As year end approaches, construction company owners should work with their tax advisor to review options for reducing their 2015 tax bills. There’s no cookie-cutter formula for year end tax planning — the right approach depends on your particular situation — but here are several strategies to consider.
Although the primary goal of year end tax planning is to minimize your 2015 taxes, it’s important to look ahead to 2016 as well. Generally, the best strategy is to defer income to next year and accelerate deductions into this year. But, as with most rules, there are exceptions.
Start by projecting your income and expenses and estimating your tax liability for 2015 and 2016. If you expect to be in a higher tax bracket next year, it may make sense to accelerate income into 2015 and defer deductions until 2016.
There are many ways to defer income and accelerate deductions. Cash-basis companies may have opportunities to delay billings or prepay certain expenses. Options for accrual-basis companies are more limited, but it may be possible to defer income by delaying the performance of certain services until after year end or electing to defer taxes on certain advance payments.
Both accrual- and cash-basis companies can defer income by making contributions to qualified retirement plans. Depending on the type of plan, companies may be able to deduct contributions this year so long as they’re made by the extended due date of their 2015 tax return.
Accrual-basis companies may benefit by deferring the payment of year end bonuses until next year. So long as bonuses are paid by March 15, 2016, the compensation is deductible on a company’s 2015 tax return. Keep in mind that bonuses paid to “related parties” — such as S corporation shareholders, partners, limited liability company (LLC) members or more-than-50% C corporation shareholders — don’t qualify for this treatment.
Use 10% method
Most construction companies use the percentage-of-completion (PCM) method, which recognizes revenues and expenses as a job progresses, to account for long-term contracts. For jobs that begin late in 2015, don’t overlook the “10% method,” which allows you to defer recognition of gross profit on jobs that are less than 10% complete at year end. To adopt this method, file an election with your 2015 tax return. There’s no need to apply for a change in accounting method.
Also, keep in mind that, if you opt to use the 10% method, the election applies to all jobs that are less than 10% complete at the end of the tax year. If you decide in a later year to switch to another method, you’ll need the IRS’s permission.
Review entity choice
Many construction companies are structured as pass-through entities, such as S corporations or LLCs. That means owners pay tax at individual income tax rates on their shares of the company’s income.
For owners subject to the top individual income tax rate (currently 39.6%), converting to a C corporation may provide a tax advantage. (The current top corporate tax rate is 35%.) But be sure to weigh the reduced rate against potential double taxation of shareholder distributions. Typically, pass-through entities offer better tax results, although a C corporation may be advantageous for companies that reinvest their earnings in the business rather than distributing them to shareholders.
Keep an eye on Congress
Several important tax breaks expired at the end of 2014, including enhanced Section 179 expensing for equipment and 50% bonus depreciation. If Congress extends these provisions retroactively to the beginning of 2015, as it has in previous years, you may have an opportunity to reduce your 2015 tax bill by acquiring depreciable assets before year end. Other expired breaks that may be revived include the research credit and the deduction for energy-efficient commercial buildings.
It’s possible that some or all of these breaks could even have been extended by the time you’re reading this. Check with your tax advisor for the latest information.
Here are a few more year end tax-savings ideas:
- Evaluate accounting methods. If your company is eligible for either cash or accrual accounting, investigate whether switching accounting methods would provide a tax advantage. Usually, the cash method produces greater income deferral, but your company may be better off using the accrual method if, for example, its accrued expenses tend to be higher than its accrued income.
- Claim the manufacturers’ deduction. This deduction isn’t just for manufacturers, so don’t overlook it. Also commonly referred to as the “Section 199” or “domestic production activities” deduction, it allows you to deduct up to 9% of your income from “qualified production activities.” These include many activities associated with constructing or substantially renovating real property located in the United States.
- Watch out for self-charged rent. Higher-income taxpayers are subject to a 3.8% net investment income tax (NIIT) on certain net investment income, including rent. But what about construction company owners who lease real estate or equipment to the company through a related entity? This “self-charged rent” is excludable from NIIT so long as an owner “materially participates” in the construction company’s business. So be sure to determine whether you’re sufficiently active in the business. If you are, you don’t need to deduct self-charged rent when calculating NIIT.