The Tax Cuts and Jobs Act has made more construction companies eligible to use the cash and completed contract accounting methods. This article provides a brief introduction to the tax accounting options available to contractors and reviews some of the factors to consider in determining whether to switch methods.
Is it time for a change?
Tax reform has expanded availability of accounting methods
Almost a year ago, the Tax Cuts and Jobs Act (TCJA) was signed into law. It may be best known for slashing corporate and individual income tax rates. But another change made by the act will have a big impact on many construction companies — particularly those with gross receipts ranging from $5 million to $25 million.
Starting this year, businesses with average gross receipts in that range can take advantage of certain tax benefits available to “small contractors.” As a result, more construction companies will be eligible to use the cash and completed contract accounting methods for tax purposes. Often (but not always) these methods allow businesses to improve cash flow by deferring taxes.
Overview of accounting methods
Most construction businesses use two accounting methods: one overall method and one for long-term contracts (those that span more than one tax year). Let’s take a closer look at each:
1. Overall method. The two most common overall methods are cash and accrual. Under the cash method, you recognize income when payment is received and deduct expenses when they’re paid. In contrast, under the accrual method, you recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments.
Before the TCJA, construction companies structured as C corporations (or as partnerships with a C corporation partner) were prohibited from using the cash method if their average gross receipts for the previous three tax years exceeded $5 million. Other entities — including S corporations, limited liability companies and partnerships without a C corporation partner — were permitted to use the cash method regardless of their gross receipts, unless they were required to account for inventories.
Businesses whose merchandise purchases were substantial in comparison to their gross receipts were required to account for inventories and use the accrual method for purchases and sales, unless their average gross receipts were $10 million or less. According to the IRS, “merchandise” includes “any item physically incorporated in a product you transfer to your customers,” such as building materials. And “substantial” generally means at least 10% to 15% of gross receipts. Some companies adopt a hybrid method, using the accrual method for purchases and sales and the cash method for other items.
The TCJA raised both the $5 million and $10 million thresholds to $25 million. That means all construction businesses with average gross receipts of $25 million or less can now use the cash method, regardless of entity type or whether they have inventories. As before, a company that doesn’t have inventories, and isn’t a C corporation or a partnership with a C corporation partner, can use the cash method regardless of income level.
2. Long-term contract method. Before the TCJA, construction businesses with average gross receipts over $10 million were required to use the percentage-of-completion (POC) method of accounting for all long-term contracts (with an exception for certain home construction jobs). Under this method, revenue and expenses are generally recognized according to the percentage of the contract completed during a tax year. This percentage is determined by calculating costs allocated to the contract and incurred during the year and dividing them by estimated total contract costs.
Construction companies with average gross receipts of $10 million or less were permitted to use the completed contract method for jobs expected to be completed within two years. Under this method, income generally isn’t reported until the contract is substantially complete.
The TCJA raised the threshold for the POC method requirement to $25 million, significantly expanding the number of firms eligible for the completed contract method. (But see “Watch out for the AMT.”)
For many construction businesses, the increased gross receipts threshold creates an opportunity to use the cash and completed contract accounting methods. But those methods aren’t right for everyone, so it’s important to determine whether switching methods would provide tax benefits.
If, like many companies, your accrued income (receivables) tends to be higher than your accrued expenses (payables), then switching to the cash method will likely allow you to defer income — reducing your tax bill. On the other hand, if your accrued income tends to be lower than your accrued expenses, switching to the cash method may likely accelerate income.
It’s also important to consider how your tax situation may change in the future. If you expect your marginal tax rate to remain steady or decline, using the cash and completed contract methods to defer income will provide a tax advantage. But if you think you’ll be in a higher tax bracket down the road, the accrual and POC methods may be the better strategy.
An accounting method change is a major business decision involving many factors. Your tax advisor can help you determine whether your construction company would benefit from switching tax accounting methods and explain the process for doing so.
Watch out for the AMT
Are you considering a switch from the percentage-of-completion method to the completed contract method? If so, keep in mind that you’re required to calculate income based on percentage of completion for purposes of the alternative minimum tax (AMT), too.
Fortunately, the Tax Cuts and Jobs Act repealed the corporate AMT and substantially increased AMT exemption amounts for individuals, so relatively few contractors will be affected. Nevertheless, if your company is structured as an S corporation, limited liability company or partnership, it’s a good idea to do the math to determine whether the completed contract method would be advantageous.