Despite tariff uncertainties, a tight labor market, and the rising costs of employee benefits, the construction industry has been flourishing in recent years and is expected to continue its economic growth into the next decade. The industry got an added boost from the Tax Cuts and Jobs Act (TCJA), passed at the end of 2017. Three provisions in particular afford contractors unique opportunities to expand and improve their businesses.
1. $25M Gross Receipts Threshold
When taxpayers’ three-year average annual gross receipts are less than $25 million — a new threshold set by the TCJA — they are presented with a host of benefits, including the ability to:
Use the cash method of accounting.
The cash method of accounting was previously only available to C corporations with a three-year average of annual gross receipts less than $5 million, or certain sole proprietors or S corporations with revenues under $10 million. The advantage of the cash method is that revenues are taxable only after cash is received and deductions are allowed after expenses have been paid. Compared to the accrual method, where items of revenue and expense are recognized as they are incurred, the cash method can be much simpler to administer. This simplicity makes it an ideal option for many contractors.
The cash method can also be a lifeline for cash-strapped businesses. Revenues only become taxable upon actual receipt, allowing contractors to more effectively match receipts with tax obligations. Although neither cash nor accrual is inherently superior, contractors benefit when they can choose the option that best supports their strategic goals.
Avoid uniform capitalization.
Uniform capitalization (UNICAP) disallows contractors from fully expensing the indirect costs they incur in the production of inventory. Instead, contractors are required to allocate a portion of indirect costs to be capitalized and expensed over time. Also known as Section 263A, UNICAP calls for a clunky and complex calculation and effectively slows down tax deductions for indirect costs. Most taxpayers avoid calculating UNICAP when given the opportunity.
Fortunately, more contractors will be able to avoid UNICAP with the new $25 million threshold. In prior years, only taxpayers whose average gross receipts were less than $10 million could avoid it.
Avoid the percentage-of-completion method.
Construction contracts spanning two or more years are notoriously difficult to account for. Under prior law, the percentage-of-completion method (PCM) was required for all long-term construction projects if a company’s three-year average annual gross receipts were more than $10 million. The TCJA increased this threshold to $25 million.
When taxpayers use the PCM, they record and pay taxes on a percentage of their contract revenues based on how much of the project has been completed, which often accelerates taxable revenues compared to methods such as the completed contracts method. Going forward, more contractors will be exempted from the PCM requirement and can choose the method that will best defer their tax liability.
2. Accelerated Depreciation
The TCJA increased bonus depreciation from 50% to 100%, but beginning in tax year 2022, it is set to phase out at 20% each year until it sunsets in tax year 2026. Tax reform also expanded Section 179 expensing. Contractors can now immediately expense up to $1 million of capital expenditures (up from $520,000) under Sec. 179. Accelerated depreciation for capital expenditures now also includes used equipment — i.e., equipment that is “new to you.”
Both tax law changes let taxpayers replace old or outdated machinery and equipment and receive full deductions for those expenses. But when bonus depreciation and Sec. 179 expensing are used in tandem, they become even more powerful.
For example, consider the limitations of bonus depreciation: Taxpayers must apply bonus depreciation across each asset class life uniformly. This means they cannot pick and choose which machinery will receive a 100% bonus depreciation deduction and which will be expensed over the asset’s useful life. Fortunately, Sec. 179 expensing does allow taxpayers to pick and choose. Contractors can select just one or two purchases to be expensed under Sec. 179 and the rest can be depreciated using conventional depreciation methods. Together, bonus depreciation and Sec. 179 expensing can help contractors optimize their tax positions.
3. Qualified Business Income (QBI) Deduction
The TCJA established a deduction available to owners of flow-through entities like S corporations and partnerships, as well as sole proprietors. The qualified business income (QBI) deduction lets taxpayers deduct up to 20% of their portion of their business’s qualified business income on their individual tax returns, subject to taxable income limitations. Taxpayers who operate in specified service trades or businesses (SSTBs), such as accounting, consulting, performing arts, and investment management, have additional limitations based on W-2 wages and business assets.
Fortunately, most businesses in the construction industry can escape the SSTB limitations. In U.S. Treasury regulations finalized earlier this year, architecture and engineering services were explicitly excluded from the SSTB definition, enabling them to take the full deduction. More recently, the IRS issued a clarification regarding the SSTB definition that enables contractors to qualify for the QBI deduction too. In its clarification, the IRS said that language that included any trade or business where the principal asset is “the reputation or skill of one or more of its employees or owners” applies only to those taxpayers whose principal asset comes from endorsements, licensing, and appearance fees.
If you would like to discuss other aspects of the TCJA or set up a meeting to address specific issues related to your construction business, contact us today. We serve thousands of construction clients, and we feel confident we can help streamline your business operations so you can grow your business.