Painting contractors are used to working against a deadline. You know that having a “drop dead” date can provide the motivation that it takes to wrap up a project, but that waiting until the last minute to complete the project leads to problems.
“Facing the much-publicized ‘Fiscal Cliff’ at December 31, 2012, our elected officials waited until January to provide guidance to contractors on the income and estate/gift tax rules that apply to 2013 and later years,” says Todd Taggart, National Construction Practice Leader for Grant Thornton LLP accounting and consulting firm. “That made year-end planning very difficult for calendar year taxpayers.”
The American Taxpayer Relief Act of 2012 (ATRA), signed into law on Jan. 2 failed to prevent a tax increase for most taxpayers. However, there are tax deductions, incentives, and planning ideas that can provide significant benefit to contractors.
Contractors have two ways to save current cash taxes by investing in equipment and other fixed assets. First, ATRA extends the popular “bonus” deprecation to include assets placed into service in 2013. Originally set to expire at the end of 2012, this provision allows a contractor to deduct half of the cost of the asset in the first year, and depreciate the remaining cost over the asset’s normal useful life. In order to qualify for “bonus,” the asset placed into service must be new and have a useful life of 20 years or less under the modified accelerated cost recovery system (MACRS).
A second provision allows contractors to write off the entire cost of qualifying assets. Known as “Section 179”, this small business tax break allows a deduction of up to $500,000 of 2013 fixed asset purchases, provided less than $2 million of assets were placed into service during 2013. “Unlike bonus deprecation, this applies to new or used assets,” Taggart says. “Originally enacted for small businesses, these enhanced limits expand this tax break to a much wider population of businesses.”
The last few weeks of 2012 brought a flurry of activity to accountants and attorneys that specialize in estate and gift planning. “Generous limits, first available in 2011, for lifetime gifting and transfers from estates were set to expire at the end of 2012,” Taggart explains, “and many contractors viewed this as a once-in-a-lifetime opportunity to transfer wealth down one or two generations. As it turned out, those laws were extended, however those accomplishments will pay off in cash tax savings in future years.”
ATRA permanently extended the ability of contractors to protect up to $5 million in assets (indexed for inflation), per person, from taxes for transfers either during their lifetime or at death. Thus, a married couple can pass $10 million or more of assets without subjecting those transfers to either gift tax or an estate tax. This is in addition to the annual gift exclusion, which is $14,000, per person per donee, in 2013. These limits open the door to planning that will allow successful contractors to transfer wealth without a cash drain or disruption of their businesses.
ATRA increased income taxes for successful contractors in a number of different ways. First, tax rates increased for taxpayers with taxable income over $400,000 (single) or $450,000 (married filing joint). Taxes on capital gains and dividends were also increased from 15% to 20% for taxpayers exceeding those income limits. In addition, higher income taxpayers will have the benefit of their personal exemptions or itemized deductions phased out to some degree. This will result, in many cases, in higher taxes for 2013 and later years than taxpayers were paying in 2012.
“Most contractors are organized as pass-through entities, like S Corporations or LLCs,” Taggart says, “thus, business income is taxed in the individual income tax returns of the owners. Assuming the owners are above the new threshold and subject to the 39.6% rate, their business income will be subject to higher taxes than their corporate competitors.”
“This means these businesses will have less after tax to invest in new equipment, hire new employees and otherwise expand their business,” says Taggart. “Congress needs to find a way to make the rates on businesses equivalent, without regard to their legal structure.”
Contractors who will pay tax at a higher rate should consider two ways to shift deductions from 2012 to 2013. “Consider electing out of bonus depreciation and deferring compensation deductions,” says Taggart, “These are simple solutions that can result in significant cash tax savings over the two year period.”