FMI's 2013 US Markets Construction Overview

Recently I attended a presentation by FMI Management Consulting.  I've known FMI for many years and have come to respect them as a leading firm in the construction industry.  The slideshow in the following link contains over 50 slides of data ranging from forecasts in different sectors of the construction industry to surety statistics to demographics/population data (including maps), profitability information and economic data, etc.  I hope you find the information useful...  

The presentation can be found here...

Proposed Revenue Recognition Changes Update

You may have heard over the last year or so about the proposed changes for how contractors will recognize revenue.  For those of us who have been in the in the industry for a while, we are most familiar with Statement of Position (SOP) 81-1 (Accounting for Performance of Construction-Type and Certain Production-Type Contracts, 1981) which was replaced by Accounting Standards Codification (ASC) 605-35.  These pronouncements dictate the current standards for revenue recognition, Percentage of Completion based primarily on costs.

The world is changing, in many ways getting "smaller".  Convergence is a word we hear tossed around regularly in terms of reporting standards internationally.  I've been following these drafts as they are called, published by the Financial Accounting Standards Board (FASB) for some time now.  They seem to be getting closer to pulling the trigger on what will change after much back and forth between industry participants and the FASB.  I'm personally a fan of how we report now, I'm not sure what is "broken" so to speak.  Again, I think it has more to do with consistency across industries and nations rather than how we here in the US Construction Industry feel about the current model for revenue recognition.

The CFMA has done a nice job of summarizing the current state of affairs.  We won't be dealing with any changes for a few years as they've set 2018 as the first year private companies will need to comply.  Here's the CFMA Synopsis...

American Taxpayer Relief Act 2012

There has been much going on in Washington in recent weeks surrounding our tax laws and fiscal policies.  Thankfully the adults in Congress reached a compromise last month and the President signed into law the American Taxpayer Relief Act of 2012.

I'm not sure "relief" is an appropriate word to be used in the title here, however we did gain some certainty, at least with respect to tax rates.  I'm also not sure the American worker who heard so much in the media about protection of the middle class felt relief when s/he opened up that first paycheck in 2013 and was puzzled why the net check went down only to learn payroll taxes went back to the normal, pre-holiday, rates.

US Bank did a nice job in summarizing, in a short two page document seen below, what they are calling the "tax highlights" of the new law.

Tax Depreciation Limits

I thought it might be nice to publish a summary of the 2012 tax depreciation limits for accounting and finance personnel to be able to reference.  If these limits don't particularly excite you, please forward to those tasked with knowing such things.

Below are the 2012 tax depreciation limits for Section 179 and bonus depreciation, since this changes year to year.  The American Taxpayer Relief Act of 2012 extended the Section 179 amounts for the 2012 and 2013 tax year.  The 50% bonus depreciation was also extended to the 2013 calendar year.

FEDERAL TAX

1.       Section 179 for 2012 tax year (see below) - Maximum Sec. 179 deduction $500,000.  Investment limit $2,000,000.  (If more than $2M of fixed assets additions of qualifying Sec. 179 assets, the Sec. 179 deduction phases out dollar-for-dollar, e.g., if there is $2,000,001 in additions, the Sec. 179 is reduced to $499,999 – Sec. 179 is completely phased out when total additions exceed $2.5M).  Most common non-qualifying Sec. 179 assets are Leasehold Improvements (with exceptions).

2.       50% Additional First Year Bonus Depreciation – Asset must be new.  The bonus depreciation was 100% for the 2011 calendar year.  (For example, if you have a 6/30/12 FYE client, 100% bonus depreciation will apply for 7/1/11 – 12/31/11, and 50% bonus depreciation will apply for 1/1/12 – 6/30/12).

CALIFORNIA – California never conforms to federal.

1.       Section 179 – Maximum Sec. 179 deduction $25,000.  Investment limit $200,000.  (Same dollar-for-dollar phase out applies – at $225k new additions, Sec. 179 is completely phased out).

2.       No bonus depreciation allowed.

TAX YEARS

The basic rule for tax years – it is determined by when the fiscal year starts.

The 2012 tax year for Section 179 is applicable for 12/31/12, 1/31/13, 2/28/13, 3/31/13, 4/30/13, 5/31/13, 6/30/13, 7/31/13, 8/31/13, 9/30/13, 10/31/13, and 11/30/13 clients.

COMMON ASSET LIVES (BNA)

1.       3 year SL – off-the-shelf software

2.       5 year MC200 – cars & trucks (see note below for limitations), computers, machinery and equipment

3.       7 year MC200 – furniture, phones

4.       15 year MC150 – land improvements (parking lot, fencing, sidewalks)

5.       27.5 year SL – Residential Real Property

6.       39 year SL – Commercial Real Property (including leasehold improvements that are structural and affixed) – certain LHI can utilize a shorter 15-year life for federal if certain criteria are met – please ask if this applies to your client.

NOTE ON CARS & TRUCKS (SEE ATTACHMENT)

1.       Most cars and trucks are limited to the amount of depreciation (including Sec. 179 and bonus depreciation) you can take each year.  The code for listed property in BNA is “AL.”  For 2012, autos are limited to $3,160 depreciation in the first year.  If bonus depreciation is taken (auto needs to be new), the first year depreciation limit is increased to $11,160.

2.       For trucks having gross vehicle weight rating >6,000 lbs. and bed length >6 feet – can take Sec. 179 for entire cost – refer to Table I in the attached file

3.       For (a) SUVs >6,000 lbs., (b) vans >6,000 lbs., and (c) trucks >6,000 lbs. with bed length < 6 feet – Sec. 179 is limited to $25,000 – refer to Table II - IV in attached file

SECTION 179 LIMIT & MID-QUARTER RULES

If Sec. 179 is being limited, and you are trying to figure out which assets to apply the Sec. 179 and which assets to not, the basic steps to take are:

1.       First, choose all the assets with the longer class life (e.g., choose the 7-year asset vs. 5-year).

2.       Second, choose the asset closer to year end (e.g., choose the asset purchased on 12/31 vs. the asset purchased on 1/1).

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Chapman 2013 Economic Forecast

Each year since 1978 Chapman University has published an economic forecast.  These reports are widely anticipated and regarded as one of the better forecasts known for their detail and, most times, accuracy.

At the bullet points below, I've provided some of the highlights per my review of the report.  For those wishing to read the full report, and I encourage you to do so, you can find a copy here.  The full report has many charts, graphs and tables which are quite useful.

• The recovery is in its 3^rd year and Chapman forecasts the recovery to continue into a 4^th year in 2013 with an estimated increase in GDP of 2.1%, roughly similar to 2012.
• Housing continues to be a bright spot.  Nationally, housing inventory is low and housing starts have increased significantly.  Housing starts increased 25% in 2012 and are forecast to increase again at a 13% clip in 2013.  Nationally, prices increased 6% in 2012 and are forecast to increase 3.5% in 2013.  In Orange County, Chapman forecasts price appreciation of 4.2% in 2012 and 6.8% in 2013.
•  Household Net Worth is forecast to return to its pre-recession high by the end of 2013 which explains the boost in consumer confidence seen in recent months.
•  “California and Orange County economies will be facing headwinds in the coming year that may derail the recent pickup in job creation.  Higher taxes – sales, income and payroll – are the primary concern.” 
•  “On the bright side, the Anderson Center’s California Consumer Sentiment Index increased to 94.2 in the third quarter of 2012, a level not seen since the third quarter of 2007.” 
•  “Another positive development is the rebound in construction spending…construction spending…is projected to grow by 10.0 percent in Orange County in 2013.” 
•  “Overall, our forecast calls for an increase of 1.8 percent in total payroll employment in Orange County in 2013…Job growth in construction, professional & business services and leisure & hospitality will outperform all the other sectors of the economy in Orange County and California.” 
•  “The combination of job and real income growth along with historically low mortgage rates bode well for the housing market.” 
•  “In fact, Orange County’s notices of default is currently the lowest in Southern California and showed the sharpest decline in the third quarter of 2012 and is also at its lowest level since the housing slump.”

New California Law Will Prevent Contractors From Shifting Liability for Their Own Active Negligence to Downstream Contractors and Suppliers

by Greg Clement, Partner, Burkhalter, Kessler, Clement & George LLP

Senate Bill 474, codified in California Civil Code section 2782.05, will broaden the types of indemnity provisions that are unenforceable under California law.  Effective January 1, 2013, “Type 1” indemnity provisions in construction contracts, which cover a contractor’s concurrent active negligence, will no longer be enforceable.  In conjunction with the new law, the contractor’s ability to shift the costs of defense to downstream contractors and suppliers will also be limited.

Under existing law, contractors can include broad indemnity provisions in commercial construction contracts which shield the contractor from liability even for its own “active” negligence.  These “Type 1” broad indemnification provisions have been enforceable as long as the liability does not arise from the “sole negligence or willful misconduct” of the contractor or owner.  Civ. Code §2782(a) (emphasis added).

California Civil Code section 2782.05 now renders “Type 1” indemnification provisions unenforceable, imposing liability upon general contractors, construction managers, or other subcontractors for “claims of death or bodily injury to persons, injury to property, or any other loss, damage, or expense” arising out of the “active negligence or willful misconduct of that general contractor…”.  Civ. Code §2782.05(a) (emphasis added).  Furthermore, although construction contracts with public agencies and owners of privately owned real property are expressly excluded from section 2782.05, public agencies and private owners are similarly prohibited from including “Type 1” indemnity provisions in their construction contracts pursuant to section 20782(b)-(c).

Another change in the law is that contractors will be prohibited from allocating the costs of defense of claims to their downstream contractors and suppliers.  The new restrictions contained in section 2782.05 prohibiting indemnity for one’s own active negligence specifically include the “costs to defend” claims in litigation.

Senate Bill 474 describes the express purpose of the new law as a means “to ensure that every construction business in the state is responsible for losses that it, as a business, may cause.”  The statute also prevents a contractor from “forum shopping” to avoid the effect of the new law by imposing a requirement that California law will apply to these contracts without regard to any choice-of-law rules that might otherwise apply.  In addition, any waiver of any of these provisions is contrary to public policy, void, and unenforceable.  Civ. Code §2782.05 (c)-(d).

Consequently, contractors must be especially mindful of the new law to ensure that any indemnification provisions included in their construction contracts or subcontractor agreements, entered into after January 1, 2013, are in compliance with the new law; and contractors must understand they can no longer shift liability for their own active negligence to downstream contractors and suppliers.

Tax Planning Considerations After the Election

With the elections now behind us, we have a little more clarity regarding what lies ahead from an economic policy perspective.  Some initiatives, such as Proposition 30 (Temporary Taxes to Fund Education) are certain to raise taxes for California residents immediately.  In fact, the terms of Proposition 30 go into effect retroactively to January 1, 2012.  Prop 30’s provisions include creating a series of high income tax bracket rate increases (see the table below) beginning at $250,000 taxable income for single taxpayers and $500,000 for joint taxpayers.  Also the sales tax rate for California will increase from 7.25% to 7.5%.  Estimated revenues expected to be generated from Prop 30 range from approximately $7 billion to $9 billion with most of the funds allocated to K-12 grade levels with the balance going to community colleges.

Other issues affecting how much we pay in taxes, often referred to as the “Fiscal Cliff”, are not quite as clear in terms of the final outcome at this point.  The “Fiscal Cliff” reference includes tax increases that will go into effect January 1, 2013 such as the reversal of last year’s payroll tax cuts, expiration of income tax rate cuts put into effect  by President Bush and his team in the early 2000’s, the start of taxes related to President Obama’s healthcare law, cuts in defense and non-defense spending (approximately equally), etc.

President Obama has been clear that he wants to let the Bush tax cuts expire on December 31, 2012 for those earning over $250,000 annually.  Although it is possible President Obama and the Democrat controlled Senate may compromise and extend those tax breaks for a year or so, there’s still a strong chance those cuts will be allowed to expire and higher Federal income tax rates will accompany higher State income tax rates for many California business owners.

TAX PLANNING CONSIDERATIONS

Generally the rule of thumb is to defer income and accelerate deductions as permissible using a variety of strategies.  With the prospect of income tax rates rising January 1, 2013, it may be wise to abandon the general rule and bring income, at least in a measured way, into 2012.  With federal tax rates set to increase as much as approximately 5 points (from 35% Federal to 39.6%), it seems quite appealing to take income now rather than paying almost 5 points higher in federal taxes next year.  In this environment, it is difficult to get much return on investment so why not consider taking the several point benefit in 2012?  Of course President Obama and Congress may extend the Bush-era tax cuts for all, including the high income earners, but in my view playing roulette with those prospects isn’t worth earning only a deferral (remember, it’s only timing we’re talking about).  If you gamble and win, you pay taxes next year (a nice benefit and supplement to cash flow to be sure) instead of this year at the same rates as 2012.  If you gamble on this issue and lose, you pay taxes next year anyway, just at higher federal rates.

Another issue that has to come back into the conversation is whether S Corporation status is as attractive as it’s been these past many years for small business owners.  See my article on S Corporations wherein I discuss this issue in January 2009 in my final paragraph of that posting.  The average corporate federal tax rate is 34% (there are lower tax rates for corporations with taxable income less than $75,000 which get phased out at higher income levels).  The California State Corporate tax rate is 8.84% and the personal tax rates (see schedule below) will fall somewhere between 10.3% and 13.3% for many business owners who are structured as S Corporations.  Given the higher personal income tax rates versus corporate tax rates, it makes sense to consult with your advisors as to whether S Corporation status still makes sense.  In many cases the answer will still be yes as avoiding the double taxation of corporations, especially in a liquidation event, will still win the day for S Corporations.

California Personal Income Tax Rate Structure Under Prop 30

Single Filer's Taxable Income	Joint Filer's Taxable Income	HOH Taxable Income	Current Tax Rate	Additional Tax Rate	Total Tax Rate
250,000-300,000	500,000 - 600,000	340,000-408,000	9.3%	1.0%	10.3%
300,000-500,000	600,000-1,000,000	408,000-680,000	9.3%	2.0%	11.3%
Over 500,000	Over 1,000,000	Over 680,000	9.3%	3.0%	12.3%