Contractors face challenges that necessitate careful consideration of accounting methods for their contracts, especially for tax purposes. The choice of tax accounting methods for contracts can significantly impact financial statements, cash flow and tax liabilities. Analyzing the advantages and disadvantages of the different methods available to contractors can also enhance overall business strategy. By understanding the pros and cons of various choices, contractors can make informed decisions that best align with their operational needs and long-term objectives.
The IRS allows for different methods of accounting for purposes of income tax reporting for long-term construction contracts.
Long-term construction contacts are defined as:
- A contract for the building, construction, reconstruction or rehabilitation of, or the installation of, any integral component to, or improvement of real property
- Contracts that are not completed within the same tax year
Contractors have up to 10 different methods to choose from for their long-term contracts, and the IRS’ “Construction Industry Audit Technique Guide” lists these 10 different methods with additional guidance. Under code Section 460, certain accounting methods must be used depending on certain aspects such as gross receipts and type of contracts. In addition, look-back rules apply to certain long-term contracts and should be addressed when estimates are used. The look-back rules require the contractor to go back and recalculate their income based on actual figures and not estimates to determine if income was overstated or understated. Interest may be due or refunded depending on the outcome.
Four commonly used methods, and what will be discussed in this article, are the percentage of completion method (PCM), completed contract method (CCM), cash method and accrual method.
Methods available to construction contractors for reference are listed below:
- Accrual
- Accrual excluding retainage
- Cash
- Completed contract
- Percentage of completion
- Exempt percentage of completion
- Percentage of completion capitalized cost method
- Percentage of completion excluding retainage payable
- Percentage of completion excluding subcontracts payable
- 10% method
Percentage of Completion Method
The percentage of completion method recognizes revenue on the percentage of the contract completion determined by the total cost-to-date divided by total estimated cost. PCM recognizes income over the life of the project. Generally, contractors with average annual gross receipts exceeding $30 million for the three prior tax years are required to use the percentage of completion method.
Advantages
From a financial reporting perspective, PCM allows a company to recognize income as work progresses on a long-term project. This offers a more accurate picture of profitability throughout the project rather than waiting until the project is fully completed to record income, which can lead to significant fluctuations in earnings.
Disadvantages
This method relies on the use of estimates, and any inaccuracies in these estimates can lead to significant errors in reporting revenue and profits throughout the project. Similarly, these estimates are subjective.
The use of estimates allows for the potential manipulation of the financial results. Cash flow management challenges may present themselves when the actual cash flow does not align with the revenue recognized through work progress. Revenue is recognized as costs are incurred and not when cash is collected, thus potentially causing cash flow issues from a tax perspective since contractors may not have the resources to pay the tax liability.
Completed Contract Method
The completed contract method allows qualifying contractors to defer the recognition of revenue and costs incurred on a long-term contract until the year in which the contract is completed.
A contract is deemed completed upon the earlier of the following two conditions:
- The customer uses the subject matter of the contract and at least 95% of the total allocable contract costs attributable to the subject matter have been incurred
- Upon final completion and acceptance of the subject matter of the contract
The completed contract method is available to contractors with average annual gross receipts less than $30 million for the three prior tax years.
In addition, home construction contracts are allowed to use the completed contract method, cash method or accrual method, regardless of their gross revenue. Home construction contracts are defined as those in which 80% of the estimated total contract costs are expected to be attributable to activities relating to dwelling units contained in buildings featuring four or fewer dwelling units. Contracts on improvements to real property directly involving such dwelling units and located on the site of dwelling units may also use CCM.
Advantages
Since the income is deferred until the project is complete, this generally will result in the maximum deferral of income for tax purposes. Aggressive billing practices can enhance cash flow and not impact taxable income.
Disadvantages
When completing several long-term contracts in a single period, the contractor may end up recognizing a substantial amount of income during that period. In addition, spending cash aggressively from early billings may cause cash flow issues when the tax liability becomes due. Losses on contacts are not deductible until the job is completed. The alternative minimum tax (AMT) still requires the use of PCM on all long-term contracts, so there will be an AMT adjustment required for contracts accounted for using the CCM, except for home construction contracts.
Cash Method
The cash method is a simplified accounting approach where income earned on a contract is recognized when cash is received and expenses are deducted when paid, regardless of when the services were provided or the expenses incurred. Contractors with average annual gross receipts of less than $30 million for the three prior tax years are eligible to use the cash method.
Advantages
This method is simpler to maintain and easier to understand when compared to other accounting methods. Contractors may defer income recognition until cash is collected and accelerate deductions by prepaying expenses before year-end. This approach helps reduce taxable income for the current year and prevent paying taxes on income that has not yet been received, providing contractors with better control over their cash flow.
Disadvantages
Unfortunately, this method is not effective in a declining economy. When construction volume shrinks, contractors may face cash flow problems and experience financial strain when owing tax and not having sufficient cash on hand. The alternative minimum tax still requires the use of PCM on all long-term contracts, so there will be an AMT adjustment required for any contract accounted for using the cash method, except for home construction contracts.
Accrual Method
The accrual method is an accounting method that records revenue and expenses when a transaction occurs instead of when payment is received or made. This method is based on the matching principle, which states that revenues and expenses should be recognized in the same period. Income is earned when the right to bill occurs under the contract terms. Costs are deductible when incurred under all events and economic performance standards.
Advantages
This method allows for better matching of income and expenses, providing a more accurate reflection of the financial performance of the construction project. It is simple and can provide a more consistent and predictable revenue stream, as income is recognized when earned rather than when payment is received.
Disadvantages
A significant drawback arises when the contractor is in an overbilled position. Overbillings are unfavorable because the contractor must recognize the overbilled amount as income and pay taxes on it. Generally, this is the most unfavorable accounting method for contractors for tax purposes due to the overbilled position.
The choice of tax accounting methods for long-term contracts is a critical decision that significantly impacts the financial health, tax liabilities and business strategy of contractors.
Each method, whether it is the percentage of completion method, completed contract method, cash method or accrual method, presents its own set of advantages and disadvantages.
The PCM offers accurate revenue recognition and enhanced cash flow planning, while the CCM provides simplicity and deferral of tax liabilities. The cash method is straightforward and offers immediate recognition of cash flows, whereas the accrual method provides a comprehensive view of financial performance.
Contractors must carefully evaluate these methods in the context of their specific operations, contract terms and financial goals to select the most appropriate approach. By doing so, contractors can optimize their financial reporting, ensure compliance with tax regulations and strategically position their business for long-term success.
