Many commercial construction projects can extend beyond one year. Federal tax law provides special rules for accounting for these long-term contracts (Internal Revenue Code Section 460). The rules apply to all long-term contracts unless the contract is exempt due to several exceptions provided by the tax law.
Not a Long-term Contract
These contracts are not considered a long-term contract, and are therefore exempt from the accounting for long-term contract rules.
- Contracts with architects, engineers or construction management
- Contracts for industrial and commercial painting
- Contracts completed before the end of the same tax year the contract commenced
- Contracts with de minimis (minor) elements of eligible construction activities
Exempt for AMT Purposes
Any individual business owner who is subject to Alternative Minimum Tax (AMT) must use the percentage of completion accounting method on long-term contracts, unless the business structure is a small C Corp (eff. 2018) or engages exclusively in home construction contracts (80% or more of the estimated total costs are expected to be attributable to 1) buildings containing 4 or less dwelling units and 2) improvements to real property located at the building site and directly related to the dwelling unit)
Talk to your CPA to determine if you will be subject to the increased AMT threshold for single or married filing jointly tax status.
To track expenses and income on non-exempt long-term contracts, contractors are typically required to use the “percentage of completion” accounting method for income tax reporting. The main disadvantage of this method is the inability to do much tax planning or tax deferment for things like accrued losses, uninstalled materials or retainage receivables, which can result in accelerated taxable income when compared with other accounting methods.
One of the exceptions to the tax law applies to companies with average gross receipts for the prior three years under $10 million. Under the new tax law effective for 2018, that threshold has been raised to $25 million. Now, long-term contracts of companies with average annual gross receipts under $25 million are considered exempt from the restrictive and complicated rules of Code Section 460.
For companies with average annual gross receipts above $25 million, compliance with the tax rules under Code Section 460 remains your only option.
If your CPA has not talked to you about the potential tax saving benefits of a different accounting method for your non-exempt long-term contracts — or explored if your company’s long-term contract status is now exempt — this year is a good time to ask about it. Because the accounting method chosen for each long-term contract must remain the same through the life of each contract, choosing the right accounting method is critical for any new long-term construction contract in 2018.
What is a long-term contract?
Before we explore various accounting methods, here is the simple definition of a long-term contract according to the tax code.
- Long-term contracts are those that on the contract commencement date are reasonably expected to not be completed by the end of the tax year.
Ironically, under this definition, a contract that is expected to take a week to complete could be a long-term contract. For example, if a contractor with a calendar year-end begins work on December 27 and expects to end on January 2 – the contract is a long-term contract.
Due to the complexity of accounting for long-term contracts tax rules — with their exceptions — as well as the variable nature of construction revenue, we often find that contractors are using a catch-all accounting method across all contracts. The key pitfalls of using the same accounting method for all long-term contracts over time may include:
- paying tax earlier than necessary;
- potential noncompliance with IRS rules as the company’s revenue grows;
- and noncompliance discovered during an IRS tax audit, which could result in additional taxes and penalties.
Are you compliant?
Interestingly, contractors that may have used a noncompliant accounting method under the former $10 million threshold may now be compliant under the new $25 million threshold for 2018 contracts.
Let’s say that a contractor’s average annual gross receipts for three trailing tax years were $15 million. The company wasn’t using the percentage of completion accounting method per the tax law for 2016 and prior years. The contractor is non-compliant with its accounting for long-term contracts with respect to 2016 and earlier years. If the IRS were to audit 2016 (and earlier) years, the non-compliance could result in significant tax, penalties, and interest.
Unfortunately for the contractor, the company is stuck with the non-compliant method in accounting for 2017 because changes from non-compliant methods in accounting must be filed prior to the end of the tax year. The risk of being assessed significant tax, penalties, and interest remains.
However, this same company will not need to change the accounting method for new long-term contracts in 2018 because, due to the increased threshold in the new tax law, these new contracts are exempt from Section 460.
Alternatively, companies under the $10 million threshold that have used the percentage of completion accounting method for long-term contracts could do an evaluation by comparing the amount of income tax they would have paid in past years (considering both regular tax and AMT if the company is a partnership or S-corporation) had they used a different method of accounting. If there is significant tax savings, a change in accounting method should be considered. This will not qualify as an automatic change in accounting method. A user fee of $9,500 will apply and Form 3115 notifying the IRS of the desired change will need to be filed before the end of the 2018 tax year.
As you can see, there are nuances to this area of the federal tax code. To prepare for the changes in 2018, each company should review accounting methods for long-term contracts with a CPA knowledgeable in this area of the federal tax code.
Continue Reading: What are Accounting Methods for Long-Term Contracts?
Scott Allen, CPA, joined Cornwell Jackson as a Tax Partner in 2016, bringing his expertise in the Construction and Oil and Gas industries and 25 years of experience in the accounting field. As the Partner in Charge of the Tax practice at Cornwell Jackson, Scott provides proactive tax planning and tax compliance to all Cornwell Jackson tax clients. Contact him at Scott.Allen@cornwelljackson.com or 972-202-8032.
