Copyright 1999 Federal Document Clearing House, Inc.
Federal Document Clearing House Congressional Testimony
June 23, 1999
SECTION: CAPITOL HILL HEARING TESTIMONY
LENGTH: 3225 words
HEADLINE:
TESTIMONY June 23, 1999 ERIC P. WALLACE
HOUSE WAYS AND MEANS
TAX REDUCTION PROPOSALS
BODY: Statement of Eric P.
Wallace on behalf of the Associated Builders and Contractors, Inc. Testimony
Before the House Committee on Ways and Means Hearing on Reducing the Tax Burden:
II. Providing Tax Relief to Strengthen the Family and Sustain a Strong Economy
June 23, 1999 Good afternoon, Mr. Chairman and members of the Committee. My name
is Eric P. Wallace, CPA, and I speak today on behalf of Associated Builders and
Contractors, Inc. ABC is a national trade association representing more than
20,000 contractors, subcontractors, material suppliers and related firms from
across the country including all specialties in the construction industry. We
would like to thank Chairman Archer and the Committee members for conducting
this hearing on "Providing Tax Relief to Strengthen the Family and Sustain a
Strong Economy." I am a practicing CPA with over 20 years of experience serving
contractors and service providers from across the country in the fields of
taxation, accounting, auditing, and consulting. I recently researched and
authored an article titled "The IRS and Cash Basis Contractors" that appeared in
publications of the Construction Financial Management Association as well as
ABC. My extensive experience dealing with this issue enables me to provide to
you specific expertise and insight concerning the need for legislation to
clarify that small business taxpayers are allowed to use the cash method of
accounting without limitation. Later in this statement, ABC would like to weigh
in on some additional key issues affecting its members, the construction
industry and the economy as a whole. The complexity and cost of these tax
burdens are taking a devastating toll on contractors-- particularly small
contractors - and their employees. Lifting the weight of these outdated and
burdensome requirements will allow contractors to devote their time, money and
resources towards productivity, growth and providing new jobs. CASH BASIS METHOD
OF ACCOUNTING The IRS is targeting just about all contractors and service
providers who report their taxable income on the cash basis of accounting. One
of the most onerous audit adjustments a contractor or service provider can face
is an IRS initiated change in its tax accounting method from the cash to the
accrual method. Such IRS proposed audit changes typically subject the taxpayer
to over $100,000 due to the IRS with a significant portion of this consisting of
mandatory assessed interest and penalties. The difference between the cash
method and the accrual method is not that the accrual method necessarily results
in a greater taxable income. The only difference is one of timing of the
reporting of income and expense. As an example, if a cash basis contractor or
service provider collects its billings in advance and delays the payment of its
payables, it will report income sooner under the cash method than it would under
the accrual method. Now, more than ever, the IRS is pushing their cash audit
change position on a national level. The IRS spelled out its position on the
cash basis when, in late 1997, it released its "Construction Audit Technique
Guide" (ATG) as part of its Market Segment Specialization Program. In this ATG,
it stated that IRS examiners should generally conclude that a contractor or
service provider should be changed from the cash basis of accounting when their
material cost, as a percentage of their gross receipts, is 15% or more, and
depending on the facts and circumstances, can be changed when the ratio is less
than 15%. This position is not based on any specific code section but is the
result of several court cases successfully litigated by the Service. This push
is based upon a certain logic flow. The Service foundation logic is generally
summarized as follows: materials are merchandise; if the cost of merchandise is
over 15% of gross receipts, it is a significant income producing factor; if
material is a significant income producing factor, the contractor or service
provider must use inventories; if the taxpayer is required to use inventories,
it is required to use an accrual method of accounting. The result of this
national push by the Service would leave few, if any, contractors or service
providers remaining on the cash basis of accounting. One of the IRS authors of
the ATG stated to me that the only type of cash basis contractor that the
Service is permitting to stay on the cash basis is an asphalt contractor who
does not produce their own asphalt in a plant. (This is based upon the
Galedridge Construction, Inc. v. Commissioner, T.C. Memo 1997-240 court case,
though the IRS has still not agreed to the Galedridge decision.) All other
contractors or service providers are "fair game." The Service denies that there
is a national coordinated effort to focus on construction contractors and
service providers and that they are merely enforcing the law as they interpret
it. I, however, do believe that there is a national effort based upon the calls
that I have received from contractors, service providers, and other practicing
CPAs from across the country. For example, the IRS audited a carpet installer
from Michigan doing $1.2 million in revenue with material and supplies equaling
12% of his revenue. The only audit issue was to change him from the cash method
to the accrual method. The cost to him of such a change was almost $100,000. The
IRS auditor had used as support the newly released IRS ATG. I advised an
underground utility pipeline contractor from Pennsylvania to voluntarily change
from the cash method to the accrual method because, if audited by the IRS, it
would face over $100,000 in interest and penalties. A window installer from
Texas, with about 20% of revenues for materials as a cost of revenue, would be
forced out of business if the IRS proposed a change from the cash method and
assessed the mandatory interest and penalties. The Service believes, based upon
a selective series of court decisions and their interpretation of regulations
and congressional intent, that their position to change all contractors and
service providers from the cash method of accounting to the accrual method is
justified. This is in conflict with congressional intent on the use of the cash
method. "The committee recognizes that the cash method generally is a simpler
method of accounting and that simplicity justifies its continue use by certain
types of taxpayers and for certain types of activities. Small businesses should
be allowed to continue to use the cash method of accounting in order to avoid
the higher cost of compliance which will result if they are forced to switch
from the cash method." House Report 99-426, at 605-606 (1985), 1986-3 C.B.
(Vol.2) 1, 605- 606. A head IRS Construction Industry Specialist stated to me
that, based upon the current IRS approach and court cases, cash basis
contractors and most service providers will not be able to maintain their cash
reporting position or have it supported in court. Their only hope is a
congressional solution. ABC applauds legislation introduced by Ways and Means
member Phil English along with Small Business Committee Chairman Jim Talent,
which would provide this much-needed congressional solution. Mr. Talent included
an identical provision in the Small Employer Tax Relief Act (H.R. 2087). The
current ATG states that "Reg 1.446-1 (a)(4)(i) and 1.471-1 provide that the use
of an inventory accounting method is required in every case in which the sale of
merchandise is an income producing factor. The fact that the use of an inventory
accounting method may result in inventory balances that are zero or minimal is
irrelevant." It is clear that the Service position is inappropriate. The
English-Talent legislation would stop the Service's universal push against cash
basis contractors and service providers and enable these small businesses to
utilize the simpler cash method without fear of severe IRS reprisal. ABC, along
with a broad-based coalition of construction and other organizations from across
the small business spectrum, endorses this legislation. We strongly urge the
Committee to include this common sense legislation as it drafts its tax
legislation this year. LOOK-BACK METHOD The construction industry has fallen
under a provision in the Tax Reform Act of 1986 aimed to target major defense
and aerospace contractors. The law requires "percentage of completion" and look-
back accounting methods for contracts lasting more than one tax year.
Contractors must estimate their costs and revenues and, upon completion of the
contract, "look back" and substitute the actual costs and revenues for those
estimated at the conclusion of the prior tax years. Construction contractors
face look-back calculations can number in the thousands and can take between 15
to 30 hours to complete for each project. Construction contractors pay thousands
of dollars each year just to comply with look-back requirements without any
justification or need to do so. Because the majority of construction contracts
are completed within one or two years and success in the industry is dependent
on financial accuracy, look-back has no effect on "catching" underreported
revenues or gains. Instead, approximately 75% of the industry's look-back
calculations result in zero dollars being remitted to the IRS, and 25% are owed
money by the IRS. Look-back accounting is an unnecessary requirement and an
onerous burden on construction contractors (as well as the IRS) with virtually
no gain to the Treasury. The current de minimis rules, including those recently
implemented as part of 1997 Taxpayer Relief Act, are not sufficient relief. ABC
strongly supports repeal of look-back for commercial construction contractors.
INDEXING OF THRESHOLDS Several key thresholds in the tax code affect
contractors' tax liability. These include the $10 million threshold under
section 460(e) and the $5 million threshold under section 448. Since 1986 these
amounts have not been adjusted for inflation. This has had the effect of forcing
contractors to use more complex accounting methods. ABC believes that these
thresholds should be indexed for inflation in the same manner as other items are
treated in the tax code. An example would be how the amount of the personal
exemption increases each year or the mileage rate increments annually.
ALTERNATIVE MINIMUM TAX (AMT) The corporate AMT was enacted in 1986 to end a
perceived abuse that corporations were reporting earnings to shareholders, yet
not paying any federal income tax in that year by taking legitimate deductions
and credits. The actual operation of the AMT has imposed a severe penalty on
companies whose businesses require large capital investments to modernize and
remain competitive. The AMT penalizes investment, particularly by imposing a
considerably slower depreciation rate. It doubles compliance costs, forcing
corporations to keep two separate deduction records and engage in complex
calculations. The AMT also adds complexity for small contractors by requiring
use of the percentage of completion method for long term contracts. AMT
proponents see it as a significant revenue source and argue that it ensures all
corporations reporting income pay at a base tax. However, the AMT treats
corporations with generally the same long-term economic incomes very
differently. The AMT penalizes capital intensive firms with relatively low
profit margins for their products. These firms are being denied the benefit of
accelerated depreciation which is afforded to their non-AMT competitors. ABC
supports repeal or a significant reduction in the adverse effects of the AMT.
ABC advocates allowing S-corporations similar treatment to C-corporations
regarding small company exemptions. Additionally, ABC favors allowing the AMT
credit to be carried back, as contractors can be unfairly penalized due to
depreciation and other unique timing preferences; ESTATE TAX RELIEF Federal
estate death tax rates have increased significantly since their implementation
in the early 1900s. They are so high now that families must often sell their
businesses in order to pay the taxes. This in turn creates disruption for the
employees, customers, and suppliers and the community. Death taxes not only
jeopardize the survival of family-owned construction companies, they also divert
critical funds that could be invested in the business to grow and provide more
jobs. Construction companies are frequently family owned and do not have the
liquid assets to withstand an assault from the IRS upon the unfortunate death of
the owner. Therefore, the construction industry is particularly hard hit by the
estate tax burden. ABC is supportive of legislation that will relieve the estate
tax burden on businesses. Specific measures ABC supports include rate relief,
increasing and simplifying the exemption for closely held businesses, and
indexing the unified credit and closely held business exclusion for inflation.
Ultimately, ABC members would like to see death taxes eliminated. ABC strongly
supports H.R. 8, the Estate and Gift Tax Rate Reduction Act. CAPITAL GAINS CUTS
AND SIMPLIFICATION The 1986 Tax Reform Act constituted the largest capital gains
tax hike in more than 50 years. Real Estate and Construction were devastated,
and have only in the last few years recovered. Increasing the exclusion for
capital gains would unlock hundreds of billions of dollars of unrealized capital
gains, thus promoting more efficient allocation of capital and increasing
capital formation, economic growth and job creation. Opponents claim a capital
gains relief will be a tax cut for the rich. In fact, a cut in the capital gains
tax would actually increase taxes paid by the wealthy and benefit poor and
working-class Americans most. It would expand economic opportunities for the
working-class by encouraging capital formation, new business creation, and
investment in capital-starved inner cities. It would lead to the creation of
more than half a million new jobs and increased wages by the year 2000. ABC
supports reducing or eliminating the capital gains tax burden on businesses and
individuals. INDEPENDENT CONTRACTOR SIMPLIFICATION Currently, the Internal
Revenue Service relies on a 20-factor test to be classified as an independent
contractor. It is often criticized as too subjective, arbitrary, inconsistent,
and burdensome. Considering the fact that back-tax assessments imposed on
businesses with reclassified employees are often large and potentially
bankrupting, ABC believes that the test for classification should be clear and
simple. The construction industry faces unique problems due to its fluctuating
work demand and seasonal forces which affect employment levels. Many in the
industry can not afford nor have the need to maintain specialized trade
craftsmen as full-time, long-term employees, which may be needed several times
throughout the year but not enough to warrant full-time or even part-time
employment. Independent contractors are often the perfect answer to a pressing
demand for the special skills and know-how often required for short term
projects. Independent contractors are an important sector of the economy --
there is no better way to become established as a small business than to begin
as an independent contractor. Many ABC members started their own businesses by
working as independent contractors. Independent contractor relationships can be
advantageous for all involved. The arrangement allows the independent contractor
to have the freedom to choose his or her work schedule, a business owner the
flexibility to adjust staff demands with business activity, and the consumer the
opportunity to benefit from a reasonably priced, quality product. ABC believes
that companies should be able to make sound economic decisions about the
classification of individuals as employees or independent contractors, without
fear of misclassification or penalty from the IRS. ABC opposes H.R. 1525. SCHOOL
CONSTRUCTION TAX CREDITS ABC would like to express its strong opposition to tax
proposals before the Committee that would limit flexibility and competition for
small contractors by expanding
Davis-Bacon requirements to
school construction tax credits. Representatives Charles Rangel (H.R. 1660) and
Nancy Johnson (H.R. 1760) have introduced bills which would allow states and
localities to issue special bonds for school improvements and construction. The
federal government would effectively pay the interest via a tax credit to the
bond holder. H.R. 1660 and H.R. 1760 include an unprecedented expansion of the
Davis-Bacon Act into the area of school construction tax
credits for purchasers of qualified school modernization bonds, by amending the
General Education Provisions Act. As a result, this is a wholly new application
of the federal
Davis-Bacon Act to tax credits, without any
justification for such an expansion into these state and local efforts.
Davis-Bacon has been shown to increases public construction
costs by anywhere from 5 to 38 percent above what the project would have cost in
the private sector. The unnecessary costs will be directly passed on to the
customers -- the American taxpayers in these school districts -- who have to pay
for the inefficiencies and waste in federal programs. Furthermore, the
application of
Davis-Bacon makes no sense because the
burdensome requirements of the Act operate as a disincentive to contractors and
corporations to get involved in school construction, undercutting the very
purpose of the bill which is supposed to be to create tax incentives to attract
capital. In contrast, Chairman Archer's school construction proposal would make
it easier for state and local governments issuing public school construction
bonds to comply with the arbitrage rebate rules, by extending the time for
issuers to spend bond proceeds from two to four years. It would preserve local
control of education funds and help scarce tax dollars go farther. Congress and
the Administration should not be hampering efforts to leverage capital into
school construction by imposing outdated and wasteful
Davis-Bacon Act requirements that act as an unfunded mandate on
local school districts. Adding federal
Davis-Bacon requirements
to local school construction tax credits would hurt those who fund, provide, and
receive public education by forcing school districts to pay more for providing
less. The inflated construction costs from
Davis-Bacon will
further limit already scarce dollars which could be better spent on real efforts
to help education, such as additional schools, more repairs and facility
improvements, schoolbooks, computers, and other educational services that
actually improve classroom learning and benefit school children. CONCLUSION As
stated earlier, these onerous tax provisions are having a dramatic negative
effect on contractors, their employees and the economy as a whole. Much needed
legislative changes to these outdated and burdensome requirements will allow
small companies to devote their time, money and resources towards productivity,
growth and providing new jobs. We would like to thank Chairman Archer and the
Committee members for allowing ABC to present its concerns regarding these
important issues, and I welcome any questions the Committee may have.
LOAD-DATE: June 25, 1999