Updated: Mar 31, 2022
Construction contractors have many tax reform measures to evaluate as they work to stay compliant with the law and minimize tax exposure. Congress passed the Tax Cuts and Jobs Act in December, of course, while additional developments are brewing in Ohio with the commercial activity tax (or "CAT"), the municipal income tax and the sales and use tax. Here we take a look at how recent tax law changes affect construction contractors and discuss strategies to maximize tax savings and limit compliance costs and risks.
The Tax Cuts and Jobs Act
Many business owners in the construction industry are still trying to determine what exactly federal tax reform means for them. One thing that we can expect is that most contractors will receive a tax savings in one form or another. The Tax Cuts and Jobs Act, or TCJA, lowers the corporate tax rate to a flat 21% rate. Contractors organized as flow-through entities such as limited liability companies or S corporations will see a new deduction of up to 20% of their business income. Another new benefit under the TCJA is bonus depreciation measures that allow for 100% cost recovery in the year of acquisition for equipment acquired prior to 2023.
But the bitter comes with the sweet, as other provisions in the TCJA may increase taxes.
Interest expense is now capped at 30% of the company's federal adjusted gross income, but an exception applies if a company's average gross receipts are under $25 million. Net operating losses are now limited to 80% of taxable income and may not be carried back to prior years. The TCJA also eliminates the domestic production activities deduction, which previously allowed a 9% deduction for certain income generated through construction activity.
We all hope that federal tax reform will generate tax savings to spur investment and create economic opportunities. As tax advisers are busy crunching the numbers, we are also hopeful that the IRS will soon provide regulatory guidance to shed light on complex provisions of the new law. Businesses weighing their options as to their choice of entity, for example, anticipate federal regulations to clarify to what extent they qualify for the new 20% deduction for flow-through entities.
Audit risk and exposure
While the IRS has its plate full writing TCJA regulations, we can also expect increased IRS audit activity. A new set of partnership audit rules passed into law in 2015 as a revenue-raising measure take effect for the 2018 tax year. The new rules centralize IRS audits at the entity level (rather than the individual partner level) and introduce the new "partnership representative" concept.
Partnerships and LLCs must now designate a "partnership representative" to make audit decisions that affect each partner's rights. The new rules introduce such sweeping changes that all partnerships and LLCs taxed as a partnership should review and amend their partnership and operating agreements to account for them.
On the state front, we are now awaiting the U.S. Supreme Court's decision in South Dakota v. Wayfair, the biggest sales tax case in over 25 years. In that case, the court is grappling with allowing states to impose sales tax collection duties on remote, online retailers for their sales to in-state customers. Though construction contractors typically do not sell items at retail, they are subject to use tax on items purchased for use in business if sales tax is not remitted to the vendor at the time of purchase. A decision favorable to South Dakota in Wayfair could impact contractors if it emboldens states to pursue more audits for both sales and use tax.
We recently saw a similar development after the Ohio Supreme Court upheld the Ohio CAT against a challenge from remote internet retailers. Businesses and tax practitioners have noticed an uptick in CAT audit activity since the Supreme Court issued its decision in the 2016 case Crutchfield v. Testa. One controversial issue that commonly arises in CAT audits is whether contractors qualify for the so-called "agency exclusion" for gross receipts passed through to subcontractors. Qualifying for the agency exclusion turns largely upon the language of construction contracts, such that they should be reviewed to ensure CAT compliance.
Centralized municipal net profits tax
One area where tax compliance has become easier for contractors working on projects in several different cities is municipal net profits taxation. Thanks to a change in Ohio law last year, all businesses may now elect to report and pay municipal net profits tax for all municipalities in one place, the Ohio Business Gateway. Previously, businesses were required to file a separate return with each municipality that imposed the tax. Though several municipalities are currently contesting this change through lawsuits filed against the state of Ohio, to date they have not been successful in lower courts.
The development is a welcome change for taxpayers as it is not unusual for the cost of preparing a municipal net profits tax return to be greater than the tax liability itself. Taxpayers making the election to file on a centralized basis should be sure to timely make the election and notify all the municipalities where they do business. The deadline to register is the first day of the third month of the tax year, for example March 1 for calendar year taxpayers.
With these developments in mind, construction contractors that are proactive in their tax planning and compliance may save money and find themselves in an advantageous position relative to competitors that are reactive to developments in tax law and audit activity.
No copyright infringement intended. This article was originally published at crainscleveland.com by Carl Grassi, Chairman of McDonald Hopkins LLC.