The ripples of tax reform have reached CPAs working in the construction industry in a big way. Emily Gunther, CPA, CCIP, a principal with CLA LLP in Plymouth Meeting Pa., discusses Section 199A, business interest, and much more. Gunther will speak at greater length on this topic at PICPA’s 2019 Construction Industry Conference on Oct. 16 in Malvern, Pa.
By: Jim DeLuccia, PICPA Communications Manager
Tax reform is having a big effect on CPAs working in the construction industry. Joining me to briefly discuss the qualified business income deduction and other critical items is Emily Gunther, CPA, CCIP. Emily is a principal with CliftonLarsonAllen LLP, or CLA as they are perhaps more commonly known. She will speak at greater length on this topic at PICPA's 2019 Construction Industry Conference on Oct. 16 at Penn State Great Valley in Malvern.
Emily, thanks so much for joining me on the phone today.
[Gunther] Thanks for having me.
I keep hearing a lot about section 199A, the qualified business income deduction. How does this affect the construction industry, and do you have a practical example to share?
[Gunther] The 199A deduction has certainly added complexity to tax planning and how taxable income is calculated for shareholders and partners of pass-through entities. Generally, an owner of a construction company really wasn't concerned if their income came via a K-1 or if it came via a W-2. It was taxed at the same rate. However, tax reform has changed that, and there's a difference now in how W-2 income is taxed versus K-1 income. When you talk about your K-1 income, you're going to talk about the 199A deduction. Effectively, that piece is taxed at 80% if you can hit certain marks relative to wages.
Most contractors, however, are still in a position to manage their income. Regardless of 199A, contractors still have the ability to manage their taxable income down with good retirement planning, utilizing research credits, and taking depreciation deductions. Depreciation became really favorable for contractors under tax reform, and there's lots of availability to write off significant pieces of equipment. Tax reform also changed accounting methods that were available to some smaller contractors making the use of cash basis a more flexible option for some. In years where there's income for a contractor and one pass-through entity, the calculation of the 199A is fairly simple. You're going to pay tax on 100% of your W-2 income and 80% of your K-1 income, provided you meet certain thresholds.
However, if you don't have a significant workforce in place and a significant portion of your work is done via subcontractors, it can certainly affect your taxable income and the amount of tax that you pay. Let's, in simplest terms, think about it if you were a contractor that had little to no payroll and reported K-1 income of $300,000, you'd pay tax on your full $300,000. But if the same contractor had significant payroll expense with bottom line of $300,000, they would be eligible for a 199A deduction of $60,000 effectively paying tax on $240,000. It makes for I'll call very circular math, between what should be paid to an owner via W-2 versus K-1 income in order to maximize that tax deduction and ultimately save some tax dollars. Good planning has always been important, and now under tax reform it continues to be vital to a contractor.
I'm also hearing a lot about changes to business interest, and I believe you just briefly touched on that in your previous response there, but what is one example from that or from small business exceptions and related disclosures that you can share with us?
[Gunther] Most good contractors are well capitalized, and interest expense isn't a huge part of their expense profile. And in years where contractors are showing income and have good profits, generally this interest limitation isn't a problem. But in years where there is a tax loss, this certainly becomes an issue because now interest is limited. In 2021, the calculation of adjusted income becomes less flexible, and so it's going to actually be more of an issue as we get further down the line. I was actually talking to a housing contractor the other day that has a limit, a $1 million limit, because of some expansion-related losses that they have. And the one good thing for them is there is sort of a back door where you can make an election to change the way you'll depreciate certain items to limit that interest deduction. So this client will be able to change the way they depreciate some items to be able to get some more of that interest to be a deduction, and their depreciation will just stretch out further.
You just have to be really careful about how you plan for future purchase of a building and equipment, and make sure you're managing those acquisitions as well as your taxable income. This really isn't an issue right now when we're in good times, but we all know that economies slip, and what's really going to be an issue is in a downturn in the economy, where the contractors are now going to have to float some losses, is where their interest is then going to become non-deductible or limited, and likely you'll have some contractors that won't be able to make it through that economic downturn because of the way the interest will be limited in bad times.
Are there any other fringe benefits and related deductions brought about by tax reform affecting CPAs in the construction industry?
[Gunther] Tax reform did little to change the rates on compensation. Tax rates dropped just a couple of percentage points. Everyone talks about the portions of entertainment that are now not deductible. One of the biggest headaches that a lot of our clients are seeing is that parking provided to employees is no longer deductible. While the employee still receives the fringe benefit of paying for parking pre-tax, the employer no longer gets a deduction for that income that is paid to the employee. And with the 199A deduction and it being more attractive now to be a subcontractor, in an already tight labor market, it's often hard to find W-2 employees or good W-2 employees, because the subcontractors will get some of that 199A benefit that an employee would not.
Finally, Emily, what's one way tax reform has affected rules for the partnership audit regime?
[Gunther] Strictly speaking, tax reform isn't what changed the partnership audit regime, it was actually the bipartisan Budget Act of 2015, but those changes came in right at the time when tax reform hit, so a lot of folks sort of put them in the same bucket. But effectively what happened was auditing partnerships was very cumbersome for the IRS, because if there was a change in the partnership taxable income, the IRS had to then go push that change down to each of the partners and effectively rerun all of the partner's tax returns. And what effectively has happened now is the IRS is trying to find a way to shift that burden onto the partnership so that as a result, the auditing a partnership maybe easier for the IRS. Because historically they've really shied away from auditing partnerships.
But the process can now get fairly ugly for a partnership, because if you have an audit of your 2016 partnership return that happens in 2018, but there's different partners in '18 than there were in ‘16 and the partnership has to pay for a liability in 2018, you're now going to have some issue related to whose liability is it? The IRS create an opportunity for the partnership to make an election to say, "We're going to pass that through to the partners that were in existence at the time that the audit of the year that was being audited." I think the key is that partners in a partnership need to understand what those rules are, how it affects them, and then make changes to their partnership agreement to reflect these new IRS changes. Because while folks are making the election for how they want it treated when we file their partnership return, I don't know if a lot of people are going back and actually making the change to the partnership agreement that needs to be made.
Well, Emily, thanks so much again for sharing this insight with our listeners today and for providing a little bit of a preview about what you'll be discussing in October. I appreciate it.
[Gunther] Thank you.
Again, you can hear more on the aftermath of tax reform at PICPA's 2019 Construction Industry Conference on Oct. 16 at Penn State Great Valley in Malvern. You can register to attend in person or via the webcast at www.picpa.org/construction.