Five things contractors need to know about taxes

By Rob Williams | February 1, 2022

It’s time to talk about taxes. This week we’re tackling five important things every contractor should know about taxes. We’ll offer some general advice, address common tax mistakes we’ve seen contractors make, and dispel some pervasive tax myths.

Topics we cover include:

How having your business structured in the wrong type of entity can affect your taxes
The difference between deferring and avoiding taxes
The importance of understanding your accounting method for tax purposes
How to use the accounting method you’re set up under
What the Credit Card Rule is and how it can affect your deductions

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Rob Williams, Profit Strategist | IronGateESS.com
Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | McWins.com

TRANSCRIPT

[00:00:00] Rob Williams: Welcome to the Contractor Success Forum. Today, we are discussing five things contractors need to know about taxes. What a good topic for this time of year on the Contractor Success Forum, because we discuss financial strategies for running a more profitable, successful construction business.

And we have Wade Carpenter, Carpenter, and Company, CPAs. And we have Stephen Brown, McDaniel-Whitley bonding and insurance company. And I’m Rob Williams, IronGate Entrepreneurial Support Systems.

So Wade, man, this is the beginning of the year here. I don’t know when other people are listening to this, but what a great time to know five things that contractors need to know about tax.

[00:00:50] Wade Carpenter: Yeah. A lot of these were things that I see all the time, mistakes people make. Sometimes it’s ignorance. Sometimes it’s doing what they think their peers are doing, or somebody said on the internet. And so hopefully we can dispel a couple of those myths today.

[00:01:05] Rob Williams: Yeah, that’d be great. I’ll let you tell us one of the first things we need to know about taxes.

[00:01:09] Wade Carpenter: Well, a lot of times people are structured in the wrong type of entity. And it’s pretty much a given that if anybody goes out there on the internet, they’re going to say, I need to be an LLC, no matter what. If they go to an attorney– and I’m not knocking the attorneys, a lot of attorneys do not do taxes, but they will put somebody in an LLC in a heartbeat with the thought of, well, you can take an LLC and turn it into anything. And it can backfire against you because in the wrong entity, it can cost you a whole lot of taxes. So we can talk about that a little bit.

[00:01:44] Rob Williams: Yeah, definitely. There’s so many factors in that. And I see people with different ones and I, and I see the same people with multiple entities also. We had that too. And, and things change over the years. Because when I think I know something about it, a lot of my knowledge and information is what it was like in the 1980s. I think some things have changed since then.

[00:02:07] Wade Carpenter: Stephen, do you see that too? Or?

[00:02:09] Stephen Brown: I do and it’s just nonstop, we’re dealing with proprietorships, partnerships, LLC, C Corp, Subchapter S Corp. All these entities, the whole intent of that is trying to limit your liability, protect a corporation. And, you know, that’s a separate entity. And it’s taxed differently and there are rules to that. And some of them are great and some of them are a pain in the butt, but, you know, that’s number one.

[00:02:36] Rob Williams: You know, one thing, Wade, you were talking about the attorneys in there. There’s two separate factors and the attorneys are probably, most of them are probably not thinking about taxes. They are, like you just said, Stephen, they’re thinking about liability.

[00:02:51] Wade Carpenter: Yeah, liability protection. And, I think about some contractors that, maybe they got a huge investment in equipment, big yellow iron stuff, and they may have a building and they’re trying to protect those assets, and we get that.

But I also see some attorneys setting entities up in trust and stuff like that, it’s a great idea on paper for your estate planning, but it can wreck you for tax purposes.

Going back to the LLC thing, a lot of people pay a ton of money in self-employment taxes needlessly, when, just swapping that over to an S corporation can save– I’m not saying that’s always the right thing because any one of the entities can be the right thing in the right circumstances.

[00:03:37] Stephen Brown: So, how do you decide?

[00:03:39] Wade Carpenter: There’s a ton of different factors that go into it. Some of it is going to be the type of work you do, it could go along the lines of the state you’re in. Some states, say for instance, they treat LLCs or S-corporations differently than the federal treats them. There’s a lot of other things like, certain equipment entities, you could have sales tax issues. You could have like for your building, if you are renting back your own building, you can get in trouble with self-employment taxes if you put it in the wrong type of entity. And it’s passive income, but a lot of people don’t realize a self rental is something very different from renting to somebody else that is not related to you.

[00:04:24] Rob Williams: You know, I just got hit this year by our development company. We’ve held the land in there for so long. And we were intending to build on it ourselves and not sell it. So we never transferred it to a different thing. So my long-term capital gains– this is a huge hit– ended up being regular income.

It’s oh, it was pretty devastating on us because we changed our plan at the last minute and there wasn’t time to do it. And so this was a very significant amount of our assets and income that we’re getting hit with regular income instead of long-term gain.

[00:05:02] Wade Carpenter: Yeah, Rob, I don’t know your particular situation, but a lot of times people will get things like real estate with long-term appreciation in like a C corporation. And you don’t get capital gains rates in a C corporation. So a lot of that depends on, what you’re in, sometimes it depends on year 10. Are you going to flip a property or you’re going to buy it and renovate it and rent it out? That can make a very different, I can give you a different answer based on–

[00:05:30] Rob Williams: That’s exactly our situation, Wade. And we, I, it’s funny, I even knew that, but the partner that’s handling that didn’t realize that. And it didn’t occur to me that we were in that when we decided to sell the property instead of build on it. We didn’t realize that this was going to happen.

That may have changed our mind, although it was good to have a bird in hand, somebody wanted to buy that property. So I don’t know that I think it, but we should have years ago because we’ve been holding this for 30 years and we still had it in the development company and we never transferred it over at that lower value to a holding-type company that would be taxing capital gains.

Wade, maybe you can explain to that, cause I know I asked you about this a few weeks ago when it came up, but if you’re a development company and that’s your primary business, then you have to do that as your ordinary income. Is that correct?

[00:06:24] Wade Carpenter: That’s true. Yes, absolutely. And, we’d also– not to change the subject too, but whatever the answer is, do you have partners in the business or is it just you, or is it a husband and wife? If you’ve got partners in it, you may want to think, well, what’s their situation? Do they, they got a spouse that their marriage is on the rocks or something like that? I’ve seen many companies that they get dragged into a divorce and innocent partners out there, they’re strung through the mud with all the stuff that goes on with their partner.

[00:06:53] Stephen Brown: So the lesson learned here, picking the right entity. There’s just a lot of elements that go into place, but the entity is how you’re taxed.

[00:07:02] Rob Williams: Yeah. One other thing, Stephen, before we moved to the next one. Wade mentioned trusts and I’ve been doing a lot of work with trusts the last couple of years, and there are so many different types of trusts. So it’s not automatic that you’re going to be paying a lot of taxes. So just because an attorney or your tax advisor advise you do a trust– there are some trusts that are just there for estate purposes. They are revokable and they are not taxed as a trust. So knowing the difference between what type of trust you have, is it a trust that is taxable as a trust? And I’m not going to get into the different factors there. Or is it a trust that is set up just to avoid probate, to be a convenience factor, and it doesn’t have to do with taxes. It’s more about control issues. So trusts are not always highly taxable.

Some trusts don’t make any taxable difference to you. It’s just a control thing. And so I think a lot of times we’re doing trusts instead of wills right now. And there’s a lot of work, so your guys may not want to do that. Cause you got to change all the titles and everything.

[00:08:12] Wade Carpenter: Yeah, and I wasn’t trying to knock a trust. It just, in the operating entity, sometimes that can be tough to get the– I mean, You can distribute out the profits and it flows through the shareholders, but if you leave it in the trust, you quickly get to the highest tax bracket.

But again, I’m not trying to generalize on anything today.

[00:08:32] Rob Williams: The big thing that I’m seeing on the negative of the trusts are trusts that were set up many years ago when the inheritance tax had a small ceiling or whatever. A small base for when you started doing it. So a lot of people have these trusts set up that are not even going to save them anything on taxes when they leave this earth.

And so if they’re not big enough, then they’re not getting those gains anymore. Some of this stuff was set up 20 years ago or 30 years ago. So those are, they’re putting them in that high bracket. And so they may have to unline those.

[00:09:04] Wade Carpenter: Well, I just brought it up because I had a situation where an attorney stuck it in there for liability protection, but had absolutely no idea what it did for their taxes. So like I said, any one of the entities in the right circumstance is the right answer. Yeah. And before, I was not knocking LLCs. In the right situation, they definitely are the right–

[00:09:24] Rob Williams: What I’m seeing on this, Wade, is that the attorney that set these up is not even involved anymore. They haven’t even talked to that attorney in 20 years. are they different?

[00:09:34] Wade Carpenter: For a contractor, I tax avoidance. Those are the things that, in Wesley Snipes in jail or something, it’s got a thing, a lot of what we’re talking about with construction is tax deferral. And,

[00:09:46] Rob Williams: It’s just to see how they’ve got this stuff set up and it’s not there anymore. So anyway, I kind of dove into that. You kind of hit one of my sweet spots that I like there.

So. All right. So, so, all right. We’re we got to get to five different things we need to know about taxes! Should we move on to Stephen? I wouldn’t let you move on earlier.

[00:10:03] Stephen Brown: Number two. Deferring your taxes.

[00:10:07] Rob Williams: Deferring versus avoidance. What’s the difference? So you’re just not paying the taxes this year, right, Wade?

[00:10:11] Wade Carpenter: Part of the game I would say is sometimes kicking the can down the road can defer the taxes. We were actually just talking before we came on. When the music stops, when we have a bad recession, things like that, but most of the games are let’s push it down the road.

[00:10:28] Rob Williams: What?! You mean my tax advisor, my accountant, he told me he was saving me all that money. What, you mean I’m going to have to pay it later?

[00:10:37] Wade Carpenter: Well, I don’t know any contractor that loves paying taxes. So

[00:10:41] Rob Williams: What?! I thought he was saving me all that, I thought I didn’t have to pay any of that.

[00:10:46] Stephen Brown: I have seen, I’m not just saying this, everybody in the bonding business. I’ve seen a lot of contractors go bankrupt trying to get out of paying taxes. And you say, well, what does that mean? Well, it’s because you just get so slick, you get so obsessed with it. Getting out of paying taxes. Deferring taxes, and then putting the money away that you’re going to have to pay at some point. That’s a good thing. That’s a good thing. Avoiding it is just I, I don’t owe it, until your business is shut down by–

[00:11:18] Rob Williams: Well, there’s a good avoidance too. When you actually save money by, by like finding something that you don’t ever have to pay it. There’s some of those, Wade, I think that’s a good point stephen was just making, can you kind of dive in just a little bit, make the point again about tax avoidance versus tax deferral, because tax federal, you’re going to have to pay it someday.

Tax avoidance…

[00:11:39] Wade Carpenter: There are ways to legally defer taxes. If you’re putting it away in retirement plan or a profit sharing plan, those are some great ways to do it. But you know, my point of this is number one, thinking about what happens when the music stops. But number two, when you’re planning this if you’re a calendar year in, on January one is too late to do anything about 98% of the ways you can change your taxes.

But number three point on this is you don’t want to wreck your financial statements and you don’t want to wreck your cashflow by trying to defer taxes and buying that new pickup truck every single year.

[00:12:14] Rob Williams: So to me, Wade, let me try to do a real simple example. Tax avoidance or things that you’d like, get a tax credit for is say, like keeping the mileage on your truck. If you keep that and you write that. If you don’t do it, you’re not going to get those this year, 50 cents a mile. You’re not pushing it down the road anywhere. You’re just saving money this year that you’re not going to have to pay later.

[00:12:41] Wade Carpenter: Yeah. I know that’s something that nobody likes to keep records and, there are some nice apps out there, like Mile IQ and stuff like that, where you can keep up with that kind of stuff.

[00:12:50] Rob Williams: Yeah. That you’re actually saving money this year and you’re not deferring it to have to pay next year.

[00:12:56] Stephen Brown: I don’t know, they made that movie, The Firm in Memphis and it was all about avoiding taxes. You remember that with Tom Cruise? Right here in Memphis, Tennessee folks. Hey so don’t do that. Okay.

[00:13:08] Wade Carpenter: And then no mind your bills with mail fraud, so.

[00:13:12] Rob Williams: Yeah.

[00:13:12] Stephen Brown: Right. You don’t want to do mail fraud. Good point. And, and we’d go on record of saying that on our, on our podcast. I like that.

[00:13:20] Rob Williams: No mail fraud!

[00:13:22] Stephen Brown: Okay, so, taxes, CPAs. You get what you pay for advice-wise. Well, I’ve talked about that over and over again.

[00:13:29] Rob Williams: Yeah. And being clear when you’re getting these savings. Make sure they explained to you whether you’re going to owe that later or not. Because it really messes up your cash flow picture. I’ve never seen– I don’t want to say never. I’ve never seen anybody when they get these tax deferrals, put the money away in an account that they’re going to be able to pay. That’s what you should do, but I’ve never seen anybody do that.

You should. Yeah.

[00:13:58] Stephen Brown: It’s a happy concept to think, okay, I’ve deferred taxes, put the money away that I’ve made interest on that I owed by, by deferring those taxes till another time.

[00:14:08] Rob Williams: If you don’t have that money later, the cost that you’re going to go through to get that money, to pay those taxes is going to dwarf any kind of savings you made from getting that tax break.

[00:14:19] Stephen Brown: I hate talking about all this sad stuff. Taxes are sad. But you know, wade is the man when it comes to taxes. And I’ve said this over and over again. I’m gonna go ahead and say it again. You get what you pay for in accountants. So you get good advice or you get bad advice. So what do you want to pay for that?

[00:14:38] Rob Williams: Yep. All right. Wade, do you have anything else on this?

[00:14:41] Wade Carpenter: No, I know we need to kind of move on. Maybe number three and four, we need to kind of combine in the interest of time.

Number three would be like understanding their accounting method for tax purposes, as well as financial statement purposes. But we’re talking about tax today. And number four would be knowing how to use that method you’re set up under.

Now going back to number three, first of all, once you set up a method, it’s sometimes hard to change methods. You have to get IRS approval normally. But I would say there’s a lot of CPAs out there that don’t really know the rules and maybe you’re on accrual basis for tax purposes, but you didn’t know about the rule about like accrual less retention. And that is a separate hybrid method. You, you may be picking up and paying taxes on retainage that hasn’t come in yet. And you can avoid that with the right method. But there’s also a ton of CPAs that didn’t know about the rule for construction being on the cash method used to be up to $10 million. Now it’s $26 million. And it’s indexed for inflation. There’s so many people, there was a rule that there was like a $5 million rule that general businesses fell under that once you got above 5 million, you have to have accrual basis tax books. Well, a lot of CPAs didn’t know the difference in construction. And so people were paying taxes on receivables that they haven’t gotten yet, so, you know, there’s a–

[00:16:10] Rob Williams: –of what we were talking about earlier, deferring. It’s like paying them early when you don’t have the cash yet for that.

[00:16:16] Wade Carpenter: Well, there’s also, and again, I could go back to stories over the years, but I’ve seen CPAs put people on percentage of completion because they think that’s what they’re supposed to do. And they don’t fall under the rules where they’re forced to go on percentage completion. There were other rules, like the completed contract method, or, those kinds of things that are, can be a huge deferral of gain if you fall under the right circumstances.

[00:16:42] Rob Williams: Can you just take a second to explain to people about how you’re keeping your books, probably in two ways, the GAAP, and then the taxation? I don’t think I realized there were two different methods that you use concurrently. You have to report in two different ways on the same year.

[00:17:00] Wade Carpenter: Well,

[00:17:01] Stephen Brown: But one set of books, Rob,

[00:17:03] Rob Williams: One set of books. I want four sets!

[00:17:07] Wade Carpenter: Well again, if you actually do have two physical sets of books, you’re probably in that Wesley Snipes category again.

[00:17:14] Stephen Brown: We don’t talk about that.

[00:17:16] Wade Carpenter: So I actually would suggest, a lot of times there are three different methods. What you do in house, somebody may be keeping something on accrual basis. But when we go to do their taxes, we may be on the cash basis for tax purposes, but we may have to put them on the percentage of completion for financial statement purposes.

And it’s not that we’re doing anything funny business, but it’s the fact that number one, tax law allows you to sometimes accelerate some depreciation and do some things like the cash method when, Generally Accepted Accounting Principles wouldn’t allow us to do that. So it’s different planning. Again, going back to the tax thing. If you plan it properly, you can keep your cash basis tax profit low while maximizing your profit and hopefully not screwing up your cash

[00:18:05] Rob Williams: So I know for me, the cash basis– for the listeners that don’t know from a non CPA, I’ll explain it. That’s the money that’s coming in and out, and you’re keeping it from when you’re actually getting paid and when you’re actually paying out. Where the accrual, to me, lets you know how you’re actually doing profitability-wise, management wise, even though the cash may not have come in yet, because it’s so hard to factor that in sometimes. Is that a reasonable layman’s explanation?

[00:18:36] Wade Carpenter: Yeah. I’d love to say everybody should like, their in-house books should be on percentage completion all the time. So that’s really a more true, but it’s, it’s more–

[00:18:47] Rob Williams: Gives you a true picture right now.

[00:18:49] Wade Carpenter: True–

[00:18:49] Stephen Brown: More–

[00:18:49] Wade Carpenter: But it’s a lot work. Yeah. But you know, the, the second part of this is, what do we do? If we know we’re going to be on the cash method versus accrual method versus completed contract method, what do we do different?

The planning is very different. It’s kind of simple on cash method. If you try to defer getting your cash in the door by the end of the year, you gotta pay out everything you can to knock down the profit. If you’re accrual then, well, maybe you shouldn’t bill it. But you know, I, again, I don’t want to give blanket advice like that, but those are generally the strategies and knowing how to utilize them can make a big difference in your taxes.

[00:19:29] Rob Williams: And that goes back to what we were talking about earlier, the deferral versus the avoidance. And I used to want to pay as little taxes as few taxes in the year, but I didn’t realize I got burned quite a few times owing a huge amount the next year. So being careful that what’s happening, especially at those into the year, whether you’re realizing it, cash versus deferral.

Cause you mentioned something that I had forgotten about, that you may be paying taxes on something that you haven’t gotten yet. And then you’re getting in trouble the opposite way where I typically think of the things that you’re just not paying it this year with the money that you made this year. So putting that money away from the profits and the revenue that you got now to make sure you do it.

That’s where Profit First comes in to play. On planning this, you know what percent of your revenue is probably going to need to go to pay those taxes at some point. So you’re reserving it. You’re putting it away. Don’t take that out and spend it somewhere else because it’s going to come back to get us.

Sort of my biggest thought point that I did not think that way when I was a contractor years ago until I learned the hard way.

[00:20:48] Wade Carpenter: Yeah, I think a lot of contractors, I can point to some examples in the great recession where, again, when the music stopped and then your receivables came in the next year and you didn’t have any expenses to use against it, but they kept using the cash to keep their employees and not realizing, hey, you know, whether it turns around or not, I can’t spend this money.

One other thing I was going to talk about, and this is just a small one, but a lot of people don’t know this. And we refer to it as a credit card rule. And even if you are on the cash basis, If you charge something on your credit card, you get to deduct it, whether you’ve paid that credit card or not.

And there are certain things like that and payroll taxes or, there’s things about like accruing a profit sharing, you can’t do that on a cash method, but say you did a match on a 401k based on payroll. You could deduct some of those things. So it’s just knowing, I guess the reason I brought up the credit card rule is just another thing that if you know the rules and you know how to play the game, you can kick it down the road and avoid paying those taxes.

But I think the point of this whole, our podcast is, let’s get you to build a healthy company. And paying taxes is not necessarily a bad thing if you’re making some money. And we want you to make some money on this.

[00:22:09] Rob Williams: You know, Wade,, that’s a great point. I wonder when I’m looking at cash basis books versus accrual, I still don’t know exactly which things–and I read the different financial statements, because somebody else has done that, but I don’t still don’t know which things on cash basis are quote, accrued, still. Like you were just talking about that contingent liability type stuff.

We could probably be almost have a whole episode on that of knowing which things, under cash basis, count– you have to take right now and then which ones you don’t and what the differences are on that, because it’s not just cashflow.

[00:22:47] Wade Carpenter: Right.

[00:22:49] Stephen Brown: Right. And good accountants wants you to know the rules. They want to teach it to you. And they want you to plan for your taxes all year round. Not right after your year end. That’s when you get the bad news, isn’t it?

[00:23:02] Wade Carpenter: Well, it is too, but it’s also when your bond agent wants you to dress up your financials too. So.

[00:23:08] Stephen Brown: Wade can do it both. He can save you on taxes and dress up your financials for bonds. That’s…

[00:23:13] Rob Williams: Wow!

[00:23:14] Wade Carpenter: –to. We try to. Some situations don’t allow that, but we, if we know the game, then we can.

[00:23:22] Stephen Brown: Well, Wade, that’s some great stuff. Thank you.

[00:23:24] Wade Carpenter: Yep.

[00:23:25] Rob Williams: All right, boy, this has been a, this has been a great topic. I could go to an all day seminar on this and maybe enjoy it. Yes, I’m a freak.

[00:23:36] Wade Carpenter: You don’t get enough sleep. So you’d get some sleep in that.

[00:23:39] Rob Williams: True. And it was because I was taking somebody’s accrual basis and transferring that into cash basis for our Profit First assessment, and it took me so much longer than I thought. I was doing that for hours and hours. So I was learning about what you’re talking about All right, guys. Well, this has been great. Anything else, Wade?

[00:24:01] Wade Carpenter: No, I know we’re kind of out of time. And unfortunately we can’t go into a lot of detail today, but I hope it helps somebody.

[00:24:08] Rob Williams: All right. Well, follow us some more. If you got some questions on that contact Wade. He does an amazing job for job costing for contractors remotely. You don’t even have to be there in the same place. So–

[00:24:21] Wade Carpenter: I’m the financial game changer for construction contractors.

[00:24:25] Rob Williams: Yeah, but you got it. You got it.

[00:24:27] Stephen Brown: That’s true.

[00:24:28] Rob Williams: Wade Carpenter, Carpenter and Company, CPAs. You can find him at ContractorSuccessForum.Com. We can find all of us and all of our contact information. It’s Stephen Brown with McDaniel-Whitley bonding and insurance company. And I’m Rob Williams with IronGate Entrepreneurial Support Systems.

Let us know how we can help you and have a great day.

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