To say that 2020 has been a challenging year would be an understatement. Many small businesses across all industries were hit hard by the COVID-19 global pandemic. The construction industry was certainly not spared in that regard.
The Government attempted to provide relief with the passage of The Coronavirus Aid, Relief and Economic Security (“CARES”) Act. The CARES Act included the Paycheck Protection Program (“PPP”), which was to provide funding for small businesses to maintain their payroll, hire back employees that were laid off and cover certain overhead costs. The details and nuances of the PPP program are beyond the scope of this article. However, at its core, the PPP intended to provide tax-free forgivable loans if the proceeds were utilized to cover eligible expenses. Unfortunately, as of the date of this writing, the Internal Revenue Service has issued guidance which disallows expenses that were paid with any portion of the PPP funding that is ultimately forgiven. This serves yet another blow to contractors. What was once thought to be tax-free funding to help navigate the early stages of the COVID-19 pandemic, has now potentially become a taxable event with real cash flow impacts.
The good news is that there are options for accounting for long-term contracts for income tax purposes that many small contractors are not currently taking advantage of. Most contractors are familiar with the Percentage-of-Completion accounting method for long-term contracts, which is required to be utilized for financial statements under Generally Accepted Accounting Principles (“GAAP”). Historically, taxpayers with average annual gross receipts of $10 million or more were also required to utilize the Percentage-of-Completion method on their long-term contracts for income tax reporting purposes.
The Tax Cuts and Jobs Act (“TCJA”) that took effect in 2018 redefined a small business for purposes of the gross receipts threshold by increasing the average annual gross receipts test from $10 million ($5 million for C Corps) to $25 million ($26 million for 2020). This means construction businesses with average gross receipts of $25 million ($26 million for 2020) or less can now use alternative accounting methods other than Percentage-of-Completion for accounting for their long-term contracts for income tax purposes. Contracts that are not required to utilize the Percentage-of-Completion method are considered exempt construction contracts. Below are several methods available for exempt construction contracts that could provide immediate tax savings and that should be considered for any contractor whose average annual gross receipts are below the threshold referenced above.
Exempt Construction Contracts
Completed Contract Method (“CCM”)
The completed contract method may be the most popular method for accounting for long-term contracts exempt from the Percentage-of-Completion requirements. CCM works such that revenue and costs on contracts are not recognized for income tax purposes until the contract is completed—or over 95% complete—and can be used for its intended purpose. The CCM in many cases results in the largest deferral for income tax purposes.
A key component of utilizing the completed contract method is making sure you are managing your backlog. Maintaining a good backlog is key in maximizing the benefits of CCM.
Cash Basis
The cash method is another popular method. In short, when using the cash method, income and expenses are recognized when cash is received or when expenses are paid. The cash method is most favorable when a taxpayer has large receivable balances and smaller payable balances.
Accrual Method
Under the accrual method, revenue is reported when billed and costs are deducted when they are incurred, regardless of when the money is received or paid. The accrual method will usually result in the smallest deferral for taxpayers. Furthermore, for taxpayers who bill aggressively the accrual method may not make sense as overbillings are taxable under this method.
Accrual Method – Less Retainage
The accrual method – less retainage is similar to the accrual method discussed above, with one exception. Under this method, the retainage receivables and retainage payables are not recognized until received or paid. This could provide benefit to a taxpayer with large retainage receivable balances, as that income is not recognized until the cash is received.
Home Construction Contracts
A home construction contract is any contract where 80% or more of the estimated costs are reasonably expected to be attributable to the construction of dwelling units in a building containing four or fewer dwelling units and improvements to real property related to these dwelling units. If a contract meets this definition, it is not required to be accounted for under the Percentage-of-Completion method and may utilize an alternative method for exempt construction contracts such as CCM, Cash, etc.
Percentage-of-Completion Contracts
While CCM, Cash Basis and other exempt construction contract accounting methods may provide the most benefit from a tax perspective, there are still some options available to taxpayer’s who must continue to utilize the Percentage-of-Completion method on long-term contracts for income tax purposes.
IRC Section 460(b)(5) Election - 10% election
An election is permitted under IRC Section 460(b)(5) for contracts under the Percentage-of-Completion method whereby income and expenses are not recognized for tax purposes until the contract is over 10% complete. The election is made with the taxpayer’s return and is an accounting method change that must be applied consistently in future tax years.
Residential Contracts - 70/30 Method
A residential contract is similar to a home construction contract except that the building is defined as containing more than four dwelling units. It is important to note however that this definition does not include establishments used on a transient basis such as hotels, motels, etc. If a contract meets the definition of a residential contract, then a hybrid method can be utilized. 70% of the contract is reported on the percentage of completion method and 30% of the contract is permitted to be accounted for under a method permissible for exempt contracts. This means the 30% may be accounted for under CCM, Cash, etc.
Other Considerations
Form 3115 – Application for Change in Accounting Method
If a change in accounting method on long-term contracts is being considered, a Form 3115 will be required. It is important to note that an accounting method change related to long-term contracts is made on a cut-off basis. That means any contracts that begun the year prior to the year of the accounting method change would remain on the original method until it is completed.
Alternative Minimum Tax (“AMT”)
The TCJA reduced the impact of the AMT on many taxpayers by repealing it for C-Corporations and increasing the exemption amount for owners of pass-through entities. Nonetheless, AMT requires that all long-term contracts are accounted for under the Percentage-of-Completion method. If a method other than Percentage-of-Completion is elected for income tax purposes, an adjustment will be required for AMT. Taxpayers should make sure to consider any AMT impact as part of any accounting method change with respect to their long-term contract accounting method.
How can we help?
Bowers & Company, CPAs, PLLC’s Construction Services group is intimately familiar with all aspects of the accounting methods discussed above. We can evaluate your current situation and advise you on which methods are available to you and would be most beneficial to your situation. We encourage you to reach out to one of our construction professionals today to learn more about how we can provide value to your company.
If you have any questions about anything regarding surety, contact an appointed agent, or reach out to an Old Republic Surety branch nearest you.
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