Tax Reform Changes Affecting Contractors
Note: This article was published to promote the TCJA; however, at the time of publication, the U.S. Treasury had not yet issued proposed regulations explaining the changes in detail. Some information contained here may be outdated.
When the conferees got together to combine the House and Senate bills they took some of the best provisions from the House bill regarding the construction industry. Here is a list of some of the significant business and individual changes affecting contractors in the Tax Cuts and Jobs Act.
Tax Rates Reduced
For contractors doing business as a C corporation, the rates are decreased to a flat 21%, from the top rate of 35%, for taxable years beginning after January 1, 2018. Corporations with a fiscal year that straddles December 31, 2017 will have a blended rate. For owners of pass-through entities and sole proprietors, the top individual rates are also decreased from 39.6% to 37%. The initial proposals called for a simpler rate structure, but the final bill left the number of brackets unchanged at seven with rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The changes in individual rates and the other individual changes are not permanent and are set to expire after 2025.
Small Contractor Exemption
The small contractor exemption is increased from $10 million to $25 million. This is the threshold that partly defines which contractors are allowed to use a method of accounting other than the percentage-of-completion method for their long-term contracts as long as the contract is expected to be completed within two years. Effective January 1, 2018, only those contractors with average gross receipts over $25 million are required to use the percentage-of-completion method.
The $10 million threshold established in 1986 was never increased for inflation, so this is a welcome change. The Senate bill called for an increase to $15 million, so this is a pleasant surprise for small contractors and will allow those contractors with average gross receipts between $10 million and $25 million to account for their long-term contracts under their established exempt method. Exempt methods, for example, could include the completed-contract method or the contractor’s overall accounting method such as the cash, accrual, or accrual less retention methods.
Contractors affected by this provision would change methods on a cut-off basis. In other words, any contract started before 2018 would continue to be accounted for on the percentage-of-completion method and any new contracts that begin in 2018 would be accounted for under the exempt method.
More Relief for Small Taxpayers
Other gross receipt thresholds in the law that are used to determine who must use the accrual method of accounting and account for inventories are also increased from $10 million to $25 million. This change will benefit subcontractors that have inventories with average gross receipts under $25 million that previously were required to use the accrual method.
Alternative Minimum Tax
The Alternative Minimum Tax (AMT) is eliminated for C corporations, but unfortunately remains for individual taxpayers including owners of pass-through entities. The good news is that the AMT exemptions and phase-out limits were significantly increased. The exemption was increased to $70,300 (single) and $109,400 (married filing jointly) from $55,400 (single) and $86,200 (married filing jointly).
The exemption amounts are reduced by 25% of the alternative minimum taxable income above $500,000 (single) and $1 million (married filing jointly) which is a significant increase from $123,100 (single) and $164,100 (married filing jointly). This means many individual taxpayers whose AMT exemptions were phased out and subject to AMT in the past will likely no longer be affected by it. Unfortunately, one of the requirements under AMT is that small contractors previously mentioned must calculate their long-term contracts under the percentage of completion method for AMT purposes. This means that those pass-through entities that are small contractors will still be required to calculate their long-term contract adjustment and look-back calculation for AMT purposes, even though the owners may not be subject to AMT due to the increased thresholds.
The new 20% deduction for pass-through entities is unprecedented and since many construction firms operate under some form of pass-through structure, this deduction will benefit many in the construction industry.
Fortunately, when the conferees came up with the final bill, they made some favorable changes from the initial proposals. For instance, because the deduction generally applies to pass-through entities in a “qualified trade or business,” which excludes service trades, architectural and engineering firms initially were not going to be able to take advantage of this deduction. In the final bill, however, both architectural and engineering services are exempted from this exclusion, leaving those industries among the qualified trades or businesses that are eligible for the deduction.
Trusts were also originally excluded from taking the deduction, but this exclusion was also taken out in the final bill. The availability of the deduction is limited in several ways. Both the House and Senate versions had varying limitations on this deduction, but in the final bill, the deduction is generally limited to the greater of (a) 50% of W-2 wages, or (b) 25% of W-2 wages plus 2.5% of qualified property.
This limitation is best explained in an example. Assume a subcontractor, which is an S corporation with one shareholder, has $7 million in qualified income after paying wages to the shareholder of $500,000 and $2.5 million to its other employees. The subcontractor also has invested in machinery and equipment with an unadjusted basis immediately after acquisition of $10 million. The shareholder would first compute the 20% deduction of $1.4 million ($7 million x 20%). Then, the shareholder would compute each wage limitation. The 50% limit would be $1.25 million (50% x wages of $2.5 million). For the other limitation, the limit would be $875,000 (25% x wages of $2.5 million plus 2.5% of the $10 million in equipment). Because the $1.25 million is the larger of the two wage limitations, but smaller than 20% of qualified business income of $1.4 million, the deduction would be limited to $1.25 million.
There are a few things to keep in mind when computing the limitations:
- W-2 wages do not include wages paid to S corporation owner-employees or guaranteed payments to partners.
- Eligible W-2 wages are allocated to shareholders and partners in the same proportion as the original deduction for such wages.
- Qualifying property is limited to tangible property held by and available for use in a qualifying pass-through trade or business. For example, if the property is sold during the year it cannot be used in determining the wage plus property limitation. The property can be included in this calculation each year until its depreciation period has ended. A special 10-year minimum depreciation period is deemed to exist solely for this purpose, even if the MACRS period ends sooner than 10 years.
It’s important to note that the wage limitations do not apply if the owner’s taxable income is less than $157,500 (single) and $315,000 (married filing jointly). There is also a range over which relief from these limits will be phased out with the limits being fully applicable for taxpayers whose income exceeds $207,500 (single) and $415,000 (married filing jointly).
In addition, the exclusion from the definition of a qualified business income for specialized service trades or businesses will not apply for taxpayers under these taxable income thresholds, meaning this deduction will be available to smaller taxpayers in any trade or business.
The new law will also make investing in capital more lucrative. The 50% bonus depreciation is increased to 100% for most property. A pleasant surprise in the bill is this provision will apply to property placed in service after September 27, 2017. So, some taxpayers will benefit from this additional deduction on their 2017 returns. Another surprise is that the final bill included a proposal in the House bill that the 100% expensing apply to used property as well as new, unlike the prior bonus depreciation rules. The 100% expensing expires after January 1, 2023 and will phase down 20% per year until it’s completely phased out in 2027.
Section 179 Deduction
The §179 provision remains and the annual limit is increased to $1 million and will begin to phase out after qualifying purchases exceed $2.5 million. The §179 provisions are made largely irrelevant as a result of the 100% bonus depreciation. However, certain real property improvement, that may not be eligible for the bonus depreciation, are eligible under §179, including certain structural components to nonresidential buildings including roofs, HVAC, fire alarm systems, and security systems.
Business Interest Deduction
Business interest deductions will be limited for any type of entity, to the sum of interest income plus 30% of adjusted taxable income. For this purpose, adjusted taxable income is equal to taxable income computed without regard to deductions for interest, depreciation, amortization, depletion, and net operating losses. It is important to note that businesses with average annual gross receipts for the prior three years of $25 million or less are exempt from this limitation. Any unused interest expense is carried forward indefinitely.
Certain real property trades or businesses, such as construction, can make an irrevocable election out of this limitation if they depreciate real property used in their trade or business under the alternative depreciation system (ADS).
The ADS is principally a straight-line depreciation system, with no half-year convention, where property is depreciated over a longer recovery period. The regular cost recovery periods is 39 years for nonresidential real property and the ADS recovery period is 40 years, so there is not much of a difference in depreciation there. However, the regular cost recovery period for qualified improvement property is increased from 15-20 years under the ADS.
Also, the 100% expensing does not apply under the ADS, so this could be a significant difference in depreciation expense. However, 179 depreciation would apply under the ADS. The definition of qualified improvement property was expanded to include any improvement to an interior portion of a nonresidential building after the building has been placed in service and is not attributable to the enlargement or structural framework of the building.
To help pay for the lower tax rates certain deductions popular in the construction were eliminated, including the domestic production activities deduction or DPAD. The DPAD deduction is repealed for tax years beginning after December 31, 2017. Also, net operating losses will no longer be available to carryback to the prior two years but are now carried forward indefinitely. The use of net operating losses, however, will now be limited to 80 percent of taxable income for losses created in taxable years beginning after December 31, 2017.
Furthermore, business losses for noncorporate taxpayers are now limited to $250,000 per year (single) and $500,000 (married filing jointly) for tax years beginning after December 31, 2017 and before January 1, 2026. This limitation applies to all personal and pass-through losses for the year, so an individual is now prohibited from deducting losses from pass-through entities in excess of these levels. Any disallowed losses are added to the individual’s net operating loss carryforward. Finally, no portions of entertainment expenses are deductible but the 50% limitation for meals largely remains in place with some modifications.
There is a lot to digest in the new tax bill. CFMA’s Tax and Legislative Committee will continue to evaluate these changes and will monitor any technical corrections bills and IRS regulations that are surely to follow.
Cord D. Armstrong, CPA, CCIFP, is a Managing Director in the Tax Department of CBIZ MHM, LLC and shareholder in Mayer Hoffman McCann, PC in Phoenix, AZ, where he is involved in all aspects of federal and state taxation, including compliance, planning, and research for both individuals and business entities.
Cord has more than 25 years of experience in public accounting, is a member of the firms National Construction Industry Practice Group, and currently serves as the Chair of CFMA’s Tax and Legislative Affairs Committee.