Construction Firms: Act Now to Plan for 2020 Taxes and Maximize Cash Flow

Many construction firms have experienced a bit of a rollercoaster during 2020. Initially, social distancing requirements, stay-at-home orders and client delays may have slowed down work on construction projects. In later months many projects resumed, but labor shortages, supply chain issues and other disruptions continued and may have led to significant changes in your operating model and/or business plans.

With more uncertainty on the horizon, now is the time to speak with your tax and financial advisors to plan for year-end and prepare your business to be in the best possible financial position for 2021. Read on for a few areas to consider as you approach year-end planning.

Your top priority should be receivables

Although most of the year-end considerations in this blog post center around tax planning, your top priority right now should be making sure you’re on top of receivables. Why? Because the biggest issue many construction companies have faced over the past few months is maximizing cash flow during this disruption.

Staying on top of receivables includes:

• Timely billing, completion of documentation and invoice authorizations
• Deciding whether to send reminder notices (known in Florida as “notice to owner” and in some states as a “preliminary notice”) earlier in the billing cycle
• Proactively and quickly notifying clients of delinquent payment amounts
• Following up on receivables that need attention
• Understanding each contract’s billing, delinquency and lien notification requirements
• Staying on top of required legal reminders, notices and deadlines related to filing liens

If you don’t already have a staff member overseeing all invoicing, billing and collections-related work, as well as one to identify and follow up on receivables that need attention, consider designating one now. Staying on top of receivables can lead to business process improvements that will serve your construction firm well now and in the coming year.

You may be able to take larger deductions for net operating losses

The Coronavirus Aid, Relief and Economic Security (CARES) Act grants temporary relief from Tax Cuts and Jobs Act (TCJA) provisions that eliminated carryback of net operating losses (NOLs) and limited their use to 80% of taxable income. Whether your construction company is a corporation or pass-through entity, here are two important changes to note:

• For NOLS arising in tax years beginning January 1, 2018, and ending December 31, 2020, you now have a five-year carryback period in which to use them.
• You can temporarily use NOLS to fully offset taxable income during the allowed tax years, regardless of when the NOL was generated, because the CARES Act temporarily suspended the 80% of taxable income limitation on the use of NOLs.

You may want to take advantage of the carryback by amending or modifying tax returns for tax years dating as far back as 2013. If you generated a loss this year, think about claiming it as soon as possible. If the IRS approves your request, you will receive a refund, plus interest, and the IRS has said it will expedite these refund requests.

Consider pandemic-relief credits before depositing payroll taxes

Federal, state and local governments may allow deferral of various tax payments, including income and payroll taxes. Some of these deferrals and credits can make it more complicated to calculate upcoming estimated tax payments, so talk with your tax advisor before making any payroll or income tax deposits. Discuss which payments you should make before year-end 2020 and plan for payments due during 2021.

Don’t overlook the R&D tax credit; you may qualify

The federal R&D tax credit covers process development and experimentation, software development and new product development. If your construction company spent a considerable amount of time and money on innovation this year – including innovation to transform your business model or your collections process – it may qualify. Read more in “R&D Tax Credit Opportunities in Times of COVID-19.”

Issues with the supply chain have also led come construction companies to experiment with alternative raw materials and redesign certain projects. If any of this sounds like your business, check with your tax advisor to see if your company qualifies for this credit.

Finally, keep in mind that, for taxable years beginning after Dec. 31, 2021, taxpayers will be required to capitalize and amortize research or experimental expenditures (which will include software development costs) over a period of five years. Those costs are currently immediately deductible as expenses.

If you’re involved in construction-related activities or processes that you think might be covered, consult an R&D tax advisor to learn more about the tax savings opportunities that may be available.

Lease and loan modifications may affect your taxes

Did you work with distributors or manufacturers to modify your office or construction equipment leases this year to help with cash flow? If you did, discuss these changes with your tax advisor. In many cases, such leases are capital leases, and treated like loans for tax purposes. That means any relief you received – such as monthly payment reductions, temporary payment suspensions or payment delays – may count as taxable income.

Renegotiating the lease on your office space or rent modification agreements may not affect your taxes, but you should still share the details with your tax advisor as these changes could affect your year-end accounting and financial reporting.

If you obtained other types of loan relief from lenders, this may also have accounting, financial and tax implications. Seemingly minor changes to covenants, agreed-upon payment delays, term expansions, agreements to set aside or ignore certain covenant provisions – any one of these may affect your accounting or taxes. This includes traditional loans, lines of credit and other financing.

CARES Act provided temporary relief from limitations on business interest deductions

The limitation on allowable deductions for business interest expense under Internal Revenue Code Section 163(j) has been increased to 50% of the taxpayer’s adjusted taxable income (ATI), for both 2019 and 2020 (after a reduction to 30% beginning in 2018). This provision of the Coronavirus Aid, Relief and Economic Security (CARES) Act also allows the use of your 2019 ATI to calculate the limitation for 2020. Note: That 30% limit is set to return for 2021.

Tax year 2022 will bring further reductions in the ability to deduct business interest. For now, ATI will be computed without accounting for depreciation, amortization or depletion, but beginning in 2022 those items will be included. This could decrease your ATI, and thus limit your interest expense deductibility further. Tiered entity structures can further complicate these calculations.

If you’re thinking about taking out a large loan, consult with your tax professional about whether the interest might be deductible.

Consider the impact of proposed rules for carried interest (i.e., promote)

In July, the Treasury Department and the IRS released long-awaited proposed regulations to the treatment of carried interest (also known as promote, profits interest or performance allocation).

If your construction firm is structured as a partnership, one of the most important notes in these proposed regulations are that partnerships should not recharacterize carried interest gains on Schedule K-1s, but instead should footnote the long-term capital gains line to indicate that it might need to be recharacterized. This essentially leaves the decision on how to characterize carried interest income up to the general partner or fund manager, or their personal tax advisor.

To learn more, read our blog post, “Proposed Change to Carried Interest Rules Prompts Strategic Reconsideration.”

Maximize tax benefits of capital expenses

Consult with your tax advisor about whether and how to deduct some or all of the costs of capital expenses under Section 179 of the Internal Revenue Code, whether to use bonus depreciation, or whether to combine the two.

Under Section 179 of the Internal Revenue Code, businesses can deduct some or all of the costs of capital expenses, including new or used equipment and improvements to roofs, HVAC, fire alarm systems and security systems in commercial property. This includes assets on which you cannot take bonus depreciation. The Section 179 deduction limit for 2020 is $1.04 million, with a spending cap between $2.59 and $3.63 million.

Bonus depreciation is 100% for tax year 2020. This may allow you to write off the full purchase price of equipment that is new to you, or the full cost of qualified improvements, and it can be less restrictive than Section 179. IRS Publication 946 details how to depreciate property.

The CARES Act has given bonus depreciation a boost this year, in the form of fixing an oversight in 2017’s TCJA that classified qualified improvement property (QIP) as having a 39-year depreciation, which also made it ineligible for bonus depreciation. QIP covers most non-structural improvements made to the interior of a commercial building. It is now classified as having 15-year depreciation and is eligible for 100% bonus depreciation.

These QIP changes apply retroactively to property acquired and placed in service after December 31, 2017. If you feel you have QIP in prior years, discuss with your tax advisor which, if any, next steps you should take. It may make sense You may want to amend your 2018 and 2019 taxes (if you haven’t already) to claim the extra depreciation, but the compliance costs may exceed any potential benefit.

Maximize your deduction for qualified business income

If your construction firm is a pass-through entity, you may continue to receive a 20% deduction on qualified business income (QBI), which may reduce your maximum effective tax rate for 2020. And pass-throughs keep the deduction on entity-level state and local taxes.

Filers who claim the QBI deduction must now show how they calculated QBI by using Form 8995. Each qualified trade or business activity must stand separately and as such, will require its own line on Form 8995. If you aggregated any of your activities last year, continue to use that aggregation this year.

The QBI deduction limitations and restrictions are set at the owner level. Planning for year-end 2020 should include discussion of salaries, timing and distribution of income in order to maximize the deduction for the tax year.

Understand Paycheck Protection Program loan forgiveness

As it stands right now, PPP loans that are forgiven will not count as taxable income, but businesses also cannot deduct any expenses paid with those funds. If you obtained a PPP loan, maintain good records of how you spent it. And discuss with your tax and financial advisors whether you should apply for loan forgiveness now or wait until there is more clarity on how forgiveness will work.

Pay attention to Schedule K-1 changes

There are a few Schedule K-1-related changes for construction companies structured as partnerships.

Starting with tax year 2020, partnerships will be required to report each partner’s capital account using a tax basis capital method. While this was expected to be effective for 2019 K-1s, Notice 2019-66 postponed it to 2020.

The IRS released an early draft of instructions related to tax basis capital reporting on October 22, 2020. These instructions indicate that partnerships should calculate partner capital accounts using the transactional approach as the tax basis method, and report the partner’s contributions, share of partnership net income or loss, withdrawals and distributions, and other increases or decreases using tax basis principles.

The draft of instructions also offers several allowable methods for calculating tax basis by partnerships that have not maintained tax basis capital account records. In those cases, each partner’s 2020 beginning tax basis capital account balance can be computed using one of these methods:

• Modified Outside Basis Method
• Modified Previously Taxed Capital Method
• Section 704(b) Method, as described in the instructions, including special rules for publicly traded partnerships

The IRS has also asked for public comment on other possible methods of reporting capital accounts to partners. Additionally, the agency has said it intends to issue a notice providing penalty relief for tax year 2020: It will not assess a partnership for errors in reporting partners’ beginning account balances if it takes “ordinary and prudent business care” in following the instructions.

As a reminder, as of tax year 2019, disregarded entity names, types and Tax Identification Numbers must be included on Schedule K-1s, along with the individual beneficial owner’s information. The IRS issued a useful FAQ to help clarify reporting on disregarded entities.

Consider which accounting method is right for your company

Remember that companies with up to $25 million in gross receipts must use one of the following accounting methods for income tax reporting purposes:

1. Cash method: The simplest method, available for construction companies with up to $25 million in gross receipts
2. Completed-contract method: Defer income or loss until a contract is completed, available for contractors with between $10 million and $25 million in annual gross receipts, though Alternative Minimum Tax (AMT) may limit its benefits
3. Percentage of completion method: Income is reported proportional to the costs incurred to-date (can be used by a contractor of any size and is required for those with gross receipts of more than $25 million)
4. Accrual excluding retainages: Allows for deferral of income associated with certain retainages until the retainage is collectible under contract terms
5. Accrual method: Report income as billings are made and deduct job costs when incurred

If your gross receipts are under $25 million, discuss the pros and cons of each method with your accounting and tax professionals.

Other year-end planning considerations

• Assess whether you have current W9s and W8s for all your partners. Some of these forms have expiration dates and need to be filled out and signed again.
• The information required for Schedule K-1, as well as several other forms, has expanded in recent years. This is a good time to touch base with your tax professional to get an idea of new information you may need to prepare.
• If you have foreign investors or foreign business connections (such as lenders), be prepared to provide more information this year to your tax advisor. This may include W-8s, copies of loan agreements, etc.
• Reporting requirements for Qualified Opportunity Funds that invest in Opportunity Zones are expected to increase this year. Funds must provide additional information to the IRS, through Form 8996. Funds must report the value of business properties, the census area tract number for each property, the value of investments allocated to each area, each investment’s current valuation and other information.

Contact your Kaufman Rossin tax advisor to learn more about these and other tax provisions that could affect your construction company as you plan for the end of 2020 and the year ahead.