Reviewing 10 Tax Accounting Methods for Construction and Real Estate Companies
Are you still using the optimal accounting method to handle your construction or real estate company’s tax deferrals? Depending on your business earnings, as well as your typical contract type and length, you can choose from various methods to align tax payments with contract revenue.
In fact, the IRS Construction Industry Audit Technique Guide lists 10 tax accounting methods for “long-term” construction contracts — that is, contracts not completed within the same tax year as they were entered:
1. Cash. Under cash-basis accounting, a construction business reports income when payments are received and deducts expenses when they’re paid. This simple, straightforward method can be used by smaller companies — defined by the IRS as having average annual taxable gross receipts that don’t exceed $27 million for the three taxable years preceding the contract — as long as the contract is expected to be completed within two years of the commencement date.
2. Accrual. This accounting method recognizes revenue as work is completed, not when cash is received, and expenses when they’re incurred but not necessarily paid. You can report revenue when you bill for work performed — even though the invoice hasn’t yet been paid.
Unlike the cash method, the accrual method complies with Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board. This is important to note because GAAP compliance is required for public companies and often preferred by lenders and investors for privately held construction businesses as well.
3. Hybrid. Qualifying companies can generally use any combination of methods if the combination clearly reflects income. This allows the use of cash-basis accounting for small projects and accrual for larger ones or GAAP compliance. Also falling under the hybrid method: The IRS currently allows contractors using the accrual method to defer reporting income from advance payments until the year after receipt.
4. Accrual with deferred retainage. If the contract states that the project owner will withhold retainages until completion and final approval is granted, you don’t have a fixed right to that income — meaning you don’t have to include it in the current year’s taxable income. In turn, retainage you hold back from subcontractors isn’t deductible until their right to receive becomes fixed and determinable.
5. Completed contract method (CCM). Under CCM, contract-related income and expenses are deferred until project completion. Any revenue collected or expenses paid won’t be recognized until the year the contract is fully or substantially complete.
Because of this tax deferral, CCM is generally the preferred accounting method for long-term contracts. It benefits construction businesses seeking to reduce their current year’s tax liability or looking to take advantage of upcoming changes to the tax code.
6. Percentage of completion method (PCM). Larger companies — that is, those with average gross receipts of more than $27 million for the three taxable years preceding the contract — are required by the IRS to use PCM for long-term contracts. In a nutshell, it recognizes income over the life of the project.
The default method of calculating PCM for tax purposes is “cost-to-cost.” Cumulative contract costs incurred through the end of the taxable year are divided by the total estimated contract cost. If most of the needed materials are bought at the start of the project, this method lets you recognize the largest portion of job revenue in its early stages.
7. PCM simplified cost method. This method may be available to smaller construction businesses — that is, those with average gross receipts of less than $27 million for the three taxable years preceding the contract — that aren’t required to use the cost-to-cost method. It determines a contract’s completion factor based on only certain components of costs versus all allocated costs.
8. Exempt-contract PCM (EPCM). Companies that aren’t required to use PCM may be able to use EPCM. This accounting method allows the use of any cost comparison method to determine the percentage of completion — such as comparing direct labor costs incurred to date to total estimated labor costs, or comparing the work performed on the contract with the estimated total work.
9. PCM 10% method. Under this method, you can defer recognition of revenue until you incur 10% of the total estimated allocable contract costs. Many contractors who use PCM ultimately choose this option.
10. PCM capitalized cost method. This method applies mainly to residential construction. It allows contractors to report 70% of a contract under PCM and report the remaining 30% under any method, such as CCM or cash.
Residential contracts can include dorms; prisons; and nursing, retirement and assisted living facilities (defined as four or more units per structure with an average stay of 30+ days). A residential contract differs from a home construction contract, which involves buildings with four or fewer dwellings and is exempt from having to use PCM.
It’s a good idea to occasionally review your accounting-method options to determine whether you’re making the optimal choice for the contract in question. We can answer any questions you have about the methods described above or any other aspect of accounting or tax reporting for construction or real estate businesses.