Most political observers agree the new administration will bring changes to the tax code. What those changes will be and how soon they arrive are the question. On average, experts say, it takes a year and a half for new tax law, which means no major changes until 2022 at the earliest. But there are some ways the tax code could change more quickly. Regardless of the timeline, HVAC contractors need to start thinking about all the ways taxes can impact their business and their personal finances.
The latest major overhaul of the tax code was the Tax Cuts and Jobs Act of 2017. It was a fairly major overhaul, especially in regard to business taxes. It especially benefitted pass-through entities, which includes a majority of small businesses, such as HVAC contractors. Qualifying pass-through business owners have been able to deduct a portion of their net business income from their personal income taxes, reducing the rate.
That creates considerable savings in many cases. However, there TCJA also changed the rules for C corporations. This structure had been unfavorable among most small businesses because C corps pay “double tax,” first at the corporate rate and then as income for shareholders. The TCJA lowered the rate for C corps to a flat tax of 21% from a progressive tax ranging from 15% to 39%. An earlier change to the tax code, called the Small Business Stock Gains Exclusion, exempted capital gains for owners of small business stocks with several caveats.
President Biden said he wants to raise the C corp rate to 28%, although his ability to do so depends on Congress. Otherwise, the rate is permanent, as is the small-business exemption. The deduction for pass-through entities is scheduled to end on Jan. 1, 2026, unless Congress acts to extend it or make it permanent. There are many reasons why HVAC contractors would choose one of the other, including long-term plans for the business.
Act As If You Are About To Sell
The ultimate long-term planning is estate planning, and this is an area that faces even more uncertainty with the new administration. For example, President Biden proposes eliminating the step-up basis that allows heirs to avoid some capital gains taxes. There have already been some high-profile instances of wealthy individuals selling assets in part because of concerns about that change.
Keven Prather, a partner with financial planning firm TransitioNext Advisors, said HVAC contractors need to start looking at their options now in case the laws do change. That starts with knowing the value of the business. Most business owners don’t really know that, Prather said. They especially remain unaware of the different types of buyers. Outside buyers usually fall into two categories: financial buyers, who are purely looking for a return on investment, and strategic buyers, who have a specific reason to buy a company — such as diversification or eliminating a competitor.
The two types of buyers will value the company differently, Prather said. He said HVAC contractors need to always behave as if they are about to sell their companies, even if they are not. That guides a wide range of decisions.
In general, Prather recommends that HVAC contractors time their revenue well and structure their income properly. He said they should use tools to manage their tax burden. Don’t take on expenses, but add assets. HVAC contractors should know now where they think they’ll be at the end of the year, Prather said.
Raising Revenue, Changing Behavior
While the exact state of the tax code remains somewhat uncertain, one thing that’s for sure is HVAC contractors should expect increased scrutiny over taxes this year. Tax policy is about raising revenue, and that’s something state and municipal governments desperately need right now. This has officials looking at any business from which they can collect some taxes from for spending even some time in their jurisdictions.
“You have states that are constantly looking for different revenue sources,” said Greg Knarr, director of CPA firm Alliant Group. “And if you can get it from people who don’t live in your state, all the better.”
The Internal Revenue Service is also looking to collect more tax dollars. The agency announced at the end of last year that it will increase the number of small business audits in 2021. The number of exams has dropped in the past few years due to a lack of funding for the IRS, Knarr said. While this sounds good to many people, it actually creates problems for businesses and their tax preparers.
“When we don’t fund the IRS, it’s very difficult to get an answer to anything,” Knarr said.
Even if it’s coming off a smaller number, the IRS does plan to conduct 50% more audits of small businesses than it did in 2020. Knarr said an audit is a stressful, time-consuming experience for anyone.
Of course, collecting money is only one aspect of the tax code. It also works to promote or discourage behavior, Knarr said. That’s why mortgages are deductible and cigarette taxes are high. This is another reason to keep up with the tax code — to find credits that could benefit an HVAC contractor‘s business. For example, the recent stimulus bill extended tax credits for residential energy efficiency and geothermal installation, as well as making the energy efficiency deduction for commercial buildings permanent.
Even paying taxes isn’t necessarily a bad occurrence, Knarr said. It means that the HVAC contractor made money.
“You want to pay what you owe,” Knarr said. “You don’t want to pay dollar more.”
Former HVAC Contractors Share His Audit Experience
Greg Crumpton knows firsthand how bad an audit can be. Before becoming the vice president of critical facilities, safety, and technology at Service Logic, Crumpton founded and ran AirTight Mechanical Inc. in Charlotte, North Carolina. He grew the commercial HVAC contractor into an $8 million company with 30 employees.
Every month, an outside CPA came in and review the books. Crumpton said they followed that CPA’s instructions to the letter. Then one day, he received notice that AirTight had been randomly selected by the state for a sales tax audit. Crumpton believed he had no reason for concern and welcomed the two young men for the North Carolina Department of Revenue.
On the first day, the auditors found an anomaly. They stayed for two weeks. The auditors couldn’t say what it was, but Crumpton could tell it was bad. The process wasn’t confrontational, he said, but uncomfortable.
“It was just the two weeks of knowing that they weren’t there for no reason,” he said.
They submitted their report at the end of two weeks, and it was bad. The CPA had provided the company with bad advice, and AirTight had been paying taxes improperly on the materials they were buying for jobs. AirTight owed $198,000. The auditors went back through seven years of records, the most allowed under state law.
So now Crumpton found himself in the situation of having to come up with almost a decade’s worth of taxes immediately. The state offered no installment plan. Crumpton tapped AirTight’s line of credit.
The financial toll of the audit was serious. It created debt that needed repayment. It also meant money was unavailable if another emergency arose. Crumpton said the audit also put AirTight’s earning ability at risk. Clients looking at their financial data when considering the company’s bids for maintenance agreements would see the company owned thousands of dollar in back taxes.
The non-financial toll was even worse. The entire process took three months. Crumpton said it was a constant distraction.