Tax Strategies in a Tough Economy

The construction industry is in its deepest decline since the 1930’s. Construction companies are not only facing unprecedented challenges in their industry sectors, but they are also facing a rigid surety market that is meticulously defining levels of acceptable risk.

There has been a flurry of federal legislation since President Obama took the oath of office. On February 17, 2009, the President signed The American Recovery and Reinvestment Act of 2009 {“The Act”}, a $790 billion stimulus package intended to unfreeze credit markets and spur the American economy. The Act contains approximately $140 billion in construction spending, the majority of which will be distributed to state governments. Hundreds of construction projects are expected to be launched across the country over the next three to six months.

State governments have enormous latitude in how they ultimately spend this money. It is vital that construction companies understand how their state legislature plans to spend its portion of the $140 billion cash infusion and adapt their business model to take advantage of infrastructure spending.

It is good business practice for construction companies to regularly apprise their lenders and bonding agents about trends in their business. Before meetings with your bonding agent and banking partners, take time to think about the following tax strategies that may improve your financial picture.

Extension of Net Operating Loss Carry back Period

The Net Operating Loss {“NOL”} carry back provisions allow taxpayers to apply current year losses against prior year income and recover the taxes paid on that income. For losses incurred in 2008 only, the Act includes a provision that allows “small businesses” to extend their NOL carry back from what is currently two years to five years. A “small business” is defined in the Act as a corporation, partnership, or sole proprietorship whose average annual gross receipts for the 3-year period preceding the 2008 year were $15 million or less. Carrying back 2008 NOL’s to the more profitable 2003 through 2007 years will result in an immediate cash infusion for cash-starved businesses. The five year carry back extension will help put much needed cash back into the pockets of construction business owners. Coordinate with your CPA to timely file your business and income tax returns and then immediately file federal and state carry back claims.

Section 179 Expensing on Capital Expenditures & 50 Percent “Bonus Depreciation”

Take advantage of targeted tax-incentives in the Act designed to bolster a slowing economy such as the increased Section 179 deduction and the 50 percent “bonus” depreciation deduction. Under Code Section 179, a taxpayer can elect to deduct as an expense, rather than depreciate, the cost of new or used tangible personal property placed in service in the taxpayer’s trade or business. The Act provides for an extension for capital investments and new equipment purchases through 2009. Companies spending $800,000 or less on total qualifying fixed asset purchases can immediately deduct up to $250,000 of capital expenditures in 2009. The 50 percent “bonus” depreciation extension allows companies to deduct 50 percent of the cost of qualifying property placed into service in 2009, in addition to regular depreciation.

Cost Segregations & Bonus Depreciation

During 2009, taxpayers will be allowed to combine bonus depreciation with cost segregation studies on any building where a contract was signed on or after January 1, 2008 and the building was completed by December 31, 2009. Even if the building has not been placed into service as of December 31, 2009, bonus depreciation will still be allowed on the percentage of work completed by December 31, 2009. The combination of a cost segregation with bonus depreciation provides an opportunity to maximize tax deductions. The benefit is two-fold: First, certain components of the construction would be broken out into categories that are depreciated over shorter lives (3 year - 15 year recovery periods). Second, these components could also be eligible for an immediate $250,000 Section 179 deduction and ALL remaining qualified components would be eligible for the 50 percent “Bonus” depreciation.

Accelerating Interest Expense

There exists an opportunity to accelerate interest expense for tax purposes on construction projects not currently in a development stage. Interest expense incurred in connection with the production of real property must be capitalized as a cost of the property produced. The interest capitalization rules apply to the production of real property and indicate that interest expense must be capitalized during the development period. However, interest expense is often capitalized by construction companies before production has begun AND is continued to be capitalized even after the property is being held available for sale. Construction companies have the ability to accelerate interest expense deductions for tax purposes that are incurred outside of the development period.

Now is a great time to assess which of your properties are currently being held available for sale and to determine if you are eligible for accelerated interest expense deductions. Contact your CPA to determine if you can take advantage of this tax deferral strategy. By accelerating interest expense deductions for tax purposes, it is possible to increase the 2008 loss that you can carry back a minimum of two years and hopefully five years, if you qualify.

Minimizing Self- Employment Taxes

Most taxpayers focus solely on federal and state income tax brackets and are unaware of the potential ramifications of self-employment (“SE”) taxes. There exists a SE tax of 15.3 percent which is applied to the net earnings from SE income earned by general partners of partnerships, self-employed individuals, and members of limited liability companies (“LLC’s”). Many taxpayers are unaware that SE taxes represent a tax liability above and beyond a taxpayer’s regular federal and state tax burden.

Many small businesses are minimizing self-employment taxes by converting their business entities from LLC’s to S corporations. Pass-through income and distributions from an S corporation are NOT subject to self-employment tax. This is significant since taxable income in excess of “reasonable compensation” to S corporation shareholders is NOT subject to SE tax. Of course the S corporation still pays SE tax on W-2 wages paid to its shareholders; however, the S corporation does receive a deduction for all SE taxes on W-2 wages. For example:

• An S corporation shareholder with W-2 Wages of $50,000 and distributable net income of $200,000 would pay $3,825 {$50,000 * 7.65 percent} in SE taxes in 2009. The S corporation would also pay $3,825 {$50,000 * 7.65 percent} in SE taxes; however, the S corporation would receive a federal and state tax benefit for this expense.
• Contrast the above example with a general partner of an LLC earning $200,000 in distributable net income. The general partner would pay $19,043{($106,800 *12.4 percent) + ($200,000 * 2.9 percent)} in SE taxes in 2009. With the proper tax planning, it is possible to avoid the entanglements of self-employment tax by electing to be taxed as an S corporation.

Take Advantage of the U.S. Construction Activities Deduction

This past year the IRS issued final regulations making the U.S. Construction Activities tax deduction more advantageous for contractors, builders, and developers. The new construction tax deduction is calculated as 6 percent of your Qualified Construction Activities Income for tax years 2007 thru 2009, and will reach a maximum of 9 percent in tax years beginning in 2010 and thereafter.

Qualified Construction Activities Income is loosely defined as the excess of your construction gross receipts over your cost of goods sold directly allocable to such receipts. For example:

If your corporation has $10,000,000 of net income, you would have historically paid about $3,500,000 in federal taxes assuming a 35 percent flat rate. However, after a deduction at the fully phased in rate of 9 percent of qualified construction activities income, federal taxes would only be $3,185,000 ($9,100,000 * 35 percent). This would result in federal tax savings of $315,000.

To qualify for the deduction you must be a contractor, builder, or developer engaged in the active trade or business of construction.

Elect to be taxed as a Real Estate Professional

The last two years have been marked by a major slowdown in the real estate and construction arena leading to large losses for many businesses, especially in the real estate and construction markets.

Generally, rental real estate properties are treated as separate activities and considered passive investments, which means their losses are not currently deductible. The result is a financial predicament in which taxpayers are seeing declining cash reserves while saddled with suspended passive losses.

But by taking advantage of an opportunity to combine separate real estate interests as a single real estate activity, real estate professionals can offset taxable income with rental real estate losses. This election is available only for qualifying real estate professionals who materially participate in real estate activities.

An individual qualifies as an eligible real estate professional if both of the following criteria are met:

• More than 50 percent of the personal services performed by the taxpayer in all trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates. A real property trade or business is broadly defined and includes real property development, construction, acquisition or conversion, rental, management or operation, leasing, and brokerage activities.
• The taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.

The immediate impact of satisfying the material participation qualifications is a transformation of current year passive losses to non-passive. All current non-passive losses are deductible on a taxpayer’s tax return as an ordinary deduction. However, passive losses suspended in prior years do not become ordinary losses.

Take advantage of these tax savings strategies to bolster cash flow, stabilize your business, and secure a higher bonding limit. Those construction companies that can stabilize their businesses through smarter allocation of resources and tax planning strategies will survive the economic downtown and better position themselves to compete for highly coveted bonded work.

Porter Keadle Moore, LLP is a founding member of ProfitCrew, an association of accountants and business advisors dedicated to helping construction companies build profitable businesses. For information, contact Adam Polakov at apolakov@pkm.com or visit www.pkm.com.