Construction contractors are planners by nature. From imagining and designing a project to reviewing the blueprints to getting “shovels in the ground,” the contractor is planning every step of the way. And the planning isn’t limited to just building. The best of the best construction contractor takes that planning discipline into the office, most notably on the financial management side of the business.
In a “cash is king” industry, planning for future financial stability depends on being able to identify the peaks and valleys of operations. But when uncertainty looms, even the best laid plans are in danger of disruption.
Uncertainty can mean several things in the fourth quarter 2020, a year already riddled with challenges. But perhaps the biggest uncertainty was the presidential election and the tax changes proposed by the President-elect Joe Biden; as well as how these changes would impact the construction contractor’s approach to tax planning.
If Senate control remains unchanged (Republican), it would be challenge for the President-elect to get major tax legislation passed prior to 2022 mid-term elections. But an analysis of his plan highlights just how close contractors came to losing some major tax benefits that should not be overlooked this income tax planning season.
Tax Deferral Strategies
Income tax deferral is a popular and effective way for a construction company to finance itself, but its benefits could have been hindered under Biden’s tax plan, which called for raising the top income tax rate to 39.6% for those making over $400,000.
A proactive income tax deferral plan enables the contractor to conserve capital that can be deployed into projects while requisitions are being funded, to avoid a lengthy dip into any credit facilities or looking to ownership to infuse additional liquidity.
This strategy can only be realized by understanding the highly specialized tax rules that govern how a construction company reports the results of their operations. For example, long-term contracts are required to be reported under the percentage of completion method, but anything that is short-term, started and completed in one tax year could be reported under a different, more advantageous method such as cash basis. Traditionally speaking, a contractor would plan to keep a long-term contract’s percent complete lower and attempt to defer cash receipts while accelerating disbursements on the short-term project, thereby lowering the current period’s tax liability by deferring it into a future year.
Under current tax law, ordinary income, which includes wages and the entity’s flow-through income, is subject to seven brackets with a top rate of 37%. Most middle market construction companies are set up as flow-through entities because this structure allows corporate income to be taxed at lower personal income tax rates. This helps the contractor to avoid double taxation (once at the corporate level and again at the personal level if a dividend is issued). While Biden’s plan may have appeared to be a minor rate increase, it was still an impending rate increase, which by its very nature would negate the benefits of deferring income into the future.