As we enter the tax planning season, especially for the increase in taxes – both through new tax rates (Hello, 39.6%) and new taxes entirely (the Medicare surtax) – contractors have some options available that might help in mitigating the impact of these items.
Our starting point is to consider - and determine - if you are categorized as a large or small contractor. The magic number for this is $10 million. If a contractor has average annual gross receipts for the prior three tax years of $10 million or less, you’re considered a small contractor. And with that determination comes a “get out of jail free” card. Well, sort of.
If you fall within the definition of a small contractor, you are exempt from IRC Code Section 460 – which is the regulation that large contractors must follow. What this means, is that you may use any method you desire to account for your contracts – as long as you meet any other requirements for those methods. At last count, there were around 10 different methods from which to choose. So, now may be the time to look over the methods to ensure that you are using the best possible one to account for your contracts. You still have time to change!
Now, if you don’t fall within the designation of a small contractor, then you are considered a large contractor subject to all the rules, regulations, bells, and whistles that come along with Section 460. These include requiring the cost-to-cost percentage of completion method (PCM) to account for your non-exempt contracts, and everybody’s favorite fun-time calculation, the look-back. You’ll notice, “non-exempt” was emphasized. This is an area that is often missed when looking at contracts. There are primarily two exceptions to the required method. These are considered “exempt contracts”, and are detailed below.
The first type of contract exempt from Section 460 is the “home” contract. A home contract is one that includes work performed on a “dwelling unit”. As long as there are not more than four residential units in a building, and the units are not used on a temporary or transient basis, the units will qualify as “homes”. The important part of this is that any work performed on the home contract will qualify for the accounting method generally used for home contracts – the completed contract method (CCM).
For example, say you are a large contractor that handles drywall installation. You usually only have commercial contracts (for which you appropriately account for under PCM). In November, you win a bid to handle the drywall installation on a townhouse complex. Since townhouses qualify as “homes”, this contract can be accounted for using CCM – which means any recognition of gross profit on this contract can be deferred until the contract is greater than 95% complete and the property is being used by the customer.
The other exempt contract is for “residential” contracts. Residential dwellings are defined in the same manner as home dwellings, except this designation captures those buildings that contain greater than four units in the building. This would include apartments, barracks, dormitories, and senior living facilities, among others. Now, for this one, the exemption is only a partial one. If you have a contract that qualifies as “residential”, you get to split the contract into two portions. One portion (30%) of the contract can be accounted for using CCM. The other portion (70%) must be accounted for using PCM. Sounds like a pain, right? However, that 30% may not be an insignificant amount.
Now, if you don’t have exempt contracts, all is not lost. There are still planning
opportunities – even in unexpected areas. As a large contractor, you are still eligible for the 10% election, which defers recognition of a contract until it is greater than 10% complete. You also have allocated indirect costs. When you allocate your indirect costs, be sure that you are correctly adjusting your total estimated contract costs, as well. If no adjustment is made to that number, or if you are not accounting for estimated future costs to be incurred, you’ll be accelerating your gross profit recognition for tax purposes. Lastly, even though we don’t like it, look-back is required unless you have only home contracts or are a small contractor also exempt from AMT. But even here, keep in mind, if you have fade jobs, those will generally indicate a refund.
To learn more about Section 460, please join McKonly & Asbury for a free one hour webinar on this topic on Thursday, November 14 at 2:00PM. For more information and to register for the webinar, please click here. If you have further questions regarding Section 460, please contact the construction professionals of McKonly & Asbury.