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Year-End Planning for Contractors

 

Year-end tax and financial planning allows a company to put itself in an advantageous position with its compliance reporting requirements. It accomplishes this by planning for and minimizing potential tax liabilities while keeping in mind various financial statement reporting issues. This balanced approach to year-end planning can help a business accomplish the following objectives:

  • Maximize profitability while minimizing taxable income
  • Meet banking covenants
  • Manage cash
  • Maintain working capital
  • Maintain a strong equity position
  • Minimize alternative minimum taxable income

 

The following should be considered to achieve these objectives:

REVIEW BANK BORROWING & OTHER CREDIT AGREEMENTS FOR RESTRICTIVE COVENANTS
Understand the restrictive covenants in borrowing agreements and keep in mind the effects of other planning objectives on these covenants. Communication with third party financial statement users is essential.

MAXIMIZE BONUS DEPRECIATION
The 50% first-year depreciation allowance generally applies to assets purchased before January 1, 2005. In order to qualify, fixed assets must be “original use.” In contrast with the income requirements of the Section 179 expensing election, a business can have a taxable loss and still qualify for bonus depreciation.

TAKE ADVANTAGE OF SECTION 179 DEPRECIATION
Taxpayers may elect to expense $102,000 of qualifying fixed asset purchases in 2004. This amount is subject to income limitations and begins to phase out if fixed asset purchases exceed $410,000. Proper timing of purchases will allow taxpayers to maximize their depreciation deduction.

MONITOR SHRINKING FEDERAL DEPRECIATION
The accelerated depreciation taken over the past two years as a result of the Sec. 179 and bonus depreciation provisions will eventually lead to a depreciation reversal. If this occurs, financial statement depreciation will be higher than tax depreciation, causing an add-back to financial statement income.

REVIEW EXPENSES THAT SHOULD BE CAPITALIZED
An effective capitalization policy can identify repairs and maintenance costs that should be capitalized.

REVIEW CONTRACTS IN PROGRESS
The percentage of completion and gross profit percentage should accurately reflect a job’s position at the end of the year. Costs to complete should be carefully analyzed and estimated. Jobs should be reviewed for potential job fade.

ANALYZE UNDERBILLINGS
A thorough analysis of underbillings is an important aspect of year-end planning. Underbillings may highlight inefficiencies in the billing system. Underbillings that are overstated may indicate accelerated recognition of revenue and profit, which can lead to job fade in successive periods and a negative impact on future earnings.

ANALYZE OVERBILLINGS
A contractor’s cash balance should be higher for jobs that are overbilled. If not, this could result in a job-borrow situation leading to future cash flow problems. In addition, costs may not be appropriately allocated to the job or estimated costs to complete are not properly calculated, resulting in deferred profit.

REVIEW COMPLETED CONTRACTS
Ideally, gross profit margins on completed jobs should approximate margins previously reported on the work in progress schedules. A trend of decreasing gross profit margins may indicate a poor job costing and estimating system.

ENSURE COMMUNICATION BETWEEN ESTIMATING AND ACCOUNTING PERSONNEL
Strong communication between the estimating and accounting staff will help to alleviate inconsistencies which affect percentage of complete calculations and, ultimately, revenue recognition.

TAKE ADVANTAGE OF TIMING DIFFERENCES
Contractors need to be aware that if they do not use the percentage-of-completion method of accounting for federal income tax reporting, their financial statement and taxable income may differ significantly. These differences can cause a contractor with a financial statement loss to have positive taxable income. Alternatively, contractors can use these different methods to defer income and to minimize income taxes over several periods.

MANAGE CASH
Plan transactions that will ensure a positive cash balance at the close of the year.

REVIEW ACCOUNTS RECEIVABLE
Review the accounts receivable aging schedule for uncollectible receivables. Accounts receivable balances in excess of 90 days are discounted heavily by financial statement users. Therefore, place additional emphasis on accelerating collections of these receivables.

ANALYZE INVENTORY AND PREPAIDS
Inventory and prepaid expenses are discounted heavily by financial statement users. Determine if these costs were incurred on a job and could be expensed to that job. In addition, prepaid insurance may be reduced through an insurance policy that runs congruent with the fiscal year.

MANAGE RELATED-PARTY RECEIVABLES
Collection of related party receivables will minimize assets that are discounted by financial statement users, as well as increase year-end cash balances.

PAY RELATED-PARTY ACCRUALS BEFORE YEAR END
Related-party accruals (i.e., shareholder wages, rent and interest) are recorded as expenses for financial statement purposes, but not for federal income tax purposes, in most circumstances. Consider paying these expenses prior to year end to trigger the federal income tax expense deduction.

FINANCE LONG-TERM ASSET PURCHASES WITH LONG-TERM DEBT
Cash or short-term financing should not ordinarily be used to acquire equipment. Consider having an equipment line-of-credit in place that will be termed out at the end of the year.

MAXIMIZE PENSION CONTRIBUTIONS
Pension contributions deducted in the 2004 tax year are not required to be paid until the extended due date of the federal income tax return. In addition to being an excellent tax savings vehicle, pension plans can help owners and key employees plan for retirement.

 

The close of the year is also a good time to review other areas for financial planning opportunities, including the following:

  • Internal controls
  • Staffing/Employees
  • Entity changes
  • Planning expansion into a new state
  • Executive compensation plans
  • Review of retirement plan compliance
  • Adequacy of insurance coverage and umbrella policy
  • Buy/Sell agreements
  • Estate planning or updating

All major decisions and transactions should be documented in the company’s board of directors’ meeting minutes.

For further information about this article, please call Mike Schmidt at (425) 454-7990 or (800) 876-6931 or email mschmidt@bpcpa.com.