LUTZ BUSINESS INSIGHTS

 

Tax Methods of Accounting for Construction Contractors

ZACH WEIS, TAX MANAGER

 

Many contractors sign contracts with customers that commence in one year but are completed the following. These are known as long-term contracts. If long-term contracts include the construction of property, Internal Revenue Code (IRC) Section 460 requires the use of the percentage of completion method (PCM) to calculate taxable income. However, there are exceptions for certain contracts that do not require PCM. In this article, we will discuss the requirements of PCM, the exceptions and the advantages and disadvantages of available methods.

 

Percentage of Completion

Revenue Recognition

1. Revenue is recognized based on comparing incurred costs with estimated total costs. The percentage of costs incurred compared with total estimated costs is multiplied by the contract price for revenue recognition. Direct and indirect costs allocated to the job are recognized as incurred.

2. There is an election available to exclude the first 10% of contract revenue and costs.

Advantages

1. Income is recognized over the life of the contract eliminating fluctuations of income.

2. Contract losses can be recognized immediately.

Disadvantages

1. Revenue is taxed before the job is completed.

2. Cash needed for income taxes could be used to fund other projects.

 

Percentage of Completion Exceptions

Internal Revenue Code (IRC) Section 460 provides two exceptions for contractors who are not required to use PCM for tax purposes. If contractors meet ONE of these exceptions, their contracts are exempt from PCM.

  • Home construction contractors,
    • Any construction contract where 80% of the costs are attributable to dwelling units, or
  • Eligible Small Contactor
    • Prior 3-year average gross receipts are under $26 million, AND
    • Estimated contract will be completed within two years.

    Methods Available for Contracts Exempt from PCM

    Taxpayers may choose any method available for contracts not subject to PCM. However, the method applied to the first exempt contract must be applied to all exempt contracts. Determining which method is most advantageous requires professional expertise.

    1. Completed Contract Method

    Revenue Recognition

    • Revenue is recognized once the contract is completed. Direct and indirect expenses allocated to the job are deferred until the job is completed.
    • Contracts are considered complete when 95% of estimated total costs are incurred.

    Advantages

    • Tax deferment of income.
    • Additional cash on hand for new projects instead of paying income taxes.

    Disadvantages

    • Losses are not recognized until the job is complete.
    • Significant fluctuations of income.

    2. Cash Method

    Revenue Recognition

    • Revenue is recognized once cash is collected. Direct and indirect expenses allocated to the job are expensed as paid.

    Advantages

    • Taxable income follows cash flows.
    • Simplified tax planning opportunities.

    Disadvantages

    • Profitability can be misleading.
    • Advance payments from customers considered income.

    3. Accrual Method

    Revenue Recognition

    • Revenue is recognized once revenue is earned. Generally, this follows when bills are issued. Direct and indirect expenses allocated to the job are expensed as incurred.

    Advantages

    • Represents economic reality.
    • Flexibility in revenue recognition.

    Disadvantages

    • Taxable income doesn’t match cash flows.
    • Complexity of revenue and cost recognition.

    Alternative Minimum Tax (AMT)

    Exempt contracts that are not reported under PCM are subject to AMT adjustments. Under AMT, taxpayers are required to recognize revenue for PCM. The difference between the exempt method used and PCM is added or subtracted for AMT. Home construction contractors are NOT subject to this AMT adjustment.

    Please consult with your Lutz Representative or contact us if you have any questions. You can also learn more about our construction accounting services or read related topics by visiting our blog

    ABOUT THE AUTHOR

    402.514.0003

    zweis@lutz.us

    LINKEDIN

    ZACH WEIS + TAX MANAGER

    Zach Weis is a Tax Manager at Lutz with over five years of experience in taxation. He is responsible for providing tax consulting and compliance services to businesses and individuals with a focus on the real estate and construction industries.

    AREAS OF FOCUS
    • Tax
    • Accounting & Consulting
    • Construction Industry
    • Real Estate Industry
    AFFILIATIONS AND CREDENTIALS
    • Certified Public Accountant
    EDUCATIONAL BACKGROUND
    • MPA, University of Nebraska, Lincoln, NE
    • BSBA in Accounting, University of Nebraska, Lincoln, NE

    SIGN UP FOR OUR NEWSLETTERS!

    We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.

    PROVIDER RELIEF FUND REPORTING

    Provider relief fund reporting

    The Provider Relief Fund (PRF) Reporting Portal opened for Reporting Period 2 on January 1, 2022, and will remain open through March 31, 2022, at 11:59 PM ET.  What you need to know:

    Providers who were required to report in Reporting Period 1, but did not report:

    • Providers who received one or more payments exceeding $10,000 between April 10, 2020 - June 30, 2020, were required to Report in Reporting Period 1.
    • HRSA states that “You are out of compliance with the PRF Terms and Conditions and must return your Payment Period 1 PRF payment(s) to HRSA.”
    • There are additional instructions on the HRSA site for returning payments and other information regarding “non-compliance”

    Upcoming Reporting Requirements:

    Period Payment Received Period   Deadline to Use Funds Reporting Time Period
    3 January 1, 2021, to June 30, 2021 6/30/2022 July 1, 2022, to September 30, 2022
    4 July 1, 2021, to December 31, 2021 12/31/2022 January 1, 2023, to March 31, 2023

     

    If you have any questions, please contact Paul Baumert, Julianne Kipple or Lauren Duren, or call us at 402-496-8800.

     

    Last Updated: 1/14/2022

     

    NEED HELP WITH PRF REPORTING?

    Lutz can help you navigate the PRF reporting process successfully. Contact us today!

    About UsOur Team | Events | Careers | Locations

    Toll-Free: 866.577.0780Privacy Policy | All Content © Lutz & Company, PC 2021