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.

The following are the primary accounting methods for long-term contracts, explained briefly, for smaller and larger contractors.

Smaller Contractors

Ave. Gross Receipts < $10 million (or < $25 million starting in 2018)

Completed Contract Method

• No revenue is reported or costs deducted until the contract is complete:
• Generally considered complete when 95% of expected costs have been incurred
• Aggressive billing and collections do not impact income
• Biggest tax deferral opportunity

The disadvantages of this method occur when several contracts finish in the same year, causing a spike in income and a spike in the tax rate. Contractors also cannot deduct losses on a contract until the job is complete.

Note that home contracts are exempt from Section 460 and that the completed contract method is generally used by home builders.

Cash Method

• Revenue reported when collected
• Costs deducted when paid
• Large deferral opportunities by managing billings and acceleration of payment of costs

The disadvantages of the cash accounting method with long-term contracts is that contractors must spend cash to claim deductions and delay receipts to defer income, which is counter to smart business planning. Aggressive billing may result in acceleration of income.  Also, a declining economy could mean large tax bills in down years due to the inevitable reversal of income deferrals.

Accrual Method

• Revenue reported when billed
• Costs deducted when incurred

The disadvantages to the accrual accounting method are that aggressive billing generally results in acceleration of revenue, accrued losses on contracts are not deductible until the job is complete and tax planning techniques may be counter to business planning.

Percentage of Completion Method

• Ongoing recognition of revenue and income, computed by the stage of project completion when compared to total costs to complete the project
• Based on estimated future costs

The disadvantages to the percentage of completion accounting method are that accrued losses on contracts are not deductible and income can be accelerated due to things like uninstalled materials charged to jobs, overbillings by subcontractors or underestimated total costs to complete a job. The accuracy of the method is dependent upon the accuracy of estimates. Inaccurate estimates could result in inaccurate reporting of tax.

A Note About Alternative Minimum Tax (AMT)

For C-corporations, AMT was repealed for 2018 forward.

The 2018 tax law increased the AMT exemptions for individuals, however AMT continues to apply.  Percentage of completion is required for AMT purposes.  Thus the difference in income between percentage of completion and the income under the taxpayer’s method of accounting for long-term contracts is an adjustment for AMT purposes. If the contractor is organized as a partnership, S-corporation, or sole proprietorship, the owners should evaluate the effect of AMT when selecting their accounting method.

Home builders, as an exception, are permitted to use the completed contract method for AMT.

Larger Contractors

Ave. Gross Receipts > $10 million (or > $25 million starting in 2018)

Larger contractors are required to use the Percentage of Completion method under Code Section 460.

To offset the potential for accelerated income, companies may elect a 10% method, which defers recognition of revenue or costs until a job is at least 10% complete. This method is also allowable under AMT. It may be useful in instances when a contract commences toward the end of a tax year.

Larger companies are also required to use a look-back approach once a job is complete. Income in prior years is recalculated using actual costs, which may result in a change in gross profit for the prior year. Tax is recalculated and compared to tax actually paid for the year. Interest is calculated on the resulting over or under payment.

Code Section 460 also requires companies to allocate certain overhead costs to contracts. This may provide a deferral opportunity if the contractor is diligent in estimating overhead costs that may be allocated to the contract in future years.

To select the most advantageous accounting method or to determine if your company should change its accounting method in 2018, controllers and CFOs may need the guidance of a CPA knowledgeable in accounting for long-term contract rules. It helps to get a second opinion to support the right accounting method for your contracts that is both tax law compliant and offers the best potential for tax planning or deferral.

Continue Reading: Plan Ahead in 2018 for Accounting for New 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.

Let’s say that your company established the completed contract method of accounting for long-term contracts that are exempt from Code Section 460 because its gross receipts fell under the $10 million threshold.

As the company grew, it continued to use this accounting method. It had two very good years in 2015 and 2016. In 2017 average annual gross receipts for 2014-2016 exceeded $10 million for the first time. For contracts that were open in 2016, the company will continue to report income from those contracts under the completed contract method. For contracts that were started in 2017, the company will be required to report under the percentage of completion method in accordance with Code Section 460 for every year until the contracts are complete.

However, for contracts started in 2018, because the gross receipts threshold was adjusted to $25 million, those contracts are exempt from complying with Code Section 460. The company will report those contracts under the completed contract method since it is the company’s established accounting method for exempt contracts.

Then again, if it was decided that it made sense to report 2018 contracts under a different accounting method other than completed contract, the company will need to file for a change in accounting method with the IRS.  The change is not classified as an automatic change; Form 3115 will need to be filed with the IRS prior to year-end.  A user fee (currently $9,500) will also need to be paid in order for the Form 3115 to be processed.

The bottom line is that companies with three-year trailing average gross receipts under the $25 million threshold in 2018 should do an analysis to determine if a change in accounting method makes sense. The analysis should include the following factors:

• Whether an overall method of accounting of cash or accrual is the most advantageous;
• The amount of taxable income deferred under the various accounting methods for long-term contracts;
• The effect of AMT on the owners’ returns given the new AMT exemptions and elevated phase-outs;
• The expected growth rate for the company and the length of time before it is expected to reach the $25 million threshold.

With thoughtful consideration and planning, the proper accounting method for long-term contracts can result in the deferral of a significant amount of income tax, which will help your company manage working capital more effectively.

Download the Whitepaper: 2017 Tax Law Impacts Accounting 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.