The Down Economy
A good time for contractors to rethink tax opportunities
The construction industry has been hit as hard as any by the recession, now in its
second year. Many small construction companies have ceased to exist while others
have dramatically downsized in order to survive.
One of the few financial bright spots for construction companies is that the recession
offers some a rare opportunity to take advantage of tax saving opportunities.
To fully understand the tax opportunities, it's helpful to examine the rules affecting
contractors.
In an attempt to help small businesses, Congress passed the American Recovery and
Reinvestment Act of 2009. A provision in the law enabled small businesses with a
net operating loss in 2008 to elect to offset this loss against income earned in
up to five prior years. To qualify, a small business had to have no greater than
an average of $15 million in gross receipts over a three-year period ending with
the tax year of the net operating loss.
This change allowed many construction companies to recoup prior tax bills and generate
an influx of cash to help survive the recession in 2009. So what happened? For many,
this cash is gone and most construction companies are still in a survival mode where
cash flow is critical.
A deferral of paying taxes is almost as good as receiving a refund. A change in
how a small construction company accounts for its long-term contracts can provide
such an opportunity, resulting in improved cash flow.
A contractor normally has a minimum of at least two methods of accounting: an overall
method and one or more methods for long-term contracts. Generally, a long-term contract
is any contract for the manufacture, building, installation, or construction of
property where the contract is not completed within the taxable year in which it
was signed.
Internal Revenue Code Section 460 generally requires a taxpayer to determine the
income from a long-term contract using the "percentage-of-completion method." The
percentage-of-completion method requires a taxpayer to include in income the portion
of the total contract price that corresponds to the percentage of the entire contract
that the taxpayer completed during the taxable year. Therefore, under the percentage-of-completion
method, a contractor is required to pay taxes on the gross profit of a long-term
contract that is not yet completed. Paying taxes on the gross profits of incomplete
contracts puts a cash flow strain on companies because often taxes are paid before
profits are collected.
IRC Section 460(e) provides two exceptions for requiring the use of the percentage-of-completion
method for long-term contracts: home construction contracts and the "small contractor
exception."
In order to meet the small contractor exception, two requirements must be satisfied.
First, at the time the contract was entered into, it must have included an estimate
that it would be completed within a two-year period beginning on the commencement
date of the contract. Second, the contactor's average annual gross receipts for
the three taxable years preceding the year in which the contract was entered into
did not exceed $10 million.
If a construction company meets the small contractor exception, then the completed
contract method may be used for accounting for long-term contracts rather than the
percentage-of-completion method. Under the completed contract method, the taxpayer
does not report income until a contract is complete, thus deferring the income taxes
on the gross profit of a long-term contract until the year the contract is completed.
In determining the tax benefits of utilizing the small contractor exception of IRC
Section 460(e) and accounting for long-term contracts under the completed contract
method, one must take into consideration the Alternative Minimum Tax (AMT). When
calculating AMT, the percentage-of-completion method must be used when accounting
for long-term contracts. Corporations with average annual gross receipts of $5 million
or less qualify for exemption from AMT. After the first year of qualification, the
corporation will continue to qualify as long as average gross receipts do not exceed
$7.5 million.
In these difficult times during which many construction companies have seen their
revenues decrease, the small contractor exception may now be available to many contractors
that could not meet the $10 million gross receipts test in the past. Meeting the
exception and using the completed contract method to account for long-term contracts
could mean additional cash flow in the form of tax deferrals.
Scott Handwerger, CPA, of Gross, Mendelsohn & Associates can be reached at SHandwerger@gma-cpa.com.