Changes in accounting methods can mean big savings for contractors
August 19, 2018
For contractors, the Tax Cuts and Jobs Act (TCJA) raised the threshold for the requirement to use the percentage-of-completion method (PCM) from $10 million average annual gross receipts (AAGR) to $25 million for contracts starting in 2018.
Two changes to note
Contractors who were previously required to switch from a deferral method because their AAGR exceeded $10 million (such as completed contract method (CCM)), a cash method, or an accrual method will be able to go back to their former method in 2018 if their AAGR is less than $25 million. The required steps are in an IRS-issued Revenue Procedure dated Aug. 3, 2018.
Contractors using or going back to an accrual method can either change to the cash method or, if retaining the accrual method, change to exclude retainage receivable from revenue as late as the date for filing the tax return. This election requires that retainage payable also be deferred until it is actually payable. Since the receivables generally are more than the payables, the net difference is a great deferral to a subsequent year.
Two ways to save
Additionally, over the past several months, Honkamp Krueger has been able to assist contractors with other accounting method changes which fall into two broad categories, both of which need to be pre-approved by the IRS.
The first involves reviewing various types of contracts to determine if, by their nature, an alternative method of recognizing revenue for those contracts might be available and favorable.
The second opportunity relates to the payment terms contained within the contract language itself. A significant benefit is available for large contractors using the PCM in certain common situations. This is not a provision of the TCJA, but a calculation that the IRS has only recently been approving for the last few months.
Revenue for the PCM is calculated with a ratio using the costs incurred in the numerator and total estimated costs in the denominator. The more costs that are incurred, the more taxable revenue will be reported. Cost deferral for contracts in progress defers revenue and thus defers and/or saves taxes.
Contractors have long been deferring income by excluding retainage payable to subs from the numerator. Now the IRS is allowing, as a change in a tax accounting method, the full exclusion of the entire subcontractor payable for contracts which are “pay-if-paid” with the subcontractor. If the contractor has not been paid by its customer for the work of the subcontractor, then, with those pay-ifpaid subcontracts, the entire payable to the sub does not meet the tax definition of a cost and can be excluded from the numerator in the calculation of the PCM.
The two possible change in methods above are not automatic changes; they require the prior consent of the IRS, and it requires a very detailed submission of numerous specific forms, documents, calculations, explanations and information. The requested change will likely not be approved by the IRS unless it is submitted precisely in accordance with all the extensive rules and regulations for:
- calculation of the PCM
- the tax definition of costs
- the enforceable payment laws of the states in which the contractor operates
- the requirements of the applicable forms
- the several IRS regulations for requesting the change
- the legal determination of the payment requirements, and more
If the requested change is approved, the tax savings can be significant.
Contractors should discuss these options for accounting method changes and determine if they qualify, and if so, which method is ideal for their situation. Then begin the process of approval with the IRS. For assistance and questions, contact us here.