For construction contractors, there are more options for accounting methods than those available to other business taxpayers due to the unique nature of construction activities and the inherent imprecision that can arise in measuring profit at different points in time during a construction contract. The IRS provides several steps for construction contractors to follow when determining which accounting method is appropriate.
Cash method – under the cash method, revenues and expenses are recognized based upon receipt and disbursement of funds. Contractors are generally eligible for the cash method of accounting, if they have $10 million or less in gross receipts annually for each of the past three years.
Accrual method – under the accrual method, revenue is generally recognized when all the events have occurred that fix the right to receive the income, and the amount of the income can be determined with reasonable accuracy (i.e., as billing invoices are issued). Expenses are deductible when all events have occurred that establish the fact of the liability, the amount can be determined with reasonable accuracy, and economic performance has occurred.
Completed-contract method (CCM) – under the completed contract method, no profit is recognized on a construction contract until completion of the contract.
Although the completed-contract method allows you to defer taxes on your income, it prevents you from deducting losses on unprofitable jobs until the contract ends. It can also push taxpayers into higher tax brackets by bunching income into a single year.
Percentage of completion method (PCM) – the percentage of completion method is a variation of the accrual method, where revenue recognition is measured not by a reference to billing but rather by applying an estimate of relative completion of a contract to the overall contract value. To determine how much income to report for each contract, calculate your project completion factor by dividing deductible project costs for that year by the total estimated cost to complete the project. For example, if you spent $100,000 on a project that will cost $1 million to complete, your project is 10% complete. Multiply that 10% factor by the contract’s total value to determine how much income to report.
Choosing the right accounting method
The choice of accounting method can have an important impact on tax-related disbursements. Effective tax planning relies heavily on the concept of deferring the payment of tax. Construction contractors and their advisors need to consider the optimal method under their specific circumstances provide the greatest benefit.
If you have questions about the accounting method you should be using for your construction firm, contact me at [email protected] or 201.655.7411.