October 24, 2021

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Despite dodging tax hikes in infrastructure bill, contractors could still see higher rates

This article is the third in a series looking at what public and private construction firms pay in federal taxes and the techniques some of them use to minimize their tax burden. Click here for the entire package.

Much of the debate around raising taxes to pay for President Joe Biden’s proposed infrastructure, social and environmental programs has focused on how much corporations and wealthy individuals actually pay.

For instance, a Construction Dive analysis revealed that publicly traded construction companies employ numerous tax strategies to pay far less than the statutory 21% corporate tax rate passed by Congress.

But while those large, public contractors get the lion’s share of attention in the industry, they are in the minority from the standpoint of how they are taxed.

According to the U.S. Census Bureau, just 16% of nonresidential construction businesses in the U.S. are registered as C corporations, and thus subject to corporate tax rates. Most of the remaining 84% is comprised of S corporations, sole proprietorships and partnerships that are treated as so-called “pass-through entities,” because profits from the business pass through to their owners, where they are taxed at individual income rates.

Currently, those rates range from 10% for individuals making up to $9,950 per year to 37% for individuals with income of $523,601 or more.

Todd Simmens

Courtesy of BDO

 

“For corporations, you can do an analysis on the 21% rate,” said Todd Simmens, national managing partner of tax risk management at consultancy BDO, who previously served as legislation counsel to the Joint Committee on Taxation in Congress. “But for individuals, it’s an entirely different rate system.” 

Personal income tax brackets and income cut offs, 2021

Tax Rate Individuals Married filing jointly
10% $9,950 $19,900
12% $40,525 $81,050
22% $86,375 $172,750
24% $164,925 $329,850
32% $209,425 $418,850
35% $523,600 $628,300
37% $523,601 or more $628,301 or more
Proposed Top Tax Rate    
39.6% $452,700 or more $509,300 or more

SOURCE: IRS, U.S. Treasury

That distinction is becoming increasingly important for the majority of construction companies that are classified as pass-through entities and pay taxes at the individual level as the debate over how to fund the administration’s proposals continues.

Big C corps seem to have avoided a corporate tax rate hike for now, with the bipartisan, $1.2 trillion infrastructure deal in the Senate being paid for via untapped COVID-19 relief funds, leftover federal unemployment dollars and more stringent tax collection, among other measures, according to the Associated Press.

But owners of pass-through companies may still face the prospect of paying more to Uncle Sam at the individual level to help pay for the $3.5 trillion in social and environmental programs that Democrats are hoping to pass without Republican support through the budget reconciliation process.

The reason why comes down to a lesser-known provision in the tax code known as Section 199A, which allows pass-through company owners to deduct 20% of net income from their taxes.


“If you take away the QBI deduction for people making over $400,000, and you increase the top rate, somebody who effectively pays 29.6% now will be looking at 39.6% instead.”

Andrew Kahn

Concannon Miller


The provision, also known as the qualified business income deduction, was enacted as part of former President Donald Trump’s 2017 Tax Cut and Jobs Act and was put in place to try to level the playing field between what C corps and pass-through companies pay.

Before the law took effect, C corps were paying a 28.4% marginal effective tax rate, compared to 25% for pass throughs, a difference of 3.4 percentage points, according to an analysis by the Tax Foundation, a right-leaning think tank.

When the TCJA cut the statutory corporate rate from 35% to 21%, though, it also gave pass throughs the 20% QBI deduction to try to even out the effective tax rate each type of company pays.

Garrett Watson

Courtesy of Tax Foundation

 

So far, it seems to have done that, with pass throughs now facing a marginal effective rate of 20.3%, and C corps paying 19.9%, according to Garrett Watson, senior policy analyst at the Tax Foundation. “It narrowed the gap between what the two entity types were paying,” Watson said.

The result of the QBI deduction theoretically means that pass-through business owners are subject to a maximum effective rate of 29.6%, instead of the current 37% tax rate if they’re in the top income bracket.

A quick exit for QBI?

While that was a win for pass-through business owners, its ultimate fate has been brought into question ever since Biden announced his American Jobs Plan in March. The original proposal to pay for the plan was to raise the corporate tax rate from 21% to 28% — an option that didn’t happen under the current, bipartisan infrastructure plan while raising the top individual tax rate from 37% to 39.6%.

It would also reduce the amount of income needed to hit that threshold from the current $523,601 to $452,700 per year, according to a breakdown of possible 2022 tax rates released in May by the Treasury Department.  

That’s where construction accountants start to worry.

Andrew Kahn

Permission granted by Concannon Miller

 

“There are a lot of very successful construction companies making well over $450,000 a year,” said Andrew Kahn, a certified public accountant who specializes in construction finances at Bethlehem, Pennsylvania-based advisory firm Concannon Miller. “Not only would you be facing a rate increase, you would be getting that rate increase at a lower income level.”

In July, Senator Ron Wyden (D-OR), who heads the Senate Finance Committee,  introduced a bill that would begin phasing out the current 20% QBI deduction for individuals making $400,000 or more, a move he intends to include in the $3.5 trillion follow-on bill Democrats have waiting in the wings.

If that happens, it would change the calculus for who’s impacted most by any potential tax hikes, with Republicans accusing Democrats of raising taxes on small businesses.

“The tax burden of those companies would obviously go up,” Kahn said.

Of course, pass-through owners would still be able to chip away at what they pay through the same tax strategies employed by their C corp cousins, such as writing off expenses for equipment and deferring what they owe to a future year. Indeed, a change in rate would make engaging in those strategies that much more important.

“There would be a greater benefit to the accelerated depreciation methods, the R&D tax credits and things like the work opportunity tax credit,” Kahn said. “All those credits and deductions would have a higher value because the benefit would be at a higher rate.”

A different prospect than expected

When the Biden administration pivoted to a focus on raising the corporate tax rate to pay for the American Jobs Plan in April and seemingly backed away from raising the individual rate, owners of pass-through businesses rejoiced.

Erin Roberts

Courtesy of Ernst & Young

 

“There was this huge sigh of relief,” said Erin Roberts, head of the global construction and engineering practice at consultancy Ernst & Young. “If that individual rate was going to go back up, it would be very burdensome and costly for those pass-through businesses to be competitive.”

But should the $1.2 trillion bipartisan infrastructure proposal now being debated in the Senate pass, that would clear the way for Democrats to move forward with their follow-on $3.5 trillion proposal that focuses on social and environmental programs, including free community college, clean energy mandates for utilities, lower prescription drug prices and expanded Medicare benefits, among other items. 

Democrats have indicated they will try to push that package through the evenly divided Senate using the budget reconciliation method, which wouldn’t require any Republican votes. Senate Majority Leader Chuck Schumer (D-N.Y.) has pledged to pass both bills before the August recess, which is currently slated to begin Aug. 9

While Schumer has said he has the votes for the budget reconciliation bill, Sen. Joe Manchin (D-W.Va.), a moderate and key swing vote, said this week he “can’t really guarantee” it will pass, citing concerns over how it will be paid for.  

But if it does, raising both the corporate rate — perhaps to 25% and the top individual rate to 39.6%, could be back on the table, in addition to phasing out the QBI deduction above $400,000.

That scenario would have a huge impact on the owners of pass-through construction companies.