January 09, 2017
Construction Contracts: Tax Planning Opportunities
By Ashlie Schlager Forum, Senior Manager, Tax & Business
When it comes to construction contracts and the IRS, the rules can be very complex. The IRS specifically addresses tax matters and construction industry issues within Internal Revenue Code Section 460.
This code section also includes tax planning opportunities of which many construction contractors may be unaware or are not utilizing. Tax planning opportunities can help contractors keep money in their pockets for day-to-day operations and other cash flow needs. Following is an overview of several opportunities that contractors may want to consider.
Long-Term Contracts: According to Code Section 460, a long-term contract is defined as any contract that expands a single tax year related to the manufacture, building, installation, or construction of property. For example, if a contractor with a December 31 year-end enters into a contract on December 1 and does not complete the contract by December 31 of that same year, the contract will be considered a long-term contract.
Percentage of Completion: Code Section 460 requires taxable income to be reported under the percentage of completion method of accounting, which requires recognition of revenue on the percentage of the contract completed determined by the total cost to date over the total estimated cost. The taxpayer includes in gross income for the tax year that portion of the total contract price that corresponds to the percentage of completion of the project for that tax year. Unfortunately, this could mean that the taxpayer will have to pay tax on income that has not yet been received.
Completed Contract Method: Income may be reported on the completed contract method. Generally, contractors prefer the completed contract method since income is reported when the project is complete and accepted. Typically, when the contract is complete, most of the revenue will have been received, and therefore the cash is available to pay the income taxes. This method generally results in the greatest deferral of income.
There are some exemptions to these income inclusion rules for businesses meeting certain parameters:
- Small Contractor's Exemption – A contractor is exempt from the percentage of completion method if the taxpayer estimates the contract will be completed within a two-year period and the taxpayer's average annual gross receipts for the three previous tax years are less than $10 million.
- Home Construction Contracts – A home construction contract is any contract where 80% or more of the estimated costs are reasonably expected to be attributable to the construction of dwelling units in a building containing four or fewer dwelling units and improvements to real property related to these dwelling units. For example, if a contractor is building single family homes or townhomes that contain four or fewer dwelling units, the contractor will not be required to report income on the percentage of completion method for this home construction contract. Income then may be reported on the completed contract method.
- Residential Contracts – A residential contract is similar to the home construction contract definition, except that the building is defined as containing more than four dwelling units (this does not include a hotel, motel, or establishment used on a transient basis). For residential contracts, a 70/30 hybrid method is allowed: 70% of the contract is reported on the percentage of completion method and 30% of the contract is allowed for an exempt method, such as the completed contract method discussed above. Some examples of residential contracts would be general contractors and sub-contractors working on apartments, condominiums, dorms, assisted living facilities, barracks, and prisons.
- Election to Use the 10% Method - If the contractor is required to use the percentage of completion method, there is an election that allows the contractor to defer income if, at the end of the year, the contract is less than 10% complete.
- Accrual with Deferral of Retainage –
- For contracts that have started and are completed in the same year (non-long term contracts),contractors may defer reporting the retainage receivable
as income until the retainage is billable, which is generally upon the owner's acceptance at the end of the project. The retainage billable
should be defined within the contract. The retainage payable for non-long-term contracts will also be accrued when the retainage receivable
For example, a general contractor has a job that will be started and completed in the same year for an owner. If the contract allows the general contractor to retain 10% of the total contract price until the owner's acceptance, then under the accrual method, the general contractor does not include the retainage in income until the owner accepts the job.
- For long-term contracts, retainages payable are not included in contract costs to date until the retention is payable to the subcontractor as defined
within the contract. This can reduce the overall percentage of the project deemed to be complete, which in turn reduces the income to be recognized.
For example, since the percentage of completion calculation is based on total costs incurred over total estimated costs, when the total cost incurred is decreased when the retainage payable is not included, this reduces the percent complete. The percent complete is then multiplied by the contract price, so the amount of income included in the tax year may be reduced.
- Tax Allocation of Direct and Indirect Costs – Direct and indirect costs should be allocated to contracts based on a burden rate or some other reasonable method. The cost allocation can reduce the overall completion percentage of the project, which in turn reduces the income to be recognized.This is the same concept as above for long-term contracts and retainages payable.
Most of the techniques noted above require a change in accounting method and approval by the IRS. Use of some of the exceptions and methods may also have different Alternative Minimum Tax (AMT) applications, which may result in taxes higher than when computing taxes on a regular tax base.
If you have contracts that fall into one of the above categories, please contact your Marcum tax advisor to explore these tax planning ideas.