whereas previously the original use of an asset had to begin with the taxpayer claiming the bonus depreciation. Interestingly, the majority of the provisions in the TCJA were effective Jan. 1, 2018; however this provision is effective for assets acquired and placed in service after Sept. 27, 2017.
In addition to the expanded bonus depreciation provisions, effective Jan. 1, 2018 the maximum amount a company can expense under Internal Revenue Code section 179 has been increased to $1 million—up from $500,000—and related purchasing limits have been increased from $2 million to $2.5 million.
The expansion of capital expenditure expensing options creates significant planning opportunities for contractors. The potential tax cash flow savings generated by immediate expensing of qualifying capital expenditures can help contractors update their equipment fleet and support increased efficiency in operations.
The 100 percent bonus depreciation is slated to be phased out during tax years 2023–2026.
A more well-known aspect of the TCJA is the corporate rate cut, which significantly reduces the amount of taxes businesses must pay. As of Jan. 1, 2018, C corporations have a flat 21 percent tax rate on taxable income, which is a significant decrease from the previous maximum rate of 35 percent.
Comparatively, pass-through entities (S corporations and partnerships) with qualifying business activities (including most contractors) can qualify for a 20 percent deduction from taxable income. It is important to note that the domestic production activities deduction, which afforded most contractors a 9 percent deduction, has been repealed. The availability of the 20 percent deduction is subject to limitations, and an exhaustive recap of those limitations is too lengthy to include here. Generally speaking, if you qualified for the previous domestic activities production deduction, then you should qualify for the 20 percent pass-through deduction. This deduction is calculated at the individual taxpayer level, so business activities unrelated to the construction activities can affect the availability of the deduction.
The significant change in corporate tax rates, coupled with the changes in taxation of income from pass-through entities, leads to a major question for business owners: Are you currently operating in the right entity form? Should your company be classified as a C corporation instead of an S corporation or partnership? Each business and industry is unique, so all variables should be considered. Other than current income tax expense, companies should consider the need to retain earnings, how the owners are compensated, what the exit strategy is and its timing, and other strategic questions that might not normally affect a tax decision. No change should be based solely on the corporate rate cut, but should be given thorough and thoughtful consideration before implementing a change that could affect your business for years to come.
Increased limits for method of accounting
While contractors can use either the cash or accrual accounting method for short-term contracts, they must account for long-term contracts using the percentage of completion method (PCM). Before TCJA, construction companies with average gross receipts of $10 million or less in the preceding three years were entitled to an exception from the requirement to use the PCM method for long-term contracts as long as they met certain requirements. TCJA increased the amount of gross receipts from $10 million or less to $25 million or less.
The TCJA also includes limitations on certain deductions and loss treatment that do not decrease one’s tax liability. The deduction for interest expense is now limited. Starting in 2018, the deduction for interest expense is limited to 30 percent of earnings before interest, taxes, depreciation and amortization. In 2022, the limitation is 30 percent of earnings before interest and taxes.
Taxpayers with average gross receipts of $25 million or less are excluded from this limitation, however. In addition, various exceptions do exist for real estate, utilities, farming and certain small businesses.
Net operating loss limitations
The TCJA also includes a limitation on the carryback of net operating losses (NOL). Previously, a taxpayer that generated an NOL could carryback that loss two years to recoup tax dollars previously paid. This often provided a much-needed cash injection into the business at just the right time. However, the TCJA has eliminated the carryback ability but it now allows the carry forward of such NOLs indefinitely to offset future income and related taxes. In addition to the carryover and carryback changes, the TJCA also introduces a limitation on the amount of NOLs that a corporation may deduct in a single tax equal to the lesser of the available NOL carryover or 80 percent of a taxpayer’s pre-NOL deduction taxable. Interestingly, this limitation applies only to losses arising in tax years that begin after Dec. 31, 2017.
The TCJA has limited the taxpayer’s ability to exchange like-kind assets to certain real property. Like-kind exchanges allowed taxpayers to exchange assets and defer any related gain on the exchange. While this is still the case for certain real property, it is no longer the case for any type of personal property. Think of trading in a car. Under the previous rules, you could trade in your car and there would be no gain or loss recognition on the transaction. Now, gain or loss will be recognized based on the fair-market value of the traded asset compared to its adjusted tax basis. This may not sound like a big deal, but think about trading in heavy equipment that has been fully depreciated. The fair-market value might be a six-figure number that you now have to pick up in income and pay tax on. Theoretically, you should be able to expense the new asset under the provisions discussed above to offset the gain. The real planning has to start when those generous bonus depreciation rules start to phase out and the depreciation offset isn’t there to shield the gain from being taxable.
The TCJA’s comprehensive tax reform highlights the necessity for proactive planning. To ensure you and your business are prepared to take advantage of these changes, a proactive approach isn’t just beneficial, it’s essential. Now is the time to talk with your tax advisor and better understand what you can do to operate tax efficiently and continue to grow your business.
1Jim Glassman, “3 Economic Impacts of the Tax Cuts and Jobs Act” (Jan. 3, 2018), JP Morgan Chase and Co.
Published In: Texas Contractor