As a business taxpayer, you have a decision to make with regard to the construction accounting methods you will use for tax filing purposes. You may be surprised to hear that your best course of action may be a different method from the one you use for reporting to banks and other parties.
Your choice can have an important impact on tax-related cash disbursements over the lifecycle of your business. Effective tax planning relies heavily on the concept of deferring the payment of tax, as long as such an action does not give rise to an offsetting increase in liability if, for example, tax rates go up in the future.
For construction contractors, accounting methods are more varied 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.
Here is a brief overview of construction accounting methods for contractors:
Cash method. Under the cash method, revenue and expense are generally recognized based upon receipt and disbursement of funds. This method provides flexibility in planning for the recognition of taxable income, often driven by a year-end process of disbursing appropriate vendor payables with a goal of reaching a desired profit level.
Accrual method. Under the accrual method, revenue is generally recognized when billing is carried out. Expenses are recognized when invoices are received or costs are determined to exist for which invoices have yet to be received.
Completed contract method (CCM). Under the completed contract method, no profit is recognized on a construction contract until completion of the contract. The IRS prescribes rules that address when a contract is considered to be complete, which may occur before all work is completed or costs have been incurred.
Percentage of completion method (PCM). The percentage of completion method is a variation of the accrual method, wherein revenue recognition is measured not by reference to billing but rather by applying an estimate of relative completion of a contract to the overall contract value.
Financial reporting using generally accepted accounting principles will typically call for the use of the PCM method for construction contracts and the accrual method for non-construction activities; for example, non-construction service activities. The IRS requires taxpayers who have average annual receipts of more than $10 million to use the PCM method for their construction contracts.
For taxpayers with receipts falling under this threshold, one of the other methods or some combination of methods is available. Typically, either the cash or CCM method is selected. The CCM method will often yield a greater opportunity for deferral in recognition of taxable income; however, the underlying accounting is more complicated than the cash method.
Unless construction activities involve home construction, IRS rules require that the PCM method be applied in carrying out alternative minimum tax (AMT) calculations, no matter whether another permissible method is available for regular tax reporting purposes. Understanding the potential impact of AMT on ultimate tax liabilities likely to be due should be an element of the accounting method selection process.
The selection of a construction accounting method is an important component of setting up a business, although establishing your accounting method is vital for a new business in any industry. As a business owner, it is a good idea to seek assistance from your tax advisors in making your decision.