One significant alteration under the Tax Cuts and Jobs Act is the change in the definition of a “small contractor.” The requirement to account for revenue and cost of revenue on long-term contracts using the percentage of completion method has been loosened. For years beginning after 2017, contractors whose average annual gross receipts are less than $25 million for the three prior taxable years are now considered “small contractors” and are not required to use percentage of completion. Previously, the gross receipts threshold was $10 million. This change will certainly allow some additional deferral of taxable income to many construction contractors, who will now qualify as small contractors for the first time in recent years.
With this development, it is a good time to review the various exceptions to the general requirement that the percentage of completion method of accounting be used to determine taxable income from construction contracts.
As is true with most tax planning, the planning around choice of tax accounting methods is directed at deferral of taxable income. For the construction contractor, the goal is to find situations in their operations that will allow them to postpone the recognition of income from specific contracts by using a slower recognition method, such as the completed contract method, rather than the percentage of completion method.
It is helpful to define some terms and provide some background relevant to contract accounting:
- These rules apply at the contract level, rather than at the taxpayer level. Consequently, a taxpayer may have contracts that are subject to percentage of completion accounting and others that are not.
- A “long-term contract” is defined as any contract for the manufacture, building, installation or construction of property if such contract is not completed within the taxable year in which such contract is entered into.
- The definition of “construction contractor” generally excludes architects, engineers, construction managers (who bear no risk of loss because of material or construction defects) and commercial painters.
The most well-known strategy for tax deferral by contractors is the application of the aforementioned small contractor exception. The caveat to owners of pass-through entities that qualify for use of the completed contract method under this exception, however, is that in determining their alternative minimum taxable (AMT) income, they still must use the percentage of completion method on long-term contracts. For C corporations, the repeal of the corporate AMT eliminated this consideration.
Another popular exception to the required use of the percentage of completion method is the “home construction contract” exception. Unlike the small contractor exception, this provision applies for both regular tax accounting and AMT accounting.
For the purposes of this exception, a home construction contract is defined as a construction contract where 80% or more of estimated total contract costs are reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of dwelling units and real property directly related to dwelling units and located at the site of the dwelling units in buildings containing four or fewer dwelling units.
When applying the completed contract method to home construction contracts, it is important to understand when a contract is considered complete; this is when all revenue under the contract will be recognized and related costs deducted. Under the law, a contract is complete at the earlier of when:
- The subject matter of the contract (generally, the building) is at the point of use by the customer for its intended purpose and at least 95% of the total contract costs attributable to the building have been incurred by the builder, or
- Final completion and acceptance of the building by the customer.
There have been several fairly recent cases and rulings around the definition of the subject matter of a home construction contract, involving taxpayers seeking to include amenities (such as clubhouses) and roads and utilities (as part of the entire development) in the contract in order to extend the completion date. In some instances, the taxpayers have prevailed and in others the IRS has. You should discuss such situations with your CSH tax advisor, if they arise.
Another strategy available to construction contractors to defer taxable income on construction contracts is the “10% Method.” Under this rule, a taxpayer who is otherwise required to use the percentage of completion method may elect not to recognize income under a contract, if, as of the end of the year, less than 10% of the estimated total contract costs have been incurred on the contract. This method can’t be used by a taxpayer that has elected the simplified cost-to-cost method of computing percentage of completion, which generally allows a taxpayer to compute percentage of completion based mainly on direct costs under the contract.
With the focus of much tax planning on deferral of income, it is prudent for construction contractors to take full advantage of opportunities to do so. This can be accomplished through adoption of contract accounting methods permitted under the law. If you would like to learn more about the strategies discussed in this article, please contact your CSH tax advisor.