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How to Choose the Best Accounting Method for a Construction Business

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There are special tax rules that control the accounting method you must use for your construction business. Generally, you choose your tax accounting method when you file your first tax return for the business.

Your choice of accounting method depends on:

  1. the type of contracts you have,
  2. your contracts' completion status at the end of your tax year, and
  3. your average annual gross receipts.

Most construction businesses use two different tax accounting methods: one for their long-term contracts, and one overall method for everything else. A long-term contract is any contract that is not completed in the same year it's started.

The majority of construction businesses use the Accrual Method for their overall method of accounting. See the Accrual section for information on the Accrual Method.

1. The Cash Method of Accounting

There are significant limitations on who can and cannot use the cash method of accounting.

How Does the Cash Method of Accounting Work?

A contractor using the cash method of accounting reports cash receipts as income when received, and deducts expenses when paid. If you pay an expense that benefits you for more than one tax year, you must spread the cost over the period you receive the benefit.

Example: You pay $1,000 in Year 1 for a business insurance policy that is effective for one year, beginning July 1st. You can deduct $500 in Year 1 and $500 in Year 2.

Using the cash method, income may be actually or constructively received. If you received a check from a customer in Year 1 but did not deposit or cash it until Year 2, it is still included in income in Year 1 because that's the year you actually received it.

Constructive receipt occurs when you have unrestricted access to income you have earned.

  • If a customer called you in December and told you that a payment for a job was ready, but you didn't pick it up until January, you would have constructive receipt of the income in December.
  • If someone else receives the money for you, you have constructively received the money.

The key to constructive receipt is IF you could have received the money in one year but chose not to receive it until a later year; if this is the case, it must be included in your income in the first year as if it had been actually received in that year. You cannot postpone including it in your income until the next year.

What are the Limitations on the Use of the Cash Method?

There are two situations in which your use of the cash method of accounting can be limited.

  1. First, you are not allowed to use the cash method if your business is a corporation or a partnership with a C corporation as a partner whose average annual gross receipts exceed $5 million. There is no exception to this limitation.
  2. Second, depending on what type of business you have, you may not be allowed to use the cash method if your total purchases of "merchandise" for the year are "substantial" compared to your gross income for the year.

So, what do the terms "merchandise" and "substantial" mean?

Merchandise includes any item physically incorporated in a product you transfer to your customers. In the construction industry, merchandise is commonly called materials. For example, the lumber used to frame a building is merchandise for tax purposes.

Merchandise is generally considered to be substantial when it is at least 10% - 15% of your gross income for the year. This percentage is not a hard and fast rule, but a guideline used in some court cases.

2. Accrual Methods of Accounting

If you can't use the cash method, you must choose an accrual method of accounting. In the construction industry, there are several specialized accrual methods available, each of which has its own set of rules and limitations. In general, all accrual methods attempt to match the expenses that relate to a specific contract to the income from that contract.

Choosing an Accrual Method

Choosing a permissible accrual method of accounting for tax purposes involves the three steps discussed below. As your business grows and changes, you might have to use a different method of accounting. You should review the following three steps every year to ensure that you are using a permissible method of accounting for your construction contracts.

Step One - Classify all Construction Contracts as either Short-Term or Long-Term.

A long-term contract is any contract that spans a year-end. If you have a contract that you start on December 26th but do not complete until January 23rd, you have a long-term contract. Therefore, a short-term contract is any contract you start and finish within one taxable year.

Use your overall method (i.e. accrual or cash, if allowed) for your short-term contracts. You must then choose an accounting method for all your long-term contracts. The rest of these steps will lead you through the process of choosing your long-term contract accounting method.

Step Two - Classify all Long-Term Contracts as either Home Construction or General Construction Contracts

Home Construction Contracts are contracts for work on buildings that have four or fewer dwelling units. Eighty percent or more of the estimated total contract costs must be for the construction, improvement, or rehabilitation of these units. If a contract is not a home construction contract, it is a general construction contract.

Example: Contracts to build single-family homes, duplexes, triplexes, or quadplexes would be home construction contracts. Contracts to build apartment buildings would not be home construction contracts.

Step Three - Classify Yourself as Either a Small or Large Contractor

This is a two-part step. The first part is to measure your average annual gross receipts for the last three tax years of your construction business. If the amount is $10 million or less, you are a small contractor. If it is more than $10 million, you are a large contractor and do not have to consider the second part of this step. Large contractors are required to account for long-term contracts using the percentage-of-completion method (PCM) for their general construction contracts. Under PCM, contract income is reported annually according to the percentage of the contract completed in that year. For example, if a contract is 50% complete at the end of the taxable year, 50% of the contract income would be included in taxable income.   

If you are a small contractor, the second part of this step requires that you separate your long-term general construction contracts into two categories. The first category is those contracts that are reasonably likely to be completed within two years from the date work begins.

The second category is long-term general construction contracts that you estimate will take two years or more to complete. For these longer-duration contracts, you must use a large contractor method, even though you are a small contractor.

Example: Carl's Construction had average annual gross receipts for the last three tax years of less than $10 million. In 2000, Carl had 20 contracts.

At the time he entered 19 of the contracts, he estimated they could be completed in less than two years from when they were started. He estimated one of the contracts would take three years to complete. Carl will use the large contractor rules for that one contract and the small contractor rules for the other 19 contracts.

Example: Use the same facts as the last example, except assume Carl's Construction had average annual gross receipts of $12 million for the last three tax years. Since his average annual gross receipts for the last three years were over $10 million, Carl is required to use the large contractor rules for all of his contracts. The estimated completion time of the contracts does not matter.

The kind of accounting system you choose should depend on the type of business you will be running. Planning your accounting system ahead of time can save you  a  lot of headaches later.

 

This article courtesy of the Internal Revenue Service whichcan be found on the web at http://www.irs.gov

Tags: Costs, Estimating Construction



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