CONSTRUCTION INSIDER

VOLUME 8 : : ISSUE 3

In This Issue:Regulations Seek To Clarify New 3.8 Percent Net Investment Income Tax What Is Reasonable Compensation?Important Reminder About The 2013 Tax Law ChangesEmployment Trends In The Construction Industry

Regulations Seek To Clarify New 3.8 Percent Net Investment Income Tax

The IRS has issued much-anticipated reliance regulations on the new 3.8% Net Investment Income (NII) Tax under the 2010 health care legislation. The surtax came into effect on January 1, 2013 and applies to individuals, trusts and estates. For individuals, the threshold is modified adjusted gross income (MAGI) over $250,000 for joint filers and $200,000 for single filers. Trusts and estates in the highest tax bracket (AGI over $11,650 for 2012) are also subject to the NII Tax. The tax is calculated on 3.8% of the lesser of net investment income for the tax year, or the excess of the individual’s MAGI over the threshold amount.

The most common items of NII for taxpayers will be interest earned on bank accounts, dividends realized on stock investments paid through brokerage accounts and net capital gains. For any income that passes through to a taxpayer on a K-1, a determination will need to be made if the income is derived in the ordinary course of the trade or business. As a general rule, if it relates to a trade or business and is non-passive

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Net investment income subject to the tax is defined as follows:

1. Interest, dividends, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business, and

2. Other gross income derived from a trade or business, that is either passive (within the meaning of Section 469), or the trading of financial instruments or commodities, and

3. Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business.

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to the taxpayer, the income will be exempt from the 3.8% tax. Conversely, if the income is not related to a trade or business or the income is passive to the taxpayer, the income will be subject to the 3.8% tax.

Interest and dividends earned by a pass through entity will generally be subject to the 3.8% tax, unless they are related to the trade or business income. Interest on loans made in the ordinary course of lending money, interest on accounts receivable and gains derived in the

activity of trading or dealing property are examples of items that may be exempt if in connection with the trade or business. Earnings from the investment of working capital to be used for the future are not considered derived in the ordinary course of the trade or business (such as income from savings accounts, certificates of deposit, money market accounts, short-term bonds, or similar investments which usually produce portfolio-type income) and as such would be subject to the NII tax.

Whether or not rental income is subject to the 3.8% tax depends upon whether

the rental is considered a trade or business. Under the definition, the rents must be derived in the ordinary course of the trade or business to not be subject to the NII tax. Similar to self-rental rules, the determination of whether someone classified as a real estate professional is subject to the tax is determined based upon whether the real estate activities are considered a trade or business. If the taxpayer’s activities are determined to be passive, prior year suspended passive losses can be utilized in the year recognized for tax purposes to reduce the passive income subject to the 3.8% tax.

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The IRS has issued much-anticipated reliance regulations on the new 3.8% Net Investment Income (NII) Tax under the 2010 health care legislation.

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The IRS may object to the compensation of shareholder-employees of a corporation. If the compensation is deemed too high or too low — in other words, it is not “reasonable” under the circumstances — the IRS could force you to make adjustments that increase taxes. This can be troublesome for S corporation owners who receive little or no compensation to reduce payroll taxes and C corporation owners and executives who are also shareholders that receive salaries the IRS considers too large because they will then be hit with double taxation. Why? Compensation is fully deductible if it’s considered “reasonable.” But if a salary is deemed too large, Uncle Sam can label part of the payments as “disguised dividends,” which are taxed twice.

Double taxation comes into play when the corporation distributes profits as salaries; the firm gets a deduction for the amount. The owner or executive pays personal income tax on the money, but it’s only taxed once. But if the corporation pays the owner or executive a dividend, the money is taxed twice — once at the corporate level and again at the personal level.

The issue of reasonable compensation is frequently contested in the courts. Here are two examples where the taxpayer loses and wins.

First, the shareholder-employee of a family-owned corporation served as its president. The three other officers of the corporation were the president’s sons. According to court documents, she voted on major corporate decisions for the waste pickup and disposal business and performed other duties, such as attending civic functions as a company representative. Nevertheless, the IRS argued that she functioned more like an outside board chairperson, rather than a chief executive, and was unreasonably overcompensated. The Tax Court determined that her salary for the three years in question should be $98,000, $101,000 and $106,000 rather than the amounts deducted by the corporation ($860,680, $818,060 and $600,060

respectively). The company appealed the decision.

The Ninth Circuit Court focused on the following factors to determine a reasonable amount of compensation for the owner-employee:

• Theemployee’sroleinthecompany• Acomparisonofthecompensation

paid to the employee with the amounts typically paid to employees of other companies in similar situations

• Thecharacterandconditionofthecompany

• Whetheraconflictofinterestexiststhat might allow the company to disguise dividends as deductible compensation

• Whethercompensationwaspaidunder a structured, formal and consistent plan

Based on these five factors, the Appeals Court concluded compensation should beadjustedtoreflectherperformanceaspresident of the company. It sent the case back to the Tax Court for “redetermination of reasonable compensation.” (E.J. Harrison & Sons, CA-9, 6/7/05) Second, by documenting the reasons for corporate salaries, you may be able to fend off the IRS. In one Tax Court case, for example, a business gained some leeway by paying a windfall amount to make up for salary shortfalls in the past.

In the case, a father and son were the owners and principal employees of a mechanical contracting business. For the year in question, the father was paid a salary of $260,000, plus standard fringe benefits. The IRS said that $65,000 of this salary represented unreasonable compensation.

But by looking at several factors, including the fact that the father had been underpaid in prior years in order to build up the company’s cash reserve, the Tax Court determined that the entire compensation amount was reasonable.

(Devine Brothers, Inc., TC Memo 2003-15)

Spell out the reasons for compensation amounts in your corporate minutes. The minutes should be reviewed by a tax professional before being finalized. Cite any executive compensation or industry studies, as well as other reasons why compensation is reasonable. Work with your tax adviser to determine whether dividends should be paid (and if so, how much they should be).

What Is Reasonable Compensation?

Corporations must justify their salaries based on factors such as the expertise of a shareholder-employee, the size of the firm and comparable industry pay.

Salary versus Dividends: Yesterday, Today and Tomorrow In the past, C corporation owners often arranged to be paid relatively high compensation amounts in order to increase business deductions instead of paying out nondeductible dividends. That’s because dividends used to be taxed at regular income tax rates. However, qualified dividends are currently taxed at the same favorable federal rates as long-term capital gains (the maximum rate is only 15 percent). As a result, high salaries are not necessarily preferred today.

But there is a “sunset provision” in the tax law. Unless Congress takes further action, dividends received after 2008 will once again be taxed at regular income tax rates, instead of the favorable capital gains rates. So shareholder-employees may someday again prefer salary payments over dividends.

 

It’s time to finalize year-end tax planning for 2013. There is more certainty for the 2013 year-end than last year, thanks to the passing of the American Taxpayer Relief Act of 2012. The key changes that were amended or extended are outlined below.

Bonus depreciation is closing for 2014, unless extended by Congress. It was extended by the American Taxpayer Relief Act through the end of the year, although some transportation and longer period property may be eligible through 2014. Otherwise, qualified property must be place in service before January 1, 2014.

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Important Reminder About The 2013 Tax Law Changes

2012 2013

CAPITAL GAINS

Capital gains rate 15% 15%

Capital gains rate for taxpayers in 10% or 15% bracket (taxed at capital gains) 0% 0%

Capital gains rate for taxpayers with AGI greater than $450,000* joint, $400,000 15% 20%

CREDITS

Energy efficiency credit 10% up to $500 10% up to $500

Residential energy credit 30% of cost 30% of cost

DIVIDENDS

Qualified dividend rate (taxed at capital gains rates) 15% 15%

Qualified dividend rate for taxpayers in 10% or 15% bracket (taxed at capital gains rates) 0% 0%

Qualified dividends rate for taxpayers with AGI greater than $450,000* joint, $400,000 15% 20%

ITEMIZED DEDUCTIONS AND PERSONAL EXEMPTION

Percent of AGI medical expenses must exceed 7.5% 10.0%

Phase out of itemized deductions for individuals with AGI over certain thresholds Not applicable 3% phase out begins

Deduction for state sales tax in lieu of income tax Allowed Allowed

HEALTHCARE PROVISIONS

Medicare tax on passive income for individuals with more than $250,000 joint ($200,000 single) of AGI

Not applicable 3.80%

Additional Medicare tax on wages greater than $250,000 joint ($200,000 single) Not applicable 0.90%

DEPRECIATION PROVISIONS

Code Sec. 179 deduction limit $500,000 $500,000

Investment limitation (on cost of property) for purposed of Sec. 179 $2,000,000 $2,000,000

Bonus depreciation on qualifying purchases 50% 50%

*Amounts are to be inflation adjusted

Statements concerning taxation within this document are provided for information purposes only, do not constitute tax advice which may be relied upon to avoid penalties under any tax statutes, and do not resolve any tax issues in your favor

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Employment in the construction industry had a strong rebound in 2012, but hiring and spending has been neutral for most of 2013. The unemployment rate for former construction employees is decreasing, but construction companies are having trouble filling positions with experienced employees due to changes in the field of work and people going back to school or retiring. Officials in the construction industries are calling for education and immigration reform measures to ensure there is an adequate supply of skilled workers because firms are having trouble finding qualified craft workers and filling professional positions. It is expected that the construction labor shortage will get worse before it gets better. Some construction firms

are mentoring future craft workers, participating in career fairs and offering internships for professional positions.

Through August 2013 employment in the construction industry increased in 35 states, but remained below peak levels in most states. This gave warning of a potential impact of a halt in federal construction investments. Michigan ranks thirty-second in state construction employment (seasonally adjusted).

In Michigan, employment in construction increased 2% over the past 12 months (roughly 3,000 jobs). With Flint and Muskegon-Norton Shores showing 14% and 11% growth, respectively. The Metro-Detroit area did not have as much

success as the rest of Michigan, showing 0% growth in Warren-Troy-Farmington Hills and -4% in Detroit-Livonia-Dearborn.

The number of available construction jobs has increased in some states, while other states are still struggling to overcome the sluggish market. The state of the construction industry will depend on how the rest of the year goes, but the industry is predicted to grow and create more jobs in 2014. It is also predicted that the industry growth will be 8 percent in 2014. The spending outlook is also positive as the rebounding housing and heavy construction markets will create new construction jobs and help the industry to continue to recover.

Employment Trends In The Construction Industry

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Our firm provides the information in this newsletter as tax information and general business or economic information or analysis for educational purposes, and none of the information contained herein is intended to serve as a solicitation of any service or product. This information does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.

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UHY LLP’s National Construction Practice is comprised of the country’s foremost experts in regards to audit and assurance, tax planning and compliance, and business advisory services for the construction industry. We work with a wide range of key industry segments including general contractors, underground contractors, underwater construction, tunnel, and bridge and heavy highway contractors. As active members of various national, state and local construction associations, state housing councils and specialty trade groups, our team keeps alert to industry trends and opportunities. Our

CONSTRUCTION INDUSTRY INSIGHT

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