Construction Contractors: Are You Using the Correct Tax Accounting Method?

July 10, 2017
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You made many decisions when you launched your business. An important one-for both you and the Internal Revenue Service-was which tax accounting method you’d use. Many contractors are required to use the Percentage of Completion Method (PCM).
But there may be other methods available for tax purposes that could result in significant tax savings or deferral of taxes. Alternative methods could help your business avoid complicated and time-consuming look-back calculations required for regular tax purposes under the PCM. The best method for you depends on:
  • The size of your entity
  • The length of your contracts
  • The types of contracts written
Small Business, More Options
 
Are you a small contractor? To be considered one, you must have had an average of annual gross receipts of $10 million or less for the past three years and contracts that are written for less than two years.
Under IRS guidelines, small contractors have more options. The first option is the Cash Method. When you choose this option, your accounting system recognizes income as it’s collected and expenses as they’re paid.
The Cash Method would be beneficial if billing occurs later in the job or after significant expenses are incurred; it could allow for income deferral. It would not be as beneficial if your company front loads billings on jobs (income would be recognized with fewer expenses to offset them).
Completed Contract and PCM
 
When a small business uses the Completed Contract Method, income and expenses are recognized at the completion of the job. This allows for the deferral of income and expenses to future periods. This method may be beneficial in years when significant jobs will be completed shortly after year-end.
If you choose the PCM (Percentage of Completion Method), income and expenses are recognized as the work is performed. This would support deferral of revenue when billings are front-loaded, and may more closely match financial statement reporting required for Generally Accepted Accounting Principles (GAAP).  The disadvantage of using the PCM method is the addition of look-back rules that are complicated and can be time-consuming.
Small contractors may be able to use the Cash Method, but will still be required to use the PCM for jobs longer than 2 years.
Large Contractors, Less Flexibility
Large contractors are generally required to use the PCM. Tax savings and other options may be available to them.
But if your business is service-based, you may be able to use the Cash Method for that element of your business, even though PCM would be required for other jobs. Service-centric jobs are generally more short-term in nature than longer-term construction jobs.
The Cash Method could allow for tax savings if the income is received in a subsequent period for work performed in the current year.
 A Critical Reconsideration
Both large and small contractors must revisit their choices of tax accounting methods each year, since fluctuations in gross revenues (increase or decrease) or types of jobs may signal a change in the method employed. We’d be happy to work with you on this annual decision-making process, to ensure that you choose the method most beneficial to you.

 

 

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