Tax Accounting Methods for Contractors

By Abe Livchitz, CPA, Senior Tax Manager
ASL Construction Group 

Contractors are unique clients operating in a specialized industry. They are resourceful, creative, thrive working under pressure of tight deadlines and constantly racing to stay ahead of economic downturns. To honor their uniqueness the tax code allows contractors to use two accounting methods that are distinctive to their business.

Contractor Accounting Methods

Unlike most taxpayers, contractors generate revenue from sales (jobs) that start in one tax year and end in a future tax year. As a result, the tax code has special provisions for long-term contract accounting. Generally, contractors are required to use the percentage of completion method. However, there are several exceptions to this requirement that are discussed in this article. Under this method, contract revenues and costs are recognized as the job progresses based upon the percentage of job costs incurred to date vs. estimated total job costs. The cost-to-cost method is the only method allowed for tax reporting. This is the method generally used by contractors for financial statement reporting but the method does not offer significant tax deferral opportunities. Accurately estimating job costs is a key to minimizing a contractor’s tax liability when using this method.

An exception to the percentage of completion requirement is provided for “Small Contractors.” To qualify, the contractor’s average annual gross receipts for the three prior tax years cannot exceed $10 million and the contract cannot have an estimated duration exceeding two years. The two-year rule is applied to specific contracts so a contractor meeting the gross receipts test could  have a few long contracts that must be accounted for under percentage of completion (two year rule not met) while their remaining contracts qualify for the exception.

Another exception is provided to “Home Construction Contracts.” A contract qualifies if 80% or more of the contract costs are for the construction, reconstruction, or rehabilitation of dwelling units in buildings containing four or fewer units.

If a taxpayer qualifies for either of these two exceptions they can use a variety of tax reporting methods, including cash receipts and disbursements, accrual, accrual excluding retentions receivable and payable, and completed contract.

The completed contract method offers the best tax deferral opportunity, as profit from jobs is deferred until the tax year the jobs are completed. Both contract revenues and contract costs are deferred and recognized upon job completion.

This article briefly discusses the tax reporting methods available to contractors. Contact a member of the ASL Construction Niche to learn more about how the various alternative choices can impact your business.