A version of this article was previously posted in the August 2018 edition of UCON Magazine.
Periods of economic growth and recession are cyclical. Downturns like the one that started in 2008 aren’t that uncommon, and neither are the booms that follow. That’s why it’s smart for businesses and their owners—especially contractors—to leverage some of the provisions in the new tax law and start planning for the next recession before it starts.
With the passage of the 2017 tax reform reconciliation act, also known as the Tax Cuts and Jobs Act (TCJA), there are now new opportunities for contractors to reduce their tax burden while revenue is high. Rates are also significantly lower—including a 20% deduction for pass-through entities that applies through 2025—which is further helping increase cash flow. However, the TCJA also eliminates or limits many other tax breaks, such as the ability to take business losses and offset other income or use them to recover taxes paid in prior tax years.
For years, a common tax planning strategy has been to defer taxes by using favorable accounting methods such as the cash method or accelerating deductions for prepaid expenses and bonus depreciation. However, if not planned for accordingly, the provisions in the TCJA may result in significant tax liabilities later when business slows down. For this reason, working with a tax advisor to plan ahead and manage cash flow is critical for most construction companies.
Opportunities and Pitfalls
To mitigate the risk, contractors can preemptively assess how the following provisions may impact their business now and in the event of a downturn when revenue and cash flow may be down.
Rates and Deductions
For tax years beginning in 2018, tax rates are lower, with the highest rate reduced from 39.6% to 37%. The TCJA also establishes a new deduction based on a pass-through owner’s qualified business income (QBI). The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.
For a simplified example: If an S corporation has $1 million in taxable income, the shareholder may be able to claim a $200,000 deduction and possibly pay tax on only $800,000 of the S corporation’s business taxable income.
This provision creates a significant tax break for contractors who receive pass-through income from S Corporations, LLCs and LPs, and partnerships. However, unlike the C corporation tax rate reduction, this deduction expires in 2025.
The availability of the cash method of accounting or other exempt methods for long-term contracts is expanded to taxpayers with average annual gross receipts under $25 million.
For qualified property acquired and placed in service between September 28, 2017, and December 31, 2022 (or by December 31, 2023, for certain property with longer production periods), the first-year bonus depreciation percentage is increased to 100% from 50%. It’s also now allowed for new and used qualifying property.
This means contractors can buy a new or used piece of equipment and expense the full purchase price immediately, reducing their current tax obligation. However, if there’s a downturn in the economy, they wouldn’t have the depreciation deduction in later years and could have higher taxes when they may not have the cash to pay the liability.
Beginning in 2018, tax-deferred exchanges of like-kind personal property assets are no longer allowed.
This means there’s no longer like-kind exchanges on equipment, which previously provided contractors the ability to defer taxes on gains received from such exchanges. During periods of both economic growth and recession, this provision will contribute to increased tax liabilities for contractors.
Under the TCJA, business net operating losses (NOLs) that arise in tax years ending after December 31, 2017, can no longer be carried back to an earlier tax year.
This provision is significant because contractors tend to do very well in upturns and have large losses in downturn economies. With the new tax act, they can no longer carry those losses back to prior years and get previously paid taxes back in times of a cash need. When the economy slows down, this will have a negative effect on contractors’ cash flows as NOLs increase without the previously associated tax break.
Excess Business Loss Limitation
The TCJA also established new excess business loss (EBL) rules that create a limitation on the amount of loss a pass-through taxpayer can deduct from their entity. For single filers, only $250,000 of a pass-through loss can be used to offset wages, interest, dividends, and other business income. The limitation is $500,000 for married couples filing jointly. Any EBL will now carryforward under the NOL rules mentioned above.
Because of this new limitation, it will become important for contractors to plan ahead and make sure that when they incur a loss, they understand that their ability to offset wages and other income is limited.
Business Interest Limitations
Affected corporate and noncorporate businesses can no longer deduct interest expenses in excess of 30% of adjusted taxable income either—starting with tax years in 2018.
While cash flow is up for contractors, this isn’t much of an issue because there’s less of a need to borrow; meaning business interest expenses may not reach 30% of adjusted taxable income. However, in a downturn—when contractors are more likely to borrow at higher rates—the impact of this limitation will be felt more acutely. Important elections can be made to reduce the negative effect of this provision.
Contractors will want to look their organizational structure to confirm eligibility for the 20% pass-through deduction. Additionally, with fewer options for contractors to reduce their tax liability during the next recession, it may be prudent for businesses to manage their cash flow to make sure they have the ability to pay any deferred taxes that may come due.
Options to Consider
While planning for future downturns, it’s important to consider the following:
- Manage cash flow to make sure there’s sufficient cash to pay previously deferred tax liabilities when they come due.
- Assess where salaries are set to help manage the excess business loss limitation.
- Carefully manage equipment fleets to avoid being taxed on gains associated with like-kind exchanges.
We’re Here to Help
For more information about how the new tax law could affect your business or help with tax planning, contact your Moss Adams professional. You can also visit our dedicated tax reform page to learn more.