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Year-End Tax Planning: Tax Benefits Available to Small Construction Businesses

Companies that qualify as “small businesses” enjoy several tax benefits, including simplified tax reporting and the ability to defer taxes under certain circumstances. Your construction company’s eligibility for these advantages depends on your gross receipts, including those earned by certain related entities.

Previously, the gross receipts threshold was $5 million ($10 million in some cases). But the Tax Cuts and Jobs Act (TCJA) increased the threshold to $25 million, significantly expanding the availability of these benefits.

So, now’s a good time to evaluate whether you qualify as a small business and, if you do, whether it pays to change your accounting methods to take advantage of the available tax benefits. Even if you don’t currently qualify, there may be planning opportunities that will enable you to do so in the future.

Perusing the pluses

The tax advantages of small business status include:

  • The ability to use the cash method of accounting, which typically allows you to defer more taxable income than the accrual method,
  • Relief from inventory accounting requirements,
  • Exemption from the uniform capitalization rules, which may require you to capitalize rather than expense certain overhead costs,
  • Exemption from the TCJA’s limit on business interest expense deductions, and
  • The option to use the completed contract method rather than the percentage-of-completion method to account for jobs expected to be completed within two years, allowing you to defer taxes until a job is substantially complete.

Note that companies structured as S corporations, limited liability companies or partnerships without a C corporation partner are permitted to use the cash method — even if their gross receipts exceed the threshold — unless they’re required to account for inventories. Also, even if you pass the gross receipts test, you may be ineligible for small business benefits if your business is considered a “tax shelter.” (See “What’s a tax shelter?”)

Calculating gross receipts

Under current rules, your construction company is a small business if its average gross receipts for the previous three tax years (ending with the year that precedes the current year) are $25 million or less. In addition to increasing the threshold, the TCJA also provides that you need to pass only the gross receipts test in the current tax year. Under previous rules, you would fail the test if your three-year average gross receipts exceeded $25 million in any prior year.

When applying the test, you must include gross receipts earned by certain related entities, namely members of parent-subsidiary, brother-sister or combined groups under common control. A parent-subsidiary group exists when one company owns more than 50% of one or more other companies. The group also includes other companies that are more-than-50% owned by group members.

A brother-sister group is two or more companies in which the same five or fewer persons collectively own:

  1. At least 80% of each company, and
  2. More than 50% of each company, considering each owner’s minimum common ownership.

For example, if someone owns 15% of Company A and 25% of Company B, his or her minimum common ownership in the two companies is the lesser of the two percentages, or 15%. The table below provides an example of two companies that satisfy both the 80% and 50% tests for brother-sister group status:

Owner Company A Company B Minimum common ownership
1 15% 25% 15%
2 30% 10% 10%
3 20% 5% 5%
4 15% 40% 15%
5 10% 15% 10%
Total 90% 95% 55%

A combined group exists when a parent company belongs to both a parent-subsidiary group and a brother-sister group. Under those circumstances, the two groups’ gross receipts are combined. Note that, when determining a person’s ownership percentage, you must include interests owned by certain family members.

Changing ownership structure

If related companies’ gross receipts push your gross receipts above the $25 million threshold, it may be possible to qualify for small business status in the future by changing your ownership structure.

Suppose, for example, that Company A and Company B from the table above have gross receipts of $20 million and $10 million, respectively. Neither company qualifies for small business benefits because they’re part of a brother-sister group with combined gross receipts over $25 million.

Now suppose that Owner 4 transfers 20% of Company B to an unrelated person. Doing so eliminates the brother-sister group, because no group of five or fewer persons owns at least 80% of each company. Both companies now meet the gross receipts test for small business status.

Tracking your receipts

Track your gross receipts to determine whether your construction company is — or could be — eligible for small business tax benefits. If you do qualify, evaluate the pros and cons of changing your accounting methods. We can provide valuable assistance.

What’s a tax shelter?

Even if your construction company’s gross receipts are less than $25 million, you may be precluded from claiming small business tax benefits if you’re considered a “tax shelter.” And while you may associate the term with investment vehicles designed to generate tax losses, even an ordinary business can meet the definition.

Under the Internal Revenue Code, tax shelters may include partnerships or other entities (such as S corporations or limited liability companies) in which more than 35% of their losses are allocable to “limited partners or limited entrepreneurs” who aren’t actively involved in the business. Businesses structured in this way may be able to avoid tax shelter status by getting certain owners more involved in management or by reducing the amount of losses allocable to inactive owners.

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