Is your construction company eligible for a small business taxpayer exception?
Construction contractors should review their method of accounting to determine if a small business taxpayer exception may apply which would exempt them from applying the percentage-of-completion method (“PCM”) to long-term construction contracts.
Overview of Small Construction Contract Requirement to Use Percentage-of-Completion Method
Final regulations were published in the Federal Register on January 5, 2021, to reflect legislative changes implemented by the Tax Cuts and Jobs Act which expanded the exception for small construction contracts from the requirement to use the PCM. The final regulations generally affect taxpayers with average annual gross receipts of not more than $25 million, as adjusted for inflation. The final regulations are applicable for taxable years beginning on or after January 5, 2021; however, these regulations may be applied for tax years beginning after December 31, 2017, and before January 5, 2021, provided certain criteria are met. A change in accounting method may also be required.
Long-term contracts are governed under IRC. Sec. 460 which requires certain businesses to use the PCM to account for income and expenses related to long-term contracts. Under the PCM, income is recognized over the life of the contract based on the percentage of estimated costs incurred to date. A long-term contract is defined as any contract for the manufacture, building, installation, or construction of real property if the contract is not completed within the tax year in which it is entered. A contract that extends beyond the tax year in which it is entered into is considered a long-term contract although the contract may last less than 12 months. The PCM also involves a look-back rule which generally requires a taxpayer to pay or receive interest on the hypothetical under or overpayment of tax that is deferred or accelerated as a result of timing differences resulting from inaccurate estimates of contract costs and price over the duration of the project.
The general requirement to use the PCM does not apply to an exempt construction contract which includes any home construction contract or other construction contract. A long-term construction contract is a home construction contract if 80% or more of the estimated total contract costs are attributable to residential construction containing four or fewer dwelling units plus the related land improvements. The final regulations clarify that other construction contracts must be entered into after December 31 2017, in a taxable year ending after December 31, 2017, by a taxpayer, other than a tax shelter prohibited from using the cash method of accounting, who estimates at the time such contract is entered into that such contract will be completed within the 2-year period beginning on the contract commencement date, and who meets the gross receipts test for the taxable year in which such contract is entered into. The gross receipts test is governed under IRC Sec. 448 which sets forth limitations on a taxpayer’s ability to use the cash method of accounting. In general, a taxpayer (other than a tax shelter) meets the gross receipts test for any taxable year if the average annual gross receipts for the prior 3 taxable years does not exceed $25,000,000 adjusted annually for inflation. Taxpayers qualifying for one of these small business taxpayer exceptions can use the completed contract method (“CCM”) of accounting.
Completed Contract Method of Accounting for Small Business Taxpayers
The CCM allows a taxpayer to defer the recognition of income and related tax liability until the contract is completed. Under the CCM, the date of completion is based upon the earlier of the tax year in which the customer uses the subject matter for its intended purpose and at least 95% of the total allocable contract costs have been incurred or final completion and acceptance of the contract. Even though a small contractor can use the CCM for tax purposes, a taxpayer subject to the alternative minimum tax must use the PCM to compute alternative minimum taxable income from any long-term contract except for a home construction contract. The Department of Treasury and the IRS expect that the modifications to the exempt construction contract including the liberalized gross receipts will increase the number of taxpayers qualifying as a small business taxpayer. Residential land developers reporting under the CCM should evaluate the finalized regulations to ensure that the correct method of accounting is utilized. In recent years, the IRS initiated a compliance campaign specifically targeting large residential land developers from misclassifying land development contracts and improperly using the CCM by deferring all income until completion of the entire development. Careful consideration should be given when determining the method of accounting for long-term contracts.
Questions on accounting methods for long-term contracts or other tax provisions for your construction company? Please contact your tax advisor or Keiter representative or Email | Phone: 804.747.0000. We are here to help.
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The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.