Accumulated Earnings Tax
Closely held C corporations are more likely to accumulate earnings and profits beyond the reasonable needs of the business in order to avoid income taxes on its shareholders than are large C corporations. Each accumulated earnings case is unique. No pro forma guide for calculating a taxpayer’s reasonable needs can be prepared. Reasonable needs that would usually be considered in any accumulated earnings case are the need for sufficient net liquid assets to pay reasonably anticipated, normal operating costs through one business cycle and sufficient net liquid assets to pay reasonably anticipated, extraordinary expenses and capital improvement financing.
In addition, the following represents a non-exclusive list of specific items that should be considered for construction contractors:
1. Working Capital necessary for Bonding Purposes: The general rule of thumb is that working capital needs to be at least 10% of “backlog” for bonding purposes. A specific taxpayer’s situation may result in a different percentage based on the bonding company’s requirements. Thus, this percentage should be determined on a case-by-case basis. “Backlog” work program is the sum of contracts in process less the billings from those contracts plus contracts not started.
2. Equipment Needs: Contractors who have high equipment needs will generally have a need to replace the equipment on a periodic basis.
The following information is included to assist an examiner during an examination of a construction company in determining whether an accumulated earnings tax issue exists. When considering whether an IRC Section 531 issues exist, examiners are advised to apply the Bardahl, Mead, or similar method used in determining the reasonable business needs. However an examiner must consider that, unlike most entities, a construction company normally needs to retain earnings and profits to have adequate bonding capacity. Relevant court cases involving the accumulated earning tax and construction contractors are:
1. Ready Paving and Construction Co. v. Commissioner, 61 T.C. 826 (1974): A paving contractor had permitted its earnings to accumulate beyond the reasonable needs of its business. A “modified” Bardahl formula was used with the case hinging on what items were and were not to be included in determining working capital.
2. Thompson Engineering Co. v. Commissioner, 80 T.C. 672 (1983) 751 F.2d 191 (6th Cir. 1985): A construction subcontractor was liable for the accumulated earnings tax. The IRS determined the taxpayer’s reasonable business needs by applying the “Bardahl” formula. The court agreed with the taxpayer that the Bardahl formula has “little or no value when applied to a mechanical contracting business that lacks a routine operating cycle.” The bonding capacity, and not the Bardahl formula, is the major consideration in determining the taxpayer’s business needs. This case was appealed and reversed.
3. Peterson Bros. Steel Erection Co. v. Commissioner, T.C. Memo. 1988-381, 55 T.C.M. (CCH) 1605 (1988): The taxpayer, involved in the steel erection of high-rise buildings, was not liable for the accumulated earnings tax. The petitioner’s ability to obtain a bond on a job when required is of primary importance and is clearly a reasonable need of the business. The fact that the petitioner was rarely required to provide a performance bond on its jobs is immaterial since it had to be prepared to provide a bond if required.
Alternative Minimum Tax
Taxpayers who are not required to use PCM under IRC Section 460) may owe alternative minimum tax. IRC Section 56(a)(3) states that the PCM must be used for long-term contracts for alternative minimum tax purposes. Therefore, taxpayers on the cash, accrual or completed contract methods must compute alternative minimum taxable income on the percentage of completion method. Exceptions to the required use of PCM for AMT:
1. Homebuilders: IRC Section 56(a) applies to long-term contracts except for home construction contracts
2. Small Corporations: Exempt from AMT for tax years beginning after 1998. Small corporations are C corporations with average annual gross receipts of $5,000,000 remain exempt in subsequent years until their average annual gross receipts exceed $7,500,000.
Many construction companies are required to prepare certified financial statements for bonding and lending purposes. Financial statements must be prepared on percentage of completion method. (Statement of Position 81-1) Thus, the difference between the percentage of completion method and the tax return method can easily be determined for alternative minimum tax purposes.
The use of subcontractors is common within the construction industry. Many taxpayers treat employees as subcontractors to avoid paying employment taxes. The agent may need to seek guidance from an employment tax specialist when confronted with potential employment tax issues. Back-up withholding can apply to subcontractors. The bargain sale of a house to an employee involving a discounted sales price could produce employment tax liability.
Many issues are common to all industries. However, some issues are specific to the construction industry, due to the nature of the business and the special accounting methods available. Additional facts and tax research will be necessary to develop the issues in this chapter.
Keywords: construction tax problem, construction tax help, construction IRS audit, construction IRS examination.
IRS El Monte, CA-IRS Los Angeles, CA-IRS El Segundo, CA-IRS Laguna Niguel, CA-IRS Camarillo, CA-IRS Glendale, CA-IRS Woodland Hills, CA