Accounting methods for construction contractors
July 22, 2021
By Steve Campana, CPA, ABV, CFF®
Owning and operating a construction business involves a lot of work between managing job sites, equipment, contracts and other projects. At times, it can be difficult to monitor everything, let alone spend additional time crunching numbers and keeping track of the bookkeeping. However, accurate books are an essential part of long-term success for your business. What might appear as a minor mistake in your bookkeeping can cause long-term financial repercussions that may cause you to be less profitable or pay more in taxes than you should. Therefore, accurate bookkeeping is essential to the longstanding financial success of your business.
Understanding what accounting method to use for the preparation of your income tax return in your construction business can be an overwhelming task due to the many different options. We have provided you with a summary of some of the common tax accounting methods available for construction contractors to help you understand the options that might be available to you.
Are you a small business taxpayer?
The first step in understanding the best tax accounting method for your construction business is recognizing whether you are considered a small business taxpayer (SBT). An SBT is a taxpayer whose three-year average annual gross receipts are under $26,000,000 for the period ending with the taxable year which precedes the current year of the entity. The $26,000,000 threshold is for tax years 2019-2021 and is adjusted for inflation each year. Certain related entities must be combined when calculating the SBT threshold.
The analysis to determine if a taxpayer is an SBT needs to be done every year. Once a taxpayer is no longer an SBT, they are precluded from using a method other than the percentage of completion method (PCM) for their long-term contracts for not only the year in which they are no longer considered an SBT, but for every year thereafter in which they are not an SBT.
It’s important to understand if you qualify as an SBT because SBTs have more options in choosing accounting methods than those not considered.
Accrual vs cash accounting
Your tax accounting method determines when revenues are recognized and included in taxable income and when purchases and other expenses are deductible. Under the cash accounting method, revenue is recognized when cash is received, and expenses are deductible only when they are paid. The cash method of accounting can be beneficial because you are not taxed on income before you have received the cash. However, it may not be the best option for construction contractors due to the uncertainty of income of long-term contracts and other ongoing projects or contracts in which the cash is not yet received or paid.
On the other hand, accrual accounting recognizes revenues as they are earned and expenses are deductible as they are incurred regardless of when the cash is actually received, or when expenses are paid. With this method, you would record revenue when the project is billed, rather than when you get paid. This method can give you a more realistic view of income and expenses at a given time, but you are taxed on the revenue before you receive the cash. A company could appear to be profitable when realistically, they have no readily available cash to cover working capital or debt obligations.
Percentage of Completion Method (PCM)
The PCM is required for long-term contracts if the taxpayer is not considered an SBT. It is considered an accrual method where revenue is calculated periodically, while working on a contract or project, by estimating the relative percentage of completion of a contract to the overall contract’s estimated costs. This can be a great method to use for long-term contracts.
Although the PCM is typically used for contractors not considered an SBT, even an SBT may need to calculate revenue under the PCM for alternative minimum tax purposes.
Completed Contract Method (CCM)
The CCM is available for all contracts if the taxpayer is considered an SBT. With the CCM, no profit is recorded on a construction contract or project until the job is complete. This method allows contractors to defer paying income taxes on long-term contracts until the project is completed. This can lead to significant tax deferral on jobs with large profit margins.
Changes in Accounting Methods
For tax purposes, SBTs are allowed to change accounting methods for their long-term contracts. If a taxpayer is an SBT currently using the PCM for long-term contracts, and desires to change their methods of accounting for long-term contracts, they must file an application with the IRS on Form 3115. Accounting method changes generally will receive automatic approval, but care must be taken to ensure the Form 3115 is completed properly.
There are additional accounting methods available for contractors that do not qualify as a SBT in determining the revenue to be recognized under the Percentage of Completion Method for Long-Term Contracts.
Reviewing these options and making the appropriate elections can also provide significant tax benefits for larger contractors.
Selecting an accounting method is an important component of setting up a construction business. It’s encouraged to seek assistance from an advisor on this decision as it can greatly influence the success of your business.
More construction and real estate blogs here.