New York City is in the middle of its biggest office construction building boom in three decades, and residential spending—which includes spending on new construction as well as alterations and renovations—is projected to reach $11.6 billion in 2018, according to a New York Building Congress analysis of multiple data sources. This is great news for large and small contractors: Large contractors will continue to grow, while small contractors have more of an opportunity to develop into large contractors.
A CPA can help both large and small contractors by creating income tax deferrals and finding tax-saving opportunities. A tax deferral postpones the necessity of paying taxes to a later date so the taxpayer has more cash on hand for day-to-day operations and better financial presentation. Deferrals can be created through understanding IRC section 460, “Special Rules for Long Term Contracts.” Long-term contracts are defined as any contract for the building, installation, construction, or manufacturing of a property if the contract is not completed within the taxable year the taxpayer enters the contract. Looking at IRC section 460 from a distance might give some the feeling that all long-term contracts are required to be on percentage of completion (POC) for tax purposes. One would need to consider the following prior to determining an acceptable accounting method:
- the type of contract that is being performed
- the contract’s completion status at the end of the tax year
- average annual gross receipts (AAGR) for the taxpayer
Large contractors, who have an AAGR exceeding $10,000,000 for the prior three years, are required to report long-term contracts on POC for tax purposes. A contractor is exempt from using the POC for tax purposes if they meet either of two exemptions under IRC section 460-3(b).
The first exemption available to taxpayers is the “small contractor’s exemption.” To qualify for this exemption, the taxpayer’s AAGR for the past three years must be below $10 million. The taxpayer must also assume that the contract can be completed in 24 months or less. Note, however, that under the recently passed tax reform bill, starting after Dec. 31, 2017 the small contractor exemption applies to contracts that are (1) estimated to be completed within two years of the start of construction and (2) is performed by a taxpayer that—for the tax year in which the contract is started—meets the $25 million gross receipts test, changed from the $10 million mentioned above.
The second exemption available to contractors is the Home Contract Exemption. To qualify for this exemption, a contractor must be for working on a building with four or fewer dwelling units while 80% or more of the estimated total contract costs relates to the dwelling units. If either of these exemptions is met, the taxpayer is not required to use POC for tax reporting.
There are several methods available to taxpayers that are exempt from using the percentage of completion for long-term contracts. When choosing the method to use, it is important to pick the method that could create the best tax deferral.
Completed contract method
The completed contract method is a popular method of accounting for exempt construction contracts. Revenue and costs on contracts are not recognized until the contract is completed—or over 95% complete—and can be used for its intended purpose. The completed contract method usually results in the largest deferral.
Job 1 in process: 40% complete
Financial revenue: $500,000
Financial cost: $350,000
Financial G&A: $75,000
Financial income: $75,000
Tax return using completed contract method:
Tax Revenue: 0
Tax cost: 0
Tax G&A: $75,000
Taxable income: (loss) ($75,000)
When using the completed contract method, it is important to plan and keep a focus on your backlog. Having a backlog helps maintain or increase a deferral, while running out of work will cause the taxpayer to recognize the total deferral.
Another common method for exempt construction contracts is the cash method. When using the cash method, income and expenses are recognized when received or when paid. This is helpful when the taxpayer has large receivable balances and small payables.
Under the accrual method, revenue is recognized the earlier of received or paid. This often creates the smallest deferral for a contractor—under the accrual method, overbillings are taxable.
Accrual method excluding retainage
Accrual excluding retainage is similar to accrual; however, it has the advantage of not recognizing retainage until it is received. Retainage receivable is common in certain types for contractors, and this method helps to postpone paying tax on some income until the taxpayer receives the cash to pay the taxes. Under this method, retainage payable is also not recognized—so that should be considered when evaluating whether this method is appropriate.
If a taxpayer is not a small contractor or performing home construction contracts, they are working on nonexempt contracts. Even if a taxpayer is required to use percentage of completion as a tax method, however, there is still an opportunity to create tax deferrals.
Percentage of completion (POC)
POC is calculated using estimates: cost incurred to date / total estimated cost = the percent complete. IRC section 460 states that most general and administrative costs not allocated to contracts under GAAP are required to be allocated to the contracts for tax purposes. Using reasonable assumptions, these additional costs can sometimes decrease the POC.
PCCCM for residential contracts 70/30
The Percentage of Completion Capitalized Cost Method (PCCM) can be used on residential contracts. Similar to the definition of “home construction contract,” an exempt “dwelling unit” is defined as a house or apartment used to provide living accommodations in a building with more than four dwelling units. Residential contracts do not include motels or hotels or a place where more than half of the units are used on a transient basis. When using the PCCM method of accounting, 30% of the contract is under the elected exempt method of accounting (possibly the completed contract method), and 70% is on the POC method of accounting. This provides an opportunity for an additional deferral when compared to the normal POC method of accounting. The 30% part of the contract is subject to an AMT preference item. Some examples of residential contracts are apartments, dormitories, barracks, prisons, and nursing homes.
Less than 10% election
For contracts on the POC method, an additional deferral is available with the opportunity to elect the 10% method. Under this election, income and expenses are not recognized for tax purposes until the contract is over 10%. Depending on the size of the contract, this could create a sizable deferral. This election is not subject to an AMT preference item.
A contractor’s tax return can have more than one method of accounting at the same time. The method of accounting will depend on the types of contracts the contractor works on. For example, a contractor will be using the POC method for non-exempt long-term contracts, completed contract method on home construction contracts, and accrual less retainage on short-term contracts.
It’s important to look at each contract to determine if a method is available to create a tax deferral and postpone paying taxes to a future date. As they say in the business of construction, cash is king—so creating these deferrals could be beneficial to the daily operations of our construction clients.
This article was originally published in the January 1, 2018 issue of The Trusted Professional.