Tax reform opened up new ways to accelerate tax deductions and defer income for contractors, especially contractors with $10 million to $25 million in average annual...
You have probably heard about the tax savings opportunities provided by tax reform, including the new 21% federal tax rate for C corporations and the 20% section 199A qualified business income deduction for owners of pass-through entities. You may not be aware, however, that there are several new acceptable methods to determine when income and deductions for your construction business are reported for tax purposes. Tax reform greatly expanded the methods of accounting available for contractors with $10 million to $25 million of average annual gross receipts, but regardless of the size of your business, tax savings may be available by switching methods.
Which accounting method fits your situation?
Before changing accounting methods, you’ll want to review how your contracts are structured, including service type, contract terms, and payment cycles as well as which methods of reporting income are permitted in your circumstances. Here are a few methods of accounting that may be available for your construction business.
The percentage of completion method (PCM) is required for the long-term contracts of most construction contractors with average annual gross receipts of more than $25 million. Prior to tax reform, contractors with more than $10 million in average gross receipts were required to use PCM. The increased threshold provides an opportunity for contractors with $10 million to $25 million of gross receipts to select a method offering better tax deferral and, thus, an immediate tax benefit. Even if a contractor is required to use PCM there may be more favorable ways to apply the method, such as the 10% method.
The 10% method allows contractors to defer income on jobs less than 10% complete into the year at which that level is reached. This works well when jobs are started late in the year or just getting off the ground. There is an optional rule to exclude retainages payable in computing the percentage of completion factor on certain contracts, which typically reduces the amount of profit required to be recognized for jobs in progress. This method is particularly attractive for general contractors with large retainages payable.
The cash method of accounting is generally available for companies with no more than $25 million in average gross receipts. This method is usually preferable if receivables exceed payables and payments are not received until after the work is completed. CLA has filed a flood of accrual-to-cash method changes for clients using the more flexible rules of tax reform. Even companies that expect gross receipts to exceed $25 million in the near future may benefit from making this change.
The completed contract method (CCM) allows taxpayers to defer the income or loss from a contract until the contract is completed. A contract is considered complete when at least 95% of the total allocable contract costs have been incurred on improvements already in the customer’s possession, or upon final completion and acceptance of the contract. For many contractors, CCM offers great taxable income deferrals, sometimes for years. Tax reform has made it available to many more contractors, though Alternative Minimum Tax (AMT) will limit the benefit for some taxpayers.
The accrual less retainages (ALR) method is beneficial for specialty contractors and subcontractors because it allows for deferral of income associated with certain retainages receivable until the retainage is payable under the terms of the contract. Contractors using the accrual method and having large retainages receivable should consider the ALR method.
SCo Saves $150,000 by Changing Accounting Methods:
SCo is an S corporation with $15 million in average annual gross receipts. Following tax reform, SCo is no longer required to use PCM for tax purposes and reverted to using the accrual method of accounting. SCo had significant retainages receivable and minimal retainages payable, so the leadership considered a number of accounting method changes, including changes to the cash, CCM, and ALR methods. They decided the ALR method was the most favorable in their current circumstances. The ALR method allowed the company to defer $500,000 of income by transitioning off PCM and simultaneously changing to the ALR method. The result was approximately $150,000 in tax savings, assuming AMT does not arise. SCo may also see state taxes deferred as a result of these techniques.
Changing your method of accounting
If you would like to change to a new method of accounting, it’s not as simple as a “flip of the switch.” Often, a Form 3115, Application for Change in Accounting Method, must be filed with the Internal Revenue Service, sometimes before the end of the initial year of applicability. Check with your CPA to discuss the timing and initiate the change.
How we can help
CLA’s construction tax professionals can assist you by analyzing your contracts and job schedules in light of your overall tax situation. We can help determine your company’s eligibility for the accounting methods discussed in this article or others, and help you select one that is appropriate for your business. As a national firm, we track the broad changes in the industry, but we also understand that each company’s environment, contracts, and books of business are different. Our deep industry knowledge and experience allow our construction tax professionals to guide you every step of the way.