Construction accounting tax tips

Over the summer the IRS released some accounting for contracts tax tips, which provides a nice summary of questions we frequently get asked.

What is an accounting method?

Every taxpayer reports income and expenses on their tax return according to a method of accounting. An accounting method is a set of rules used to determine when and how to report income and expenses. Basically, accounting methods are divided into two categories: the cash and accrual methods. There are several different accrual methods.

You must use an accounting method that clearly shows your income. An accounting method clearly shows your income when it treats all income and expenses the same from year to year and is appropriate for your line of work. Choosing the right method is important to your business because it will affect when you report income and deduct expenses.

How do I choose a method?

There are special tax rules that control the accounting method you must use for your construction business. Generally, you choose your tax accounting method when you file your first tax return for the business.

Your choice of accounting method depends on:

The type of contracts you have,

Your contracts’ completion status at the end of your tax year, and

Your average annual gross receipts.

Most construction businesses use two different tax accounting methods: one for their long-term contracts and one overall method for everything else. A long-term contract is any contract that is not completed in the same year it’s started.

Most construction businesses use the accrual method for their overall method of accounting.

Cash method of accounting

One method that some construction contractors can use for both their overall method and for their long-term contracts is the cash method. However, there are significant limitations on who can and cannot use this method.

There are two situations in which your use of the cash method of accounting can be limited. First, you are not allowed to use the cash method if your business is a corporation, or a partnership with a C corporation, whose average annual gross receipts exceed $5 million. There is no exception to this limitation.

Second, depending on what type of business you have, you may not be allowed to use the cash method if your total purchases of “merchandise” for the year are “substantial” compared to your gross income for the year. There are exceptions to this.

Accrual methods of accounting

If you can’t use the cash method, you must choose an accrual method of accounting. In the construction industry, there are several specialized accrual methods available, each of which has its own set of rules and limitations. In general, all accrual methods attempt to match the expenses relating to a specific contract to the income from that contract.

Choosing an accrual method

Choosing a permissible method of accounting for tax purposes involves the three steps discussed below. As your business grows and changes, you might have to use a different method of accounting. You should review the following three steps every year to ensure that you are using a permissible method of accounting for your construction contracts.

Step one: classify all construction contracts as either short-term or long-term

A long-term contract is any contract that spans a year-end. If you have a contract that you start on Dec. 26 but do not complete until Jan. 23, you have a long-term contract. Therefore, a short-term contract is any contract you start and finish within one taxable year.

Use your overall method (i.e., accrual or cash, if allowed) for your short-term contracts. You must then choose an accounting method for all your long-term contracts. The rest of these steps will lead you through the process of choosing your long-term contract accounting method.

Step two: classify all long-term contracts as either home construction or general construction contracts

Home construction contracts are contracts for work on buildings that have four or fewer dwelling units. Eighty percent or more of the estimated total contract costs must be for the construction, improvement or rehabilitation of these units. If a contract is not a home construction contract, it is a general construction contract.

For long-term general construction contracts, there is one more step to take to choose the correct accounting method.

Step three: classify yourself as either a small or large contractor

This is a two-part step. The first part is to measure your average annual gross receipts for the last three tax years of your construction business. If the amount is $10 million or less, you are a small contractor. If it is more than $10 million, you are a large contractor and do not have to consider the second part of this step. Large contractors are required to account for long-term contracts using the percentage-of-completion method (PCM) for their general construction contracts. Under PCM, contract income is reported annually according to the percentage of the contract completed in that year. For example, if a contract is 50% complete at the end of the taxable year, 50% of the contract income would be included in taxable income.

If you are a small contractor, the second part of this step requires that you separate your long-term general construction contracts into two categories. The first category is those contracts that are reasonably likely to be completed within two years from the date work begins.

The second category is long-term general construction contracts that you estimate will take two years or more to complete. For these longer-duration contracts, you must use a large contractor method, even though you are a small contractor.

Are you a small or large contractor?

Determine if you are either a small or large contractor by answering the following questions:

Q: Are your annual gross receipts for the last 3 years $10 million or less?

Y: Answer the next question.

N: As a large contractor, you must use the PCM for your general construction contracts.

Q: Do you have any general construction contracts that you estimate will take more than 2 years to complete?

Y: Use the PCM for your longer-duration general construction contracts.

N: As a small contractor, you should use either: accrual, exempt percentage of completion method (EPCM), completed contract method (CCM), or PCM for all your general construction contracts.

Small contractor methods

Accrual Method of Accounting

Income: You include an item in income in the tax year when all events have occurred that fix your right to receive the income and you can determine the amount with reasonable accuracy.

Income is generally earned when you have finished the work to your customer’s satisfaction and due when you bill your customer. This means that sometimes you will include an item in income before you have actually received payment.

You may use this method for your long-term contracts only if your annual gross receipts do not exceed $10 million and the estimated completion time does not exceed 2 years.

Exempt percentage of completion method – general rule

The EPCM is a method that only affects how your income is computed and reported on your tax return. When you use this method, all G&A and job costs are deducted using the accrual method.

With this method, you report income from long-term contracts as work progresses. A long-term contract is any contract that spans a year-end. If you have a contract that you start on Dec. 26 but do not complete until Jan. 23, you have a long-term contract. You will report some income in each year of a long-term contract.

Advantages to using EPCM:

It is the most accurate way to measure income;

It evens out the reporting of income over the life of the contract;

Losses may be recognized based on the percentage of the contract completed; and

It is the method preferred by most banks and bonding companies.

The main disadvantage is its complexity and the fact that it accelerates income compared to other methods.

To determine your current year’s gross receipts from a long-term contract, you multiply its “completion factor” (i.e., percentage of completion) by its “total contract price” and then subtract the amount of gross receipts you previously reported for this contract. You compute your gross receipts in this way even if you bill the customer for a different amount.

Completed contract method

With this method, you report all the income from the contract and deduct all the related job costs in the year the project is considered complete.

The number of indirect costs that you must characterize as job costs will vary depending on your size. In general, a large homebuilder has to capitalize a greater number of indirect costs than a small homebuilder or small general contractor. You should consult your tax advisor regarding types of indirect costs that you must capitalize.

The advantage of the completed contract method is that it normally achieves the maximum deferral of taxes.

Disadvantages of the completed contract method:

The books and records do not show clear information on operations;

Income can be bunched into a year when a lot of jobs are completed; and

Losses on contracts are not deductible until the contracts are completed.

It is important to note that the CCM may only be used by small contractors and any home construction contracts.

Many taxpayers will choose to use PCM as their long-term contract method for their books (so they can give their banks and bonding companies the type of financial statements they prefer) and CCM for their tax returns (so they can have the maximum deferral of taxes).

Shelby L. Stenson, CPA, is a partner with Mengel, Metzger, Barr & Co. LLP and may be reached at [email protected].