Louisiana Joint CFMA Conference 2019 James C. Lundy, Jr., CPA Tax & Construction Partner

ConstructionTaxUpdateRevenue Recognition / TCJA / Legislation / and other Items That May Accelerate Your Retirement Louisiana Joint CFMA Conference 2019 James C. Lundy, Jr., CPA Tax & Construction Partner Nashville, TN

Topic 606 – Revenue from Contracts with Customers (“Topic 606”) • The Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) worked together • Designed to have all entities recognize financial statement revenue the same way. • Currently, many industries, including the Construction industry, recognize revenue based on a methodology employed in that industry • Going forward, revenue recognition methodology will require all entities to recognize revenue from contracts with customers based on the same set of rules regardless of the industry in which the entities operate

Topic 606 – Revenue from Contracts with Customers (“Topic 606”) • Does not necessarily mean changes to tax returns • Nothing in 606 says you have to change your tax return • It is possible that your taxable income will be exactly the same as if there were no Topic 606 • However, it is very likely to change temporary differences between tax returns and financial statements • IRS issued Notice 2015–40 requesting comments • Asked again (pretty please) with Notice 2017-17 • Do you know anyone that made comments?

FASB and IASB Core Principle • Entities to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services.

IRS Core Principle • Taxpayer recognizes income under the “All Events Test” (Code Section 451) • Has a fixed right to receive the income • Can determine the amount with reasonable accuracy • Contractors recognize income under Code Section 460 • Percentage of completion (460a) • Look-back (460b) • Exempt contracts (460c) • Notice 2017-17 IRS requested industry specific feedback re: • To what extent will the Standards accelerate or defer income compared to Section 451? • To what extent do they deviate from 451? • Does required allocation of price and cost affect taxpayers ability to satisfy tax obligations. • Do you recognize revenue before receiving the cash to pay the taxes!

Five Step Process

Step 1 – Identify the Contract(s) with a Customer GAAP • Entities shall account for a contract with a customer that is within the scope of this topic only when all of the following criteria are met: • Parties to the contract have approved the contract • Parties have agreed to terms and are committed to perform • Master Service Agreements are not contracts unless there is a work authorization • Each party’s rights and payment terms can be identified • Contract has commercial substance • Collection is probable IRS • No material difference (1.460-1) • A construction contract is a contract to construct or improve real property

Contract Modifications (Approved and Unapproved) GAAP • Change orders can be approved or unapproved. • Approved change order would be added to the contract value of a contract. • Change order that has been approved for scope but not price: • Entity would need to estimate the transaction price the entity expects to collect • There are times when a contract modification will result in the contract modification being recorded as a new contract. If both of the following conditions were present, a new contract would be required for the contract modification: • Scope of the contract changes due to added goods or services that are distinct (i.e. a separate performance obligation) • Price of the contract increases by the standalone selling price of the added goods or services • Similar to IRS requirements (and prior GAAP) (1.460(c)2ii) • Fairly unusual, and could require Commissioner’s approval to “sever” contract

Step 2 – Identify the Performance Obligations in the Contract • Performance obligation is defined by Topic 606 as a promise (explicit or implicit) to transfer a distinct good or service (or a bundle of distinct goods and services). • Originally freaked out construction industry and statement users • Bridge construction could require: • Demolition • Grading • Bridge construction • Paving • Guard rail & striping

One or Multiple Performance Obligations GAAP • Must be highly dependent and interrelated to be one contract with multiple performance obligations. • Design/Build contracts – Yes? • Multiple buildings – No? • Operation and or maintenance of a facility – No? • Construction management – No. IRS • No major differences (1.460-1)

Combining vs. Segmenting GAAP • If any of the following apply, a contract would be required to be combined into one contract: • The contracts are negotiated as a package with a single commercial objective. • The amount of consideration to be paid in one contract depends on the price or performance of the other contract. • The goods or services promised in the contracts (or some goods or services promised in each of the contracts) are a single performance obligation IRS • No major differences • So why are we talking about this? • See the next page!

Warranties GAAP • Assurance Type - Provide assurance to the customer that the product or service will comply with the agreed-upon specifications. • Considered part of the required product the entity is delivering • Not considered a separate performance obligation • Service Type - Provide service in addition to providing assurance related to the product complying with the agreed-upon specifications • Promises to provide the service to the customer in addition to the product that has the functionality described in the contract • Would be considered a separate performance obligation • How are warranties accounted for currently under GAAP?

Warranties IRS • Accrued warranty costs are generally not deductible for tax purposes • Koch Industries included warranties for 20 year period in POC calculation • District Court originally allowed • Determined that it was a question of “when / not if” warranty costs were going to be incurred • 10th Circuit Reversed • Court determined warranty was different than for standard defects • What’s the tax impact? • Backing out estimated warranty costs from accrued, and from estimated, as applicable. Changes percent complete. • Costs reflected in overbilling are deductible (accrued job costs) • Accrued warranty cost will be non deductible for tax purposes

Step 3 – Determining the Transaction Price • The transaction price is defined in Topic 606 as the amount of consideration to which an entity expects to be entitled in exchange for the transfer of promised goods or services to a customer.

Variable Considerations and Consideration Payable to a Customer GAAP • Variable Consideration • Awards and Incentives • Liquidated Damages, backcharges, etc. • Most Likely Amount • Amount based on the single most likely amount based on specific possible outcomes • Used when you have a situation where the transaction will produce only a few possible outcomes • The Expected Value • Range of possible outcomes • Required to calculate possible outcomes & apply %s • Liquidated Damages (LDs) calculated (Days x Liquidated Damages x Likelihood) • Need to calculate likelihood (can’t be none) • No longer “contingencies” – Need to adjust contract value

Variable Considerations and Consideration Payable to a Customer IRS • Price = Amount reasonably expects to receive (1.460-4 (4)i) • Includes hold backs, retainages, and cost reimbursements • Bonuses and incentives when reasonably predicted • Events after year-end have to be considered • Claims awarded/received

Construction Claims GAAP • Unapproved change order for scope and price • Considered variable consideration • Major change from how we have assessed claims under the old standards • Previously recognized only to the extent of cost • Entity is able to recognize revenue and profit on a claim, as long as it is probable that a significant reversal of the revenue recognized on the claim will not happen in the future (i.e. will rely heavily on past collection history) • Distinct change order – new contract • Continuation change order – cumulative obligation

Construction Claims IRS • Reasonably predicted? (1.460-4 (4)(i)B) • IRS historically has included claim revenues as taxable when recognized for financial statements • Tutor-Saliba case • IRS Coordinated Issue requiring consistent inclusion was dropped • No precedent for “expected value” adjustments • What’s the impact? • May have different contract price book vs. tax • Common to have different cost for tax (in fact, it’s required under 460(c)) but not price • TaxPoc Schedules

Reassessment of Transaction Price • An entity should reassess the transaction price on a regular basis but is required to reassess a transaction price as of the end of each reporting period. A reporting period is the period for which a financial statement is prepared.

Step 4 – Allocate the Transaction Price to the Performance Obligations • The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer. • The transaction price for a performance obligation should be modified based on which performance obligation is affected by a variable consideration. • Once a transaction price has been allocated to each performance obligation of a contract, that transaction price should not be subsequently changed unless there was a contract modification or change in the estimate of variable consideration. IRS • No major differences

Step 5 – Recognize the Revenue When (or as) Each Performance Obligation is Satisfied GAAP • Recognition of revenue is the satisfaction of a performance obligation • Transferring of a promised good or service (that is, an asset) to a customer • An asset is transferred when (or as) the customer obtains control of that asset • Revenue to be recognized over time (i.e. use of percentage of completion), the transfer of control of the goods and services have to meet one of the following three criteria: • The entity creates or enhances an asset that the customer controls as it is created or enhanced • The entity’s performance does not create an asset with alternative use, and the entity has a right to payment for the performance completed to date • The customer simultaneously receives and consumes the benefit of the entity’s performance as the entity performs

Step 5 – Recognize the Revenue When (or as) Each Performance Obligation is Satisfied IRS • Revenue recognized based on cumulative allocable contract costs as a percentage of estimated total allocable contract costs (Cost to Cost) (1.460-4(b)) • What’s the impact? • Need to determine if revenue has been recognized for financial statement purposes consistent with cost to cost • Could circumstances exist that would result in revenue recognition prior to cost completed? • Retainage payable removed from cost incurred to date? • Reduces percent complete for tax vs. book • Has not satisfied all events test • “Pay if paid” clause included in contract • Some states will not allow Pay if Paid language to be included in contracts • Method change required (Form 3115) if not already excluding

Uninstalled Materials GAAP • Uninstalled materials are goods purchased for a project that have not been installed on the project • If control has not passed to the customer, uninstalled materials that are not distinct should be considered inventory until control passes to the customer • Has control passed to the customer? • If not, costs incurred for the “inventory” are not indicative of performance • Not totally different than prior practice for Blue Chip contractors IRS • Can be included in cost incurred to date if purchased or designated to be used for contract • What’s the impact? • Can accelerate percent complete for tax purposes • Going to be difficult to determine • Asking client to identify costs so they can pay more taxes?

Significant Inefficiencies in Performance GAAP • Cost determined to result from “inefficiencies” can be removed from contract? • Deducted currently • Expense account called “Significant Inefficiencies in Performance”? • Another name for “Superintendents Soon to be Retired Account”? IRS • No provision for deducting currently • Included in costs to date and estimated cost • What’s the impact? • Possible variance from book treatment (current deduction) and tax (percentage of completion)

Cost Incurred That Does Not Transfer Value GAAP • Entity incurs cost that does not provide value to the customer, the entity is not allowed to recognize revenue related to this type of cost • Mobilization to the site • Surety Bonds • Administrative costs to setup a project • Etc. • Cost of these items would be removed from the cost incurred on the project and amortized over the life of the contract (Contract Assets) IRS • Cost to cost • What’s the impact? • Can result in acceleration of revenue – POC vs. Amortization

Loss Contracts GAAP • Board elected to retain current guidance, with certain amendments, on loss contracts in ASC 605-35 for construction-type and production-type contracts • The provision for losses is determined at the contract level (100% of loss) • Possible to separate for a losing performance obligation • Making money on job except for specific performance obligation? IRS • Can only deduct percent complete of estimated loss job • No change from current treatment

Retainage GAAP • Classification on Balance Sheet • Contract Asset – If contingent upon additional performance by the entity and/or acceptance by owner • Receivable – Conditional based upon the passage of time IRS • Previously could be deferred on exempts (non long-term, etc.) (Rev. Rule 69-314) • TCJA does not allow deferral if recognized by accrual taxpayer on audited Applicable Financial Statements • Complications or reviews? • Automatic method change allows audit protection and 481 adjustment if 3115 filed • Automatic change treatment is available for either and/or Retainage Recognition or Revenue Recognition compliance • Simplified method does not get either

Independence Related to Hosting Services • Affects everyone performing non attest services (tax, etc.) to attest clients • Must provide copies to clients of any workpapers they may not provide or receive (maintaining internal control over data & records for client) • G/L • Fixed Assets • Amortization • Tax Provisions • Accrual to Cash • Tax POC Schedules • Partner Allocation Schedules • 163(j) Interest Limitations • 263A Calculation • Etc. • Statements delivered after July 1, 2019

Ten Things Contractors Need Needed to Know About the New Tax Law

On December 26, 2017, President Trump signed the most significant piece of tax legislation passed in the last 30 years. What was in it for contractors?

Lowers the top corporate tax rate from 35% to a flat 21% • Applies to C corporations. • Were 4 brackets ranging from 15% to 35%. • Eliminates the corporate alternative minimum tax. • Previously required a recalculation of tax if certain deductions were taken (accelerated depreciation, depletion, contract methods, etc.). • Apportioned for fiscal year end C corporations. • Huge benefit for contractors < $25 million in revenue. • Includes “personal service corporations.” • PSCs included doctors, lawyers, CPAs, engineers, architects. Previously paid 35% on all income.

Distributions and sales of assets will still be subject to “double tax” in C corporations. • Distributions to owners are subject to federal tax up to 23.8%, plus state tax. • 21% bracket is prorated for fiscal years ending in 2018. • Could result in renewed accumulated earnings assessments by IRS. • Net operating loss carrybacks not allowed after 2017. • Intended to be for calendar year ends 12/31/18. • Glitch in the law disallowed for years ending after 12/31/17. • Pending fix by Congress • Consider 179D/Cost segregation, etc. to amend prior year (high tax rate) returns  Simplification

An individual taxpayer may deduct 20% of domestic qualified business income from partnerships, S corporations or sole proprietorships (199A) • The deduction is a post Adjusted Gross Income (AGI) item. • Deducted between AGI and itemized deductions. • The deduction is not affected by whether the owner is passive or active. • Deduction is limited to: • 50% of wages paid; or, • 25% of wages plus 2.5% of cost of business assets

For specific service businesses, such as those in accounting, law, consulting, and investing (but not engineering or architecture), the 20% deduction will apply only if the taxpayer's taxable income is less than $157,500 (single) or $315,000 (joint). • No limitations apply for engineering, architecture, insurance, or real estate agencies. • Aggregation of activities (including rental real estate involved in qualified business) • Real estate activities can qualify as trade or business • Triple net lease?

The act retains a modified Individual Alternative Minimum Tax (AMT) as of 2018 and provides for increased exemptions and higher phase out limitations. • Exempt income increases from $86,200 (married) to $109,400 and phases out at $1 million in 2018 vs. $508,900 in 2017. • 26% if alternative taxable income is less than $191,500. • 28% if greater than $191,500. • Impacted taxpayers due to required add back of state and local taxes. • Expecting increased impact on contractors allowed to use cash or completed contract method.  Job Security for CPAs!

Allows immediate expensing of 100% of the cost of investments in depreciable assets acquired after September 27, 2017, and before January 1, 2023 • Unlike the previous bonus depreciation rules, the asset does not have to be new property; however, it must be the business taxpayer's first use of such property. • “Qualified property” does not include any real property, but can include components or qualified improvement property (QIP). • Qualified improvement property includes restaurant, retail or leasehold improvements if structure is more than 3 years old. • Glitch puts QIP with 39 year property and has not been fixed!

Section 179 expensing is increased to $1 million for years 2018 to 2022. A phase-out of the Section 179 benefit will begin when the purchases exceed $2.5 million. • Some states allow Section 179 deduction – not bonus depreciation. • Review allocation and limitations between related businesses. • Like-kind exchanges will only apply to real property. • Disallowed deferring gains on trade-ins of equipment. • Luxury auto business depreciation in first year increases to $10,000 for 2018 (from $8,000).  Tax “Crack” (Once you start you can’t stop!)

Eliminates the deduction under Internal Revenue Code § 199 for domestic production (DPAD) • Was 9% of qualified net income. • Included income for construction, engineers and architects, manufacturing, etc. • Replaced by lower tax rates and pass-through deductions. • Some “double dip” results for fiscal year end pass-throughs. DPAD plus QBI deductions.  199A is DPAD on steroids

Entities with average gross receipts of less than $25 million (indexed for inflation) are allowed to use the cash method of accounting • Entities with less than $25 million ($26 million for 2019) in average annual gross receipts are allowed to use the completed contract method for construction contracts. • Threshold has been $10 million since 1986. • Businesses that meet this gross receipts threshold can automatically change their accounting method for 2018. • File Simplified Form 3115 for 2018. • 481a for cash method change. • Cut-off method for completed contract method (new contracts on new method).

Have to continue to calculate related parties and common ownership to determine eligibility. • Companies that were on completed contract previously, exceeded $10 million but never elected to change to percentage of completion, simply elect to return on new contracts.  Thank you Congress, it’s about time!

Businesses will be subject to disallowance of a deduction for net interest expense in excess of 30% of the business' adjusted taxable income (EBITDA) 163(j) • Added to tax bill to offset accelerated deductions for purchases. • Net interest expense is determined at the tax filer level (e.g., the partnership versus the partner). • Businesses with average gross receipts of $25 million or less will be exempt from the interest limitation rules. • Related parties and consolidation impact? • Real estate trade or businesses (including construction) can elect out of this limitation, but they lose bonus depreciation on eligible assets.

Interest limited by income carries forward to following years. • “Tax Shelters” can be limited regardless of gross receipts. • Tax losses on return. • 35% owned by limited partners. • Capital accounts required to be reported on tax basis for entities with losses.  ???????

The act's final version retains the seven overall individual tax brackets, but tax cuts are achieved by cutting the rates themselves. The final version cuts the top rate to 37%

The "Pease" limitation, which previously limited itemized deductions if income exceeded $313,000, has been repealed for 2018. • The deduction for non-business state and local income, sales and property taxes will be limited to $10,000 in aggregate. • No limitation on taxes owed by businesses or rental properties. • The deduction for mortgage interest is subject to the following rules: • Interest on acquisition debt currently in existence can be deducted under current rules ($1 million). • The $1 million debt limit is reduced to $750,000 for debt incurred after December 15, 2017, and will only include mortgage interest deduction on a principal residence and second residence.

Home equity interest will be nondeductible beginning in 2018 unless spent on home improvements. • Consider converting second homes or vacation homes into rental properties (subject to business interest limitations). • Elimination of deduction for alimony payments effective for any divorce decree or separation agreement executed or modified after 2018. • No deduction for payer. No income for payee. • The act repeals all miscellaneous itemized deductions that were previously subject to the 2% floor. Miscellaneous deductions included investment fees, tax preparation expenses, unreimbursed employee business expenses, moving expenses, gambling losses, etc. • Congress is giving up their $3,000 per year deduction! • More expenses allocated to businesses and properties?

The standard deduction (vs. itemized deductions) doubles to $24,000 on joint returns. Personal exemptions are eliminated for 2018 (would have been $4,150 per person phasing out at $313,800). • Consider “bundling” contributions to maximize deductions. • Allows use of Section 529 plans to pay up to $10,000 of elementary or secondary education (per student). • “Kiddie tax” rate changed from parents rate to estate and trust tax rates. • Income > $2,100 if under 19, or full time student. • Hits top bracket at $12,000. • Carried interest holding period increased to three years for capital gain treatment. • Other capital gain rules did not change (15% if income is between $77,200 and $479,000, then 20% plus 3.8% Medicare tax).

Business losses can only exceed business income by $500,000 in a year. • Excess losses carry forward to future years. • Wages included in business income. 10,000 more reasons to live in Tennessee!

Doubles the basic exclusion amount for gift and estate tax purposes from the exclusion of $5.49 million in 2017 to $11.2 million in 2018, which will be indexed for inflation • Repeals the estate and generation-skipping transfer taxes in 2024, while retaining the stepped up basis rules. • President has “deregulated” proposal to eliminate discounts for gifts to family members. • Often up to 40% discounts for minority interest and lack of marketability. • No more estate planning, right?  Might need to “disappear” before 2021 or after 2024.

No deduction will be allowed for entertainment, amusement or recreation facilities, or membership dues relating to such activities or other social purposes • Business meals are still deductible (subject to 50% limitation). • Amounts paid to be able to purchase athletic tickets will not be deductible (a portion previously qualified as charitable). • Golf or sporting event deductions eliminated. • Sponsorships vs. entertainment?

Louisiana Joint CFMA Conference 2019 James C. Lundy, Jr., CPA Tax & Construction Partner