The end of the tax year provides an annual opportunity to manage tax situations to the most advantageous position possible. The traditional approach to year-end tax planning is deferring income and accelerating deductions, thereby minimizing current-year taxes. As everyone in the residential construction arena is aware, profits have taken a hard hit over the past 18 months. So the traditional approach or what was always done in the past may or may not be the best answer this year.
Whether its corporate-level tax in the case of the C corporation, or individual-level tax in the case of the S corporation, partnership or sole proprietorship, the United States tax system uses graduated rate brackets. Lower-income amounts are taxed at lower percentages and higher-income amounts are taxed at higher percentages. Managing these rate brackets from year to year can have a significant impact on how much tax ultimately is paid on income.
On an individual level, federal income tax rates vary from 15 to 35 percent. If it’s a down year and the marginal tax rate is 15 percent, while you generally will be in the 35 percent tax bracket you likely will be costing yourself money by accelerating deductions or deferring income. Assume you will be in the 15 percent tax bracket in the current year and the 35 percent tax bracket in the following year. If you accelerate $10,000 of deductions to the current year, it will save you $1,500 in tax now; however, the loss of that deduction in the following year will cost you $3,500 next year. The same principles will apply to C corporations that pay tax at the corporate level.
It is important to work with tax advisors to manage taxable income from year to year. The fact that a business may be in a down cycle could make this planning even more important than it has been in the past. Tax situations are not exactly the same from person to person, or business to business. Develop a tax strategy based on personal facts, not facts about other people or businesses.
Reduce Current Tax Liability
A business may elect under Code Section 179 to deduct as an expense, rather than depreciate, up to $125,000 per year of new equipment, furniture or fixtures in 2007. The deduction is phased out dollar-for-dollar as purchases exceed $500,000. These limits were increased under the Small Business and Work Opportunity Act of 2007.
The domestic production deduction introduced in 2005 is increased to 6 percent of qualifying taxable income in 2007. Taxpayers are allowed a deduction of 6 percent of income from domestic production gross receipts (9 percent after 2009). Domestic production gross receipts are from items manufactured, produced, grown or extracted within the United States.
Most construction contracts will qualify for this deduction. The sale of land does not qualify for the deduction, but the regulations provide a safe harbor for allocating the sale proceeds between land and actual construction. Consequently, even the sale of residential lots can qualify as there is a component of the raw land which does not qualify and the development or construction which does qualify. The deduction is limited to 50 percent of wages paid in the activity.
Does your spouse or child perform services for your business? If they do or could, there’s an opportunity to take advantage of additional tax deductions. Employing a spouse can make him or her eligible for health benefits on a tax-deductible basis, and retirement benefits on a tax-deferred basis. For example, your spouse could defer up to $15,500 into a company 401(k) plan or $10,500 into a SIMPLE plan. These limits are increased to $20,500 and $13,500 if your spouse is age 50 or older. They would also be eligible for the applicable company contributions to the retirement plan. Children also could take advantage of these benefits, or they could earn up to $9,300 and pay no income tax by contributing $4,000 to an IRA.
Residential contractors are eligible for a $2,000 tax credit for energy-efficient homes sold in 2006, 2007 and 2008.
Qualifying homes must be certified to provide a reduced level of heating and cooling energy consumption compared to a comparable structure as defined in the International Energy Conservation Code. Due to strict building codes in some states, many homes currently being constructed will qualify for this credit or could qualify with slight modification in design or materials. The credit falls under the general business credit. As such, it cannot be used to reduce the alternative minimum tax.
Defer Your Income?
Cash-basis taxpayers can take measures to delay the receipt of income such as delaying billings close to year-end. They can also accelerate expenses by prepaying expenses (other than rent and interest) as long as the goods or services purchased are consumed within the next year.
An accrual-basis taxpayer will need to pay all items accrued to owners by year-end to obtain a deduction in the current year. This applies to S corporations, personal service C corporations and partnerships (including LLCs). Accrual-basis taxpayers can also prepay expenses (other than rent and interest) to be consumed within the next year.
Contractors using the completed contract method of accounting may wish to delay completion of a job to the following year to defer the income to the following year. Contractors using the percentage of completion method of accounting may wish to defer incurring costs to the following year to reduce current-year income recognition.
To determine which moves are appropriate in a tax-planning strategy, the first step is to complete a current income and income tax projection. Then determine if deferring income and accelerating deductions is an appropriate strategy. Many strategies for deferring or accelerating income will require advance planning. The earlier you get started with your projections, the more time you will have to execute an effective year-end strategy.
Paul Longsdorf, CPA, is a senior tax officer at HLB Tautges Redpath and leads the firm’s construction accounting and tax group. He works extensively with closely held contractors and developers focusing on tax-efficient entity structures, tax planning, consulting, and banking and surety relationships. Paul can be reached at 651-407-5831 or firstname.lastname@example.org.
John Redpath, JD, is an associate at Fabyanske, Westra, Hart & Thomson, P.A., practicing in the areas of corporate and tax law, and estate succession planning. He works primarily with closely held companies and their owners helping them develop and implement various business strategies. Prior to joining Fabyanske, Westra, Hart & Thomson, P.A., John was a CPA at Ernst & Young, LLP. John can be reached at 612-359-7667 or email@example.com.