Business Advice for Contractors and Developers: An Interview with Area Expert Jerry Lopatka

After the Business Ledger’s most recent Newsmaker Forum for the construction industries, we had the opportunity to interview panelist Jerry Lopatka.  Jerry Lopatka is the Managing Principal of Dugan & Lopatka, CPAs in Wheaton and one of the area’s leading experts to contractors and real estate developers.  Following summarizes the advice he shared with Business Ledger readers.

Can you give us an example of a common challenge construction firms have with the IRS?

One of the most common challenges we see is in the area of compensation for business owners.  The IRS is on the lookout for any unreasonable salaries that a closely-held company doles out to its shareholder-employees. In fact, this has been one of the tax agency's favorite audit targets in recent years.  The IRS gets especially upset if a salary is considered too low and can be levy additional taxation and possibly penalties if they believe S-corporation shareholders are trying to avoid social security, payroll and other taxes by keeping owner salaries low and distributing company proceeds in the form of distributions. Unfortunately, there are no hard and fast guidelines you can use to establish salaries that will pass muster with the IRS. Auditors take several factors into account, such as compensation levels at comparable construction companies, the profitability of the company and the role the employee plays in the business.

When times are tough, the payroll taxes a business has been withholding from employee paychecks might seem like an easy source of temporary cash. Some business owners think they’ll just borrow some money to pay urgent expenses and put it back later.
But that is often a serious, costly mistake. If the money isn’t there when it’s due, there won't be any sympathy from the IRS. In fact, in the eyes of the tax collector, the business owner is a thief. That money belongs to the employees and is meant to stay in a trust fund to pay income taxes, Social Security and Medicare.  With the "Trust Fund Recovery Penalty," the government can fine the business owner personally for 100 percent of the amount due, plus interest. The IRS frequently pursues collection of unpaid trust fund taxes from officers, directors and stockholders of the business, but can also go after other people who are considered "responsible" parties who acted "willfully."

Parceling out work to subcontractors can save construction companies time, money and headaches. But there are considerable accounting and tax implications. And you cannot treat all workers as independent contractors.  Let's say you decide to hire an independent contractor and the IRS reclassifies that person as an employee. Your company can be hit with a tax bill for unpaid taxes, interest and penalties. You might also be liable for state taxes, unemployment taxes and employee benefits.

Can you share any of your “golden gems” for tax savings for our readers?

Sure. Here is one we use all the time with our clients.  As a commercial property owner, you’re probably depreciating the building over 39 years. So every year, you get to deduct 1/39th of the property’s value (excluding land) from your taxes. That's a long time to wait to receive all the tax benefits. Fortunately, there may be a way to accelerate the deductions and reduce the current year's tax bill.  By conducting a "cost segregation study," you can dramatically speed up the depreciation process. That's because certain items that are part of the building may qualify for faster write-offs. Depending on the property, a cost segregation study takes a percentage of the cost out of 39-year depreciation and puts it into five, seven or 15-year recovery periods.  It's best to do a cost segregation study when a building is placed in service but there may be opportunities available to your company if the building is less than ten years old too. Be careful to get an engineering-based study.  That is what the IRS is accepting.

Have children in the business? If you operate your business as a sole proprietorship, a single-member LLC (treated as a sole proprietorship for tax purposes), or a husband-wife partnership, here's a great family tax planning deal: Hire your under-age-18 children as legitimate employees of the business. It doesn't matter if they work part-time or full-time. Why does this idea makes sense? Your teenagers can set aside some or all of the wages earned and invest the money. The investment earnings and gains will be taxed at low rates. Later, your child's savings can be used to help pay for college, which means you won't have to come up with quite as much cash. So far so good, but here are some more advantages:

Your child's wages are exempt from Social Security, Medicare, and federal unemployment taxes. Even better, your child can use his or her standard deduction to shelter up to $5,150 in wages from federal income taxes in 2006. So your child may owe absolutely no federal taxes under this arrangement. 

Your side of the equation is also excellent. First, you get a business deduction for money you might have just handed over to your child anyway. The write-off reduces both your federal income and self-employment taxes. Your adjusted gross income is lowered too. That means less chance of all those unfavorable phaseout rules biting you in the pocketbook.

After your child reaches 18, things are not quite so great. The Social Security and Medicare taxes kick in. As the employer, you'll pay half and the other half will be withheld from your child's wages.

Just make sure you pay wages that are reasonable for the work performed. Keep the same records as you would for any other employee to substantiate hours worked by your child. And don't forget to issue a Form W-2 early next year.

Here is another little gem. Out-of-Town Jobs.  Generally speaking, you can get a tax deduction for living expenses incurred while you are on a temporary construction job as long as the assignment is realistically expected to take one year or less.

For example, let's say you live and work mainly in one city. But because of a shortage of construction jobs, you take a temporary assignment in another city that is expected to last eight months. Under these circumstances, you can write off "ordinary and necessary expenses," including transportation, meals, lodging, computer rental fees and business phone costs.

However, you must meet certain conditions before you take a deduction and there are exceptions to the general rules. For instance, what happens if a job is expected to last less than a year but then drags on longer? You might still qualify for write-offs under an exception in the tax law to the general rule.

What is a good way for a construction company to improve profits?

Accurate job costing improves profits. Be sure to include all of your costs when preparing a contract bid.  Job costing involves not only the direct expenses of labor and materials, but many indirect costs such as depreciation, overhead, employee benefits, equipment, tools and other outlays necessary to operate your construction business — even if they are not related to any one specific job.  Don’t forget to consider all of these indirect costs and compute them accurately when you bid a job. With detailed job cost reports, you can track the profitability of each project.

At the Newsmaker Forum panelists such as you mentioned that there is plenty of money available for construction and real estate projects.  Is it really that easy to get cash?

Before awarding credit, lenders demand detailed budgets, including cash flow forecasts. They want realistic projections, not unfounded profit and revenue estimates. Cash flow projections are an important element for lenders because they show how you plan to repay the money.  Even if your construction firm doesn't need credit, a well thought-out budget, including cash flow projections, is important for the ongoing operation of your business. For some construction projections, surety companies look closely at budgets before issuing the bond needed. Additionally, by preparing an effective annual budget and comparing it to your actual financial performance, you can find certain situations that need to be addressed.

What advice do you have for people wanting to capitalize on appreciated property?

Thanks to Section 1031 of the Tax Code, a properly structured like-kind exchange allows an investor to sell a property in certain situations, reinvest the proceeds in a different property, and defer capital gain taxes. The four basic steps in a 1031 exchange are:

 1. The seller arranges for sale of property and includes exchange language in the contract.

2. At closing, proceeds from the sale go to a qualified intermediary for a 1031 exchange.

3. The seller identifies potential exchange properties within 45 days of closing.

4. The seller completes the 1031 exchange within 180 days of closing.

Here's how it works: Let's say you have a $200,000 tax liability (depreciation recapture, federal and state capital gains taxes) on a $1,000,000 sale. Only $800,000 remains to reinvest in another property.

Without the 1031 exchange, you would only have $800,000 in equity to purchase a different property. However, with a 1031 exchange, you'd be able to reinvest the entire $1,000,000 of equity in the purchase of real estate, with no current tax bill to pay.

Not everyone wins on real estate projects, what advice do you have for those people with losses?

Losses from real estate can generally only be used to offset income from “passive activities.” Any remaining losses must be carried forward — unless you're a real estate professional.  There's another catch: Even real estate professionals must pass a "material participation" test in order to use passive losses to offset non-passive income.

If you’re not a real estate professional, you can still qualify for an extra tax break if you “actively participate” in rental real estate and you meet certain income requirements.

Jerry Lopatka is Managing Principal of Dugan & Lopatka, CPAs in Wheaton.