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A Guide to Tax Planning for Construction Companies

Effective tax planning is essential for construction companies that want to stay financially healthy and maximize profitability. Whether you own a construction company or are in a leadership position, understanding the unique tax situation of your business and planning accordingly can unlock significant benefits. 

This guide provides practical insights into tax planning tailored specifically for the construction industry. You'll learn how to:

  • Maximize deductions unique to construction projects
  • Leverage tax credits that encourage energy efficiency and innovation
  • Optimize your business structure for tax efficiency
  • Implement effective succession planning to preserve wealth

By applying these strategies, you can use proactive tax planning to strengthen your company's financial position and ensure long-term success in a competitive market.

The Basics of Construction Tax Planning

Effective tax planning for construction companies begins with understanding the factors that impact your tax situation. Specifically, before diving into specific accounting methods and tax incentives, you need to consider how your business structure and industry-specific factors influence your tax planning strategy.

Business Structures and Their Tax Implications

Construction companies can operate under various business structures, each with distinct tax consequences. Choosing the right entity structure is one of the most important decisions that a construction company can make, as it impacts taxation, reporting requirements, liability protection and the ability to raise capital. 

Here’s a closer look at how different corporate structures impact these areas. 

Partnerships:

  • Taxation: Income and losses pass through to partners' personal tax returns based on their ownership percentage. Partnerships file Form 1065 and issue Schedule K-1s to partners.
  • Reporting requirements: Partnerships must file an annual information return (Form 1065) and provide Schedule K-1s to partners.
  • Liability Protection: General partners have unlimited liability, while limited partners have liability limited to their investment.
  • Capital raising: Flexible, with the ability to bring in new partners and allocate profits and losses in ways that do not strictly follow ownership percentages.

S Corporations:

  • Taxation: Income and losses pass through to the owners' personal tax returns, avoiding double taxation. Owners can also potentially save on self-employment taxes by taking a reasonable salary and receiving the rest as distributions.
  • Reporting requirements: S corps must file IRS Form 1120-S annually and provide Schedule K-1s to shareholders.
  • Liability protection: Shareholders are generally protected from personal liability for business debts.
  • Capital raising: Limited to 100 shareholders and one class of stock. This restricts the ability to deduct financed losses. 

Limited Liability Companies (LLCs):

  • Taxation: By default, single-member LLCs are taxed as sole proprietorships and multi-member LLCs as partnerships. However, LLCs can elect to be taxed as S corps or C corps, providing flexibility. 
  • Reporting requirements: LLCs must file different forms depending on their tax election (e.g., Form 1065 for partnerships, Form 1120 for C Corporations).
  • Liability protection: Members enjoy limited liability protection, similar to corporations.
  • Capital raising: LLCs have no limit on the number of members and allowance for different types of ownership interests, but if the LLC chooses to be taxed as an S corporation, they must follow the ownership rules for S corps described above.

Sole Proprietorships:

  • Taxation: Business income and expenses are reported on the owner's personal tax return (Schedule C), making it simple but potentially less tax efficient.
  • Reporting requirements: Minimal, as there is no separate entity; the owner files a Schedule C with their personal tax return.
  • Liability protection: No liability protection; the owner is personally liable for all business debts and obligations.
  • Capital raising: Limited, as it relies solely on the owner's personal resources and credit.

C Corporations:

  • Taxation: Subject to double taxation, where the corporation pays taxes on its income, and shareholders pay taxes on dividends received. The corporate tax rate is currently a flat 21%.
  • Reporting requirements: C corps must file Form 1120 annually and comply with the same reporting and record-keeping requirements as other entity structures.
  • Liability protection: Shareholders are protected from personal liability for business debts.
  • Capital raising: Easier to raise capital through the sale of stock, with no limit on the number of shareholders or types of 

What’s the Best Fit?

There are a couple of important factors to consider when determining the most appropriate entity structure for your construction company. Ensure that the entity structure you choose shields its owners against personal liability. You should also consider the tax implications of your choice of entity structure. Flow-through entities tend to be the best option, but it’s always worth consulting with a construction tax professional to determine the most tax-efficient option.

What do we see among our client base? While some construction companies are structured as C corporations, the vast majority are structured either as partnerships or S corporations. We typically see early-stage construction companies start out as wholly-owned LLCs and then make the transition to S corporations over time.

Industry-Specific Tax Considerations

Construction businesses operate in a unique environment, frequently grappling with project-based income, fluctuating labor costs and significant investments in equipment. This creates specific tax planning challenges that can significantly impact a company's financial health.

By being proactive and informed, construction firms can leverage their unique circumstances to achieve better financial outcomes.

  • Project-based income: Revenue often fluctuates based on project timelines, affecting tax liability from year to year. To be proactive, implement a robust forecasting system that anticipates revenue fluctuations and their tax implications. Regularly review and adjust estimated tax payments based on project progress. This approach can help avoid underpayment penalties and ensure sufficient cash reserves for tax obligations, ultimately leading to more stable cash flow and reduced financial stress.
  • Equipment and asset management: Proper tracking and depreciation of equipment can significantly impact tax deductions. Develop a comprehensive asset management strategy, including regular reviews of depreciation methods and consideration of Section 179 expensing or bonus depreciation for new equipment purchases. This proactive approach can maximize tax deductions, potentially reducing taxable income and improving cash flow for reinvestment or debt reduction.
  • Labor costs: Correct classification of workers (employees vs. independent contractors) is crucial for tax compliance and planning. Establish clear criteria for worker classification based on IRS guidelines and conduct regular audits of your workforce. Consider implementing a formal review process for all new hires or contracts. This proactive stance can help avoid costly misclassification penalties, ensure proper tax withholding and maintain compliance with labor laws, potentially saving significant amounts in back taxes and fines.
  • Job costing: Accurate allocation of costs to specific projects affects profitability and tax liability. Implement a detailed job costing system that tracks direct and indirect costs for each project. Regularly review and reconcile job costs to ensure accuracy. This proactive approach allows for more precise bidding on future projects, identifies areas for cost reduction and provides a clear picture of project profitability for tax planning purposes. This could lead to improved profit margins and more accurate tax projections.

By recognizing and addressing these industry-specific tax considerations, construction companies can develop tailored strategies that enhance profitability and ensure compliance. Proactive management of project income, equipment, labor costs and job costing can lead to significant tax savings and improved financial performance.

Additional Key Considerations

Beyond the core tax considerations, construction companies must navigate several other factors that can significantly impact their tax strategies. Understanding and addressing these elements can lead to substantial tax savings and improved compliance.

  • Sales tax complexities: Construction services and materials often face varying sales tax treatment across states. Implement a system to track the taxability of services and materials for each project location. Regularly review state-specific exemptions for construction activities. This approach can prevent overpayment of sales tax, reduce the risk of audits and potentially increase profit margins on projects.
  • State and local tax landscape: Each jurisdiction may have unique tax rules affecting construction projects. Develop a multi-state tax strategy if operating across state lines. By proactively managing state and local tax obligations, companies can avoid unexpected liabilities and possibly uncover tax incentives specific to certain locations.
  • Long-term contract reporting: IRC 460 governs the reporting of long-term contracts, affecting how income and expenses are recognized for tax purposes. Evaluate the benefits of the percentage-of-completion method versus the completed-contract method for your specific projects. Consistent application of the chosen method can smooth out tax liabilities over time and provide a more accurate picture of the company's financial position.

Effective management of these areas not only minimizes tax-related risks but can also contribute to improved cash flow and profitability. And by building them into your tax strategy proactively, you can improve your tax position while staying compliant across jurisdictions.

Remember, tax regulations in the construction industry are complex and ever changing. Regular consultation with tax professionals who specialize in construction can help you stay ahead of regulatory changes and maximize available tax benefits.

The Impact of Your Long-Term Contract Accounting Method on Tax Planning

In the construction industry, where long-term projects and variable cash flows are common, the long-term contract accounting method you choose can significantly influence your tax planning strategy and overall financial management. Keep in mind that the method used for tax purposes may differ from the one employed for financial reporting under Generally Accepted Accounting Principles (GAAP). 

When selecting a long-term contract accounting method, consider these key factors:

  • Business size and revenue: Recent changes in the Tax Cuts and Jobs Act (TCJA) have expanded eligibility for certain accounting methods based on gross receipts. Companies with average annual gross receipts up to $30 million may select any permissible accounting method, whereas companies above this threshold are required to use the percentage of completion method. 
  • Project duration: The length and complexity of your typical projects can impact which method is most suitable.
  • Cash flow patterns: Some methods align better with unpredictable or seasonal cash flows common in construction.
  • Financial reporting needs: Your choice may affect how you report to stakeholders, seek financing or obtain bonding.
  • State-specific rules: Different states may have unique regulations that impact your choice of accounting method.

Understanding these factors will help you make informed decisions that align with your business goals. Remember, regularly reviewing your long-term contract accounting method with a tax professional can ensure you're using the best approach for your specific situation.

Cash Accounting Method

The cash accounting method recognizes income when cash is received and expenses when they are paid. For example, if you complete a renovation project and bill your client $50,000, you only record this income when the client pays you. 

The TCJA expanded eligibility for the cash accounting method by increasing the gross receipts threshold to $26 million (adjusted annually for inflation). As of 2024, the gross receipts threshold is $30 million. 

Consider the cash accounting method if:

  • Your annual gross receipts are under $30 million.
  • You primarily work on short-term projects.
  • You prefer a simple, straightforward accounting system.
  • Your business has unpredictable cash flow patterns.

This method allows you to control the timing of income recognition, which can help you defer income to future tax years.

Accrual Accounting Method

The accrual accounting method recognizes income when earned and expenses when incurred, regardless of when cash is exchanged. For instance, if you complete a phase of a large commercial project and bill your client $100,000, you would record this income when the $100,000 is billed. 

While recent tax law changes have expanded eligibility for other methods, many larger construction companies still use the accrual accounting method due to their size or other factors. 

Consider the accrual accounting method if:

  • Your annual gross receipts exceed $30 million.
  • You have significant inventory.
  • You're seeking financing or bonding.
  • You want to provide a more accurate picture of your company's financial health to stakeholders.

With the accrual method, you often recognize income earlier, which can increase your current tax liability but provides a clearer view of your financial position.

Completed Contract Method

The completed contract method is a type of accrual accounting that allows you to defer income and expense recognition until a project is substantially complete. Let’s say you're working on a multi-year infrastructure project and incur $500,000 in costs while billing the client $600,000. You would not recognize any income or expenses until the project is substantially complete. 

Recent tax law changes have made this method available to more construction companies by increasing the gross receipts threshold. 

Consider the completed contract method if:

  • Your annual gross receipts are under $30 million.
  • You have projects with uncertain outcomes.
  • You want to defer tax liability on long-term projects.
  • Your projects typically span less than two years.

This method can delay tax liability, but you may face larger tax bills when projects are completed.

Percentage of Completion Method

The percentage of completion method is another type of accrual accounting that recognizes income and expenses based on the percentage of work completed at any given time. Imagine you are working on a large residential development project expected to cost $1 million and generate $1.2 million in revenue, and you complete 25% of the project in the first year. You would recognize 25% of the total revenue ($300,000) and 25% of the total costs ($250,000) as income and expenses for that year. 

The IRS general requires larger construction companies to use the percentage of completion method to account for long-term construction projects. 

Consider the percentage of completion method if:

  • You primarily work on long-term contracts (over 1-2 years).
  • You want to provide accurate ongoing financial reporting.
  • You want to smooth out tax liabilities.

Using this method allows for more consistent income recognition and tax liability over the life of a project.

Learn More: A Comprehensive Guide to Construction Accounting

Tax Planning Opportunities for Construction Companies

Building on the accounting methods we've discussed, effective tax planning can further optimize a construction company's financial position. By leveraging industry-specific strategies, firms can:

  • Reduce tax liabilities
  • Improve cash flow
  • Enhance overall financial stability

This section will explore key tax planning opportunities tailored to the construction industry's unique operational landscape. We'll cover deductions, credits and strategic techniques that can lead to significant savings, helping your company navigate the complexities of project-based income and fluctuating costs.

Look-Back Method for Long-Term Contracts 

Construction companies often deal with long-term contracts that span multiple tax years. The look-back method is a required calculation for these contracts to ensure that taxes are paid accurately over the life of the project. 

This method compares the estimated income reported in previous years with the actual income upon contract completion. If there's a discrepancy, you may be charged or refunded interest. Proper management of your work in progress (WIP) schedule helps you avoid surprise interest you may owe as a result of the lookback calculation. 

Depreciating Key Purchases

Depreciation is a significant tax planning tool for construction companies. By depreciating key purchases, businesses can spread the cost of large investments over several years, which helps reduce taxable income each year. 

This is particularly important in the construction industry, where substantial investments in equipment and property are common. Construction companies typically rely on depreciable assets like machinery and equipment, vehicles and buildings. 

There are a few different approaches to depreciation to consider, each with distinct advantages:

  • Cost segregation studies: This strategy involves a detailed analysis of building costs to identify and reclassify personal property assets. By breaking down the components of a building, certain elements can be depreciated over shorter periods (5, 7, or 15 years) instead of the standard 39 years for commercial property. This can significantly accelerate depreciation deductions, resulting in increased cash flow in the early years of a building's life..
  • Section 179 deduction: This deduction permits businesses to deduct the full purchase price of qualifying equipment and software purchased or financed during the tax year. Recent changes under the Tax Cuts and Jobs Act (TCJA) have increased the limits for this deduction, making it more accessible for construction firms.
  • Bonus depreciation: This enables businesses to immediately deduct a large percentage of the purchase price of eligible assets, with the TCJA expanding the definition of qualifying property.

For construction companies, aligning depreciation schedules with project timelines can help manage cash flow and tax liabilities more effectively. 

Consult with your construction accounting advisor to determine the best depreciation strategy for your specific situation and to ensure compliance with current tax laws. 

Retirement Planning

Effective retirement planning not only helps attract and retain employees but also provides significant tax advantages. By choosing the right retirement plans and managing them effectively, construction companies can optimize their tax positions while ensuring long-term financial security for their workforce. 

Here are some popular plans that can offer substantial benefits:

  1. 401(k) plans: These plans allow employees to save for retirement using pre- or post-tax dollars, which reduces their taxable income. Employers can further enhance participation by offering matching contributions, which are also tax-deductible for the business. This not only incentivizes employees to save but also provides immediate tax relief for the company.
  2. Simplified employee pension (SEP) IRAs: SEP IRAs are easy to set up and allow business owners to contribute up to 25% of their income, with a maximum contribution limit of $69,000 for 2024. Contributions to SEP IRAs are tax-deductible, making this an attractive option for self-employed individuals and small business owners looking to lower their taxable income.
  3. Defined benefit plans: These plans provide predictable retirement income based on a formula that considers salary and years of service. They can offer larger tax deductions compared to defined contribution plans, making them a compelling choice for businesses that want to provide robust retirement benefits while maximizing tax savings.

To make the most of these retirement plans, consider the following strategies:

  • Stay informed: Keep up to date with current contribution limits and tax regulations for each plan type. This ensures compliance and helps you optimize tax savings.
  • Encourage participation: Promote employee participation by offering educational seminars or one-on-one consultations. Highlight the tax advantages of retirement savings to motivate employees.
  • Plan contributions: Strategically time contributions to maximize tax benefits for both the company and employees. For instance, making contributions before year-end can help reduce taxable income.

By integrating retirement planning with overall tax strategy, construction companies can create a comprehensive approach that benefits both the business and its employees. This proactive planning not only enhances employee satisfaction and retention but also supports the long-term financial health of the company. 

Tax Credits for Construction Companies

Tax credits offer a powerful way to reduce your company's tax liability directly. Unlike deductions that lower your taxable income, credits provide a dollar-for-dollar reduction in the taxes you owe. Several tax credits are particularly relevant to construction companies:

Fuel Tax Credit

The fuel tax credit is available for companies using off-road vehicles or equipment, providing a credit on fuel taxes paid. This credit is particularly beneficial if your company uses a significant amount of fuel in off-highway business activities, such as construction equipment. To pursue this credit, it’s essential to have systems in place to track fuel usage separately for off-road and on-road vehicles. The administrative effort to track and claim the credit should be justified by the potential savings. 

To claim this credit:

  • Keep detailed records of fuel purchases and usage for each piece of off-road equipment.
  • Work with your tax advisor to calculate the credit based on your specific fuel usage and equipment types.

Energy Efficient Commercial Building Deduction (Section 179D)

This deduction incentivizes the construction of energy-efficient commercial buildings and is now a permanent part of the tax code, providing more certainty for long-term planning. Consider this deduction if you’re involved in designing or constructing commercial buildings and are willing to incorporate energy-efficient designs that meet specific standards. To claim this deduction:

  • Incorporate energy-efficient designs in your commercial construction projects.
  • Engage a qualified engineer to certify the energy savings.
  • Maintain detailed documentation of the energy-efficient systems installed and their projected savings.

In 2024, this deduction can be up to $5.65 per square foot for buildings achieving significant energy savings, which can result in substantial tax benefits for larger projects.

Residential Energy Efficient Property Credit (45L)

This credit is available for builders of energy-efficient residential properties. It is particularly relevant if you build single-family homes or multi-family residential units and are willing to incorporate energy-efficient features that meet the credit's standards. 

To claim this credit:

  • Design and build homes that meet the energy efficiency standards required by the credit.
  • Obtain certification from an eligible certifier for each qualifying dwelling unit.
  • Keep detailed records of energy-efficient features installed in each unit.

Work Opportunity Tax Credit (WOTC)

The work opportunity tax credit encourages hiring from certain target groups who have consistently faced barriers to employment. This credit can be beneficial if you are hiring new employees, especially for entry-level positions, and are willing to implement a screening process to identify potentially eligible employees. 

To claim this credit:

  • Implement a screening process during hiring to identify potentially eligible employees.
  • Submit Form 8850 to your state workforce agency within 28 days of the employee's start date.
  • Maintain detailed records of hours worked and wages paid to eligible employees.

Research and Development (R&D) Tax Credit

While not exclusive to construction, many construction companies can benefit from the R&D tax credit for innovative building techniques or materials. This credit encourages innovation and technological advancement in areas such as developing new construction techniques, creating innovative building materials, designing energy-efficient systems, and improving safety or efficiency. 

To determine whether your company may qualify:

  • Identify activities that may qualify as R&D, such as designing innovative solutions or testing new materials.
  • Document all potentially qualifying activities, including time spent, resources used and specific technical challenges encountered during the process.
  • Keep detailed records of associated costs, including wages, supplies and contract research expenses.
  • Consult with a tax professional experienced in R&D credits for the construction industry to ensure proper documentation and calculation.

The definition of R&D for tax purposes can be broader than you might think. Activities that may appear routine or part of your regular business operations could still qualify for the credit if they involve experimentation or efforts to solve technical challenges. 

For instance, if your company tests new materials to improve durability or experiments with innovative methods to enhance efficiency, these activities may be eligible for the R&D tax credit. 

To make the most of this broader definition:

  • Review your projects: Regularly review your projects to identify any activities that involve experimentation or technical problem-solving.
  • Document thoroughly: Keep detailed records of these activities, including the objectives, processes and outcomes.
  • Consult experts: Work with a tax professional who specializes in R&D credits to evaluate your activities and ensure they meet the criteria for the credit.

By understanding and applying the broader definition of R&D, your company can potentially unlock significant tax savings through innovation.

Tax Planning Opportunities for Construction Company Owners

In addition to the general tax planning strategies available to construction companies, there are specific opportunities that owners can leverage to optimize their tax positions and build wealth. These strategies can enhance financial outcomes for owners while also benefiting the business as a whole.

Qualified Business Income Deduction (QBI) 

The qualified business income (QBI) Deduction allows owners of pass-through entities, such as S corporations and partnerships, to deduct up to 20% of their qualified business income on their personal tax returns. This deduction can significantly reduce taxable income and enhance overall tax efficiency, making it a valuable strategy for construction company owners. Key points to consider include:

  • Income sources: QBI encompasses income earned from your business operations, specifically the profits generated from your core business activities. However, it does not include items like capital gains, dividends and interest income that are not directly related to the business.
  • Limitations: The deduction is subject to limitations based on the taxpayer’s taxable income, the type of trade or business, and the amount of W-2 wages paid by the business. For example, if your taxable income exceeds certain thresholds, the deduction may be limited or phased out.
  • Specified service trade or business (SSTB): For high-income taxpayers, the QBI deduction might be limited if the business is classified as a specified service trade or business (SSTB). Fortunately, most construction activities do not fall under this classification, allowing for more favorable treatment under the QBI rules.

Understanding and optimizing the QBI deduction can provide substantial tax savings for construction company owners. It’s essential to work with a tax advisor to ensure you are maximizing this deduction within the parameters of the law.

Pass-Through Entity Tax (PTET)

The pass-through entity tax (PTET) is a tax strategy available in certain states that allows pass-through entities, such as S corporations and partnerships, to pay state income taxes at the entity level rather than passing the tax liability to individual owners. This approach can provide significant tax benefits, particularly in states with high income tax rates. 

Here’s how it works:

  1. The pass-through entity elects to pay state income tax at the entity level.
  2. The entity receives a deduction for the state taxes paid, which reduces the amount of income passed through to the owners.

This can have several key benefits:

  • Bypassing SALT cap: PTET allows owners to circumvent the $10,000 cap on state and local tax (SALT) deductions imposed by the Tax Cuts and Jobs Act. By paying state taxes at the entity level, companies may be able to deduct these taxes fully on their federal returns.
  • Potential tax savings: For owners in high-tax states, this can lead to substantial federal tax savings and improved cash flow.

This strategy is beneficial for construction company owners who operate in states that offer PTET opportunities. Other states, including Florida, don’t tax pass-through income, so they have no need for a PTET.  

Strategic Use of Fringe Benefits

As an owner-employee, you can potentially reduce your taxable income by taking advantage of certain fringe benefits:

  1. Health insurance: The company can deduct premiums paid for your health insurance, which are not taxable to you as income.
  2. Disability insurance: Company-paid disability insurance premiums can be deductible to the business and are not taxable to you.
  3. Company car: If structured correctly, the use of a company vehicle can provide tax advantages.
  4. Education assistance: The company can provide up to $5,250 per year in tax-free education assistance for job-related courses.

By taking advantage of these opportunities, owners can optimize their personal tax situations while enhancing the overall benefits available to employees.

James Moore: Your Partners in Construction Tax Planning

Effective tax planning is not merely a compliance obligation; it’s also vital for your construction company’s sustainable growth. By using proactive tax planning strategies — such as maximizing deductions, leveraging available credits and optimizing your business structure — you can enhance your financial resilience and drive profitability. 

But tax regulations can be complex, and navigating them requires vigilance and expertise, especially in an industry that is constantly changing. Partnering with experts who understand the unique challenges of the construction sector can make all the difference.

Contact James Moore today to discover how our specialized construction tax advisors can help you build a solid financial foundation for your company’s future.