As 2020 draws to a close, although many construction companies are still dealing with the impact of the COVID-19 pandemic, annual financial closing tasks are on the agenda. This means that tax planning and other financial considerations are imperative, with the goal of helping contractors enter 2021 in the best possible shape.

While it is wise to consult tax and accounting experts to properly handle each company's unique situation, some basic points can help business owners and managers initiate relevant discussions. The following are the topics most worth attention:

Accounting Method Changes

The construction industry is unique: contractors need to use different accounting methods to both minimize tax liability and present a solid financial position to banks and other stakeholders. So says James Lundy Jr., tax leader for construction services at Marcum LLP in Nashville, Tennessee.

"Tax law is designed to allow construction contractors to report one set of amounts to banks and another set to the IRS," Lundy said during a recent Marcum webinar. "This requires us to keep two sets of books, and it is completely legal."

He noted that all contractors must use the percentage-of-completion method for financial reporting, but for tax filing, they can choose from a variety of accounting methods, often using up to four simultaneously. Overall tax methods include:

  • Cash basis
  • Accrual basis
  • Accrual basis (excluding retainage)

Accounting methods for long-term contracts (defined as contracts that begin and end in different years) include:

  • Completed contract method
  • Percentage-of-completion method
  • Tax percentage-of-completion method
  • Percentage-of-completion capitalized cost method

Considering tax methods in 2020 planning is critical because some method changes require filing an application with the IRS before the end of the tax year. Lundy said that choosing the right method helps contractors save or defer as much tax as possible.

Presidential and Congressional Policy Changes

In a typical year, many contractors maximize deferred taxes by delaying collections and deferring income to the next year, noted Michael Ceschini, managing member of Ceschini CPAs Tax & Advisory in New York. Companies can also accelerate or increase current-year expenses through significant purchases, paying bonuses, and paying invoices before December 31, further reducing tax liability.

However, 2020 is far from a typical year. Currently, contractors need to work with their financial advisors to decide how to incorporate the impact of President-elect Joe Biden's tax plan into year-end strategies.

Among other tax law changes, Biden is expected to raise the corporate income tax rate from 21% to 28%, said Frank Scala, partner in Marcum's assurance services group in New York City, and increase individual rates for those earning over $400,000 annually. The latter would affect shareholders who report business income on their individual returns through pass-through entities such as S corporations.

Whether Biden can achieve tax reform largely depends on the outcome of the Georgia Senate runoff election on January 5, which will determine whether Republicans lose or maintain their majority, said Raymond Haller, tax partner at Grassi in New York.

"Unfortunately, we have to get everything done by December 31 without knowing what the outcome will be five days later," he said.

Haller noted that if contractors believe tax rates will rise in 2021 under the Biden administration, some have reason to accelerate income and increase their 2020 tax liability. If taking this strategy, they should also defer large purchases to next year to offset potentially higher rates. The idea is: pay more tax in 2020 at lower rates rather than waiting until 2021 when rates may rise.

CARES Act and PPP Loan Impact

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, passed by Congress in March 2020, was designed to alleviate the burden caused by the pandemic while also providing some tax benefits. According to Warren Hennagin, Marcum's California construction services leader, these benefits include:

  • More opportunities to carry net operating losses back to prior years.
  • More business interest can be deducted.
  • Qualified improvement property can retroactively enjoy 100% bonus depreciation back to 2017.
  • The employer portion of Social Security taxes can be deferred to 2021 and 2022.
  • Refundable payroll tax credits equal to 50% of qualified wages.

The CARES Act also established the Paycheck Protection Program (PPP) loans through the Small Business Administration. PPP loans can be forgiven if companies use the loan funds for qualified expenses such as payroll, rent, and utilities. Portions used for other expenses must be repaid at a 1% interest rate.

However,the IRS has issued guidancestating that expenses paid with forgiven funds are not deductible, which could result in larger tax bills for some contractors.

Ceschini said accounting professionals originally thought these expenses could be written off. The new guidance "does not align with the spirit in which the accounting industry understood it."

Barry Fischman, Marcum's New England construction services leader, said that to change this situation and make these expenses deductible, Congress would need to pass legislation, but so far that has not happened.

Research and Development Tax Credit

Fischman said that as construction companies develop their own innovative processes and products, more and more companies are becoming eligible for the federal research and development tax credit. The advantage of this credit is that it directly reduces taxes on a 1:1 basis.

"Wages typically drive the credit amount, and contractors should ask themselves whether they have qualifying expenditures to generate these credits," he said.

As a general business credit ranging from 6% to 12% of qualified expenditures, the R&D credit can provide cash savings to support reinvestment and growth,according to Cole Marr, R&D director at Sensiba San Filippo LLP in California。

Marr noted that unfortunately, much of the R&D that many construction companies engage in qualifies for the credit in the eyes of the IRS, but they are unaware of it due to lack of awareness and common misconceptions. Activities in the construction industry that may qualify include:

  • Developing new, improved, or more reliable products, processes, or technologies.
  • Design improvements for LEED or energy-efficient projects.
  • Developing unique assembly or construction methods and processes.
  • Experimenting with new construction materials.
  • Developing or improving construction equipment.
  • Any project requiring additional testing or certification.

Cash is King

However, the ultimate factor determining which tax rules contractors should utilize is their cash position, Ceschini said. For example, if a contractor needs funds to pay wages before year-end, deferring collections to 2021 makes no sense.

Ceschini said that despite the pandemic challenges, his clients are performing well. On the other hand, some clients' project pipelines are shrinking, and many are not winning new projects as successfully as before.

The construction industry often lags behind other industries in economic downturns, adding more uncertainty for companies entering 2021, making cash reserves even more important.

"You run your company with cash," he said.