This article is the third in a series, focusing on the federal tax burdens of public and private construction companies and their common tax optimization strategies.Click hereto view the full special report.

Around the financing proposals for infrastructure, social, and environmental projects put forward by U.S. President Joe Biden, the tax debate has largely focused on the actual taxes paid by large corporations and high-net-worth individuals. For example,an analysis by Construction Dive revealedthat publicly traded construction companies use various tax strategies, resulting in effective tax rates well below the statutory 21% corporate tax rate set by Congress.

However, although large publicly traded contractors receive the most attention in the industry, in terms of how they pay taxes, they are only a minority. According to U.S. Census Bureau data, only 16% of nonresidential construction firms in the United States are registered as C corporations, subject to corporate income tax. The remaining 84% are mostly S corporations, sole proprietorships, and partnerships, classified as so-called "pass-through entities"—business profits pass through directly to the owners' individual level and are taxed at individual income tax rates.

Currently, the rate brackets range from 10% for individuals with annual income up to $9,950, to 37% for individuals with annual income of $523,601 or more. Todd Simmens, National Managing Partner of Tax Risk Management at advisory firm BDO, noted: "For corporations, you can analyze at a 21% rate; but for individuals, it's a completely different rate system." Simmens previously served as a legislative counsel to the Congressional Joint Committee on Taxation.

2021 Individual Income Tax Rates and Income Thresholds

(Table data source: IRS, U.S. Department of the Treasury)

  • 10% bracket: $9,950 for individuals; $19,900 for married filing jointly
  • 12% bracket: $40,525 for individuals; $81,050 for married filing jointly
  • 22% bracket: $86,375 for individuals; $172,750 for married filing jointly
  • 24% bracket: $164,925 for individuals; $329,850 for married filing jointly
  • 32% bracket: $209,425 for individuals; $418,850 for married filing jointly
  • 35% bracket: $523,600 for individuals; $628,300 for married filing jointly
  • 37% bracket: $523,601 and above for individuals; $628,301 and above for married filing jointly
  • Proposed top rate of 39.6%: $452,700 and above for individuals; $509,300 and above for married filing jointly

This distinction is becoming increasingly critical for most construction firms that pay taxes as pass-through entities. The bipartisan $1.2 trillion infrastructure agreement in the Senate, funded by unspent COVID-19 relief funds, remaining federal unemployment benefits, and stricter tax enforcement, among other sources, according to the Associated Press, has temporarily spared large C corporations from a corporate rate increase. But pass-through entity owners may still face higher individual taxes to fund the $3.5 trillion social and environmental programs Democrats hope to pass through budget reconciliation without Republican support.

The reason lies in a little-known provision of the tax code—Section 199A—which allows pass-through entity owners to deduct 20% of their net income from their tax liability. Also known as the Qualified Business Income (QBI) deduction, it was part of former President Donald Trump's 2017 Tax Cuts and Jobs Act, designed to level the tax burden between C corporations and pass-through entities.

Before the act took effect, according to analysis by the right-leaning Tax Foundation think tank, the marginal effective tax rate for C corporations was 28.4%, compared to 25% for pass-through entities, a difference of 3.4 percentage points. The Tax Cuts and Jobs Act lowered the statutory corporate rate from 35% to 21% while also granting pass-through entities a 20% QBI deduction to balance the actual tax burden between the two types of entities. Garrett Watson, Senior Policy Analyst at the Tax Foundation, said that currently, the marginal effective tax rate for pass-through entities is 20.3%, compared to 19.9% for C corporations, "narrowing the tax burden gap between the two types of entities." In theory, the QBI deduction means pass-through entity owners face a top effective tax rate of 29.6%, rather than the current top bracket of 37%.

Could the QBI deduction be phased out quickly?

Although this is good news for pass-through entity owners, its ultimate fate has been in question since Biden announced the American Jobs Plan in March. The initial financing proposal was to raise the corporate rate from 21% to 28%—an option not realized in the current bipartisan infrastructure plan—while also raising the top individual rate from 37% to 39.6%. According to a Treasury Department May release detailing possible 2022 rates, the proposal would also lower the income threshold triggering the top rate from the current $523,601 to $452,700 per year.

This is where construction industry accountants begin to worry. Andrew Kahn, a CPA at Concannon Miller, a consulting firm in Bethlehem, Pennsylvania, specializing in construction finance, said: "Many very successful construction companies have annual income well above $450,000. Not only would you face a rate increase, but you would hit that increase at a lower income level." In July, Senate Finance Committee Chairman Ron Wyden, an Oregon Democrat, introduced a bill to phase out the current 20% QBI deduction for individuals earning $400,000 or more annually, planning to include it in the Democrats' forthcoming $3.5 trillion follow-up package. If this comes to pass, the group most affected would change, with Republicans accusing Democrats of raising taxes on small businesses. "These companies' tax burdens would clearly rise," Kahn said.

Of course, pass-through entity owners can still reduce their tax burden using the same tax strategies as C corporations, such as expensing equipment and deferring taxes. In fact, rate changes would make these strategies more valuable. "Accelerated depreciation, the research and development tax credit, and the Work Opportunity Tax Credit will yield greater benefits because the value of the deductions will be calculated at higher rates," Kahn said.

A different outlook than expected

When the Biden administration shifted focus in April to raising corporate rates to fund the American Jobs Plan and seemed to shelve individual rate increases, pass-through entity owners were initially elated. Erin Roberts, Global Construction and Engineering Leader at advisory firm EY, recalled: "There was a huge sigh of relief at the time. If individual rates went back up, it would become extremely burdensome and expensive for these pass-through entities to remain competitive."

But if the $1.2 trillion bipartisan infrastructure proposal being debated in the Senate passes, it would clear the way for Democrats to advance their $3.5 trillion follow-up package. That package focuses on social and environmental programs, including free community college, clean energy mandates for utilities, lower prescription drug prices, and expanded Medicare benefits. Democrats have said they will use budget reconciliation to push the package through the evenly divided Senate without needing any Republican votes. Senate Majority Leader Chuck Schumer (D-N.Y.) has pledged to pass both bills before the August recess, which is currently scheduled to begin August 9.

Although Schumer sayshe has enough votesto support the budget reconciliation bill, key moderate swing vote Senator Joe Manchin (D-W.Va.) said this week he "cannot really guarantee" the bill will pass, citing concerns over its financing. But if it passes, raising the corporate rate to 25%, the top individual rate to 39.6%, and phasing out the QBI deduction for incomes above $400,000 could all return to the agenda.

This scenario would have a huge impact on owners of pass-through construction companies. "If you eliminate the QBI deduction for those earning over $400,000 and raise the top rate, those currently paying an effective 29.6% would face a 39.6% rate," Kahn said. "That effectively increases their tax burden by a third. These company owners would have less after-tax money in their pockets." By comparison, a 25% corporate rate would only be a one-fifth increase over the current rate.

S corporation or C corporation?

Given that the proposed top individual rate is 18.6 percentage points higher than the current 21% corporate rate, should S corporation owners re-register as C corporations? Kahn believes it likely should not. The reason again lies in the unique tax mechanisms of C corporations versus pass-through entities. Although a 39.6% individual rate appears higher than the corporate 21%, pass-through entities pay no federal tax at the entity level, so their owners pay at the individual level. C corporations, on the other hand, pay a 21% rate at the corporate level, and their employees—including CEOs and presidents—still pay individual income tax on salaries. Kahn calls this mechanism "double taxation," and he believes that even if the 20% QBI deduction is eliminated, converting to a C corporation structure would not necessarily benefit S corporation owners currently taxed at individual rates. "Because as a C corporation you pay a second level of tax, I think that would make your total tax burden higher than what you would pay as a pass-through entity," Kahn said. "I think you would want to keep your S corporation status."

Higher taxes, but potentially higher profits

Ultimately, regardless of how the infrastructure and subsequent social and environmental programs are financed, some argue that the scale of stimulus injected into the overall economy will still result in greater overall profits for construction company owners—whether C corporations or pass-through entities. In fact, during a recent EY webinar, two-thirds of the 1,600 participants voted that they would accept some additional tax burden to get the infrastructure deal passed. "I think people are starting to see how government initiatives can benefit contractors through long-term, meaningful investment," Roberts said. "People are weighing it and concluding that some level of tax increase to fund these projects might be worth it."