For contractors, the question of which accounting method to use for tax purposes has never been an easy one to answer. There is often no single right answer. Many construction companies must choose two methods — one for the business itself and another for its long-term contracts. We will take a closer look at the choices for both.
Two Common Approaches
The IRS rules require, from a business perspective, that you choose a tax accounting method that clearly reflects your income. Although you have a number of options, there are two commonly recognized approaches:
1. The cash method. A cash-method taxpayer recognizes gross income (whether in the form of cash, property or services) in the tax year in which those items are actually or constructively received. Expenditures are deducted in the tax year in which they are actually paid. This method is generally not available if the taxpayer has inventory.
However, some taxpayers with $10 million or less in average annual gross receipts are possibly exempt from the required accounting for inventories and use of the accrual method for buying and selling merchandise. Unfortunately, most contractors do not qualify for this exemption because they exceed $10 million in gross receipts.
2. The accrual method. Since the cash method often is not a viable option in the construction business, many contractors rely on the accrual method. Generally, under this method, income is to be included in the taxable year when all the events have occurred that fix the right to receive the income, and the amount of the income can be determined with reasonable accuracy.
Liability is incurred and generally is taken into account, for federal income tax purposes, in the taxable year in which:
A major benefit of the accrual method is that it provides a more accurate matching of revenue and expenses, as both are recorded when incurred, not necessarily when paid. This method can also allow additional tax planning opportunities through year end accruals.
Due to the accounting complexities of long-term contracts, the IRS requires contractors to choose a specific method for these arrangements. A contract is considered “long term” if it is not completed in the same tax year it is started, regardless of the time needed to actually complete the job. Therefore, you must pick an accounting method in the first year of the contract.
One of the two most common long-term contract approaches is the percentage-of-completion method. Here you report income according to the percentage of the contract that is completed during the year. This percentage is calculated by comparing expenses allocated to the contract and incurred during the year with the estimated total contract costs.
One benefit of this method is a more accurate allocation of income and expenses. However, under this method, the IRS requires you to do a separate calculation for tax purposes that may result in interest charges upon the completion of the contract.
The other common approach is the completed-contract method. Under this approach, income is not reported until you complete a contract, even though you may receive payments in years before completion. Thus, the completed-contract method is advantageous because you can defer taxes.
The downside is that you cannot include the cost of supplies or materials you allocated to the contract, yet never used as an allocable contract expense. These supplies must remain on the books as an asset until they are used in a project and may be deducted at the time the project is completed.
The size of your construction company, as measured by gross receipts, determines your ability to use the completed-contract method. If you have average gross receipts for the previous three years under $10 million, you may use the completed-contract method for contracts you will complete in less than two years. Larger construction businesses (those with average gross receipts over $10 million for the previous three years) must always use the percentage-of-completion method.
Not a One-time Decision
Picking the right accounting method, whether for your overall business or for long-term contracts, will not likely be a one-time decision. The IRS, the Tax Court and even Congress itself take varying perspectives on the rules, and changes could occur at any time.
For this reason, revisit this topic regularly with your CPA to be sure you are not at risk for additional tax charges and penalties.
Are there Alternatives?
There is a variety of alternatives available for both the overall tax accounting method and the long-term contracts method.
For instance, an alternative to the overall approach, the accrual-excluding-retentions method is similar to the accrual method except that revenue from retainages is not recognized until the contractor is entitled to receive it. Additionally, a few contractors may opt for a hybrid method that combines both the cash and accrual methods.
Similar to your overall business methods, long-term contract methods have other, less widely used varieties as well. For example, there is the percentage-of-completion–capitalized-cost method and the exempt-contract–percentage-of-completion method. In either case, these methods are seldom used and too complex to describe in this article.
These alternative methods occasionally do come into play and your tax advisor can explain them in detail.
Byron Largen, CPA