Assistance for workers and employers affected by COVID-19-related layoffs in Iowa was announced by Governor Reynolds on March 16. Included in the guidance is information on unemployment insurance claims and available programs for employers like the Voluntary Shared Work program.
“Iowa has incredible employers accommodating the needs of Iowans during the disruption caused by COVID-19,” said Gov. Reynolds. “The state of Iowa is doing everything we can to ease the process and shorten the time it will take for Iowans to receive unemployment benefits. All of our state agencies continue to work as one team to lessen the impact COVID-19 will have on our economy and our people.”
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.
At the end of 2021, most term loans, lines of credit or other debt instruments with variable interest provisions tied to the London Interbank Offered Rate (LIBOR) will need to switch to an alternative benchmark.
LIBOR is a benchmark interest rate global banks use to lend to one another in the international interbank market. According to data provided by the Alternative Reference Rates Committee, in 2012, there were more than $200 trillion worth of transactions that were associated with LIBOR, so a change to alternative rates has been a major undertaking for the financial services industry.
Historical context for the LIBOR change explains why the transition is necessary. Additionally, it’s important to understand what impact this transition will have on any U.S. based loans that have previously used LIBOR.
What is LIBOR
To determine LIBOR rates, panels from some of the largest global banks submit an estimate of their daily borrowing to the British Bankers Association (BBA) each morning. This data is calculated for five currencies: U.S. dollar, euro, British pound sterling, Japanese yen and the Swiss franc, and allowed banks to use a global benchmark to determine borrowing interest rates. The benchmark is calculated by taking out the top and bottom 25% of quotes and averaging the remaining numbers.
LIBOR was scrutinized for market manipulation that occurred in 2008 and 2012 by certain institutions for profit. A bank’s true rate could be in the top quarter, but if they report numbers in the bottom 25%, another bank’s numbers would be lifted from the bottom 25% and used for the remaining middle numbers used to calculate the average. When multiple banks understate the rates, the average rate will be lower than it should be.
In 2008 and 2012, multiple global banks teamed up to report false numbers lower than their actual estimated borrowing numbers. While the LIBOR calculations were created on what banks estimated their daily borrowing to be, there was no way to test and verify the data for the quotes.
New alternative rates
Since LIBOR rates have proved to be subject to manipulation, LIBOR will be discontinued across all global banks. In December 2021, LIBOR rates will no longer be used for sterling, euro, yen or the Swiss franc. The U.S. will discontinue using most LIBOR rates. However, for some accounts not easily transferable, the U.S. is giving those accounts until June 2023 to fully transition.
In the U.S., the Secured Overnight Financing Rate (SOFR) is emerging as the preferred alternate rate identified by the Alternative Reference Rates Committee.
SOFR is a measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is based on directly observable U.S. Treasury-backed repurchase transactions, unlike LIBOR that was based on estimations. SOFR is not the only alternative reference rate that is emerging, however.
Market participants also are looking for an index that incorporates credit risk. One notable index is the Bloomberg Short Term Bank Yield Index, which is a proprietary index that incorporates systematic credit spreads and has a forward term structure similar to LIBOR.
Negotiating new loan agreements
While no immediate action is needed for existing agreements involving LIBOR, it’s important to be aware when entering new debt agreements or renewing agreements in 2021. Banks have been preparing for the eventual transition away from LIBOR. If your bank has not contacted you, they likely will in the normal course of business in the next few months. Depending on the maturity date for your existing variable rate debt (i.e., before Dec. 31, 2021) and the renewed maturity date (i.e., 2022, 2023 or beyond), you can likely expect at least one of these options:
• The new agreement will use a benchmark rate other than LIBOR
• The new agreement will specify LIBOR but will specifically describe the new rate (e.g., SOFR) plus prescribed rate adjustment language designed to replicate, as best as practical, the current negotiated effective rate of the LIBOR based loan
• Rather than specifying an alternative index and transition language, the language will be more general in nature to formally establish how the new interest rate will be determined when it becomes necessary
Many variable rate loans in the U.S. will not be impacted by this change since they already use a different benchmark such as a prime rate index, however, it is important to be aware of the transition as it may influence future rates and loan agreements.
This article was previously published in the Tri-State Business Times.