The IRS has rules for just about everything , and construction contracts included. Anyone in the construction industry would do well to review IRS guidance and make sure they're in full compliance, and understand that they have choices in how they address the requirements.
Choosing an accounting method
Contractors must choose an accounting method for their business. The choice depends on three criteria, according to the IRS:
- The type of contracts they have.
- Their contracts' completion status at the end of their tax year.
- Their average annual gross receipts.
Contractors are not limited to one method. The IRS states that many companies use one method for long-term contracts and another for everything else. "long-term" contract is defined as any project started in one year and completed in another.
The cash method
One method that some construction contractors can use for all contracts is the cash method.
A contractor using the cash method of accounting reports cash receipts as income when received and deducts expenses when paid. If an expense benefits the business for more than one tax year, it must be spread out over the period the benefit is received.
It's fairly straightforward, but businesses may not use the cash method "if your business is a corporation or a partnership with a C corporation as a partner, whose average annual gross receipts exceed $5 million," according to the IRS.
And there's another limitation. Businesses may be prohibited from using the cash method if its merchandise purchases are substantial compared to its gross income. How are "merchandise" and "substantial" defined? It's best to discuss that with your tax professional.
The IRS says if contractors can't use the cash method, they must choose an accrual method - and construction companies have several specialized accrual methods available, each with its own rules.
According to the IRS, "In general, all accrual methods attempt to match the expenses that relate to a specific contract to the income from that contract."
Accrual methods aren't as simple as the cash method. Here's some of the paperwork that must be completed before the business decides which accrual method to use...
- Classify all construction contracts as either short term or long term.
- Classify all long-term contracts as either home construction or general construction contracts.
- Classify yourself as either a small or large contractor.
Large construction companies must use the percentage of completion method, while small companies have a choice of the PCM, standard accrual, exempt percentage of completion or completed contract method.