Strategies forConstruction Contractors:

Improving Profitability and Succession Planning

Mid-Atlantic Build Expo | August 2010

What we’ll discuss

• Cost cutting strategies in a recession

• How to present your financial statements in the best possible light, particularly with surety in mind

• Project management – overcoming roadblocks and improving execution

• Are you taking advantage of all possible tax incentives?

• How to position your business now and for the future: exit strategies and succession planning

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How to Present YourFinancial Statements in the

Best Possible Light

Financial statements

• Working capital and equity are of prime importance to the surety

• Having statements that address their concerns helps smooth the path

Statement of earnings

• Revenues, costs and gross profit should agree with supplemental schedules

• Should be a relationship between GP% of completed contracts and open contracts and preferably a positive one

• G&A expenses should be presented and not include job costs

Balance sheet

• Underbillings – analyzed and traced to following month

• Overbillings – should be in bank and not permanent job borrow

Financial statement footnotes

• Contract receivables – open and closed, retainage by status, consider aging and disclosing

• Deferred costs on unapproved change orders

• Income taxes for pass-through entities

• Proper revenue recognition

Financial statement footnotes

• Line of credit disclosures – look out for covenants and collateral

• Concentrations of credit risk

• Related party disclosures

• Subsequent events

• Backlog

Financial statement footnotes

• Contract guarantees

• Accounts payable – subcontractor retainage

• Change in profit estimate

• Litigation

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Project Management Conceptsfor Success

Roadblocks to effective planning and project management

• Everyone knows that up front planning and effective project management increases profitability

Roadblocks to effective planning and project management

• So why is it often not done?

• Because there is no immediate pain associated with not getting it done

Roadblocks to effective planning and project management

Source:“The 7 Habits of Highly Effective People,” Franklin Covey

Roadblocks to effective planning and project management

• We live in a Quadrant 1 world and it is only getting worse

• Planning and management is a Quadrant 2 activity

Roadblocks to effective planning and project management

• There are two aspects of pricing psychology that directly impact profitability1. Price leverage – Who has the most or least price sensitivity at a given

time?

2. Payment resistance – Can ultimately be due to lack of respect … step into the shoes of the owner

Roadblocks to effective planning and project management

• What are your WIGs?

• Need to incentivize project managers to achieve your goals – specified gross profit, client satisfaction, etc.

• Concept of weekly “clear the path” meeting

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Are You Taking Advantage of All Possible Tax Incentives?

Accounting methods

• Using the right long-term accounting method can defer contract profits and the associated taxes

• American Recovery and Reinvestment Act of 2009• Small contractor exemption

American Recovery and Reinvestment Act of 2009

• Residential Energy Property Credit that was available in 2009 also available in 2010

• Increase in the Earned Income Tax Credit for taxpayers with three or more qualifying children that was available in 2009 also available in 2010

• Making Work Pay Tax Credit that was available in 2009 also available in 2010

Cash vs. accrual methods

• Many small businesses report income on the accrual method, which generally accelerates income, when they could use the cash method of reporting for tax purposes

Expensing assets vs. depreciation

• Create a fixed asset purchase strategy that will minimize taxes

• Bonus depreciation extended into 2009 and might be extended into 2010

Cost segregation studies for real property

• This provides for faster write-off of buildings used in a business by segregating the cost into smaller components, and using a shorter tax depreciation life for items specific to the use of the building and not merely a structural component

Production deduction

• Certain contractors are allowed a deduction based on their profits; careful planning can maximize this tax benefit

Deduction of prepaid expenses that meet certain criteria

• This came about because of a law change regarding the deductibility of assets that have a useful life of one year or less

Payroll taxes

• Taking distributions versus drawing a salary for the owners of the business can save payroll taxes

Contributions to qualified retirement plans

• The right retirement plan can reduce current taxes and create a comfortable retirement for the owner

ESOPs for retirement owners

• Employee Stock Ownership Plans (ESOPs) are gaining popularity as a tax-advantaged exit strategy for retiring business owners

Worker, Homeownership and Business Act of 2009

• Includes a 5-year NOL carry back for losses in 2009 irrespective of size of company (only applies to 2009)

• In 2010, it is a 2-year NOL carry back for losses

Homebuyer tax credit

• New legislation, the Homebuyer Assistance and Improvement Act of 2010 (H.R. 5623), extends the homebuyer credit from 6/30/10 to 9/30/10

• If homebuyer had a ratified contract in place as of 4/30/10, he/she needs to close before 9/30/10 to get the credit

HIRE Act

• Hiring Incentives to Restore Employment (HIRE) Act provides tax incentives for hiring and retaining workers and purchasing equipment and many other business assets (applicable in MD, but not DC or VA)

HIRE Act – payroll tax forgiveness

• Employers who hire unemployed workers after 2/3/10 and before 1/1/11 may qualify for a 6.2 percent payroll tax incentive, exempting them from their share of Social Security taxes on wages paid to these workers after 3/18/10

HIRE Act – payroll tax forgiveness

• The reduced withholding will have no effect on the employee’s future Social Security benefits, and employers still need to withhold the employee’s 6.2 percent share of Social Security taxes, as well as income taxes

• The employer and employee’s shares of Medicare taxes still apply to these wages

HIRE Act – retention credit

• For each worker retained for at least a year, businesses may claim an additional general business tax credit, up to $1,000 per worker, when they file their 2011 income tax returns

HIRE Act – Sec. 179 expensing

• HIRE Act extends the increase in the Section 179 limit for initial year expensing to $250,000 (from $134,000)

• Sec. 179 expensing election allows a current deduction for newly acquired assets that otherwise would have to be depreciated over a number of years

HIRE Act – Sec. 179 expensing

• HIRE Act also extends the increase in the threshold at which the expensing election begins to phase out to $800,000 (up from $530,000)

• The higher limits apply for calendar year 2010 or a business’s fiscal year that begins in 2010

HIRE Act – other provisions

• New election to convert tax credit bonds to Build America Bonds

• Extension of highway and transit programs through 2010

• Deferral of implementation of “worldwide allocation of interest” to 2020

Employee misclassification

• Possible new law, “Employee Misclassification Prevention Act” (EMPA), would crack down on employers who misclassify workers as independent contractors

• Federal and state leaders believe employers are misclassifying some of their workers to save costs

Employee misclassification

• IRS, Department of Labor and the courts have issued guidance to employers for correctly classifying workers

• Consult www.irs.gov and/or www.dol.gov for more info

Employee misclassification

• If passed, the EMPA will:– Require documentation of worker status

– Require employees to notify workers of their classification status and rights

– Create an employee rights website

– Increase penalties under FLSA for not paying appropriate overtime or minimum wages to misclassified workers

Employee misclassification

• If passed, the EMPA will:– Direct the DOL to conduct audits on “problem” industries

– Create information agreements between the IRS, DOL and state agencies

– Require states to develop and enforce their own employee misclassification enforcement programs with DOL oversight

Estate tax

• In 2009 there was an exemption of $3.5 million, top rate of 45 percent, and step-up basis of assets

• In 2010 there is no federal estate tax or carry-over basis

Estate tax

• In 2010 there is an exemption of $1 million, top tax rate of 55 percent and step-up basis of assets

• There is discussion about passing estate tax law that would be retroactive to 1/1/10, but no one knows if this will happen

Bush tax cuts to sunset

• The Bush tax cuts are expected to sunset at the end of 2010:– 10 percent income tax bracket

– Raised the standard deduction for couples to double the single amount

– Increased the child tax credit from $500 to $1,000 per child and made it refundable

Bush tax cuts to sunset

• The Bush tax cuts are expected to sunset at the end of 2010:– Lowered the 28 percent bracket to 25 percent

– Lowered the 31 percent bracket to 28 percent

– Lowered the 36 bracket to 33 percent

– Lowered the 39.6 bracket to 35 percent

Bush tax cuts to sunset

• The Bush tax cuts are expected to sunset at the end of 2010:– Phase-out rules for personal exemptions and itemized

deductions gone in 2010 but back in 2011 to 3 percent phase-out up to 80 percent of itemized deductions

IRA rollovers

• No adjusted gross income (AGI) limit on traditional IRA rollovers to Roth IRA in 2010

• Tax can be deferred until 2011 and 2012

Required minimum distributions

• No required minimum distributions from IRA and pension plans were needed in 2009

• However, you must make IRA distributions in 2010

Alternative minimum tax

• Always consider the impact of the alternative minimum tax (AMT) in tax planning

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How to Position Your BusinessNow for the Future: Exit Strategies

and Succession Planning

Planning for succession

• Typically a three- to five-year process at a minimum until a plan is actually executed

• Need to decide what your future goals and financial needs are

Planning for succession

• Assuming desire to receive fair value for business and desire to leave a legacy, which would exclude an outright gift or liquidation, the owner is typically left with a sale to a third party, family member, or key employee or group of employees

Planning for succession

• ESOP is the other alternative, but has significant hurdles and administrative costs; generally not a practical solution for the average construction company that has less than $25M in revenue

Planning for succession

• Hurdles limiting sale to a third party at acceptable price to owner– More volatile earnings stream given nature of contracts and challenge to

maintain backlogs

– Lack of management of depth and impact on nature of goodwill

– Potential buyer generally looking to pay lower multiple of earnings than owner expects

Planning for succession

• Hurdles to sale to family– Demographic changes from prior generation – smaller families

– Other opportunities for children – college

• Often sale to key employees is the only realistic option that involves accepting certain realities

Planning for succession

• BYOWYOM

• General reluctance to accept risk like prior generations

• Lack of access to capital

Planning for succession

• To produce a plan that incorporates a win-win requires a fairly long buy-out term of 7-10 years

• Requires identification of potential employee or group with plan for leadership training

Planning for succession

• Education, communication, review, education, etc. –takes time to settle in and give a vision for how the plan can work

• Value must be realistic with future cash flow

Who is Steve Ball?

• CPA who specializes in working with contractors and architectural/engineering firms

• CPA, Certified Valuation Analyst (CVA) and Certified in Construction Industry Financial Professional (CCIFP)

• Gross Mendelsohn is a CPA firm specializing in helping Mid-Atlantic contractors grow

celebrating 50 yearsin business

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Questions?

Steve Ball, CPA, CVA, CCIFP

sball@gma-cpa.com | 410.685.5512 | www.gma-cpa.com

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