The IRS requires all taxpayers, businesses included, to determine their taxable income within an annual accounting period (i.e., a tax year) using a consistent practice. To do this, taxpayers must use a predetermined accounting method (or a combination of accounting methods).
Determining which accounting methods to use for taxable income in your contracting business is a critical decision. Choosing the right option can allow you to defer taxes and improve cash flow.
What are your options?
The most commonly used accounting methods are the cash method or accrual method. (If your business provides financial statements, you’re required to use the accrual basis of accounting to comply with GAAP. However, you must also choose an accounting method for calculating your annual income tax.)
If required, you’ll need to also choose an accounting method to calculate your taxable income on long-term contracts (the most common methods are the completed contract method or percentage-of-completion method).
One thing to know: Your business’ size will dictate its eligibility for certain accounting methods. If you qualify for the small business exemption (available to contractors with $29 million and under in average gross receipts based on the three-year average of gross receipts for 2023, 2022, and 2021), you’ll have more options than your larger counterparts.
It’s important to get familiar with your options and carefully weigh their pros and cons with an expert. Here’s a brief summary of methods that could be available to you.
Cash method vs. accrual method
These are the two main tax methods of accounting for any business. Small business contractors are permitted to use either; contractors that do not qualify are limited to the accrual method.
Cash method
Allows the deduction of expenses when paid and recognizes revenue when received. If you qualify for the cash method, the work-in-process determined from a job schedule is not considered to be part of taxable income.
Accrual method
Under this method, you recognize revenue in the year it is earned and expenses in the year they are incurred.
Completed contract method vs. percentage of completion method
These methods represent two ways to account for revenues in long-term contracts.
Completed contract method
This method lets you to defer revenue from all uncompleted contracts and recognize revenue only from completed contracts. Only homebuilders and small contractors who pass the gross receipts test can use this method.
A few things to keep in mind:
- In order to be considered a home construction contract, the contract must show at least 80% of the costs are for improving dwelling units with four or fewer units.
- Small contractors’ contracts should be expected to be completed within 2 years at the commencement date. If your average gross receipts surpass the gross receipts threshold and you are no longer eligible to use the completed contract method you must adopt the percentage-of-completion method.
- When using the completed contract method, you also need to evaluate for alternative minimum tax (AMT). This is because the completed contract method can only be used for home-construction contracts to determine AMT. For any other contracts, you must use the percentage-of-completion method and determine their AMT income.
Percentage-of-completion method
This method allows you to calculate percentage of completion by comparing costs incurred under the contract to estimated costs, and then recognizing the same percentage of total estimated contract revenue. Any contractor can use the percentage-of-completion method.
A couple things to note:
- While using the percentage-of-completion method, you may elect to exclude income recognition for contracts less than 10% complete. This is known as the “10% election.”
- Do you need to perform a look-back computation? If you are using percentage-of-completion, you must also determine if you need to perform this computation. Under this requirement, you either pay or receive interest on the amount of tax liability that was deferred or accelerated as a result of management estimates for the contract price and costs.
- Homebuilders and small contractors are exempt from the look-back requirement.
- The look-back requirement also does not apply to specific contracts if they are completed within 2 years or if the gross contract price is less than $1 million or 1% of annual gross receipts for the prior 3 years.
Determine which method is best for you
When you’re overwhelmed with projects, it can be hard to think about accounting methods or know when it could be tax-advantageous to make a change.
This is where JAK + Co. can help. We can guide you through your options and make sure you’re using the best ones for your business. If you need to make a change, we can help you do so when you file your tax return.
To learn more about how JAK + Co. could help your contracting business, give us a call anytime.