We haven’t met a contractor who likes to pay taxes, but many take avoiding taxes to the extreme. What are the true implications of making it your goal to pay no taxes every year? Let’s talk about it.
Topics we cover in this episode include:
- Four ways contractors can be taxed
- An example of an extreme outcome of tax avoidance
- The purchases and tax choices that get many contractors in trouble
- How Profit First can help you save enough for taxes and remain profitable
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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com
[00:00:05] Wade Carpenter: I haven’t met a contractor yet who likes to pay taxes. With that said, many contractors take things to the extreme to avoid taxes. And there are definitely some deferral games you can play in construction. Should you be paying no taxes? Should that be your goal? Come on in, let’s talk about it.
This is the Contractor Success Forum. If you’re new here, I’m Wade Carpenter with Carpenter Company CPAs. With me is my co host, Stephen Brown with McDaniel Whitley Bonding and Insurance.
Stephen, you brought this topic up after a conversation with your client, and paying no taxes is usually the expectation of a CPA. Any thoughts to start us off here?
[00:00:42] Stephen Brown: Well, a good friend of mine that had been a bond underwriter and a bond agent for 40 years made the comment, I’ve seen a lot of contractors go broke trying to get out of paying taxes.
[00:00:52] Wade Carpenter: Right.
[00:00:53] Stephen Brown: What do you think he meant by that, Wade?
[00:00:55] Wade Carpenter: Well, as I said in the opening, contractors particularly hate paying taxes and a lot of them, the goal is always, I don’t want to pay any taxes no matter what. And that is the expectation of a CPA is you’ll get me out of taxes. But there’s some long term effects that I think we need to kick around in this episode where, if you’re never making profit, you’re perpetually digging yourself a deeper hole.
[00:01:21] Stephen Brown: Well, I’ll tell you, that’s exactly what he meant. The long term effects of being obsessed with not paying taxes. And this may be an unpopular subject. I don’t know, but it’s real, and our listeners need to learn about it.
[00:01:34] Wade Carpenter: I agree that, again, taxes are never popular, but a lot of times if we would sort of delay some of the gratification and control our growth as we were talking about before the podcast, and making sure that we have the capital– those were your words. That goes a long way to getting what you want in life. Right?
[00:01:51] Stephen Brown: That’s right. Having cash, having net worth, having working capital gets you bonding, it gets you banking but it’s also a measuring stick of you truly understanding how you’re performing on the projects.
[00:02:06] Wade Carpenter: Right. So, that’s what I was wanting to kick around today was more of, if you never make any profit, you’re constantly running on December 29th and buying a new pickup truck to expense the whole thing out, and then you’ve got to pay a note on that thing for, what, seven years afterwards on these, what are they, 150, 000 trucks now?
[00:02:27] Stephen Brown: Yeah. I mean, what’s the interest rate on that? I’m wondering that right now.
[00:02:31] Wade Carpenter: They’re not pretty, I’m sure.
[00:02:33] Stephen Brown: Yeah.
[00:02:33] Wade Carpenter: Part of my point is nobody wants to pay any more taxes. There are definitely some deferral games and we shouldn’t pay any more taxes than we legally have to. But if we’re constantly doing things to artificially bring it down or go to extremes, well, you never build wealth. You never build that net worth. Not only in your business, but also in yourself.
Four ways contractors can be taxed
[00:02:56] Stephen Brown: Before you get into some examples of what happens when you try to defer income too long, its effect on your balance sheet, its effect on your business operations, there are, I think, four different ways of which contractors can be taxed. Would you just tell our listeners a little bit about that?
[00:03:16] Wade Carpenter: We’re basically referring to the methods of accounting and a couple of hybrids. But in general, you’ve got cash basis, where if cash comes in, income, you’re going to pick it up as income. If cash goes out, gets paid out during that year, it’s going to get expensed during that year.
Accrual means if you invoice a project before the end of the year, you’re going to pick that up as income. By the same token, if you got a bill from a subcontractor or a supplier that is dated before December 31st, whether you paid it or not, that’s an expense for accrual.
Then there’s the other ones that we’ve talked about, the percentage of completion. If you’re X percent complete of a job, no matter how much you build or whatever, we’re making an adjustment to say this is how much you’ve actually earned on this project. And this is really where you are. So you’re going to pay taxes on it as you go.
And the final one I’m going to talk about is the completed contract method, where when you’re done with a job, then you pay taxes on it. You pick up the revenue as well as you pick up the expenses all at the same time. And a lot of people think, well, that sounds great, but there also can have some huge profit dumps in one year for basically any of these, and you’ve got to treat them properly is the point.
[00:04:36] Stephen Brown: Okay.
[00:04:37] Wade Carpenter: Part of what we were also talking about before this is working on your tax method and working with your CPA. If you’re going to play tax deferral games or just make sure it doesn’t screw up your cash flow as well as your bonding and banking. And sometimes they’re not necessarily mutually exclusive, but I think as we’ve gotten older, I know I have, I’d rather have a contractor of mine build long term wealth and retire comfortably than– I see a lot of them just, they, they’ve saved nothing their entire life. Company has never really been profitable. And then something happens where they die suddenly and they leave a burden on their family to scramble to pay things.
[00:05:19] Stephen Brown: Mm hmm. Well, that makes sense. When you think about the effect on your balance sheet of deferring taxes, one of my friends who’s a bond underwriter said, I always see the effect of deferred taxes as high receivables are on their financial statements. Low payables. And they’re generally maxed out on their bank line of credit.
So, I understand that and you please correct me if I’m wrong, but you’re paying down your expenses. You’re not recognizing revenue. So your receivables are high. And then you’re using your bank line to pay your expenses because your revenue is not coming in. What do you think about that comment?
Is that generally a rule of what you see for a contractor that’s deferring their taxes?
[00:06:06] Wade Carpenter: Yeah, it definitely is a perpetual thing and you see every year and it’s a game most people play every year.
An example of an extreme outcome of tax avoidance
[00:06:13] Wade Carpenter: One of my points today is some of the extremes that come when somebody dies. The one example I started pulling together was one that I vividly remember after 2008. It was a commercial contractor, so they held up like through 2009. They had plenty of work. And they had plenty of work and they played the deferral game at the end of 2009. They paid all their expenses and they held all these checks from putting it in their bank.
On January 2nd, they deposited like $800,000, which can get you in trouble with IRS if they catch you doing all that. If it’s legitimate, that’s one thing, but when all of a sudden you have a huge dump of cash into one year.
So here’s what happened. So they paid out all these expenses. They also bought some more trucks at the end of the year, because they had a huge year in 2009 and things were going well and they didn’t want to pay any taxes.
So, they had been buying trucks. As I said, it can take five, seven years to pay off a truck now. They had several of these long term things where they’ve had to expense the whole thing out immediately, but they’re still paying the cash flow.
So 2010 hits, well 2009, they’ve paid all the cash out. They’ve actually ran the checking account negative. It’s funny how all these checks were dated December 31st. And yet they still didn’t start clearing until the end of February, but they pay no taxes. You’re smiling because I think you’ve seen this before, right?
[00:07:41] Stephen Brown: Yeah, like a lot. And you’re just screwed for bonds for the next year. That 12/31 statement is what paints the picture of how you performed.
[00:07:52] Wade Carpenter: Right.
Okay, well, what happens? Well, 2010 hits and they’re out of work. And they’ve got all these people they had all the cash really did come in and so they dump all this in there and they had some money to run for a little bit, but they’re really out of work.
And construction people are sometimes hard to find. Keeping good ones, you understand that. But these people had them do all kind of stuff around their house and, kept them busy as much as they could and they kept everybody on payroll, and nothing was turning up.
Meanwhile, they were cash based. So they dumped all that profit in, in January. All of a sudden they have no work and these trucks that are sitting idle and they’ve still got to continue paying these notes payable for all these things. So their cash is going out very quickly, but they don’t have the expenses to go behind it.
So now they’re trying to get rid of all these trucks. They eventually had to lay everybody off. They held on as long as they could, but they lay everybody off and they have to start fire selling these trucks. And obviously when you fire sale, you’re not going to get top dollar, especially back then. A lot of equipment was on the market and nobody wanted to pay you anything for it.
But the problem was, even though they didn’t get full value for selling it, they had to pay off these notes and sometimes come to the table with cash to get rid of the note payment.
[00:09:13] Stephen Brown: Mm hmm.
[00:09:14] Wade Carpenter: And what’s even worse was the fact that they’ve already expensed these trucks up front and even though they got something less than what it should have been valued for, they had a gain on these trucks. They weren’t fully depreciated.
[00:09:27] Stephen Brown: Yeah.
[00:09:28] Wade Carpenter: I don’t want to get too deep into a tax issue, but, if you, section 179, were expensing the truck up front, there’s a ordinary income recapture, depending on how long you’ve held the truck and all that stuff.
So, they had all these trucks that they, normally you would get capital gains treatment on, if you had a gain on that. So, I guess insult to injury, is the term, they paid ordinary income on these trucks that they had to come to the table with cash to get rid of so that they could get out from under the notes. And unfortunately, they did not survive that.
[00:10:01] Stephen Brown: Mm hmm.
[00:10:02] Wade Carpenter: I’m leaving parts of the story out, but I think that’s–
[00:10:05] Stephen Brown: My guess too is that when they deposit all that cash after the first of the year, they didn’t pay their bank line off. You know, a lot of contractors are like, well, you know, I just like looking at this cash flow, but I just wait another month. It’s nice, but the clock is ticking on your bank line too, and your car note, and insurance, and car tags, and everything else it takes to run a vehicle.
You could have the same scenario with equipment or anything else that you’re using as a way to to expense a bunch of things that you think you need in order to defer your taxes.
[00:10:40] Wade Carpenter: Right, well, as you can imagine, you got all this profit. That was the rest of the story. The cash came in, but they kept paying all these people, even though there was no income to go behind it. And they did not pay that credit down.
So they get to the end of the year, they had all these ordinary income gains on the truck. They had income gains, really from the prior year’s income, because they had no expenses to use it. They couldn’t do another truck. They didn’t need any more trucks. They couldn’t afford it, so they couldn’t play that deferral game one more time. All of this, it was sort of the perfect storm that hit all at the same time.
And from these examples you see contractors, somebody gets disabled, hurt on the job or something and they can’t work or they continue the company or they die suddenly. They’re leaving their loved ones with a burden.
[00:11:30] Stephen Brown: Yeah, if there was any time that a construction company needed a lot of cash, it’s if something happens to the owner.
[00:11:39] Wade Carpenter: Right. And I think we’re going to do an episode about some of that.
[00:11:43] Stephen Brown: We are.
[00:11:44] Wade Carpenter: Pretty soon. But–
The purchases and tax choices that get many contractors in trouble
[00:11:45] Stephen Brown: Well, hey, this is such a good example. What would you have advised in retrospect having studied this situation that they did? So, 2009, they had a profitable year. Everything’s going fine. They’ve got good employees. They’ve got plenty of work. And then in 2010, the work starts drying up.
In retrospect, it’s easy to Monday morning quarterback both. But what’s the key flaw in, you think, most likely was a thing that definitely did them in? High overhead? Tax payments?
[00:12:16] Wade Carpenter: We talk about these, well, whether we want to get into it, we’re probably getting in trouble with our contractors here. But it’s nice to roll up on that job with that $100,000, $150,000 pickup truck.
[00:12:28] Stephen Brown: Yeah. Well, in defense of contractors most contractors spend such an insane amount of time in your truck, you want a comfortable one. But as far as an ego thing, showing off to your workers, I had a customer whose truck was so over the top that the employees were talking behind his back.
Kind of like me as an insurance agent, I pull up to your office in a Mercedes, you think I’m charging too much for insurance. It’s the same sort of scenario.
As you think back about that case study, everything contributed equally to their downfall?
[00:13:01] Wade Carpenter: There was a lot of things that did, and again, Monday Morning Quarterback, we were all hoping things would turn around. And construction is cyclical, but that was a particularly long downturn. I’ve got other stories just like that. Some guy that I think I’ve talked about a few times that had a big job when everybody else had nothing to do, and he’s taking the cash and started buying equipment with it because it was cheap on the market.
And six months later, he was in the same boat because he had no cash for it. So again, it does happen where, at some point there’s a day of reckoning.
[00:13:36] Stephen Brown: Mm-Hmm.
[00:13:37] Wade Carpenter: My point here is that if you’ve never build wealth, you’re going to retire broke, if you You don’t figure out how to get profitable.
How Profit First can help you save enough for taxes and remain profitable
[00:13:46] Wade Carpenter: And I guess if you’re asking my opinion, because we talk about Profit First and I’ve actually started developing some stuff. Profit First wasn’t written until 2014. The first version of it. I wish I had that for contractors back in 2008.
[00:14:03] Stephen Brown: Mm-Hmm.
[00:14:03] Wade Carpenter: And there’s been some other downturns over the years, but that one was pretty vivid. And if they had some of these controls in place on cash, you would have figured out pretty quickly that, hey, the cash is not coming in and we’re out of money in our OPEX to cover payroll. When that starts happening, you have to borrow from these other things. And it’s hey, it hits you right in the face where–
[00:14:26] Stephen Brown: A lot faster too. Yeah. You recognize your mistake a whole lot faster when you’ve accounted separately for that. And, that’s how we met, Wade. You and, and Rob, were master Profit First Coaches and as a construction business coach and MBA, Rob, and you as a construction CPA, you saw the merit of it.
And after 30 or 40 podcasts, including Mike Michalowicz as a guest and explaining the concept to different bond underwriters, it’s a fantastic system. It’s a fantastic way of thinking.
[00:15:01] Wade Carpenter: Well, if you wrap your business around it, and again, that’s where I’m developing a whole seminar about knowing how to bid and knowing how to mark up your jobs profitably so that you do have the cash flow. That is huge, and it can stop those ups and downs of borrowing from the next job to pay for the last job. Same thing I say all the time. It’s like, get the owner from taking less home than the receptionist.
[00:15:29] Stephen Brown: Right. And the whole concept is for you to take your income as owner of the company, for you to make income to meet your expenses for whatever your needs are. And to go backwards from that, this situation where this contractor went under, I would guess that that particular contractor was living so hard through his company in order to not pay taxes that he didn’t have the necessary income and personal net worth to help bail the company out when problems happened.
And it’s the reason bonding companies want to see work and capital and net worth in your construction company to give you bonding.
[00:16:04] Wade Carpenter: Yeah, well, again, it definitely can result in a brutal tax bill like that guy got. And it took that guy 10 years to pay that off, even though, he tried to do an installment agreement, but the IRS won’t let you go that far. So it ruined him for a while. And it’s, it’s really sad. And I guess my only point is don’t lose sight of the fact that you really are in business to make profit. And again, there’s the expectation of CPAs, and a lot of prospects will ask me, you know, I want to pay nothing and whatever, and I don’t mind getting into the gray, and when–
[00:16:40] Stephen Brown: That’s a great first conversation.
[00:16:42] Wade Carpenter: –into that gray, then, unfortunately, I won’t work with you. If you realize that you’re never going to have anything this way. I probably shouldn’t have said that on this podcast, but you know, if you can’t sleep well at night, knowing the IRS could show up at your door, that I’d rather sleep well at night knowing you’re building wealth and eventually get to the point where–
[00:17:03] Stephen Brown: Listen, as a construction CPA, your contractors that are so adamant about not paying taxes. If they have to pay any taxes, it’s your fault. It’s your fault. Wait, I owe what? No, I don’t. I’m not paying it. Well, yeah, you have to. Why didn’t you tell me? I’ve been telling you. It’s a kind of a vicious game for everyone.
I always think of what a friend of mine says about contractors and taxes is, from an underwriting standpoint, you look at the scales. You don’t want to pay any taxes, you don’t take advantage of any legitimate deductions that you can use to lower your tax base.
Those two sides of the scale, you’ll want to be in the middle, and like you said, be able to sleep at night. So, you know, if it’s true that the government’s going to hire 80,000 new IRS tax agents, what does that mean? That means they plan on getting more than enough to pay their salary, that’s for sure.
[00:18:00] Wade Carpenter: Yeah, well, unfortunately, what a lot of times they actually do end up gearing up all that, the ones that suffer are these contractors, the salts of the earth guys that are out there working hard every day. Trying to build a life for their family and themselves. And unfortunately, those are the ones that get hurt by these things.
[00:18:18] Stephen Brown: Sure. Well, maybe if we did a podcast titled, Tips and Tricks for Not Paying Taxes for Contractors, might be a huge hit. I don’t know. I hope not, but all my best customers that seem to make the most money, get the highest bonding, the best rates, best bank terms, they’re not playing that game. That’s all I have to say about that.
I really like your point, too, about making the profit as a measuring stick. And take it out of the company.
[00:18:45] Wade Carpenter: My goal is like, hey, if I can make sure that you know how to make profit, as well as Profit First puts aside the money to make sure that you have the money to pay those taxes. People dislike me a lot less when they do that, especially when I can show them how they can keep a lot of that money.
And so that was the only point for today, really. But this may end up being our least popular episode. I don’t know.
[00:19:09] Stephen Brown: I don’t know either, but I enjoyed it. And sometimes, Wade, we have podcasts that you and I may enjoy more than our listeners. I don’t know. But in this situation, it’s very apropos. Is that the word I’m thinking of? Very appropriate to today’s times and what we see. So, I can tell you that the tax deferral game, there’s stress involved.
You can’t just keep telling your, your account, I’m not paying tax, I’m not paying tax, and then just blow up and pitch a fit and threaten to fire them when you do have to pay taxes. I see that all the time, so I appreciate your comment and I appreciate you explaining. There’s a lot to contractors and taxes. And a good construction CPA can keep you from paying too much taxes, that’s for sure.
[00:19:55] Wade Carpenter: But an even better one can show you how to make profit and keep some of that at the end of the day.
[00:20:00] Stephen Brown: Right. A whole lot better one. Yeah. Good point, Wade.
[00:20:04] Wade Carpenter: That was a shameless self plug, but anyway.
[00:20:07] Stephen Brown: It wasn’t shameless. It’s a fact. It is a fact. So, thanks, Wade.
[00:20:12] Wade Carpenter: All right. Well, thank you all for listening to the Contractor Success Forum. Check out the show notes at ContractorSuccessForum. com or on the CarpenterCPA’s YouTube channel for more information. We would appreciate it if you’d consider subscribing and follow us every week as we post a new episode. We will look forward to seeing you on the next show.