Year-End Tax Planning for Contractors

As December 31 quickly approaches, it is important for contractors to begin the process of year-end tax planning. Tax planning not only provides the taxpayer with an estimate of their potential tax liability, but also gives them opportunities for tax reduction and deferrals. There are many ways in which these objectives can be accomplished, especially with the enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003.

One part of tax planning that contractors must assess is their future need for equipment. Acceleration of equipment purchases prior to year end may allow the taxpayer to enjoy significant write-offs. In fact, the most important aspect of the new tax act for contractors is in the depreciation changes. One such change is the modification of Internal Revenue Code Section 179, in which a taxpayer may deduct as an expense, rather than depreciate, a specified amount of the cost of certain qualifying personal property. In 2002 the amount which could be expensed was $25,000. Under the new tax law, a taxpayer may expense up to $100,000 of qualified property, subject to certain income limitations. Qualifying property includes most tangible personal property, including construction equipment and SUVs which are rated at more than 6,000 pounds gross (loaded) vehicle weight. Furthermore, a taxpayer may purchase $400,000 of qualified property before this benefit is reduced.

Many equipment intensive contractors regularly purchase equipment and vehicles in excess of the $400,000 limitation each year. To complement the expensing liberalizations, the 2003 tax act allows for 50% bonus first-year depreciation on certain eligible property acquired after May 5, 2003 . For property to be eligible for bonus depreciation, it must be “original use” property which is defined as the first time the property is put to use, whether or not that use corresponds to the use of the property by the taxpayer. Therefore, the purchase of used equipment does not qualify for the bonus depreciation. As a result of the bonus depreciation, the taxpayer may be able to depreciate up to 60% of the cost of most new construction equipment in the first year.

Through proper planning, contractors can maximize both the expensing election and bonus depreciation. In addition, there is no Alternative Minimum Tax (AMT) exposure as the expensing election and the bonus depreciation provisions apply for AMT purposes. The following examples demonstrate how tax planning can maximize depreciation through the various methods available:

The total amount of equipment purchased in the first and second examples are under the $400,000 property acquisition limitation and are qualifying property. Therefore, the taxpayer in Example 1 takes advantage of the $100,000 expensing election and deducts the entire cost of the equipment in the first year. In Example 2, the taxpayer benefits from both the expensing election and the bonus first-year depreciation. First, the $100,000 of equipment qualifies for the $100,000 expensing election. Second, the remaining $100,000 of depreciable property is original use equipment. As a result, $50,000 is depreciated using the 50% bonus first-year depreciation. Last, the taxpayer claims $10,000 on the remaining $50,000 of equipment using accelerated federal tax depreciation. The third example illustrates the depreciation options available to contractors which normally purchase equipment in excess of $400,000 per year. Since bonus first-year depreciation of $200,000 can only be taken on the original use equipment, the remaining $300,000 of equipment is depreciated using accelerated federal tax depreciation.

One significant caveat from the higher depreciation limits will take place in future years. The $100,000 expensing election and the bonus first-year depreciation contain provisions that the $100,000 expensing election can only be used in tax years beginning after 2002 and before 2006, and the 50% bonus first-year depreciation applies to property acquired after May 5, 2003 , and before January 1, 2005 . While a taxpayer can significantly reduce their tax liabilities in the current year, there will be less of the asset to depreciate in future years. As the assets near the final year of their depreciable lives, the depreciation used for GAAP basis financial statements, in which no accelerated depreciation was taken, will be larger than depreciation taken for federal income tax purposes. Consequently, taxable income in future years may be higher than financial statement income.

While planning for major equipment purchases and maximizing depreciation are significant tax planning and tax deferral tools, another tool contractors can benefit from is closely managing their work in progress. A solid understanding of individual jobs can help forecast the operating results of the company for the year and thus, its tax liability. For a contractor using the completed contract method of accounting for long-term contracts for tax purposes, slowing the progress of an individual job late in the year can defer revenue into future years. Contractors not using the percentage of completion method of accounting for long-term contracts for tax purposes must also be cognizant of potential AMT implications as AMT income is required to be computed using the percentage of completion method.

Another method to reduce income tax liability while providing owner and employee benefits is through qualified profit sharing plan contributions. A profit sharing contribution can be made by the extended due date of the federal income tax return to qualify for a deduction in the current year. Therefore, a calendar year corporation has until September 15, 2004 , to make a deductible profit sharing contribution for 2003. For businesses without a current profit sharing plan, proper year-end planning would include an evaluation of the total cost of such a plan versus the benefits which would accrue to the owners and key employees of the company. Even though the actual cash contribution is allowed past the end of the year, the plan must be established before the end of the year.

Through careful management of work in progress, proper timing of expenses, including profit sharing plan contributions and utilization of depreciation changes, contractors can accurately assess and reduce their tax exposure for the current year. Proper planning can alleviate April 15 th tax surprises by allowing the taxpayer several months to prepare for tax payments.

Mike Schmidt, CPA
Construction & Real Estate Group