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Testimony to the House of Representatives Ways and Means Committee

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 Lifting the weight of these outdated and burdensome requirements will allow contractors to devote their time, money and resources towards productivity, growth and providing new jobs.


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.


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.


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.


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;


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.


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.


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.


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.


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.