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Taxation
of Construction Contractors
Tax Accounting Methods for Contractors Hartford Construction CPA Accountants by William Brighenti, Certified Public Accountant, Certified QuickBooks ProAdvisor  It is not surprising that many contractors
are not employing the most advantageous accounting method for their tax
returns. The literature on the subject is often confusing, if not
ambiguous, including that published by the Internal Revenue
Service. Perhaps contributing to the overall confusion of
construction tax accounting is the myriad of methods available to most
contractors:
Also compounding the confusion surrounding construction tax accounting is the practice within the industry of a contractor having a minimum of at least two methods of accounting. Typically, contractors have an overall method of accounting, such as the cash method, the accrual method, or some hybrid method of accounting. In addition, they have one or more methods for its long-term contracts, such as the percentage-of-completion method, the percentage-of-completion capitalized cost method, and the completed-contract method of accounting for long-term construction contracts. Although Section 460 of the Internal Revenue Code generally requires large contractors to use the percentage-of-completion method of accounting for long-term construction contracts, small contractors are exempted from this requirement in Section 460(e)(1)(B)(ii), wherein small contractors are defined as those contractors having average annual gross receipts not exceeding $10 million over the past three preceeding taxable years. Less understandable, and perhaps less forgivable, are the number of certified public accountants who are unaware of the variety of methods available to contractors, who lack a correct understanding of the details of implementation of these various methods of accounting, and who have failed to select the most appropriate tax accounting methods for their contractor clients, given their individual characteristics, conditions, and circumstances. Needless to say, CPAs are expected—if not required—to understand the subtleties and nuances of all of theses different methods of accounting for taxes, particularly those that apply to contractors and long-term contracts since construction is a major industry in our national economy and, consequently, represents a significant class of clients to most public accounting firms. A number of years ago I recall disagreeing with a certified public accountant about the gross receipts threshold for a construction company. Even though she had many years of public accounting experience, was a partner of a public accounting firm, and had served on the board of directors of a construction trade association, apparently she was unaware of the 2002 Revenue Procedure 2002-28’s increase of the gross receipts threshold to $10 million annually for cash basis contractors. That is unacceptable for a certified public accountant who presents herself as a specialist in the construction industry. As a certified public accountant to contractors, I attempt to select the tax accounting methods that result in the greatest deferral of taxes for my clients. Typically there are two methods that accomplish this objective for small contractors (as defined above): the cash method of accounting; and the completed-contract method of accounting. Of course, the cash method defers the recognition of revenues upon the receipt or constructive receipt of cash, whereas, the completed-contract method of accounting defers the recognition of any income on a contract until its completion. Since many of the contractors that I have dealt with had revenues and receipts of less than $10 million annually, I typically recommended the cash basis of accounting for their overall method of tax accounting. Needless to say, I am surprised when I discover small contractors using an accrual method for their overall method of tax accounting. By overall method of accounting, here, I mean the method of accounting applicable to all revenues and expenses other than those pertaining to long-term construction contracts. It is true, though, that historically tax law has held that construction-in-process constituted inventory and, consequently, required the use of an accrual method of accounting by contractors. Section 471 of the Internal Revenue Code necessitated the accrual method of accounting for companies with inventory in general, while Treasury Regulation 1.446-1(c)(2)(ii) required the accrual method for companies creating assets possessing a useful life beyond year-end: As a further example, under
section 263 or 263A, a liability that
relates to the creation of an asset having a useful life extending
substantially beyond the close of the taxable year is taken into
account in the taxable year incurred through capitalization (within the
meaning of §1.263A–1(c)(3)) and may later affect the computation of
taxable income through depreciation or otherwise over a period
including subsequent taxable years, in accordance with applicable
Internal Revenue Code sections and related guidance.
But in 2001, Revenue Procedure 2001-10 allowed the use of the cash basis of accounting by contractors with average gross receipts not exceeding $1 million. While in the following year with the issuance of Revenue Procedure 2002-28, this gross receipts threshold was increased to $10 million for all non-tax-shelter contractors, except for C corporations and partnerships with a C corporation member, which were restricted to a $5 million gross receipts threshold. As a result, many of the contractors for whom I prepared tax returns were able to use the cash basis method of accounting since they were organized largely as S corporations or limited liability companies consisting entirely of individuals as members. So how does the cash basis of accounting work for these small eligible contractors when there are contracts-in-process open at year-end? These contractors can account for them as materials and supplies that are not incidental under Treasury Regulation Section 1.162-3. That is, they would recognize the deduction of contract costs when those materials, supplies, subcontract and direct labor, and other construction costs are used and consumed in the construction process or when they pay for those costs, whichever occurs later. Of course, revenues would be recognized upon receipt or constructive receipt of cash. However, as mentioned previously, these small contractors are allowed to use a different method of accounting for long-term construction contracts. And long-term construction contracts are simply contracts that are open or in process at year-end. So instead of accounting for open contract costs as materials and supplies that are not incidental under Section 1.162-3, these small contractors can simply elect to defer all revenues and expenses associated with these contracts under the completed-contract method of accounting for long-term construction contracts. Presuming in general open contracts would ordinarily generate additional income over their contract lives, as a contractor I would elect the completed-contract method as my long-term construction contract method of accounting, since it would tend to maximize my deferral of tax liabilities over time, rather than simply elect the cash basis of accounting under Revenue Procedure 2002-28, and risk recognizing taxable income on contracts-in-process. Revenue Procedure 2002-28 has simplified tax accounting matters and methods for many small contractors. Since the majority of them are organized as limited liability companies or S corporations, they can elect the cash basis of accounting as their overall method of accounting and the completed-contract method of accounting as the method of accounting for all long-term construction contracts. In general this set of elections will result in the greatest deferral of tax liabilities for the contractor and provide a very important boost to cash flows, especially in these dire economic times for contractors. However, it is important to make these selections upon filing your initial tax returns, otherwise a change in accounting method would be required, necessitating the filing of Form 3115, Application for Change in Accounting Method. Even more important, if your current certified public accountant failed to select the most appropriate tax methods of accounting for your construction business, requiring the filing of Form 3115 to change from your current accounting methods, perhaps it may be time for you to consider a change in accountants, too. If such is your situation, please contact us: we would be glad to assist you. This article is provided for informational purposes and is not intended to be construed as legal, accounting, or other professional advice. For further information, please consult appropriate professional advice from your attorney and certified public accountant. Have a tax, a QuickBooks, or an accounting question? Please feel free to submit it under "Comments" on our blog, Accounting, QuickBooks, and Taxes by William Brighenti, Certified Public Accountant, Accountants CPA Hartford, LLC. For information and assistance on any tax, QuickBooks, or accounting issue, please visit our website: Accountants CPA Hartford, LLC. If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein. The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor. |
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| Supreme Court Justice George Sutherland: "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, by means which the law permits, cannot be doubted." |
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