Contractor Profit Pools Require a New Business Model

Profit Pools for Contractors

Are you a contractor with different profit pools? Now maybe the time to change your business model.

This past year we have been presented with some unique planning opportunities for our contractor clients. While they have had very profitable years, several are now pursuing separate profit lines requiring further analysis.

Most contractors stick to their strengths, presenting themselves as highly competent and experts in executing difficult construction projects. This requires a unique skill set that includes general project management to organize subcontractors that are crucial to completing a project and a contractor's niche skills that ensure satisfactory project execution for their clients.

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This past year we have consulted with multiple contractors who are interested in pursuing profit lines in addition to construction. One case study involves a contractor establishing a real estate entity to pursue real estate acquisition, development, and property management.

A second case is that of a residential homebuilder investing in talent to perform manufacturing activities as part of their contracts. These manufacturing activities would include wood cabinet manufacturing and metal fabrication, such as that required for stairways.

This tweaking of business models leads us as advisors to evaluate whether all this activity should be captured under one entity or whether separate entities for the different business lines should be established.

As advisors, we evaluate the choice of entity for construction clients on what seems like a yearly basis. This evaluation is especially imperative when a new political party takes office in Washington, DC, as the implementation of new tax plans may be on the horizon.

C Corporation vs. S Corporation

There were numerous important conversations being had when former President Donald J. Trump took office, given his tax plan and the significant reduction in income tax rates, in which we recommended that several profitable construction companies change from an S corporation to a C corporation to take advantage of the new rates.

Now, we anticipate conducting similar evaluations for the same clients, with the expectation of a new tax plan under President Joe Biden. Many construction companies incorporate as C corporations to take advantage of lower corporate tax rates, while those that are growing and continue to be profitable are likely forming or converting to an S corporation to take advantage of the increase in shareholder basis as they become more profitable. This increase in basis reduces the tax obligation on a future sale down the road.

The valuable tax analysis of construction income subject to self-employment tax, as in a sole proprietorship or a limited liability company (LLC), versus income that is not subject to self-employment tax, such as that of an S corporation, is certainly a factor in our recommendations as to what entity type a company should choose to conduct its business.

Manufacturing and Prefabrication

Some challenges emerge when a successful contractor begins evaluating a step into prefabrication or manufacturing, which can qualify in certain states for valuable manufacturing tax credits. To be a manufacturer requires conducting oneself as a manufacturing entity (i.e., the labor and the materials specific to the manufacturing process need to be identified and reported consistently and separate from those activities that are construction related). Most software systems today have the capability to provide separate reporting for separate activities, which makes it easier to establish business lines for manufacturing and other activities.

Some controllers may have an aversion to the work required to isolate construction and manufacturing expenses. It is especially important that the controller has a solid working relationship with the project managers and estimators who identify necessary materials and is able to identify the invoices for the jobs to which materials are delivered. It is also imperative that the support for different activities be organized in case of any audits.

In Wisconsin, revenue charged by a manufacturing entity is less than the normal cost of goods, and an allocation of operating expenses will result in manufacturing profit eligible for a manufacturing tax credit at 7.5 percent. This can be a significant sum of money.

Contrast this with a scenario in which the manufacturing activity is included with construction company entity revenue and expenses, and this profit is not eligible for the credit. A second glance would suggest a separate entity solely for manufacturing may have some real value to the owners of the company.

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Real Estate

For those who have an interest, the specific Wisconsin manufacturing form is Schedule MA–M. Another example in which contractors are confident in pursuing separate profit pools is in real estate. Many contractors are investing in land acquisition, which leads to land development for commercial office buildings, multifamily apartments, and residential housing developments.

Some of this activity certainly elevates the success of a contractor capable of performing certain phases of the contract. The analysis advisors need to undertake and develop is an understanding of the revenue and expenses related to that specific development parcel or rental activity income being generated. Further analysis should evaluate whether a certain parcel, location, or activity should be held in a separate LLC with separate debt allocated to the real estate entity.

Not every situation has only one model. Factors such as ownership of the real estate, different levels of capital contribution by the owners, and various ages of the owners that could impact a current succession plan are a few of the items advisors need to consider. Real estate usually is accompanied by depreciation and interest expense deductions because outside debt is used to acquire property in addition to equity.

Qualified Business Income Deduction (QBI)

This often creates tax losses in an entity that reduce taxable income from construction activity and will impact the 20 percent qualified business income deduction (QBI). Again, advisor analysis needs to include all business activities for a member or shareholder, not just the profitable ones. I would argue that separating real estate activity from the construction entity is more valuable than having all activities combined.

Today, most construction companies are profitable, resulting in taxable income that is eligible for a free 20 percent QBI deduction. Having the construction company income combined with possible losses from real estate activity within the same entity will create a reduction in overall taxable income. The net result is that the company will pay more taxes. I want to be careful here because taxes are not the sole factor in determining the optimal structure of your business model.

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Often, from a banking and bonding standpoint, it is easier to analyze the actual profitability of business lines that are separate entities. One must remember that the approval for bank loans is usually predicated by a decision from a board of directors made up of a variety of individuals with different levels of business acumen. Having all profit lines of business intermingled in one entity can make it very confusing for those board members to understand the true cash flow of one line of business versus another.

This specific scenario was raised in three separate discussions over the past 12 months working with different contractors. I thought this feedback would be valuable in understanding an advisor's thinking as we advise contractors focused on growing their shareholder value.

Ultimately, it is imperative to step back on occasion and assess the opportunities one has to lower tax obligations by using a different business model.

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I hope this summary has encouraged advisors to think differently about assisting construction companies as they ponder pursuing different lines of business.