Promises of tax reform are leading to some unexpected ideas that could impact construction contractors and their surety relationships. While much of the tax reform talk has dwelled on attractive rate reduction promises, other proposals restrict deductions, exemptions and credits. Among the emerging issues, two topics of interest will be discussed here: the loss of the interest deduction and the possibility of restrictions on S corporation status. We will briefly discuss how these proposals, if enacted, could impact bonding capacities and surety relationships.
Rethinking the Deduction for Interest Expense
Current Trump and House proposals replace many depreciation rules with full asset expensing, a more cash-flows based model of taxation. This seems indirectly linked to the loss of much interest expense deductibility also included in these proposals. According to John Dorn, Construction and Real Estate Principal with CliftonLarsonAllen LLP, “Today’s tax code favors borrowing over equity capital since interest expense is deductible while dividends are not. In the absence of an interest deduction, borrowing costs would effectively rise, diminishing the after-tax benefits of financial leverage. This imposes a high (and permanent) tax cost on many businesses and is likely to encourage the retention of earnings in the business, and a corresponding reduction in debt. A drop in tax rates may allow companies to accumulate equity more quickly to make this shift toward heavier reliance on equity, but it would still take time.”
Sureties would need to be attentive to the financial implications nondeductible interest may have to the financial stability of contractors. Meanwhile, much capital investment becomes immediately deductible, which, for equipment-intensive contractors, reduces taxable income in the short run (a very favorable change) though it is essentially a change of timing. “Leveraged contractors will see an increase in effective tax rates as they lose interest deductions, increasing further the risks of leverage. Lower tax rates may cushion this, but the impacts will vary by taxpayer.” If successful over the long term, the proposal suggests balance sheets may strengthen and bonding capacities improve.
Another factor bearing on construction contractor behavior are decisions on equipment procurement. Those contractors with equity resources may tend to buy equipment and thereby secure substantial write-offs. Meanwhile, contractors with less capital may tend to opt for equipment leases that can be considered operating leases for tax purposes since the interest expenses associated with capital leases would be nondeductible while simple rent expense remains a deductible cost. As the lease accounting standard of Generally Accepted Accounting Principles shifts to the required capitalization of leases (beginning, for private companies, on January 1, 2020), financial statement obligations associated with GAAP operating leases will begin to impact financial statements. Where financial statements begin to capitalize leases at the same time as a deduction for interest expense becomes restricted, some contractors could be caught unawares, with a balance sheet weakened by accounting standards and a bank account hit with more tax. Certainly, the evaluative process sureties use in reviewing the new financial statement format will influence the consequences. From the accounting perspective, we might expect more differences between financial statement income and taxable income due to these differences in lease accounting. In a recent presentation before the AGC Financial Issues Committee, Cullen Walsh, Assistant Director of the Financial Accounting Standards Board, noted that implementation of the new leasing standard is proceeding timely, with some early adoption already beginning to happen.
Rethinking Use of S Corporations
Recent comments from the Hill have suggested efforts are quietly afoot to limit access to S corporation status or its traditional tax benefits in the formulation of tax reform. In an industry dominated by small and mid-sized contractors, the S corporation is the traditional entity of choice. While Subchapter S is expected to survive reform, restrictions could be added to reduce the benefits to smaller businesses or phase out its use by medium and larger taxpayers. “Tax code changes that discourage use of S corporations could have significant implications for many companies,” Dorn noted. “Mandated or coerced conversions to C corporations may undermine decades of tax practice, estate planning, succession planning, financing relationships, bonding capacity and operating practices if corporate tax liabilities are brought back onto the books of contractors and a double tax regime applies again. No doubt administrative and professional costs will rise as companies work to adapt to the new tax models with altered entity structures and new business practices.”
Promises for Tax Reform
Proponents of tax reform remain optimistic. House Ways and Means Committee Chairman Kevin Brady (R-TX 8th) said in July, “We will deliver bold reforms this year that spur job creation, allow workers to keep more of their hard-earned paychecks, and improve the lives of all Americans for generations to come." Echoing this sentiment in recent remarks to AGC, Congressman Erik Paulsen (R-MN 3rd), also an influential member of the House Ways and Means Committee, observed that our economy’s growth rate should be accelerating while corporate inversions should be decelerating. An outdated tax code was seen as a key underlying cause of stifled growth and the increasing number of corporate headquarters migrating abroad. Paulsen was optimistic that a tax code overhaul based on objectives of growth, simplicity, international reform, and permanency may yet be achievable in 2017, though likely very late in the year. As our tax system remains in flux, business taxpayers, including construction contractors, face increased risk, even in an environment in which rates are widely expected to fall. Assuming reform occurs, it would be naive to assume that all taxpayers will be impacted equally.
CliftonLarsonAllen believes engagement in legislative and governmental oversight is important for our contractor and surety clients and the health of the industry. In a polarized political landscape, it’s more important than ever to have contractors and sureties engaged with their industry associations, like NASBP, as they speak with authority for the enduring vibrancy of the construction marketplace.
Perry H. McGowan, CPA, JD is a Tax Director in the Construction and Real Estate Group of CliftonLarsonAllen LLP in Minneapolis, MN. He serves the firm as a national tax services resource, focused on planning and strategy for a wide range of construction and real property businesses. He can be reached at perry.mcgowan@CLAconnect.com or 612.376.4632.