The adoption of an appropriate accounting method for long-term contract is key to ensure that your company is in the most tax advantageous position possible. Thanks to the Tax Cuts and Jobs Act, other reporting methods are now permissible for construction contractors who meet certain thresholds.
Contractors generally utilize the percentage-of-completion method (PCM) when accounting for long-term contracts for tax purposes. However, this does not apply to construction contracts entered into that is estimated to be completed within the two-year period beginning on the contract commencement date and also meets the gross receipts test for the taxable year in which the contract is entered. Contractors that previously met these requirements were able to elect the small contractor exemption. Effective January 1, 2018, the gross receipts threshold increased from $10 million to $25 million during the three prior years as part of the Tax Cuts and Jobs Act (TCJA). This has allowed contractors within these thresholds to elect a better suited tax method like completed contracts or even cash method. The small contractor exemption only applies to contractors who meet the two-year requirement and receipts threshold.
For those considering the adoption of the cash method under the Tax Cuts and Jobs Act, there is a key distinction based on a contractor’s corporate structure. C-corporations or partnerships can only use the cash method if their average annual gross receipts does not exceed $25 million for the three-taxable-year period. In most cases, S-corporations can use the cash method as an overall tax method regardless of gross volume.
When calculating the total amount of gross receipts for the small contractor exemption, an entity must also factor in receipts from commonly controlled entities and joint ventures. If a contractor has 50% or greater ownership in a commonly controlled entity or joint venture, this will need to be included as income for the gross receipt calculation. If a contractor’s ownership interest is only 5% - 49%, then the contractor must aggregate a proportionate share of any construction-related gross receipts.
In the instance that a contractor wants to change their contract accounting method they must file form 3115. For contractors who were previously forced to PCM due to the $10 million threshold and are now under the $25 million threshold, filing of a 3115 is not required if you would like to return to the prior method used, as long as it is still an acceptable method. If in future years a contractor ends up exceeding the average gross receipts threshold, they are not required to notify the IRS, however they will need to implement the PCM for all new contracts for the following tax year.
Upon switching accounting methods for long-term contracts, a contractor is to only use the new method of accounting in the taxable year of adoption. For any contracts started in a prior year, the contractor must account for those contracts under the prior long-term contract method. It should be noted that if switching from the cash method to the PCM or accrual method, for cut-off purposes, contractors should compute the status of each contract on the cash basis as the contract enters the tax year. A 481(a) adjustment may be needed as a “catch-up” when switching from one method to another.
Contractors structured as S-corporations should be cognizant of the fact that if they are utilizing the small contractor exemption, there is a possibility that they may be subject to Alternative Minimum Tax rules (AMT). For tax purposes, if you use a method other than PCM, you will need to report an AMT adjustment for the difference between the two methods on the Company’s tax return.
Implementing the most tax advantageous accounting method related to long-term contracts could make a significant financial difference for a contractor. It is important to meet with your tax advisor to discuss what methods are most beneficial for your company.