With many experts suggesting the possibility of another economic downturn in the not-so-distant future, today’s financial climate has many construction financial managers asking what they can do to better prepare for the next recession.
Jobsite recently sat down with Eve Dreyfuss, partner and CPA at Moss Adams, a leading accounting firm, to discuss how contractors can leverage tax reform to be better prepared—both now and in the future.
This is the first half of a two-part Q&A.
Jobsite: Can you briefly explain what the 2017 tax reform reconciliation act is, commonly referred to as the Tax Cuts and Jobs Act (or TCJA), and how it might impact contractors?
Eve: The TCJA was signed into law on December 22, 2017. Many provisions in the Act directly affect contractors, including lower tax rates, reduced deductions, and the removal of certain tools that helped contractors in a downturn economy. However, some of these provisions are only temporary.
Taking both federal tax reform and other state provisions into account, now is the time for companies to be strategic and put themselves in a strong cash position.
Taking both federal tax reform and other state provisions into account, now is the time for companies to be strategic and put themselves in a strong cash position in advance of a downturn.
For example, it may be beneficial to utilize lower tax rates to pay down taxes that have been deferred into future years. In 2017 and previously, many contractors deferred income because they knew lower tax rates were coming. Those lower rates are now here, and they may not stay for long. For example, the 20 percent deduction for flow-through entities and S corporations sunsets after 2025.
Jobsite: What key considerations regarding tax rates and deductions might contractors want to consider in the event of another economic downturn when revenue and cash flow are down?
Eve: There are a few key items contractors will want to consider. For example, there's currently a 20 percent deduction for S corporations and flowthrough entities, which goes away after 2025. Additionally, bonus depreciation is set at 100 percent right now but declines after 2022. Both provisions reduce current tax rates for contractors.
Because everyone’s situation is different, it can be beneficial to work with an advisor who can provide guidance based on a company’s unique situation. In general, contractors may want to consider taking deferrals, including bonus depreciation, because these allow for a deduction to be taken upfront instead of being spread over the life of the asset.
Taking a deferral means a company benefits in the present. However, companies that previously deferred may have to pay more tax in a later year. This leaves them with less cash on hand because the company took the benefit in an earlier year.
A possible solution to this dilemma is to take a portion of the deduction in the current year while paying some of the taxes that were previously deferred. This allows contractors to pay down debt, putting themselves in a strong cash position while there's a lot of available work. Those same companies may then be able to buy cheap equipment, pay expenses, and even expand in a downturn.
Jobsite: You touched on bonus depreciation. Can you elaborate on how it might impact contractors in the event of a downturn?
Eve: Bonus depreciation allows taxpayers to take a 100 percent deduction in the purchase year of an asset. For example, if a contractor buys a $500,000 piece of equipment this year, the entire purchase can be written off in 2018. It’s important to note this decision will generally result in higher taxable income than book income for the rest of the life of that asset because of the accelerated tax deduction.
Bonus depreciation allows taxpayers to take a 100 percent deduction in the purchase year of an asset.
As an example, a contractor purchases a five-year asset. For financial statements, 20 percent can generally be deducted each year. For taxable income, if bonus depreciation is used, the contractor could take 100 percent the first year. Then, in years two through five, that contractor would have more taxable income than financial-statement income, assuming this depreciation timing difference represents the only book-tax difference.
If a contractor accelerates an asset deduction this year, when there’s no downturn, he or she may end up paying the tax in the future when the same amount of work or income isn’t available. To help avoid this situation, contractors can choose not to take 100 percent of the bonus depreciation now. Again, contractors should work with an advisor to develop a strategy in case of a downturn.
Jobsite: How might simplified methods—cash method of accounting or other exempt methods for long-term contracts—affect contractors?
Eve: The option of simplified methods only affects contractors with up to $25 million in gross receipts—a substantial increase from the previous $10-million limitation.
Contractors that meet the $25-million threshold aren’t required to recognize revenue on their eligible long-term contracts using percent complete—an estimate based on actual costs divided by estimated cost to complete a job. By determining how much of a job has been completed, contractors using the percent-complete method know the percentage of income that must be recognized.
Contractors that are able to use the cash method or other exempt methods have a lot more control over what revenue they recognize. Using the cash method, contractors recognize revenue based on the cash received and recognize expenses based on cash paid.
Next week, in part two of Eve’s Q&A, we discuss how companies can better manage their cash flow ahead of an economic downturn.