So Many Accounting Method Choices. But Which Is the Right Choice?
As we teased in our article, Strategic Tax Planning Tips For Construction Industry Professionals, which appeared in the January edition of our Construction Industry Advisor newsletter, construction companies are unique in that they can choose from different accounting methods for income tax purposes. To better understand the accounting methods, let’s dive into what the IRS considers a “long-term contract.”
Read Also: How To Prepare WIP Reports For Long-Term Contracts
What Is Considered A Long-Term Contract (To The IRS)?
The IRS defines a long-term contract under Section 460 of the Internal Revenue Code as a contract that is:
- Started and completed in two different fiscal years, and
- For the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of real property.
That being said, non-applicable activities for the evaluation of a long-term contract include architects, engineers, engineering services, and construction management.
The first step in evaluating an accounting method is to determine if a taxpayer is exempt from accounting for long-term contracts (as defined above) under Internal Revenue Code (IRC) §460. The following two types of taxpayers are exempt from these accounting method requirements:
- Home Construction Contracts
- “Small” Contractors”
Home Construction Contracts
The Internal Revenue Code has outlined a broad set of rules when it comes to the definition of a home construction contract. For the requirements to be met, this type of contract must be able to attribute 80 percent of the estimated total contract costs to a dwelling unit that contains four or fewer dwelling units and improvements to real property directly related to the dwelling unit (etc., sidewalks, sewers, road, clubhouses, etc.). If you have a home construction contract, you should account for this contract under your overall method of accounting or the completed contract method (more information about both can be found below).
Additionally, a home construction contract does not have alternative minimum tax (AMT) preference items (more on that later), nor are the contracts subject to lookback provisions.
Small Contractor Exemption
The Internal Revenue Code states that a taxpayer is a small contractor if both of the following qualifications are met:
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- At the time the contract is entered into, the contractor estimates the contract will be completed within two years, and
- The contractor’s annual tax gross receipts for the three taxable years preceding the taxable year in question are less than $31M (for 2025). This amount is annually adjusted for inflation.
Assuming a contractor meets these two tests, the overall accounting method or the completed contract method may be used to account for long-term contracts (otherwise known as the “exempt methods”)
Overall Accounting Method
The overall accounting method (cash and accrual methods) applies to any taxpayer, whether a contractor or not. Contractors would also default to the overall accounting method for any non-long term contract, such as construction management and repairs contracts – to name a few examples. The following is an overview of these two overall accounting methods:
Cash Method
The cash method is the optimal method for a growing contractor. Under the cash method, income is recognized when it’s actually or constructively received, and expenses are recognized when paid. This approach has numerous benefits, such as the deferral of income until cash is collected and the payment of taxes when the cash is available. Naturally, this method is pretty simple to understand. However, the cash method can lead to “bunching” of income as backlogs slow down, which can result in lumpy taxable income (i.e., high taxable income in Year 1 and low taxable income in Year 2 – even if the income you had in the books was similar over the two years). Furthermore, you will have to have a healthy backlog to continue to have a deferral of tax. This method can also lead to poor business practices, as a contractor may delay billing and speed up cash expenditures to minimize taxable income.
Accrual Method
Generally speaking, the accrual method is the least optimal tax method. When using this method, income is either recognized when it’s received or earned (whichever is earlier), and expenses are deducted when the “all events” test has been met (which typically matches expenses with income recognition). For contractors, this is usually the worst method as overbillings are taxable. However, this method can have benefits, such as matching income and expenses and expensing under billings. However, tax planning may not correlate with business planning for an accrual method taxpayer. In short, this method should only be used in limited or unique circumstances.
Completed Contract Method
Finally, we will dig into the completed contract method, which means that any revenue and costs incurred as part of a contract are not recognized until the contract is “completed and accepted,” which means the contract must be 95 percent complete, and the property must be occupied for its intended purposes.
This method typically results in the greatest deferral of income – with the caveat that the contract in question must be accounted for under the Percent Complete method for AMT, a separate tax base that imposes a tax rate of 26 to 28 percent. With the current income tax rate being 29.6 percent for most taxpayers, the deferral only has an effective savings of 1.6 percent.
The Completed Contract Method has many advantages, including:
- It’s easy to understand
- It allows you to maximize the deferral of income
- It can improve cash flow thanks to your ability to deploy aggressive billing practices with no impact on taxable income.
However, the completed contract method can also lead to poor business planning decisions, such as delayed jobs, lumpy income when several jobs are completed in the same taxable year, and the need for a growing backlog of work to continue tax deferrals. Even so, the completed contract method should be considered for small contractors alongside the cash method. It is also the preferred method for C Corporation taxpayers as these entities are not subject to AMT.
Taking The Next Steps
If you meet the definition of small contractor or are working on home construction contracts, take the time to ensure that you are using the optimal method of accounting for your specific needs. Additionally, if your average annual revenues are around $30,000,000 and you are not using one of these methods, it may be worth ensuring your tax basis gross receipts are accurate. For example, if you are utilizing the cash or completed contract method, your tax basis gross receipts could be significantly different from what is being reported on your internal financial statements. This might open the door for an opportunity to elect a different (and perhaps more optimal) tax accounting method.
If you believe your business’s tax method could be optimized, contact your tax advisor today. Alternatively, you may reach out to the construction services team for further evaluation. Stay tuned for our next installment, when we will explore the options for contractors that are required to use the Percent Complete Method of accounting for tax.
By Ryan Kilpatrick, director, tax and business advisory services
Looking for more great insight to help empower your company’s growth? Check out these resources:
Property Tax 101: Understanding Your Rights, Responsibilities, & Opportunities For Tax Savings
GAAP Checklist For Construction Companies
Strategic Tax Planning Tips For Construction Industry Professionals
