How Does a Contractor Build a Resilient Tax Foundation?

One of the most common questions I am asked by clients, and especially contractors, is “How do you take advantage of the opportunities that exist in the tax code to pay as little tax as possible?”

Taxes are an ongoing obligation that must be addressed by every business, and contractors are no exception. As revenue increases the tax exposure to contractors can increase at a rate that greatly affects their cash flow. While many have argued regarding the legitimacy and purpose of taxes, it is important to recognize that the tax code is intentionally structured to provide opportunities for those who are ready to take advantage of them. The tax code contains provisions that, when understood and properly applied, can allow taxpayers to legally minimize their tax liability.

Yes, there are legitimate ways for taxpayers to reduce what they owe, but preparation is essential—and these opportunities are accessible only to those who are adequately prepared to act on them. Without careful planning and a thorough understanding of the tax code, these benefits may be overlooked. Therefore, it is crucial for individuals and businesses to be proactive and informed in their approach to taxes, ensuring they are positioned to benefit from the options available within the law.

Contractors are cautioned not to practice “Monday-Morning Quarterbacking” when it comes to their taxes, as the risk of not paying what is owed in a timely way can be detrimental on both a business and a personal level.

Begin with the Accounting System

Any business’s approach to taxes must begin with their accounting system. Having the right accountant can greatly improve the chances of reducing one’s tax liability. What can be challenging is that some contractors are of the opinion that all accountants are the same.

They are not. Just as contractors have different areas of specialization—carpentry, plumbing, electrical, etc.—so do accountants who specialize in different industries.

Accountants who specialize in the construction industry understand the industry and create an accounting system that reflects the nature of the contractor’s operations. This allows the reports generated to serve to inform how the business performed in the past.

This information is reported in the form of financial statements such as cash flow statements, debt schedules, accounts receivable aging reports, profit and loss statements and balance sheets. The information acquired in the reports can then serve a variety of purposes such as measuring operational efficiency, cost control, cash flow management, tax planning, tax reporting, and perhaps most significantly, tax compliance, including audits.

Example: Single-Member LLC

At a basic level, consider a contractor who initially incorporated as a single-member LLC in order to test the market in the area and evaluate their ability to successfully operate the business. (As a single member LLC, the owner can take withdrawals from the business, and cannot be on payroll.)

When a contractor withdraws money from the business account for personal use, this money is not taxed. The contractor determines $15,000 is needed for monthly personal expenses and decides to take withdrawals in that amount. Over 12 months, this totaled $225,000. This amount is reported on the contractors tax return for which it now has to be taxed.

In addition to the federal income taxes, the contractor is now responsible for the entire amount of the self-employment taxes which consists of both the employer and employee FICA contributions. The self-employment taxes in this instance are estimated to be approximately $26,000 and federal income taxes $43,000, totaling $69,000. This amount does not even include any state income taxes, and obviously would be a hard hit on a contractor’s finances.

Not surprisingly, in this situation, a contractor might want to dispute this amount when presented with the total at the end of the year.

So...how can an outcome like this be avoided? Actively engaging in tax planning can effectively reduce this tax liability. Tax planning is organizing one’s financial affairs is a way that allows them to legally minimize their tax liability. Experienced contractors recognize that inadequate tax planning can lead to increased tax liability.

Trust the Professionals

A crucial point to be aware of when engaging in tax planning is to seek professional assistance. Each contractor’s situation is unique and what may be beneficial to one contractor can be detrimental to another. A tax planner will assist in identifying the areas in the tax code contractors can benefit from. Once this information is obtained, explained, and understood, contractors can adjust their finances to achieve the most favorable legal tax outcome.

Contractors know the state of their business can change quickly; materials and labor costs vary throughout the year and can contribute to cost overruns. Interest rate changes and bank underwriting guidelines affect their ability to obtain financing. Owner financing and willingness to pay invoices affects accounts receivable, and unexpected delays can greatly affect the overall job cost.

For that reason, accounting systems should be updated in a timely way to provide guidance on the financial effect of these changes, which will almost certainly impact the outcome of the tax plan created earlier in the year. This is why I consistently stress to my clients the importance of maintaining ongoing, transparent communication with your accountant and tax preparer all year ‘round.