Contractors: Year End Tax Planning

As 2011 winds down, it time to think about year end tax planning. The right moves depend on your construction company tax and financial circumstances. It critical to take a strategic approach, balancing your desire for short-term tax savings against your interest in preserving the long-term financial strength of your business.

Be Tax-Smart With Timing

Traditional year end tax planning principles say you should defer income and accelerate deductions as much as possible. But if you expect your marginal tax rate to be higher in 2012, consider shifting taxable income into this year.

There are many techniques for deferring income. If your company uses the cash method of accounting, you can delay billings until next year or accelerate payables into this year. If you use the accrual method, you may be able to defer income by delaying certain services until after year end. Also, you may be able to defer taxes on advance payments you receive this year for services that won't be performed until next year.

In some cases, accrual-basis businesses can deduct employee compensation accrued this year, such as year end bonuses or vested vacation pay, even if it not paid until next year. To qualify, payments must be made within the first 2½ months of next year and must not be made to a related party such as an S corporation shareholder or a partner.

Both accrual - and cash - basis companies can claim a deduction on this year return for qualified retirement plan contributions made up until the return extended due date.

Also consider longer term strategies that allow you to defer income indefinitely, such as like-kind exchanges of equipment or other property, and sales of stock to an employee stock ownership plan.

Review Your Accounting Methods

As you can see, your accounting method can have a major impact on how you can time income and expenses. Many contractors use the accrual method of accounting, but some qualify for the cash method. In general, you're eligible for the cash method if:

• Your average annual gross business receipts are $1 million or less,
• You operate as a C corporation (or a partnership with at least one C corporation partner), your average annual gross receipts are $5 million or less and you don't have inventories, or
• Your company is a sole proprietorship, S corporation, limited liability company, or partnership (without any C corporation partners) and either your average annual gross receipts are $10 million or less or you don't have inventories.

If your company is eligible for either method, consider whether switching methods would reduce your tax bill.

It also important to consider that contractors are generally required to account for long-term contracts using the percentage-of-completion method (PCM), which recognizes revenues and expenses as a job progresses. But there are exceptions that allow you to use the completed-contract method to defer taxable income until a job is substantially complete.

Home construction projects (such as single-family homes and townhouses) are typically exempt from PCM accounting, and the IRS has issued proposed regulations expanding the definition of the term to include some larger projects (such as infrastructure work in a subdivision). In addition, contractors can defer up to 30% of the profits on residential projects, such as apartments, using PCM accounting for the other 70%.

Even if a job requires PCM accounting, you can defer reporting income and expenses until it reaches the 10% complete stage. Doing so may allow you to defer taxable income to next year on projects you start late this year.

For PCM contracts, be sure to examine your job schedules carefully before year end and adjust estimated revenues and costs if appropriate. Otherwise, if profits on a job are declining, you may overreport your income in the current year.

Take Advantage of Tax Breaks

Consider tax deductions and credits that may also reduce your 2011 tax bill, such as:

• Bonus depreciation and expensing for equipment purchases (see the sidebar Investing in fixed assets),
• The manufacturers' deduction, which can allow you to deduct up to 9% of your income from many construction activities,
• The Work Opportunity credit for hiring workers from certain disadvantaged groups,
• The research credit (often referred to as the research and development R&D or research and experimentation credit), which may be available for certain construction or engineering innovations, and
• Tax incentives for energy-efficient buildings.

Some of these tax breaks require you to take a particular action, such as purchasing equipment, before year end. But you may already qualify for others, such as the manufacturers' deduction, you simply need to claim them on your tax return. Keep in mind that some of these breaks expire at the end of 2011.

Consider The Financial Impact

As you review year end tax moves, consider the impact they may have on your lending and bonding relationships. Banks and sureties look for strong year end financial statements, but some strategies for reducing taxable income may cause you to violate loan covenants or reduce your bonding capacity.

As jobs come to a close and backlog shrinks, banks and sureties may be concerned about your cash flow in the coming year. To ease these concerns, report a healthy cash balance on your year end financial statements and boost your backlog by executing prospective contracts before year end.

Strategize & Optimize

As you can see, there are plenty of ways to be strategic this year end when it comes to your tax planning. Your tax advisor can help you determine which strategies will help optimize your construction company overall financial position while lowering its tax bill.