As underground contractors approach year end, as with any engineering contractor that relies on equipment to perform their work, they tend to be highly focused on tax planning and tax minimization strategies. The recent significantly healthier economy coupled with healthier profitability makes this all the more a focus as economic improvement continues. At the same time, any contractor who bonds any meaningful portion of their work knows that bond companies focus on liquidity and working capital in their underwriting decisions that determine the levels of bond support that apply to the client. Bottom line: the annual CPA Review or Audit is the foundation for the next year’s levels of support and you have one shot to get it right. The one unfortunate outcome of these two competing forces involves the approach to managing fiscal year end results and the often crippling impact that tax planning and significant equipment purchases has on working capital and your resulting bond program limitations that arise from overly aggressive tax planning.
Certainly, the key partners in this analysis and preparation process should be the underground contractor’s CPA firm and their bond agent. A strong construction oriented CPA firm will be focused on both the taxes and the balance that is required to maintain the levels of bond support that will keep their client operating at their ideal capacity for profitability and growth. Of course, the CPA firm needs to know what the client’s business plan for their future bond needs will be. A strong bond agent will know what the challenges of getting recent bond support for the client have been and what the key underwriting determinants are of the balance sheet and how the particular client is evaluated by their bond company. The bond agent’s input will allow the CPA and the client to make well planned and careful adjustments, equipment acquisitions and strategic planning moves including retirement funding, bonuses and other FYE moves that optimize the following year’s bond capacity.
All too often, a contractor’s desire to eliminate any dollars flowing to the IRS puts a significant damper on the bondability of a company after the dollars are spent prior to FYE. One thing contractors forget in the planning process is that paying taxes is a measure of success. Only profitable companies pay taxes. A good construction CPA will advise a contactor that paying a certain level of taxes, relative to the level of bondability required to run and grow the business, is an investment in the business no different than buying equipment. The decision comes down to whether the investment in equipment or working capital, provides the greater return.
This scenario would arise, for example, in a very oversimplified outcome such as this. Let’s consider a contractor that has a financial profile where they have $200K in working capital and $400K in equity and they are growing steadily. Based on their strong experience and capabilities, they are presently bondable on jobs as large as $3MM (MM = million) with an aggregate bondable backlog of $5MM based on their prior year end CPA financial statement. They anticipate requiring $5MM individual bond needs in the coming year with the backlog growing to $7MM or larger. They anticipate a ‘pre-FYE planning’ bottom line of $400K that will result in additional working capital of $500K and $700K in equity (after $100K in tax distributions to the owner). They effectively made a $100K ‘investment’ in taxes and increases working capital to boosts their bondability by $2MM on a single project basis and on an aggregate basis to $8MM or more. At a 10% profit level, should they turn this single and aggregate backlog only twice the next year, this would result in $400K in additional profit, or a 400% return on that tax payment with no additional equipment purchases. They simply hold onto the cash. Certainly, under this scenario, the company, all things being equal, will qualify for the increased bond capacity and likely for more.
On the other hand, should the company bonus out significant profits and purchase a significant amount of equipment, even if it is not really needed but simply reduces taxes, they can avoid the $100K tax bill and likely return something akin to a marginal bottom line limiting the potential boost to their backlog, if at all. The company can easily spend $300M or more on equipment and bonuses, avoid taxes and limit their growth in revenues and the resulting profits that come with the stronger balance sheet. They could be stuck at the same bondability threshold that they had when they entered the year. While this is a very oversimplified example, it is real and it happens year after year to many contractors. I have worked with numerous underground contractors who prevent the growth of their balance sheet simply to avoid paying any taxes. Inevitably, once they undertake this proactive planning involving their bond agent and CPA, as a team, vested in the company’s success, the results surprise people and the planning model changes rapidly. I cannot count the number of times I have seen proactive planning accelerate the growth in a company’s bondability, success on their P&L and health of their balance sheet.
There is one simple way to summarize this evaluation and the miniscule cost involved: A one hour commitment of the owner’s time. Nothing more than one hour of time needs to be invested with the owner, the CPA and the bond agent in order to evaluate the possible outcomes and their potential impact. All that is required is that the contractor places an appointment reminder on their calendar, early in October of each year, to meet with their bond agent and CPA together before the end of the month for a planning meeting. This simple step ensures that all the proper resources, financial and physical, required to meet the needs and opportunities of the future will be evaluated in a strategic fashion with a focus on the future, not just the present. Planning is the key to maximizing bondability as the year comes to a close, especially a successful year. Good luck with your planning and your future!