By JACK A. CALLAHAN
ON DECEMBER 22, 2017, the Tax Cuts and Jobs Act was signed into law. The most sweeping tax change since 1986, the Act is intended to encourage economic growth and bring back jobs and profits from overseas by reducing corporate tax rates and providing other incentives. It is too soon to analyze the entire Act and to determine if it will achieve the desired results. Early signs have been very positive, with a surge in the stock market and growth in stocks of home builders and infrastructure companies.
The timeline on the Act—from a start date of October 2017, to signing on December 22, 2017—was certainly impressive. The legislation moved at a record pace for such comprehensive reform. As a result of the speed at which the Act was passed, there are portions of the Act that need to be corrected through the technical corrections process. Without these changes, there could be unintended consequences.
One interesting note: the words “tax simplification” were dropped from the title of the legislation; for many contractors, there will be nothing simple about the new tax law.
Below are 10 key items related to the new legislation that have the greatest impact on engineering and construction companies and their employees. These are high visibility items that may have significant impact and should be carefully considered when assessing positive actions to take in order to maximize the benefits of the Act. The changes to international tax and the details on executive compensation are too detailed to cover in this article. As with any new tax law, the Internal Revenue Service (IRS) and U.S. Treasury Department will need to chime in to clarify important “gray areas.” It could take months for the IRS and Treasury to provide such guidance.
1. Whether or Not to be a C Corporation
C corporations are clearly the big winners in the Act. Corporate tax rates have been cut from 35 percent to 21 percent, effective for tax years beginning after Dec. 31, 2017. This 14% reduction is the largest single cut, and it is compounded by numerous other significant wins for C corporations, including:
• The repeal of the corporate alternative minimum tax (AMT) • Increased ability to expense acquisitions and capital improvements (see discussion below)
There are some other provisions that temper the big benefits above. While many engineering and construction entities have organized as S corporations or LLCs, there are still a number that operate as C corporations. Each entity and tax advisor must look at the specific facts to decide whether the company would benefit from converting to a C corporation. There may be some good reasons to consider a change; however, the double taxation concerns that drove the original entity selection decision still exist. Any changes in entity need to be made with careful thought and discussion.
2. Reduced Tax Rates are Not All Created Equal
While corporate tax rates were dropped to a 21% flat rate, the trust and personal rates cut were not that generous or as simple. For trusts, we now have four tax rates: 10%, 24%, 35% and 37%. Individual rates are 10%, 12%, 22%, 24%, 32%, 35% and 37%. The highest individual rate had previously been 39.6%.
Capital gain tax rates have remained at 0%, 15% and 20%, with new inflation indexes added for the determination of the phase-in rates. These rate reductions did not come without offsets, such as the elimination of the personal exemptions and the elimination of other itemized deductions, discussed below.
3. Pass-through Deductions May—or May Not—Provide Significant Relief
For tax years beginning in 2018, the Act adds a new deduction for taxpayers that earn qualified business income (QBI). We call the deduction the “pass-through deduction.” The pass-through deduction is generally 20 percent of a taxpayer’s QBI from partnerships, S corporations, or sole proprietorships (there are quite a few defined terms contained in the Act). The calculations and the eligibility will be very fact specific. For surety bond production attorneys and accountants, it depends. The rules are somewhat complex. It will take a detailed analysis of your specific facts and circumstances to determine the benefits, and you should get used to hearing the term “it depends.”
4. Small Contractors Get Some Significant Relief
In keeping with the goal of the Act to benefit businesses and create jobs, the small contractor may well benefit here. Additionally, the small business provisions might simplify tax filings for qualified businesses. A small business is one with average annual gross receipts of $25 million or less. While specific rules are not available, it is likely that the IRS will require a company to aggregate revenues from related companies to determine if the businesses meet the $25 million test. Those contractors that meet the $25 million gross receipts test will have the following advantages:
They can use the cash method.
They are not required to account for inventories (though inventories would be treated as supplies).
They are exempt from applying uniform capitalization rules.
They do not have to use percentage of completion.
They face no limits on the deductibility of interest expense.
They do not need to worry about conformity to financial statements.
These are all very beneficial and will provide tax benefits; however, it is important to caution the need to plan carefully around the timing differences and be certain that cash for taxes will be available when the timing differences turn around.
5. SALT (State and Local Taxes) in the Wounds
This was one of the more controversial matters in the Act. Beginning in 2018, individual deductions for state, local, and foreign property taxes and state and local income and sales taxes are limited to $5,000 for individual filers, or $10,000 for joint filers. The deduction for such taxes is not limited if the taxes were paid or incurred in carrying on a trade or business. We are not certain at this time what any states might do in response to the new limitations.
6. Interest Expense Deduction Gets Interesting
Residential home mortgage interest will now be limited to interest on a first and secondary residence with a principal amount capped at $750,000. This amount is a reduction from the prior $1 million, but better than what had been proposed initially. Interest on home equity lines of credit will no longer be deductible.
On the business side, starting in 2018, the deduction for business interest will be limited to 30% of the business’s adjusted taxable income. In simplest terms, if a company has EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of $1 million, its interest expense deduction will be limited to $300,000. Real property trades or business can get around the limitation by electing to be a “qualified real property trade or business.” However, doing so will subject them to less favorable depreciation methods. Once made, the election is irrevocable. The definition of a “qualified real property trade or business” is broad and includes construction companies. Companies potentially subject to the interest deduction limits should weigh the long-term cost of interest deductibility versus the effect on depreciation.
Floor plan interest for auto dealers and “certain” equipment dealers will continue to be deductible; the qualification of types of dealers will likely be challenged. And again, the small business exclusion will exempt small contractors from this limitation.
7. Equipment Purchases and Capital Improvements Provide New Opportunities
The Act provides for 100 percent expensing (bonus depreciation) in connection with qualified property acquired and placed in service after Sept. 27, 2017. Bonus depreciation now applies to used equipment as well as new. The new bonus depreciation rules, combined with an increase in the Code section 179 expensing (from $500,000 to $1 million), will provide a real opportunity to maximize the amount of deductions related to fixed asset acquisitions and construction. These new rules could make cost segregation studies even more beneficial. Lives for certain assets have been shortened; however, Congress needs to provide a technical correction as it relates to Qualified Improvement Property. It is critical to remember that depreciation is only a timing item that will turn around quickly. The Act changes section 1031 to allow like-kind exchanges of real property only for exchanges occurring on or after Jan. 1, 2018.
8. Where did the Net operating Loss Carryback Go?
The new Act eliminates the ability to carry back net operating losses. However, there is the opportunity to carry those losses forward indefinitely. There are also limitations in place that cap the amount of net operating loss utilized to 80 percent of taxable income. Given the recent hurricanes and wildfires, a provision was built in to allow property and casualty companies to carry back two years and carry forward 20 years and offset 100% of taxable income. This had been available to contractors, and in the past a troubled contractor often relied on the quick cash infusion from a loss carryback refund to get them through a tough time. That remedy will no longer be available. Be certain to have adequate cash reserves.
9. Deductions: Then You had Them; Now You Don’t
While there are several attractive elements in the Act, most notably, the near doubling of the standard deduction for individuals to $12,000 (individual filer) and $24,000 (joint filer), there are some long-valued deductions that will no longer be allowed. These include:
Domestic production activity Code section 199
Unreimbursed employee expenses form 2106
Personal casualty and theft losses, except for federally declared disasters
College athletic seat licenses
Alimony paid for separation agreements dated after Dec. 31, 2018
Moving and relocation expense
Living expenses of members of Congress
Fines and penalties
Settlement of sexual harassment claims
Limitations on deductibility of employee meals
These are some of the more relevant and interesting deductions. As they impact your business, it is recommended you begin discussions with your tax advisor to account and plan accordingly.
10. Time is Now to Revisit Estate, Gift and Trust Planning
Estate and gift taxes have been substantially impacted by the Act. While not delivering on the elimination of estate and gift taxes, the Act did double the basic exclusion to approximately $11 million. We recommend revisiting with your estate and trust professionals and looking at your gifting and inheritance strategies to be certain you maximize your family’s estate tax deductions. Not all of us can be as prudent a planner as George Steinbrenner was to die in the short window of time when the United States had repealed estate taxes. The rest of us must be certain to react to the laws in place each time they adjust and be certain that our estate plan is appropriately adjusted.
The taxability of trusts also may present some interesting tax planning opportunities. Revisit your plans.
This Saga Promises a Sequel
The Act provides a roadmap to the future. However, there are many details that still need to be worked out and many areas that need to be clarified or fixed. There is no set timetable for IRS guidance or for the necessary technical corrections. It is important to take time to absorb all the changes and determine how they impact your business. There is still time to analyze these changes in personal and business cases and take appropriate, informed action. Every individual case will have a different outcome.
Jack A. Callahan, CPA, is a partner with CohnReznick and serves as the firm’s Construction Industry Leader. In this role, Callahan is responsible for developing a team of accounting, tax, and consulting professionals dedicated to, and experienced in, servicing contractors. He serves on the NASBP CPA Advisory Council. He can be reached at firstname.lastname@example.org or 732.380.8685.