Savvy Contractors Should Bone Up on Tax Changes

By Jim Jordan

Jordan outlines four new and important tax issues for contractors that can be tricky to understand.

It seems many contractors still aren’t fully aware of how H.R. 5140 – the Economic Stimulus Act of 2008 signed into law earlier this year – can help their business. The confusion is understandable because media attention has focused mainly on the rebates going out to about 128 million American households.

H.R. 5140 is one of several recent new laws and tax changes that have significant implications for contractors. I’ll talk more about the others, but first let’s look at H.R. 5140. Intended to give the economy a shot in the arm, H.R. 5140 is providing rebates of up to $600 to eligible individuals and rebates of up to $1,200 to eligible couples. But the law also offers incentives to spur business investment, and here is where contractors can benefit in a major way.

The Economic Stimulus Act saves businesses about $50 billion in near-term taxes through a temporary change to the tax code that allows contractors who buy new equipment this year to deduct an additional 50% of the cost of their investment in 2008. Ostensibly this will encourage contractors and other businesses to expand and create new jobs because buying equipment, software and tangible property this year will dramatically lower taxes.

The law also increases deductible expenses for small businesses. This means that a contractor placing less than $800,000 of equipment into service this year is able to immediately deduct up to $250,000 – up from $128,000 – of their investment in 2008.

For contractors who haven’t discovered these benefits, there still is time to reap the rewards. Helpful information can be received from the leading trade associations and certified public accountants.

In addition to H.R. 5140, there are three other tax items that are particularly significant. They are the 3-% withholding tax, the “look-back’’ calculations required by the 1986 Tax Act, and the death tax. The Associated General Contractors of America and other leading trade associations are working diligently to repeal or amend these laws, but it isn’t easy. It’s important that contractors understand how they are being affected by these laws, so let’s take a brief look at each.

3% Withholding Tax In 2011 a new law will require federal, state and local governments to withhold 3% from all payments for goods and services as a guard against tax evasion. This withholding, however, applies to the total contract, not to the net revenue generated from a project. The problem, of course, is that most general contractors do not earn a 3% profit on a contract. According to AGC, this actually constitutes a 350-% withholding on government construction contractors’ net income until the government repays what is owed.

Here’s an example supplied by AGC: A small business contractor may hold one government contract that is estimated to be completed in one year for $10 million. This law requires withholding of $300,000 on that contract. Meanwhile, assume the contractor expects to net about 2.5%, $250,000, after paying for supplies, services, subcontractors and other ordinary expenses. The tax on the revenue generated is at most 35% of the net amount, which means the maximum tax owed on the $10 million project is $87,500 (35% of $250,000). In this scenario, the government has withheld $300,000 for $87,500 in tax liability.

The law creates other problems as well. Sureties look at cash flow when deciding to issue a bond for a project. The withholding law reduces the contractor’s cash flow, leading to higher costs for bonds or denial, which drives up the cost of construction. This situation can drive smaller contractors out of the market. Suffice it to say, AGC and other groups are trying their best to get the law repealed before 2011.

Death Tax Another front-burner issue for contractors is the death tax, otherwise known as the estate tax, which Congress tried to repeal in 2001 but only made more confusing. As it stands now, the law gradually reduces the 55% death tax through 2009. This year, for example, the rate is 45%. The law also increases the tax exemption to $3.5 million ($2 million this year) until the tax is repealed in 2010. But for 2011, everything reverts to the pre-2001 level.

Many owners of contracting companies, who assume the tax will be fully reinstated in 2011, say they are directing many of their valuable resources toward ways to pay for this tax, including liquidation strategies. What the owners and trade groups want most of all is some type of permanent reform. This tax issue is even more relevant for contractors because many are baby boomers, a group retiring at an estimated rate of 10,000 per day.

Look-Back Accounting Rules The 1986 Tax Act required contractors to use the percentage of completion method of accounting, and to apply “look-back’’ calculations to certain contracts accounted for under this method. The rule requires that when a contract is completed, the contractor must “look back’’ and substitute the actual costs and revenues for the estimated costs and revenues that were used in the percentage of completion calculations. The contractor calculates the difference between the taxes paid on the previously estimated amounts and what would have been paid on the actual amounts, as well as interest, and determines whether money is either owed or due to the Treasury.

Because contractors must be accurate in estimating their contracts, look-back accounting doesn’t really serve its purpose, which is to catch underreported income. That’s partly why contractors received some relief by way of the 1997 Taxpayer Relief Act, which allows contractors to forego the look-back method of a contract if, for each prior taxable year, the estimated taxable income – or loss – under the contract is within 10% of the actual taxable income of the contract.

In the minds of most contractors and trade industry officials, the 1997 changes were helpful, but don’t go far enough. In fact, industry officials are working hard to repeal look-back rules altogether.