Contractor's Year-Round Tax Guide Revised

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How to set up and run your construction business to minimize taxes: corporate tax strategy and how to use it to your advantage, and what you should be aware of in contracts with others.



Covers tax shelters for builders, write-offs and investments that will reduce your taxes, accounting methods that are best for contractors, and what the I.R.S. allows and what it often questions.

Weight 1.5000
ISBN 1-57218-006-4
Page Count 208
Author Michael C. Thomsett
Publisher Craftsman Book Company
Dimensions 8-1/2 x 11

How to set up and run your construction business to minimize taxes: corporate tax strategy and how to use it to your advantage, and what you should be aware of in contracts with others.

Covers tax shelters for builders, write-offs and investments that will reduce your taxes, accounting methods that are best for contractors, and what the I.R.S. allows and what it often questions.

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You're reviewing: Contractor's Year-Round Tax Guide Revised

Contractor's Year-Round Tax Guide
Revised Edition
by Michael C. Thomsett
Contents
1. Taxes and Forms of Organization, 5
A New Tax-Planning Strategy, 6
The Corporation, 7
The S Corporation, 8
Partnerships, 9
Proprietorships, 9
Self-Employment Tax, 10
When to Incorporate, 11
Subsidiary Corporations, 11
First-Year Tax Strategy for Corporations, 14
Owners As Consultants, 16
2. Capital Assets, 7
Modified Accelerated Cost Recovery, 18
Personal Property Depreciation, 18
Real Estate Depreciation, 19
Expensing Assets, 20
Capital Asset Tax Benefits, 21
3. The Ordinary and Necessary Rule, 23
Deciding to Capitalize Expenses, 24
Expenses Not Allowed, 24
High-Visibility Categories, 25
4. Compensation, 29
Reasonable Payments, 29
Dividends, 30
Salaries and Wages, 30
Bonuses, 31
Stock Options, 32
Consulting Fees, 32
Contracts with Employees and Consultants, 35
5. Profit Sharing and Pension Plans, 39
Why Have a Plan? 39
Qualified Pension and Profit-Sharing Plans, 40
Other Retirement Plan Options, 41
Social Security Retirement, 42
6. Tax Shelters, 45
At-Risk Limits, 46
Real Estate Investments, 46
Consider the Tax Consequences, 47
Expectation of Profit, 47
Tax Shelter Checklist, 48
7. Real Estate Transaction, 49
Tax Advantages, 49
Buying and Selling Property, 51
Who Should Own the Property? 52
Real Estate Income, 55
Deductions, 55
Record Keeping, 57
Real Estate As a Tax Shelter, 58
8. Write-Offs, 59
Bad Debts, 59
Casualty Losses and Theft, 61
Abnormal Obsolescence and Abandonment, 62
Inventory Write-offs, 63
Involuntary Conversions, 64
Intangible Asset Write-Offs, 64
Organizational Costs, 65
9. Accounting Methods, 67
Cash Accounting, 67
Accrual Accounting, 68
Completed-Contract vs. Percentage-of- Completion Rules, 69
Cash or Accrual Accounting: Other Considerations, 71
The Importance of Record Keeping, 73
10. Documenting Tax Deductions, 75
The Need to Document, 75
The Burden of Proof, 76
Travel and Entertainment, 77
Documenting Other Expenses, 80
Proper Documentation, 85
Subsidiary Accounts, 85
Tax Return Support, 86
Record Retention Rules, 86
11. Taxes and Cash Accounting, 89
Cash: A Tax Control Account, 89
Statement of Cash Flows, 90
Reducing Expenses, 91
Multiple Accounts, 92
Specialized Accounts, 93
Petty Cash Account, 93
12. Investing Fundamentals, 95
Compound Interest, 95
Income Taxes and Inflation, 96
Dividends and Capital Gains, 97
Types of Investments, 98
Finding Investment Advice, 102
Investment Objectives, 103
13. Buying and Leasing Equipment, 107
Advantages of Leasing, 107
The Option to Buy, 108
Rental Deductions, 108
Other Tax Aspects of Leasing, 109
14. Transactions Between Related Parties, 111
Other Related Party Transactions, 112
Consequences of Reallocation, 113
Multiple Corporations, 114
15. Corporate Contributions, 115
Reasons for Making Contributions, 115
Other Contribution Rules, 116
Contribution Strategies, 116
16. Death of Partner or Stockholders, 119
Comparison Between Organizations, 119
Buy-Out Agreements, 121
Consequences of Liquidation, 122
17. Taxpayers' Elections, 125
Extending Filing Deadlines, 125
Amending Tax Returns, 126
Form of Organization, 126
Accounting Methods, 127
Fiscal Year, 127
Depreciation Methods, 127
Auto Mileage, 127
Contributions, 128
Deferrals, 128
Expensing, 128
Inventory Valuation Methods, 128
Retirement Plans, 129
Capital Gains and Losses, 130
18. Tax Planning, 131
Tax Avoidance vs. Tax Evasion, 132
Sound Business Purpose, 132
Tax Avoidance Plans, 133
Interim Statements, 134
19. Filling Tax Returns, 135
Corporate Tax Return 135
S Corporation Tax Return, 136
Partnership Tax Return, 137
Individual Taxation and Schedule C, 138
Supporting Schedules, 139 / Schedule E, 140
20. Getting Professional Advice, 143
Preparing for the Tax Return, 144
Tax Professionals, 146
Special Situations, 146
Periodic Meetings, 147
21. Tax Records You Need, 149
Cash Controls, 149
Accounts Receivable Controls, 150
Inventory Controls, 151
Capital Asset Controls, I51
Accounts Payable Controls, 151
Notes Payable Controls, 151
Other Controls, 153
22. Changing Your Tax Year, 155
The Natural Business Year, 155
Changing Tax Years, 157
Taxes in a Short Year, 158
Ending-Day Methods, 158
Monthly Accounting Alternatives, 159
Fiscal Years and Personal Cash Flow, 159
Tax-Year Selection Strategies, 159
23. The Profit Motive, 161
The Business Purpose, 161
Examples of Intent, 162
24. Deductions, 165
25. Taxable Income, 171
Damages Received Through Legal Action, 172
Other Special Situations, 173
26. Nontaxable Income, 175
Tax-Free Exchanges, 176
27. Nondeductible Expenses, 179
28. Inventories, 183
Recording Inventory, 183
Inventory Valuation Methods, 185
What You Can't Do, 187
Writing Off Inventory, 187
29.
Benefits, 189
Common Flows, 190
Basic Rules for Coding, 191
Mid-Year Changes, 192
Timing of Corrections, 192
Tax Considerations, 193
Budgeting Time for Account Analysis, 194
Identifying and Solving Coding Problems, 194
Accounting Entry Classifications and Taxes, 189
Appendix: Tax Publications, 195
Index, 197

Contractor's Year-Round Tax Guide
Revised Edition
by Michael C. Thomsett

Chapter 1

Taxes and Forms of Organization

This is a tax guide for construction contractors. If you're running a construction company, this manual will help you to:

  • Steer clear of tax problems, and
  • Reduce your tax burden, so you can
  • Make a better living at your chosen profession.

I'm going to offer dozens of tax-planning ideas that can reduce both your taxes and the risk of loss when (and if) your return is audited. No one has to pay more tax than the low requires. And, in spite of what you may have heard, the tax code doesn't have to be an impediment to building a successful construction company. There are perfectly legitimate ways to both minimize your tax liability and limit the time you spend complying with the Internal Revenue Code. I hope that's what you want from this book, because that's exactly why I wrote it.

But please understand: This manual won't take the place of professional tax counsel. It doesn't have the technical details and references to the Internal Revenue Code an accountant or tax lawyer needs. And I'm not going to explain line by line how to fill out a 1040. (Dozens of good tax preparation manuals are published for that purpose every year.) But this manual will help you reduce legal and accounting expense by:

  • Making you more aware of what can (and can't) be done under the tax code,
  • Helping you recognize when expert tax advice is needed, and
  • Equipping you to evaluate the quality of the tax advice you're getting.

Very few construction contractors can afford to keep accountants and lawyers standing by, ready to give tax advice. Most of the builders I know wouldn't even try do business under those conditions. Better that you, the decision-maker in your company, have the knowledge and background needed to make sound tax decisions when and where decisions have to be made. Let the lawyers and accountants review the paperwork and clean up the details later. For most day-to-day work, rely on your own knowledge of what the tax law requires. If that's the way you like to conduct business, this book will suit you to a T.

You don't have to be a tax whiz to make it in the building business. Tax law is just one more area where construction contractors need a working knowledge of the basic principles, like estimating, accounting, labor relations, debt collection, and finance.

There's a basic body of tax law that most contractors can and should understand, even if they have an accountant and never fill out their own tax return. Most successful contractor's take care of many minor tax problems themselves. When a. tougher problem comes up, they Usually have the decision pretty well thought through before they get counsel from a tax professional. That saves time and reduces accounting fees. Your knowledge of the tax law will help your accountant give you better service at a lower cost.

Finally, this book should help you avoid expensive tax mistakes. No one should have to learn tax law by trial and error. That's the most expensive, most painful way to learn what the code requires. Because you've read this for into Chapter 1, I suspect that you agree.

A New Tax-Planning Strategy

During my lifetime the tax code has changed dramatically. There was a time when the code was far less fluid than it is today. Twenty or thirty years ago, we knew that changes would occur in the tax law. We also knew that most of the changes would be little more than tinkering with the details.

The Economic Recovery Act of 1981 introduced new and significantly different ways to compute depreciation, take investment tax credits, and contribute to retirement plans.

Change accelerated in the late 1980s and early

1990s as Congress redefined the way most business is taxed. In the process, entire industries were decimated. What had been good investment strategy in 1988 became foolish a few years later. Look at what happened to commercial construction between 1988 and 1992.

We can expect more of the same in the future. But don't be concerned. Change isn't necessarily bad. It just means that the rules are different. Some will be helped and others will be hurt. Those with the foresight and flexibility to adapt will continue to thrive.

Major Changes Coming?

Contractors and their tax advisors face special questions and problems in tax planning. For example, are you allowed to use the completed contract method of accounting for major jobs? Under completed contract accounting rules, you delay recording income for a job until the year when work is actually completed. The tax advantages should be obvious. Under completed contract accounting, the tax collector makes an interest-free loan of the tax money that will be due in later years.

As this book is being written, Congress is considering liberalized capital gains treatment and possibly even a new investment tax credit. There's no way to know what compromises Congress will make between the conflicting goals of maximizing tax revenue and stimulating the economy. No tax law on the books today or being written tomorrow can be permanent. Everything is up for negotiation every year. And that brings me to an important point.

While the information in this book is up-to-date with the latest tax rules at the time of publication, there are no guarantees about the future. So what's a construction contractor supposed to do? My advice is to rely on the IRS. The Internal Revenue Service is an excellent source of general information on the rules and rule changes. You're paying them to take your money. It's only fair that they provide assistance on figuring out how much you owe. They offer many free publications and have a telephone hotline where you can get answers to specific questions. That number is 800-829-1040.

Professionals and Tax Planning

As I said, this book isn't a substitute for professional advice. Instead, you'll find it a good supplement to the professional help you're getting now. Master the information between the covers of this book and you'll save many hours of your accountant's time and prevent at least some of the more common mistakes builders make when paying taxes.

Most construction contractors doing between several hundred thousand and several million dollars in business annually retain an accountant or CPA who prepares an annual tax return and provides counsel from time to time. That may be all the tax assistance some contractors need. But as your business grows, so does the need for tax planning. In fact, your need for tax planning will probably grow considerably faster than your business grows.

Proper tax planning can save you a lot of money. It's legal and it's smart. Most construction contractors can both reduce their liability and defer payments to later tax periods - while operating strictly within the low.

Experienced accountants who counsel and prepare tax returns for contractors and builders will tell you that some of the most successful contractors know the most about taxes, even though they have little or no formal training in accounting. They've learned enough of the basics over the years to recognize the important tax considerations in most of the decisions they make.

And the most basic decision of all is how a company is organized, as the tax liability and the way it is calculated are different for each type of organization. So we'll begin with that important subject. There are three choices: proprietorship, partnership or corporation.

Proprietorship, Partnership or Corporation?

A construction company operated as a corporation has to file a tax return and pay tax at corporate rates.

A construction company operated as a proprietorship (someone doing business under their own name) doesn't file a tax return and doesn't pay any tax. Instead, business income and expenses are listed on Schedule C of the proprietor's tax return. The proprietor pays tax on net income from the business.

Partnerships file an informational tax return but don't pay any tax. Instead, net income to the partnership is divided among the partners. Each pays tax on a share of that income. If three partners are taxed on a third of the year's profits, it's likely that each will pay a different rate of tax. For example, if one is single and has income from other sources, he or she will pay a relatively high rate. If the second partner is married, has several children and sizable deductions, his or her taxable income will be considerably less. The third partner may be able to offset part of his or her income with losses from other ventures.

Let's take a closer look at these three forms of organization and the tax obligations of each.

The Corporation

Corporations pay taxes on net income (profit) on a graduated scale. As income increases, more of each dollar earned goes to tax. Corporations have more rate classifications than individual tax payers. If you're running a contracting company that's a corporation, you may want to consider each of these graduations or plateaus. Here's an example.

Suppose at mid-year you forecast that income for the year will reach the top tax bracket. Every extra dollar of profit earned during the year will be taxed at the highest rate. So every job you bid for the remainder of the year will offer about 10 percent less after-tax profit. Now ask yourself this: How does that affect your competitive position against contractors who will be paying tax at lower rates?

Tax planning is in some ways easier for partnerships or small contracting businesses run by individuals. Even though individual tax rates are also graduated, the rate changes aren't as abrupt as they are for corporate profits.

For example, let's look at a father-and-son business run as a corporation. The two owners set their own compensation each year in the form of salary. Within limits, they can adjust their wages to control the amount of tax the corporation has to pay. What are those limits? The owners should get some tax advice before adjusting compensation, especially if they've adjusted compensation to match net income in previous years. The IRS considers this form of "Planning" to be abusive and has authority to assess additional taxes.

A corporation has to file at least a four-page tax return every year. It includes not only a summary of income, like individuals have to file, but also a beginning and ending balance sheet for the year, and a record of all changes in retained earnings. Supplementary schedules are appended to explain or substantiate key items on the tax return.

Larger corporations file detailed returns because of the complexity of their business organization. A corporation is treated as a separate entity for tax purposes. A corporation is a taxpayer, just like you and me. But the IRS wants more information about corporations than about individuals. The corporate tax form, Form 1120, requires a listing of assets and liabilities, retained earnings, and dividends paid to stockholders. Even if one person owns all stock in a corporation, the corporation is a separate entity.

Stock traded on stock exchanges is stock issued by publicly-held corporations. Anyone can buy stock in one of these companies. Most construction companies organized as corporations aren't publicly held. They're closely-held companies owned by a few individuals, often members of the some family.

Most publicly-held corporations pay dividends to stockholders. A section of the corporate tax return, Form 1120, is dedicated entirely to dividends. Many closely-held corporations don't pay dividends, preferring to invest after-tax earnings in the company.

The Advantages

The corporate form of ownership allows you to deduct some expenses that unincorporated businesses can't deduct. And in the past, a lower tax rate made the corporation an attractive alternative to partnerships or sole proprietorships. But today, tax rates are very nearly the same for individuals and corporations.

The real advantage of the corporate form has nothing to do with taxes: It is that a corporation doesn't stop operating just because ownership changes. In a proprietorship or partnership, if one of the owners wants to sell out, or dies, the business terminates and a new business entity has to be formed. This usually requires closing the books in the middle of the year and starting a new set of books.

A corporation can continue in business forever. If a stockholder dies, the stock can be sold to someone else. The company, however, can continue without interruption. That's a major advantage when your company has major jobs under contract. Imagine how hard it might be to dissolve a partnership, form a new company, and then have the company write new contracts on all the existing jobs.

Financing business growth may also be easier for the corporation. A new corporation probably won't be able to borrow from the bank without the personal pledge of an officer or stockholder. But a corporation can raise capital by selling stock or trading stock for equipment. Of course, there's a disadvantage to selling stock rather than borrowing money. Each new stockholder becomes a part owner of the business. Lenders expect to get repaid, but they don't own a part of the company.

If a corporation goes into bankruptcy, stockholders aren't liable for the corporation's debts. Federal liens attach to corporate property only.

Individual owners aren't liable unless corporate assets were distributed to them when insolvency was declared. A tax assessment against the corporation doesn't affect individual stockholders except that the value of their stock might fall or even become worthless. The owners of proprietorships and partnerships are usually liable for company debts.

The Disadvantages

The corporation also has disadvantages. Its dividends are taxed twice under federal law. The corporation must pay taxes on the profits from which dividends are paid. When the dividend is paid, recipients must declare the money received as income on their individual returns.

In some cases, corporations are taxed more heavily than individual taxpayers. If the corporation is used to avoid taxes, an accumulations tax is levied. The IRS proves this by citing an unreasonable level of retained earnings, more than the company needs for day-to-day operations. Also, in the past, an "excess profits tax" has been temporarily imposed only on corporations.

Finally, the constitutional guarantee against self-incrimination (the Fifth Amendment) doesn't apply to corporations in tax matters.

The S Corporation

For tax purposes there are two types of corporations. Up to this point we have been talking about "C" type corporations that are taxed at corporate rates. The S corporation, or "Small Business Corporation" is taxed more like a partnership. That is, the stockholders pay tax on net income of the corporation (even if none of that income is actually distributed to the stockholders).

A corporation can elect to be treated as an S corporation. In effect, this hybrid form of organization enjoys the advantages of a corporation (like perpetual existence) but is taxed more like a partnership. Here's a point worth remembering: S corporations are created under federal low. How that corporation is taxed under state low varies from state to state. If your state assesses an income tax, you'll probably have to file a state corporate tax return for an S corporation. The S corporation also, files a federal tax return, but on a different form than the one used by C corporations.

In an S corporation, all income is "passed through" to the owners, just as in a partnership. The owners pay tax on the income, whether or not they withdraw it. For example, your S corporation might have been very profitable lost year, but the profits were used to pay down debt, buy new equipment and pay subcontractors. Since the profits were earned by the company, they'll be taxed to the stockholders even though no money was actually received. See Figure 1-1.

Type of corporation Year Profit (Losses) Carry-Over Losses

Losses
Taken by Shareholders

S Corporation 1996 (43,000) ----------- (43,000)
S Corporation 1997 ( 4,500) ----------- ( 4,500)
Regular 1998 ( 2,100) ----------- ------------
Regular 1999 5,900 3,800 ------------
Regular 2000 ( 1,400)* ----------- ------------
Regular 2001 2,100 700 ------------

Figure 1-1 *Losses can be carried back to previous years' but if you expect
Examples of S corporation future profits, the wisdom of carry-backs is questionable


You can elect to have your corporation treated as an S corporation if you meet the following rules:

  • First, you have to be a domestic corporation. No foreign corporations can elect to be treated as an S corporation. And none of the stockholders can be nonresident aliens.
  • Second, you can't have more than 35 shareholders. And, among those 35 shareholders, no partnerships or other corporations are allowed. (A corporation's stockholders can include not only individuals, but other companies as well. But you can only become an S corporation when all of the stock is owned by individuals.)
  • Third, you can have only one class of stock. In some corporations, different types of stock are issued in different circumstances. For example, there might be common stock and preferred stock. That won't be possible for a corporation wanting to switch to S corporation status.

Plan to get professional assistance before forming either a C or S corporation. All states and the federal government have laws that regulate how stock can be sold and to whom you can offer stock. If you plan to sell stock to raise capital, you'll need legal assistance.

Partnerships

A partnership is two or more individual taxpayers working as a team. But for tax purposes, they're considered individuals.

Partnerships are not taxed. The partners are taxed whether profits are distributed to them or not. In a good year the partners could be pushed into higher brackets, even if all profits remain in the company and none are distributed.

The partnership must file a tax return which includes both an income statement and a balance sheet. In addition, there is a reconciliation of the partners' equity accounts. An additional schedule (Schedule K-1), must be filed for each stockholder, showing his share of income and credits.

So a partnership locks some of the corporation's major advantages and must file a more complicated return. And many accountants agree that partnerships are more likely to be audited.

The partnership offers a key advantage: Losses are passed directly to its members. In low-income years or years when the organization loses money, losses can be used to offset other sources of income, lowering an individual's tax bracket.

Proprietorships

Most builders go into business as proprietors. There's nothing about a proprietorship that promotes poor record keeping, lack of tax planning, or failure to coordinate business strategies with personal tax considerations. But many accountants would say that these characteristics are more common in proprietorships than in other forms of organization.

A proprietorship is usually a one-person show with the owner too busy handling construction problems to do much planning or to spend much time on business records. The result is that most proprietorships never mature into other forms of business. But nearly all successful corporations have their roots in a proprietorship that did succeed!

One of the most serious accounting errors made by business owners is mingling business and personal funds. Business transactions must be kept separate from personal accounts. Don't try to run a business from the family checking account. IRS regulations require that all businesses keep separate records.

Even if your business is a proprietorship, estimate your income tax liability from time to time so you can plan your business affairs to minimize taxes. The tax code requires that you estimate liability for the year and make quarterly estimated tax payments. Our system of taxation is a pay-as-you-go system. All taxpayers - individuals, corporations and associations - are required to pay estimated income taxes in installments during each year. For employees, this is done by withholding from each paycheck. The self-employed individual must pay estimated taxes. Estimates are due on the 15th of April, June, September and January, on Form 1040-ES.

Like a partnership, the sole proprietor is taxed on all profits, whether taken out of the business or not. Without good tax planning, this can lead to some problems. For example, suppose Jack Smith, Builder showed a profit of $78,000 in a calendar year. Jack will pay substantial taxes on these profits. But even though profits were good, there may be little ready cash available to pay taxes. Assume the total tax bite (including self-employment tax, covered later in this chapter) was $24,000. Jack's $78,000 in profits may actually have been used as follows:

In Increased outstanding accounts receivable $12,000
Used to reduce long-term liability (notes, etc.) 16,000
Used to purchase new equipment 18,000
Withdrawn for living expenses 32,000

Total

$78,000

It may be very tough to raise the cash needed by April 15. Tax planning wouldn't create any more cash, but it would make meeting the payment deadline easier. Accurate quarterly estimated tax payments split the burden over several months. This would have disclosed the problem much earlier. The builder might have decided to pay off liabilities over a longer period, promote additional financing, purchase his new backhoe at a different time (or lease it), and pressure his clients to accelerate payments.

With a minimum of tax planning, the dilemma could have been avoided. In addition, the liability itself could have been reduced substantially through proper timing. If you don't anticipate tax liabilities and adjust business transactions accordingly, you can't expect a tax savings. If Jack Smith expects another year with profits of $78,000, it's probably time for him to incorporate his business.

Figure 1-2 compares the forms of organization.

Self-Employment Tax

Employees have Social Security tax (FICA and Medicare) withheld from their pay checks each pay period. Employee contributions are matched by the employer. Those who are self-employed don't have these taxes withheld. Instead, they make an estimate of the taxes owed and remit that amount with their tax return. The tax rate for the self-employed is higher than the rate for employees because the self-employed have no employer to match their contributions. The self- employed have to pay at a rate that is approximately one and one-half times the employee's rate. The contribution rate for the self-employed is, at the time of this printing, around 15 percent. The contribution required for a year's income is a significant amount of money. Don't overlook it when estimating taxes due.

Self-employment taxes are computed on Schedule SE and filed with the individual tax return. The amount to be reported on this form is the net profit from Schedule C (business income). If you have more than one business, the reportable amount is the combined profit.

There's no legal way to avoid the self-employment tax. Paying yourself as an employee would actually increase your tax burden. Although the withheld amount is less, as an employer you would have to match the amount withheld. In addition, there are the added expenses of disability insurance, workers' compensation and filing payroll tax returns.

C Corporation S Corporation Partnership Sole Proprietorship
Taxes Paid by company. Rate set by law. Paid by shareholders. Rates vary with individual. Paid by partners. Rates vary with individual Paid by individual. Rates vary with individual
Losses
Are carried back or forward.
Applied against other earnings.
Applied against other earnings.
Applied against other earnings.
Tax Return Four pages, including balance sheet. Four pages, including balance sheet. Schedules for shareholders Four pages, including balance sheet. Schedules for shareholders. Individual return; Schedule c, Schedule SE
Life of Organization Outlives shareholders Outlives shareholders Must dissolve and re-establish with ownership changes Dissolves when business stops.

Owner Limits

None

35 or less

None

One
Liability Stockholders usually liable only to the value of stock. Stockholders usually liable to the value of stock. General partners jointly liable for partnership liability. Full liability
Tax Years Can choose any fiscal year. Usually has to use the calendar year. Usually has to use the calendar year. Usually has to use the calendar year.

Figure 1-2
Comparison of types of organizations


Self-employed business owners are allowed to claim a deduction for one-half of the self-employment tax they pay. That means that, while you have to pay an additional tax for being self-employed, you are also given some tax relief.

The total self-employment tax is called SECA (Self-Employment Contributions Act). It includes two parts: Old Age, Survivors and Disability Insurance (OASDI), which is generally referred to as Social Security; and HI (Hospital Insurance), also called Medicare. The distinction is important even though they represent the sum of self-employment tax, because the tax rate is different for each

When to Incorporate

Doing business as a proprietorship or partnership limits your ability to accumulate earnings or avoid heavy taxes in unusually good years. The corporate form can be beneficial in both good and bad periods. Use the S corporation to take losses and small profits as an individual. When larger profits are expected, change to the regular corporation form. If you expect an extended period of growth for your construction company and need to accumulate earnings in the business, the corporation is the best form of organization.

Before incorporating, talk to an accountant. You need a full understanding of how the changes will affect your particular business and how to keep your records. Once the corporation is formed, dissolving it isn't as simple as terminating a partnership or sole proprietorship.

A successful, growing business will usually convert to a corporation. See Figure 1-4 for an example.

Subsidiary Corporations

A corporation may acquire other corporations or create other corporations (called subsidiaries) to handle related business. There are many reasons to do this.

Specialization: Many builders specialize in one type of work. But a company that specializes in new construction may decide to form a subsidiary to handle remodeling work. Some of your customers may prefer to do business with a company that caters exclusively to their needs.

Financing: Many banks have limits as to how much they will loan any one corporation. To get around this, subsidiary corporations may be formed. Usually loan officers will require financial statements from all corporations in an affiliated group.

Accounting reasons: If you have one corporation that does service work, you might want to have it keep books on a cash or accrual accounting basis. A related corporation that handles larger, long-term contracts might use completed-contract accounting. A third related corporation that maintains a large supply of material might use a cost basis (or market value basis) for valuing inventory. Creating subsidiary corporations will increase the administrative overhead, but will also offer more options when filing tax returns.

Liability protection: If you anticipate the possibility of large lawsuits, creating separate corporations may insulate each part of the company from any liability of the other parts.

Benefit plans: Consider creating subsidiary corporations so compensation or benefits can vary widely for employees in different lines of work. That may help avoid a claim that the company Pension plan discriminates against a class of employees.

Unemployment insurance: To avoid overall unfavorable experience ratings for an entire company, you can concentrate high turnover positions in a separate corporation.

Union considerations: Specialized subsidiaries in different areas of activity or geographical locations can avoid union jurisdictional debates. This also prevents union auditors from seeing the accounting records of the entire organization.

Segregation of products or services: To keep the quality of one operation from affecting the reputation of another, create a subsidiary corporation for the less desirable business.

Personalities: Some key employees may have personal conflicts. A subsidiary corporation can separate them.

Geography. It may be impractical to manage business over a wide area. Subsidiary corporations can be used to deal with the problems of distance.

Local directors: There may be advantages in appointing Board of Directors members from the communities served. Use subsidiary corporations to have representatives from several areas.

There are three categories of controlled groups:

Parent-subsidiary: The parent corporation owns 80 percent or more of the subsidiary's stock or voting powers.

Brother-sister. Two or more corporations, in which 80 percent or more of the stock is owned by five or fewer stockholders.

Combined group: Three or more corporations meeting the specifications of parent-subsidiary or brother-sister groups.

Figure 1-5 shows a typical set of subsidiary corporations.

Consolidated Returns

Consolidated returns (several corporations combining their operating results on a single tax return) are allowed for affiliated groups. Your tax consultant will have specifics on this. Consolidated returns offer several advantages:

Operating losses in one corporation may be absorbed by gains in another.

Capital losses (not deductible by individual corporations) can be used on a consolidated return to offset capital gains.

Inter-company transactions (for example, the paying of rent from one company to another, creating income on one side and an expense on the other) are eliminated on consolidated returns.

A group of controlled corporations is allowed only one surtax exemption (the $25,000 level of taxation), but it can be used in many ways and can be varied from year to year.

Two major disadvantages of consolidated returns are:

  • The election to file a consolidated return is considered permanent; it can be reversed only with IRS permission.
  • When losses of one corporation are absorbed by gains in the other, the right to carry losses into future years is lost.

Even with the proper inter-company connections through stock ownership, consolidated tax returns could be disallowed by the IRS. If a corporation is established only for tax benefits, without a true business purpose, a consolidation may be denied. However, there are many legitimate reasons to operate subsidiary corporations. Only blatant abuse will cause problems. Many of the provisions related to subsidiary corporations and consolidated returns are designed to discourage the formation of scores of corporations for the purpose of burying income.

When considering the formation of a subsidiary corporation, remember that additional accounting documentation, payroll accounting and administration will be required. The extra paperwork burden may outweigh even a sound business reason for splitting operations.

Some builders just aren't able to manage multiple corporations. I've seen many subsidiary corporations abandoned, merged, or sold to decrease the burden placed on management. Be sure you have the good management you need to help run a subsidiary corporation before forming one. The tax problems you solve may be less important that the management problems you create by forming a subsidiary.

Corporations

First-Year Tax Strategy for Corporations

Most larger construction contracting companies are corporations because of the flexibility that this form offers. From the time a corporation is organized, it has more options, especially tax return filing options.

Choosing the First Fiscal Year

During the first year, the corporation has the choice of ending its first fiscal year in any month it chooses. For example, a corporation which begins operations in July may close its books and file a tax return as early as July 31 - a one-month first year - or as late as July 30 the following year, a full twelve months.

Here's how to use this flexibility to your advantage: Try to include less profitable periods in the same tax year with more profitable periods. That way the tax due on the year as a whole will be smaller. A new business might absorb its early months of flat or money-losing operations into later profitable periods. Or, if you have an early profit, let the first year stretch through a slower period.

Here's an example: A contractor incorporated in July. He had an initial contract which was to lost through the summer months. During this period profits were good. But he had no commitments for future jobs once the initial contract was completed.

When the first job was finished, the contractor had a net profit of $50,000. He laid off most of his crew and cut back on overhead during the slow winter months. By early spring the $50,000 profit had dropped to less than $20,000. In March he got another large contract that was expected to be reasonably profitable. It was scheduled to begin in mid-May.

The contractor reviewed the estimate and work schedule for the new job. May and June looked like very profitable months since he was using percentage-of-completion accounting. The expected profit was recognized for accounting purposes as the job was completed. During these months he expected to show a profit of $20,000 a month. It was obvious that the first corporate fiscal year should end on April 30.

Here are the advantages of cutting off the first year at April 30:

  1. The year ended at the close of a natural cycle of business.
  2. In the first fiscal year profits were controlled so that taxes were low.
  3. In the second fiscal year profits will be partially absorbed by the slower winter period.
  4. Profits in May, June and July are pushed into the next fiscal year, so that the tax liability is put off for one year.

If the situation changes in future years, he can file an election to change the fiscal year to another closing date. (You can't do this too often, however. The tax code restricts arbitrary changes in the fiscal year.)

S Corporation Election

Here's another option you have in the first year of incorporation. You may file as an S corporation. It's especially useful if your business loses money the first year. The C corporation can't pass losses to individual stockholders, although it could carry forward those losses and apply them against future profits. But the S corporation can pass losses through directly to stockholders who can claim those losses to offset other income.

S corporation status gives you the protection from liabilities that all corporations enjoy. But at the some time, you have the tax advantages of a partnership. You can eliminate or reduce personal income taxes. For example, if you had capital gains, or your spouse had substantial income from a job, a loss from your business reduces your tax liability. Be careful, though. You can only claim losses up to the limit of your investment in capital stock. That is, if you invested $40,000 in the corporation, you can't deduct accumulated losses over $40,000.

You have to make the election to be taxed as an S corporation within 30 days of the end of the fiscal year. (in most cases, the fiscal year is also the calendar year.) Remember, too, that to make this election, all stockholders have to agree to the idea. Being taxed as an S corporation must be a unanimous decision by all stockholders.

If you're a stockholder in an S corporation with a substantial operating loss, you might be able to eliminate your tax liability altogether. This assumes that you don't have income from other sources in excess of your losses and that your losses don't exceed money you've invested in the S corporation. If you don't take the S corporation election during the first year, losses can be only be carried forward to future corporate years.

Planning Based on the Rules

The decision to incorporate or not, and then which type of corporation to use, all depends on your personal tax situation and what is most advantageous. Remember, you can't switch your election every year as circumstances change. Make a good decision and then be prepared to live with it.

Let's say that you want to incorporate because you have associates who want to be partners. As a partnership, each of you would be jointly liable for business liabilities. That means your exposure to risk is virtually boundless. So you and your partners need and want the corporate protection. But at the some time, you expect losses during the first two or three years. So you elect to be taxed as an S corporation. That makes sense.

Here's another possible situation. Let's say your corporation is very profitable, but your spouse also has a business which loses money every year. It might make sense to take an S corporation election and have profits passed through to you. Your profits could be offset against your spouse's losses, saving taxes. Why pay corporate tax when you, individually, have losses to report? One problem with this idea: If you have other partners, they have to agree to the election as well. This plan would work only when all the stockholders are in your immediate family, or when your business partners would also like their profits passed through to them each year.

A number of business deductions are legitimate for a corporation but not allowed to proprietor- ships or partnerships. For example, corporations get favorable tax treatment for organizational expenditures, dividend income, and charitable contributions. Corporations have some additional leeway in deducting employee benefits such as health insurance premiums. Sole proprietorships and partnerships are either limited or excluded from deducting expenses like these.

Owners as Consultants

An owner-employee of a corporation has taxes withheld on regular income. In addition, the corporation must pick up the employer's share of withholding taxes. This increases the cost of each employee by from 10 to 12 percent over the wage cost. Compare the advantage of hiring a consultant instead of an employee. There's no "employer burden" because the consultant is either employed by another company or is self-employed. In either case, you're not responsible for employer taxes and insurance on that employee. Thus, there's a temptation to hire more consultants and less employees.

In some cases, it's perfectly legitimate to receive substantial consulting fees from a corporation, even if you are part or substantial owner. But be cautious. The IRS may view this arrangement solely as a means to minimize taxes. The result could be a major tax liability.

For example, suppose Joe Contractor pays himself as a consultant but takes personal deductions for home office, entertainment, travel, and business use of his car. On audit, the IRS decides that the relationship was one of employer-employee. Joe will be liable for the taxes that should have been withheld. He will probably also lose the deductions for office entertainment, travel and auto, even if there would have been legitimate deductions for other employees. The best rule is to pay yourself as a consultant only after getting very specific accounting and legal advice.

Contractor's Year-Round Tax Guide
Revised Edition

by Michael C. Thomsett

This isn't a guide to filling out your tax return. It's a complete tax advisor for contractors, revised to conform to the latest changes in the tax code. Filled with the type of advice high-priced accountants and tax "pros" give their contractor clients, it shows how to set up and run your business to minimize your tax burden. If your company is making money and paying taxes, Contractor's Year-Round Tax Guide can save you thousands of tax dollars. This new manual:

  • Explains in language any contractor can understand the tax advantage of each form of company organization, how to handle equipment purchases and leases, what the IRS allows and what it often questions.
  • Shows how to use the asset recovery system, what forms of compensation are deductible, and how to protect your company from tax traps that many contractors fall into.
  • Describes corporate tax strategy and how to use it to your advantage, why you should consider incorporating to save tax dollars, what you should be aware of in contracts with others (includes sample contracts), and how real estate can work as a tax shelter for your company.
  • Covers the tax advantages of profit-sharing and pension plans, special tax shelters for builders, how investments can reduce your tax liability, accounting methods that are best for contractors, how to keep records that meet IRS requirements, and the best filing method for your company. Includes a checklist of deductions you should take and a list of what income is deductible and what is not.

This practical working manual has clear examples, diagrams and checklists that can reduce the taxes your construction company has to pay. If your accountant and tax advisor don't specialize in tax strategies for construction contractors, you need this new reference.

The Author

Michael C. Thomsett, an accounting consultant to several construction and engineering firms in the Northwest, has written 46 books on business and finance, and published over 500 articles for trade and business magazines. He specializes in introducing practical business systems for builders and contractors. His other books specifically for builders are Builder's Guide to Accounting, Builder's Office Manual, Bookkeeping for Builders, and Contractor's Growth & Profit Guide.