Tax methods for contractors

Choices of tax methods to recognize income for contractors

If you’re a contractor, you have more choices of tax methods to recognize income than most businesses. However, it carries many complexities.

With the uncertainty surrounding the economy, tax rate changes and future construction projects, it makes projecting the success of your business challenging. There are numerous decisions occurring daily. From a taxable income calculation prospective, contractors have more choices of tax methods to recognize income than most businesses. However, when certain methods can be utilized, the timing of the election to change methods and how the change to the new method is carried out can provide various complexities.

What you need to know

Most construction companies utilize the percentage-of-completion method of accounting for long-term contracts on both their financial statements and tax returns. The Tax Cuts and Jobs Act significantly expanded contractors availability to use the completed contract method for tax purposes if the average of the prior three years’ gross receipts falls below a certain level.

Currently, to be considered a small contractor, the gross receipts threshold stands at $26 million. The threshold also opens the ability of construction companies to utilize the overall cash method of accounting as opposed to the accrual basis for taxable income reporting. For small contractors, changing to these accounting methods is considered automatic. It does not need to be determined until shortly before the filing of the annual tax return. Having the ability to wait until eight or nine months after year-end is helpful, particularly when tax rates may be rising under democratic leadership, but the timing of such increases is unclear. To effect these changes, a taxpayer needs to complete Form 3115 Application for Change in Accounting Method and file with the IRS, along with attaching to their current year tax return.

Accounting method alternatives for long-term contracts still exist for contractors over the gross receipts’ threshold. However, they might not be as easy or lucrative in their application. Under the right circumstances, it may produce significant tax deferral opportunities. Here are two variations of the percentage of completion method for consideration:

  • Percentage-of-completion with deferral of the subcontractor retainage payable: The contractor does not include the subcontractor costs related to retainage in the cost incurred to date. This effectively lowers the percentage-of-completion, resulting in a larger deferral of contract income.
  • 10% deferral under percentage-of-completion: An often-overlooked contract method, this allows contractors to not recognize income for projects that have not reached 10% completion at the end of the year. The amount deferred then is recognized in the next year when the project crosses the 10% completion level.

In certain instances, the accounting method changes for large contractors still require a Form 3115 filing but includes a user fee of $10,800. The forms must be completed before the beginning of the tax year the taxpayer wishes to implement the new accounting method. This requires more advanced planning prior to the tax year being completed. The IRS must approve the method changes and the approval needs received prior to the tax return filing.

The effect of a change in accounting method for long-term contracts are calculated on a cut-off basis starting with the first day of the tax year it is applicable for. Meaning, only contracts started during the current tax year can be calculated on the new method at the end of the tax year. Any contracts started in prior years must continue to be calculated utilizing the previous long-term accounting method. Hence, if a large taxpayer thinks tax rates are going to increase in 2021 and they’d like the ability to defer income on contracts started in 2021 using one of the aforementioned methods, the application to change methods must be filed by the end of 2020.

With the currently lower tax rates and possibility for future taxable income and tax rate changes, the sooner you analyze the potential tax benefits of accounting methods will provide more flexibility in the application to your taxable income. Like most tax planning, the selection of accounting method changes depends on numerous factors which need consideration in the analysis.

In summary

If interested in your options, we can help complete this analysis for you. Contact Rick Golubski using the information below.

Rick Golubski

Vice President
Tax Services

Rick Golubski is a certified public accountant, with extensive experience in the fields of accounting, auditing, and taxes and frequently works with clients in the banking industry. He graduated from Emporia State University with a business degree.

Rick is a member of the Kansas Society of Certified Public Accountants, the American Institute of Certified Public Accountants, and the local chapter of the Construction Financial Management Association, including serving previously on the CFMA board of directors. He joined AGH in 1994 and has served in leadership positions in both audit and tax at the firm. He has been honored by the Wichita Business Journal as a “40 Under 40” young community leader and currently serves on the board of the Harvey County United Way.

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