Tax planning is critical in managing cash flow and ensuring the government gets no more than its fair share. Most contractors know they must manage taxes but may be too busy to plan. All tax planning strategies have deadlines, and most tax savings tactics must be implemented by the end of the calendar year. However, there are still options to mitigate tax liability. Below are five tactics that contractors can implement right now.
1. Analyze Current Accounting Methods
Contractors have many accounting methods to choose from and may identify cash-saving tax deferrals by changing to the most advantageous method. The IRS allows two types of method changes: automatic (accrual to cash, accrual excluding retainage), which can generally be made after year-end, and nonautomatic (completed contract method), which must be made before year-end. Since nonautomatic changes must be requested before year-end, we will focus on automatic changes.
Automatic Changes (Can Be Made After Year-End)
a. Accrual to Cash (Overall Method)
A contractor may have multiple methods because they have an overall method of accounting and a method of accounting for long-term contracts.
The overall method of accounting is how they account for all aspects of the business, except long-term contracts, and is typically cash or accrual basis. Small business taxpayers with average annual gross receipts of less than $30 million for the prior three years can choose cash or accrual, generally choosing the most beneficial method. Generally accepted accounting principles (GAAP) typically requires accrual for financials, but it isn’t always the most advantageous method of accounting for contractors as they are taxed on their overbilling.
b. Accrual Excluding Retainage (Overall Method)
One potential tax-saving method for large taxpayers with average annual receipts greater than $30 million could be accrual excluding retainage, an automatic change that can be made after year-end. This method allows a contractor to defer recognition of retainage receivable and payables on non-long-term contracts. This deferral can be significant, as retainage is a large part of any specialty subcontractor’s receivables and payables.
2. Ensure Proper Tax Percentage on Long-Term Contracts
Long-term contracts, which begin in one tax period and end in another, must be accounted for under the percentage of completion (POC) method, but to no surprise, the tax code requires taxpayers to calculate POC differently for tax purposes than GAAP purposes. Because of this difference, the tax return will (or should) show a gross profit and net income different from the GAAP financials.
The IRS requires taxpayers using the POC method to allocate selling general and administrative expenses (SG&A) to the jobs. This contradicts GAAP principles and can increase the estimated cost to complete the jobs, resulting in tax deferrals on profitable, uncompleted jobs. The requirement to allocate SG&A to the jobs is not an election but a requirement imposed by the tax code. Therefore, the taxpayer can analyze and implement the tax percentage of completion calculations after year-end.
3. Choose the Best Reporting Method for Non-Long-Term Contracts
a. Identify Contracts
Earlier, we mentioned exceptions to using POC for large contractors. One often overlooked exception occurs when a taxpayer lumps all their contracts into the POC method instead of just the long-term contracts. Long-term contracts span a taxpayer’s year-end and must be accounted for under POC, but jobs started and finished in the same year are not considered long-term and should be accounted for under the overall method of accounting. The contractor should analyze whether changing to the cash or accrual excluding retainage methods would be beneficial.
b. Contracts That Are Less Than 10% Complete
Contracts less than 10% complete at year-end may be excepted from the long-term contract requirement to use POC. There is no election associated with the less than 10% complete exclusion, so taxpayers who haven’t previously implemented the strategy can still implement it after the end of the year but before filing their returns.
c. Home Construction Contracts
Another exception that can be applied after the end of the year relates to home construction contracts. A home contract exists where each building constructed has four or fewer dwelling units. Townhomes also meet the definition of a home construction contract. A taxpayer does not need to recognize income on POC for home construction contracts but can recognize it in its overall method of accounting. The IRS generally requires all costs and revenue associated with home construction to be capitalized until the home is sold, resulting in taxpayers’ ability to defer all gross profit on home construction contracts until completion.
4. Analyze Depreciation Methods & Elections
Bonus depreciation provisions can generate significant tax deductions for contractors. For 2024, the default rule is that 60% of each eligible asset must be depreciated in the first year, with the remaining 40% depreciated under the MACRS rules over the specified useful life of the asset.
The bonus depreciation percentage was 100% until 2023, when it decreased to 80% and 60% in 2024. It will decrease by 20% annually until it reaches zero at the end of 2026. When the bonus was a 100% write-off, taxpayers had less reason to consider which method of expensing was best, but as the percentage decreases, it is more important to analyze the method used.
IRC Section 179 allows a taxpayer to expense the entire cost of the eligible property (up to $1.22 million) the first year it is placed in service. The election can only be used if the taxpayer has positive income after the deduction and the taxpayer only places a certain amount of assets in service during a year ($3.05 million for 2024).
With the bonus at 60% for 2024, it is vital to analyze whether to capitalize an asset or expense the cost as a repair. Repairs do not improve or extend the useful life but maintain the asset’s normal operating condition. However, with some of the larger pieces of equipment, the benefit of expensing versus capitalizing is significant.
5. Consider Cost Segregation Studies (Even If the Asset Was Purchased in a Prior Year)
Many contractors require substantial real estate to operate, including equipment repair shops, equipment yards, office space and more. If the contractor owns the real estate, it is possible to increase and accelerate depreciation deductions on the depreciable aspects of the real estate.
A cost segregation study allows the taxpayer to break each asset component into the proper bucket for tax, generally resulting in costs moving from the bonus-ineligible 39.5-year asset to shorter terms from five to 15 years, which are typically bonus eligible. The savings could be substantial, and a cost segregation study increases tax deferrals and provides audit protection if the IRS ever questions the deduction.
The study may also be completed any time up to three years after the asset is placed in service, and the depreciation can be caught up in the year the taxpayer completes the study by filing an accounting method change related to the depreciation on that asset. This method change can be made at any time up to the extended due date of the return, so there still may be time to complete a study if the contractor placed an asset in service in a previous year.
While it is objectively better to complete tax planning during and before year-end, these are just a few opportunities to save in the new year.
