Like so many areas of the tax code, the rules for construction accounting can be difficult to navigate. The starting point is the determination of whether a taxpayer has any long-term contracts. A long-term contract is defined as a contract that is not completed within the tax year it is started. As an extreme example, a contract for a calendar year taxpayer could begin on December 27 and end on January 6, and this would be considered a long-term contract since the activity spans more than one tax year.
Construction contractors generally must account for long-term contracts using the percentage of completion method of accounting under IRC Code Sec. 460, unless an exception applies. Under the percentage of completion method, taxable income from the contract is recognized as the contract progresses. The net income for the year is equal to the percentage of the contract that was completed multiplied by the total estimated gross profit. The percentage of the contract completed during the tax year is determined by comparing costs allocated to the contract and incurred before the end of the tax year with the estimated total contract costs.
However, there is a “small contractor exemption” available to taxpayers with average gross receipts (prior three years) of $29 million for 2023. This dollar threshold is adjusted each year for inflation. Taxpayers who qualify for this exemption may account for long-term contracts using the completed-contract method or any other permissible exempt contract method. However, contractors (other than those taxed as C-Corporations) are still required to use the percentage of completion method for Alternative Minimum Tax (AMT) purposes regardless of their tax accounting method for regular tax purposes.
For small contractors (i.e. those with less than the $29 million gross receipts limit), there are a few common methods that are available that can potentially defer the timing of revenue recognition for tax purposes. These alternate methods are as follows:
Businesses often prefer the cash method because it permits more flexibility in managing the amount of taxable income reported in a tax year. For example, under the cash method, cash basis taxpayers don’t report accounts receivable as revenue until received, and expenses are deducted in the tax year actually paid. Near the end of a tax year, cash method taxpayers can defer the receipt of income and accelerate the payment of expenses to minimize taxable income for that year. If a contractor uses the overall cash method of accounting, no additional methods need to be applied to the jobs in progress.
The advantages of the cash method of accounting are:
- Easier and cheaper to maintain
- Matches cash flow better
- Permits more flexibility in managing the amount of taxable income reported in a tax year.
One disadvantage of the cash method is that taxable income can vary from year to year depending on the timing of cash receipts, and tax planning can be a more difficult and time-consuming process at year-end.
Completed Contract Method
Under the completed contract method, no revenue or expense is recognized on a long-term contract until the contract is completed. A contract is considered to be complete for tax purposes in the earliest tax year that:
- The customer uses the subject matter of the contract and at least 95% of the total allocable contract costs attributable to the contract have been incurred, or
- Final completion and acceptance of the subject matter of the contract.
While it is generally desirable to defer income as long as possible, contractors should be aware that when several contracts are completed during a single period, the completed contract method may require a company to recognize substantial income during that period. In other words, the amount of taxable income reported can vary from one year to the next depending on which jobs are finishing in each particular year.
The Accrual Method
The accrual method is common as an overall method of accounting (e.g. when combined with the percentage of completion method), but less commonly it is used by itself without any additional method for long-term contracts. This is often referred to as the “pure accrual method” for tax purposes. Under this method, revenue is recognized when it is billable under the terms of the contract and expenses are deducted when they are incurred, regardless of whether the job is complete or in progress.
An advantage to the pure accrual method is that it is easy to apply – no separate calculation of the percentage of completion or conversion to cash basis is needed.
A significant disadvantage occurs when a contractor is in an overbilled (or front-loaded) position, which is common in the construction industry. Under the pure accrual method, the contractor would need to pay tax on the amount overbilled at year-end. Contactors who use the pure accrual method for tax purposes should monitor their billings at year-end to ensure that they are not in an overbilled position.
Making a Change in Accounting Method
Contractors who qualify for these methods, and who wish to change their method of accounting for tax purposes for any of the above items must timely file IRS Form 3115, Application for Change in Accounting Method. Form 3115 generally is attached to the income tax return for the year of change. In addition, a copy of the Form 3115 must be filed with the appropriate IRS office no later than the date the tax return is filed.