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TCJA Opens Doors to New Accounting Methods

12/17/2019 Dan Kraft

Tax law reform

Although the Tax Cuts and Jobs Act (TCJA) was signed into law more than a year ago, its impact continues to reverberate. Just one example of this is that, because of changes wrought by the law, many construction companies can now choose from a wider variety of accounting methods for tax purposes.

Count your cash

Many contractors have grown accustomed to the assumption that they must use the percentage-of-completion method for federal income tax purposes. But this may no longer be the case.

The TCJA raises the gross receipts threshold for many types of contracts from $10 million up to (but less than) $25 million averaged over the past three years. Doing so will classify more construction companies as “small businesses,” allowing them access to a wider array of accounting methods.

Perhaps most notably, you may now be able to choose the cash method of accounting for federal tax purposes. This is the least complicated way to report revenue and, eventually, file your taxes.

Under this method you recognize income when you receive cash from a project owner and, likewise, recognize expenses when you remit cash to suppliers. It may not be feasible for construction businesses with multiple, complex jobs. But, if the cash method would suit your company, it’s well worth considering.

Using the cash method removes the temptation to “work up different scenarios” for taxable income and tax liabilities. One of the traps some contractors fall into is shying away from growing their companies out of fear that paying taxes on higher income levels will become untenably costly. The cash method can help prevent this by keeping things simple and allowing a contractor to stay focused on completing jobs and getting paid without fear of tax on “excessive profitability.”

Look to other changes

Another important new wrinkle is that, under one regulation, construction companies executing home construction contracts aren’t required to use the percentage-of-completion method. From a tax perspective, home construction is identified as a project under which the builder expects at least 80% of the costs (including land) to be used for buildings with four or fewer dwelling units. This includes improvements to those units.

Still another notable development relates to construction companies that estimate (at inception) that their contracts will be completed within two years of commencement. They’re exempt from the percentage-of-completion method for income tax purposes, so long as those businesses earn less than the gross receipts threshold mentioned above.

Strive for simplicity

If you’d prefer to continue using the percentage-of-completion method, there may still be a simpler way to handle it. As you may know, federal tax law requires construction businesses that report under the percentage-of-completion method to use a cost-to-cost comparison to make their calculations. Doing so entails estimating the total cost to complete for each project at regular intervals, because the calculations will likely be inaccurate otherwise.

If you’ve grown weary of using cost-to-cost comparisons to report under the percentage-of-completion method, you may choose the exempt-contract percentage-of-completion method. This allows you to use another permissible method to derive the percentage of completion so long as “such method is used consistently and clearly reflects income.”

Two examples of “another permissible method” cited in IRS regulations are:

  1. “… comparing direct labor costs incurred to date to estimated total direct labor costs,” and
  2. “… comparing the work performed on the contract with the estimated total work to be performed.”

You may also want to look at how you account for postcontract completion income, such as warranty work on your tax returns, because there are different options there.

Construction businesses may prefer the exempt-contract percentage-of-completion method because their in-house engineers can more easily estimate the percentage of completion by quantifying what (operationally) has been performed on the job so far and dividing that by the total of all the work contracted to be performed on the entire job’s work schedule.

Some contractors may already be using the exempt-contract percentage-of-completion method and not even know it. Others may gain clarity and improve efficiency from choosing this more formally as their new accounting method.

Plot your move

These are just a few of the ideas and issues involved with changing your tax accounting method in light of the TCJA. Thoroughly plot any move you’re considering with your CPA, because a change of accounting method will require an IRS filing and the overall impact on revenue and tax impact isn’t always clear-cut.

One final word of caution: A construction business that makes an accounting method change may have to report what’s called a Section 481(a) adjustment to differentiate construction contracts already in place, where retainages may have already been billed or accrued, from upcoming contracts. Again, your CPA can explain further.

Straight accrual method offers simplicity

If your construction company is no longer required to use the percentage-of-completion accounting method for tax purposes, a straight accrual method may now suffice. You’ll likely find this a simpler approach to reporting revenue for tax purposes.

When using a straight accrual method, be careful about your treatment of retainages. You may want to treat these amounts as income, so your tax returns will reflect retainages as income when you bill the gross amounts as progress billings.

IRS regulations provide two choices for reporting retainages when using the accrual method. You can use either the straight accrual method or wait “… until you have an unconditional right to receive [the retainages].” Choosing the latter option could significantly reduce your construction company’s taxable income, which, in some instances, could be more advantageous.

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