Strategies for Tax Efficiency in Construction Accounting

Construction contractors have options for accounting for long-term contracts for income tax purposes that many small contractors may not be currently taking advantage of. While most contractors are familiar with the Percentage-of-Completion accounting method required for financial statements under Generally Accepted Accounting Principles (GAAP), the Tax Cuts and Jobs Act (TCJA) expanded opportunities for small businesses through 2025.

Historically, contractors with average annual gross receipts of $10 million or more were required to use the Percentage-of-Completion method for income tax reporting. However, the TCJA increased the threshold to $25 million, allowing construction businesses with average gross receipts of $25 million or less to explore alternative accounting methods for their long-term contracts.

For contracts exempt from the Percentage-of-Completion requirements, several methods can provide immediate tax benefits. These exempt construction contracts include:

Completed Contract Method (CCM)

Revenue and costs on contracts are not recognized for income tax purposes until the contract is completed or over 95% complete. CCM often results in the largest deferral for income tax purposes, making backlog management crucial for maximizing its benefits.

Cash Basis

Income and expenses are recognized when cash is received or paid, making this method favorable when a taxpayer has large receivable balances and smaller payable balances.

Accrual Method

Revenue is reported when billed, and costs are deducted when incurred. The accrual method may result in the smallest deferral for taxpayers, but aggressive billing may impact its suitability.

Accrual Method – Less Retainage

Similar to the accrual method, retainage receivables and payables are not recognized until received or paid, providing benefits for taxpayers with large retainage receivable balances.

Home Construction Contracts

Contracts where 80% or more of estimated costs are attributable to the construction of dwelling units in a building with four or fewer units and related improvements are exempt. Alternative methods such as CCM or Cash can be used.

For contractors still required to use the Percentage-of-Completion method, there are options to optimize tax outcomes:

IRC Section 460(b)(5) Election – 10% Election:

An election allowing income and expenses to be recognized for tax purposes only when the contract is over 10% complete.

Residential Contracts – 70/30 Method:

For contracts involving buildings with more than four dwelling units, 70% can be reported on the percentage-of-completion method, and 30% can use a method permissible for exempt contracts.

Contractors considering a change in accounting method should be aware of Form 3115 requirements, and any change made is on a cut-off basis. Additionally, the Alternative Minimum Tax (AMT) may require adjustments if a method other than Percentage-of-Completion is elected for income tax purposes.

Exploring alternative accounting methods can offer construction contractors more accurate financial reporting, better expense-revenue matching, and improved cash flow management, ultimately contributing to enhanced project and financial management. Consulting with accounting professionals is recommended to determine the most suitable method based on project characteristics, industry standards, and regulatory requirements.