EPISODE 44: As the year 2020 comes to a close, contractors may already be considering tax planning options at year-end and also opportunities for the new year in 2021. DHG's Sarah Windham, a tax partner with vast industry experience for construction, real estate and agribusiness companies, joins John Locke to discuss some of those specific considerations for construction and real estate for year-end tax planning as well as some focus points as those companies look forward to 2021.
[00:00:09] JL: Welcome to today’s edition of DHG’s GrowthCast. I’m your host, John Locke, and at DHG, our strength lies in our technical knowledge, our industry intelligence and our future focus. We understand business needs and are laser-focused on company goals. In this ever-changing world, DHG’s Growthcast provides insights and thought-provoking conversations on topics and trends that address growth opportunities and challenges in the current and future marketplace.
Thanks for joining us as we discuss tomorrow’s need today.
[00:00:42] ANNOUNCER: Views and concepts expressed by today’s panelists are their own and not those of Dickson Hughes Goodman LLP. Always consult the advice of your legal and financial professional before taking any action.
[00:00:58] JL: As the year 2021 comes to a close, we’ve already discussed on GrowthCast some general tax planning considerations for businesses and individuals. Today, we want to focus that discussion more specifically on some considerations for construction in real estate, as well as some focus points as those companies look forward to 2021. Perhaps one of the most common and important aspects of this is the PPP loans. Sarah, can you share with us how this PPP impacts tax considerations for construction real estate?
[00:01:33] SW: John, I’d be happy to discuss PPP and it’s not necessarily a construction real estate specific topic, but most of our construction a lot of our real estate clients have taken advantage of the PPP loan program. This program continued to change throughout the year and even has changes as recently as the beginning of November. If you have not had opportunity to discuss the tax treatment of your PPP loan with your advisor, I would highly suggest that you do that before the end of this year so that you’re prepared for any consequences. Currently as the role stands, if you use the PPP funds for the appropriate expenses and those are payroll, rent and utilities and you anticipate qualifying for forgiveness whether or not you have been forgiven yet, those expenses would be nondeductible on your 2020 tax return.
Basically, in layman’s terms what that means is you’re going to pay tax on the PPP funds that you received in 2020 if you anticipate full forgiveness. I will say with the PPP loan, the roles for this as most people know have changed many, many times since it passed earlier in the spring, and there still are discussions going on in Congress, even right now that this could change. So stay on top of those discussions and continue to talk to your advisors about how that may impact you.
[00:02:56] JL: That’s good advice for everyone including contractors, but stay tuned because all the PPP rules and regs seemed to be evolving every week, don’t they?
[00:03:08] SW: Correct. Yes, more to come I’m sure.
[00:03:11] JL: What about accounting methods for contractors themselves, Sarah. What should they be thinking about this time of year?
[00:03:18] SW: Accounting methods is one of the interesting planning aspects that we can take advantage of for contractors. There is an entire code section in the RS Code that is specific to contractors and your average person probably doesn’t realize that since they don’t spend their time in the tax code. This is one of the places we can often look to allow contractors to take advantage of the different methods that they are permitted to use to minimize their tax and plan short-term and long-term for tax deferral opportunities. Depending on the size of the contractor depends on the amount of methods that they’re eligible to use, that there are several different methods.
Most contractors when they’re looking at their books, some of them are looking at their jobs, they use what we call the percentage of completion method, which is is just what it says. It calculates their job in their contract on the percentage of complete that that job is so they can see how much profit they’ve made so far if the job is 40% complete let’s say. That’s not always going to be the best tax method, especially if you’re looking for planning ideas. That depends on the type of contractor and the size of contractor, what type of methods and planning opportunities there are with those methods. Some of the smaller contractors and in tax world, smaller contractor means $25 million of gross revenue or less. That is being now inflation-adjusted so it would be $26 million for 2020.
They may be able to use the cash method of accounting for example, and sometimes, this presents an opportunity for them to defer taxes or to plan a little bit better to match their taxes with the cash that they’re actually spending and receiving. Because the cash method is basically what it says, you’re going to pay tax on money you collected and you’re going to write off the money that you have written checks and things for.
Some other methods that may be available are completed contract. Again, that depends on the size of the contractor but that method is very self-explanatory. If the contract is complete, you pay tax on it. If the contract is not complete, you defer it to another year. And there are some details and some caveats to that rule, but that’s probably more than we want to get into today. Even our large contractors who are required to use the percentage of completion methods, there’s opportunities there where we can look for small things to plan such as the 10% election. The 10% election basically says, if you’re less than 10% complete with a job, you may not really have a good gauge on how that job is going to go yet since you’re so early in the job. So if you’re 9% complete and you’ve already made $100,000 profit on that job, you can defer that $100,000 until the following year.
Lots of opportunities for planning and thinking out of the box with the various methods that contractors are allowed to use.
[00:06:17] JL: Yeah, lots of options for them for sure. I know a lot of our listeners are probably familiar with the Section 199(a) deduction. Can you just refresh our listeners on this deduction and really what are the benefits that they can take advantage of heading into the end of the year into 2021?
[00:06:38] SW: This deduction has a lot of different names that float around out there. Section 199(a) is the tax code that it refers to. So a lot of people refer to as the 199(a) deduction. You’ll hear people refer to it as the small taxpayer deduction. You’ll hear people refer to it as the 20% flow-through deductions. It has a lot of different names that are used, so just wanted to put those out there in case somebody wasn’t familiar with 199(a). This came about with the Tax Cuts and Jobs Act that was passed at the end of 2017.
Corporate tax rates were lowered significantly at that time. And during the debating of that bill, the smaller taxpayers and the family-owned businesses, that are typically structured as partnerships or as corporations said, “Hey! What about us? We need a flow-through deduction that flows through from the business to the shareholder where we pay our tax.” The 199(a) deduction or the 20% flow-through deduction came out of that discussion.
If you are a small business and your tax is a flow-through entity or even large businesses for that matter, typically they’re smaller and your tax is a flow-through entity, you qualify potentially for 20% deduction from your profit off of your calculation for your tax. This is coming from US businesses who are investing in employees, and investing in equipment, and assets, and capital and improvements. That was the thought process behind this deduction. So let’s just say that you have $100,000 of profit in your company. When you flow that through to the shareholders or to the members of the partnership, they’re going to get $20,000 deduction from the $100,000 and they’re going to pay tax on the net $80,000.
This deduction does have some limitations if your income is higher. If you’re a taxpayer who have taxable income over about $166,000 if you’re single, and about $326,000 if you’re married filing joint, then you may have some further limitations. And you would want talk to your tax advisor about what those limitations may be and make sure that you’re maximizing those. That’s something we can do with year-end planning if you’re over those thresholds, and make sure that your wage base and things of that nature are high enough to qualify for the full 20% deduction and you’re not leaving that on the table.
[00:09:04] JL: Yeah, that 20% is a significant number to leave in the table. You need to pay attention to that, right>
[00:09:11] SW: Yes, absolutely. If you’re in the highest tax bracket at 37%, it can lower your tax rate all the way down to closer to 29%. It can be a pretty significant savings.
[00:09:21] JL: Yeah. I know that the timing of these deductions can be important as well. Can you tell us really what’s at stake with paying attention to the timing associated with these deductions?
[00:09:33] SW: Well, we talked a little earlier about accounting methods and how those can play into certain tax planning opportunities. This is very similar with the timing of deductions and it kind of goes back to the prior discussion on accounting methods. For example, if you’re a cash-basis taxpayer and you’ve taken advantage of that cash method of accounting, you want to make sure that you’re looking at the money that’s coming in, particularly close to the end of the year. And that your timing, your expense checks going out, so that you can get those expenses paid before the end of the year. You may have some prepaid insurance or some other prepaid fees that you typically — let’s just say you pay your liability insurance in December and that liability insurance covers part of the following tax year, you can go ahead and pay the liability insurance and get a deduction for it in 2020, even though it covers part of 2021, if you’re cash-basis taxpayer or if you meet what we call the recurring exception test.
There’s a little bit of detail behind that that I won’t go in today, but basically, if it’s a recurring expense that you’re going to use up within 12 months and you do it every year, even though maybe a prepaid on your books because it covers 12 months, you can go ahead and take that deduction for tax purposes and lower your taxable income. We also want to take a look at the timing of other payroll tax expenses and things of that nature and make sure you’re getting all those paid on time.
[00:11:00] JL: What about year-end bonus accruals and retirement plan contributions?
[00:11:06] SW: I think that’s a good way particularly for contractors who have family-owned businesses or the owners in the businesses are all employees and working in the businesses to take a look at ways to take advantage of retirement plan contributions or bonus accruals to sort of pay themselves first. To always tell people if you’re contributing to your retirement plan, you may put that money out for later, but it’s going to get a tax deduction now when you’re taking it out of your right pocket and putting in your left pocket so to speak. Because you’re putting it in in the left pocket which is your retirement down the road, but you’re taking a tax deduction for it now.
Most people typically are in lower tax bracket when they’re in retirement than they are when they’re working and running a business, and that can be a good way to get a deduction now and pay less tax later. Also, you want to be sure if you’re doing bonuses and things of that nature that you are careful on the timing of those. So if you’re an owner or an executive in a company and you’re going to pay yourself a bonus, you’ve got to get it paid by December 31 to deduct it. If you’re paying your employees bonuses, let’s say it’s calculated on a year-end number and you don’t know that number until the middle of January after your books have closed. You can accrue that bonus back if you’re on the right method of accounting into 2020. You just have to pay your employees by March 15th, which is typically the due date of the tax return.
[00:12:36] JL: Pay attention to dates, right?
[00:12:38] SW: Pay attention to the methods of accountings and days. I think I’ve said all of those two or three times.
[00:12:44] JL: Yeah, great advice. Well, I would also think the this is the time to consider the impact and opportunity associated with the research and development known as the R&D credits. How can those be valuable for contractors?
[00:12:59] SW: We’ve seen a growing opportunity over the past probably five or six years for contractors to look at these R&D credits, I tell people typically when you say R&D credit, the average person thinks about someone in a white lab coat in a lab somewhere doing research on some type of pharmaceutical or things like that. That’s actually not the way the tax code defines R&D credits. So R&D credits are things that you’re doing where you’re trying to figure out problems so to speak.
If you’re a contractor and you’re doing design assist, design build or value engineering work, that may be an opportunity for us to use some expenses you’re already incurring and create a tax credit out of those through this R&D study. So that you can get the benefit of the tax credit for something you’re already doing. Where we typically see that is, for example if you receive a set of plans from one of your customers and they ask you to build a building. And there’s some items in those plans are incomplete or maybe inaccurate and you spend time on value engineering those or finding a solution to fix the problem with the plans. That may give you an opportunity for the R&D credit.
The great thing John about R&D credit, is credit is the key word there. So if you’re getting a credit on your tax return, that’s a dollar for dollar reduction in the tax you owe. So if you get a $10,000 credit and you owe $12,000 of tax, you will write the IRS a $2,000 check. But there are some limitations on those credits, but just to give you a basic example. That’s how it works.
[00:14:40] JL: It pays to do a little research into some of the work that you’re already doing tto see if they qualify, right?
[00:14:45] SW: Correct, absolutely. And we would do an R&D study, which is basically an analysis that backs up what you’re doing to support that credit calculations. If the IRS ask us for it, we would have that available.
[00:14:56] JL: Great. Well, in the spirit of finding ways to lower 2020 taxable income, should we also consider planning for potential higher tax rates in ‘21 or 2022?
[00:15:10] SW: Yes. This has been an interesting six or eight weeks to have tax planning discussions with our clients. Typically, at the end of the year, we spent a lot of time advising our clients how to lower their tax liability. This year, we’re having a little bit different discussion. While we’re looking at all these ideas that you and I have been talking about as well as others to lower client’s 2020 tax bills, there may be some consideration in the administration change that’s coming and the potential tax law changes that that may bring. You may want to balance lowering that 2020 taxable income with the threat of higher rates in 2021 or ’22.
If you’re accelerating income into 2020, we know we’re going to have a lower tax rate in 2020. We know there’s a possibility of higher rates down the road, so we want to make sure that we’re considering the timing of all of these things and that we’re not actually pushing too much income into future years where we may have higher tax rates.
[00:16:12] JL: Yeah, that’s a reality, isn’t it? It doesn’t seem like it could go much lower, but it could possibly go higher considering all the variables in play. Yeah, great, great advice. So much packed into this episode today and I know this is going to be a lot for our listeners to consume. If you could share with our listeners, if they have questions, where do they go t get some answers to further explain some of this information.
[00:16:40] SW: Sure, I’ll be glad to. If you’ve got questions about planning or any other tax concerns or accounting concerns, you can just reach out to us at our construction email address. That’s email@example.com or you can always visit our website, which is dhg.com and the construction section is dhg.com/construction, and we’d be more than happy to help you through any of your questions.
[00:17:05] JL: Great. Well, Sarah, thank you so much for your insights today. I know that people will really get a lot of good information to take with them to hopefully if they’ve already started their planning to make some good decisions about their planning here over the next few weeks, so thanks for spending time with us today.
[00:17:25] SW: You’re welcome, anytime.
[00:17:26] JL: Thank you for joining us on today’s episode of DHG GrowthCast with tax partner, Sarah Windham. We hope that this year-end tax planning reminders would be valuable to you as you set priorities for both year-end decision and 2021 opportunities.
I’m your host, John Locke, and I look forward to reconnecting with you soon on another episode of DHG GrowthCast.