Keeping books is so important. It overlooks aspects of the construction business. It’s the most important part of your business. You “live and die” by your job cost numbers. It’s the only way to find out if you are estimating accurately, whether you making a profit or whether certain type of jobs is even worth undertaking. This is the key to the accounting challenge in the construction industry.
BARR CPA LLC will leverage the power of QuickBooks to get the accounting done. We will show you some of the workaround and tricks needed to record transaction unique to contractors. QuickBooks is a generic software and was not design specific for construction business.
We extend beyond contractors to include service professionals who offer business services. Are you a General and Specialty Contractor, Remodeler, Builder, Building Maintenance, Handyman, Landscaper, Interior and Exterior Designer? Is your focus New Construction, TI's, Residential Remodel, or Service and Repair? Sales & Use Tax for General Contractors.
The sales and use tax treatment of a construction contractor is complicated by the varying roles that a contractor may assume in fulfilling a contract or performing a job. Generally, contractors can act as either retailers or consumers, depending on the nature of the work involved in a particular project. On other projects, contractors install or apply tangible personal property as a real property improvement and are treated as the consumers of the incorporated materials. As consumers of the materials incorporated into the project, contractors are subject to tax on the cost of the materials so incorporated.
On other projects, contractors install or apply tangible personal property as a real property improvement and are treated as the consumers of the incorporated materials. As consumers of the materials incorporated into the project, contractors are subject to tax on the cost of the materials so incorporated. Distinction between real and tangible personal property. Actual physical Annexation of an Item to the Real Property
Generally, the tax jurisdiction evaluates the degree of attachment of an item to the real property and whether its removal would cause irreparable damage to the real estate. If the degree of annexation of an item is sufficient to cause irreparable damage to the real estate upon the item’s removal, the item installed or applied is more real property than tangible personal property. By contrast, if tangible personal property is easily removed from the real estate without damaging its function or use, that would generally be evidence that the item installed or applied retained its character as tangible personal property.
Application or Adaptation of an Item to the Purposes to Which the Real Property Is Devoted. Another issue that often arises involves the treatment of the construction contractor when the construction contractor is performing a contract for a tax-exempt entity or organization. In some jurisdictions, contractors performing real property improvements for tax-exempt entities or organizations are allowed to assume the exempt status of the tax-exempt entity or organization in making purchases of tangible personal property for incorporation into the real estate of the tax exempt entity or organization. In other states, the contractor is taxed as a consumer of the materials incorporated into the real estate of a tax exempt entity or organization.
Repair Transactions in many instances, the contractor acts as a repairer of property. When the contractor repairs real estate, in most states the contractor is treated as the consumer of materials and owes tax on the cost of materials incorporated into the project. The labor associated with the repair of real estate is typically not subject to tax. The contractor acts as a retailer of the property when the contractor repairs tangible personal property.
Small construction contractors often use the cash method of accounting. Under this method, cash receipts are recorded as income when payments are received. Expenses are deducted when they are paid. A construction contractor is not allowed to use the cash method if the business is a corporation or in a partnership with a corporate partner. The cash method is also not permitted for a construction contractor with annual gross receipts exceeding $10 million. There is no exception to this limitation.
In addition, a construction contractor may be disallowed from using the cash method if the total purchases of "merchandise" for the year are "substantial" compared to annual gross income. Merchandise is any item physically incorporated in a product for customers. For the construction industry, merchandise is commonly called materials, such as lumber or concrete. Merchandise is generally considered to be substantial when it is at least ten to fifteen percent of gross income for the year. This percentage is not established by statute, but has been applied in some court cases.
It is not surprising that many contractors are not employing the most advantageous accounting method for their tax returns. The literature on the subject is often confusing, if not ambiguous, including that published by the Internal Revenue Service. Perhaps contributing to the overall confusion of construction tax accounting is the myriad of methods available to most contractors:
- Accrual with Deferred Retainages
- Completed Contract Method (CCM)
- Exempt-Contract Percentage of Completion Method (EPCM)
- Percentage-of-Completion Method (PCM) or Cost-to-Cost as required by IRC Section 460
- Percentage-of-Completion Simplified Cost Method
- Percentage-of-Completion 10% Method
- Percentage-of-Completion Capitalized Cost Method (PCCM)
In addition, there are a number of exceptions and sub methods within many of the above-mentioned methods of accounting, contributing to the difficulty in understanding construction tax accounting in general. The Internal Revenue Service allows this extensive variety of accounting treatments for taxes on the part of contractors in order for them to clearly reflect their income on their tax returns, given the diversity of contracts, conditions, and circumstances in the construction industry.
Also compounding the confusion surrounding construction tax accounting is the practice within the industry of a contractor having a minimum of at least two methods of accounting. Typically, contractors have an overall method of accounting, such as the cash method, the accrual method, or some hybrid method of accounting. In addition, they have one or more methods for its long-term contracts, such as the percentage-of-completion method, the percentage-of-completion capitalized cost method, and the completed-contract method of accounting for long-term construction contracts. Although Section 460 of the Internal Revenue Code generally requires large contractors to use the percentage-of-completion method of accounting for long-term construction contracts, small contractors are exempted from this requirement in Section 460(e)(1)(B)(ii), wherein small contractors are defined as those contractors having average annual gross receipts not exceeding $10 million over the past three preceding taxable years.
Many CPA are unaware of the variety of methods available to contractors, who lack a correct understanding of the details of implementation of these various methods of accounting, and who have failed to select the most appropriate tax accounting methods for their contractor clients, given their individual characteristics, conditions, and circumstances.
As a CPA to general contractors, I attempt to select the tax accounting methods that result in the greatest deferral of taxes for my clients. Typically there are two methods that accomplish this objective for small contractors (as defined above): the cash method of accounting and the completed-contract method of accounting. Of course, the cash method defers the recognition of revenues upon the receipt or constructive receipt of cash, whereas, the completed-contract method of accounting defers the recognition of any income on a contract until its completion. Since many of the contractors that I have dealt with had revenues and receipts of less than $10 million annually, I typically recommended the cash basis of accounting for their overall method of tax accounting.
In 2001, Revenue Procedure 2001-10 allowed the use of the cash basis of accounting by contractors with average gross receipts not exceeding $1 million. While in the following year with the issuance of Revenue Procedure 2002-28, this gross receipts threshold was increased to $10 million for all non-tax-shelter contractors, except for C corporations and partnerships with a C corporation member, which were restricted to a $5 million gross receipts threshold. As a result, many of the contractors for whom I prepared tax returns were able to use the cash basis method of accounting since they were organized largely as S corporations or limited liability companies consisting entirely of individuals as members.
So how does the cash basis of accounting work for these small eligible contractors when there are contracts-in-process open at year-end? These contractors can account for them as materials and supplies that are not incidental under Treasury Regulation Section 1.162-3. That is, they would recognize the deduction of contract costs when those materials, supplies, subcontract and direct labor, and other construction costs are used and consumed in the construction process or when they pay for those costs, whichever occurs later. Of course, revenues would be recognized upon receipt or constructive receipt of cash.
However, as mentioned previously, these small contractors are allowed to use a different method of accounting for long-term construction contracts. And long-term construction contracts are simply contracts that are open or in process at year-end. So instead of accounting for open contract costs as materials and supplies that are not incidental under Section 1.162-3, these small contractors can simply elect to defer all revenues and expenses associated with these contracts under the completed-contract method of accounting for long-term construction contracts. Presuming in general open contracts would ordinarily generate additional income over their contract lives, as a contractor I would elect the completed-contract method as my long-term construction contract method of accounting, since it would tend to maximize my deferral of tax liabilities over time, rather than simply elect the cash basis of accounting under Revenue Procedure 2002-28, and risk recognizing taxable income on contracts-in-process.
Revenue Procedure 2002-28 has simplified tax accounting matters and methods for many small contractors. Since the majority of them are organized as limited liability companies or S corporations, they can elect the cash basis of accounting as their overall method of accounting and the completed-contract method of accounting as the method of accounting for all long-term construction contracts. In general this set of elections will result in the greatest deferral of tax liabilities for the contractor and provide a very important boost to cash flows, especially in these dire economic times for contractors. However, it is important to make these selections upon filing your initial tax returns; otherwise a change in accounting method would be required, necessitating the filing of Form 3115, Application for Change in Accounting Method. Even more important, if your current CPA failed to select the most appropriate tax methods of accounting for your construction business, requiring the filing of Form 3115 to change from your current accounting methods, perhaps it may be time for you to consider a change in accountants, too. If such is your situation, please contact us: we would be glad to assist you.
We keep abreast of tax law changes throughout the year to ensure that you are taking advantage of ALL tax incentives within the limits of the law.