Tax Accounting for Construction

With the passing of the Tax Cuts and Jobs Act (TCJA), contractors with average annual gross receipts less than $26 million for the three prior taxable years are now considered “small contractors” and are not required to use the percentage of completion method (PCM) for years beginning after 2017. This modification will certainly allow more taxpayers the opportunity to defer taxable income, since prior to TCJA the gross receipts threshold was $10 million.

Internal Revenue Code (IRC) 460(f) defines “long-term contract” as “any contract for the manufacture, building, installation or construction of property if such contract is not completed within the taxable year in which such contract is entered into.” With all the various types of contractors and possible circumstances, it’s important to understand how to properly apply the provisions of IRC 460 to your particular situation.

Simply stated, if the construction contract meets the definition of long-term, contractors are required to use the PCM to compute taxable income. While this is a general requirement, exceptions do exist for home construction contracts or if the entity is classified as a small contractor: 1) the taxpayer estimates that the contract will be completed within two years, and 2) average annual gross receipts do not exceed $26 million.

Contractors who don’t meet the above exceptions have another method to defer taxable income with an election under IRC Section 460(b)(5), under which they can delay recognition of gross profit from long-term contracts accounted for under the PCM until the first tax year in which the contract is more than 10% complete.

For the recognition of contract losses, Generally Accepted Accounting Principles (GAAP) and the IRC handle things differently. GAAP requires the contractor to report the total loss on a contract as soon as it’s evident the loss will occur. The IRC, on the other hand, requires taxpayers to recognize the loss as the job is completed (if on the completed contract method) or based on the percent complete (if on the PCM).

A warning: owners of S corporations and partnerships who are not required to use the PCM may owe alternative minimum tax (AMT). IRC Section 56(a)(3) states that the PCM must be used for long-term contracts for alternative minimum tax purposes. For C corporations, the repeal of the corporate AMT eliminated this consideration.

It’s important to know that recent changes triggered by tax reform may change a company’s ability to defer income for tax purposes. For assistance in determining whether your company could benefit from these changes, please contact a member of the Schneider Downs Construction Industry Group.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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