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.
Understanding Exempt Contract Opportunities
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.
Options for Non-Exempt Contracts
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.
Key Considerations Before Changing Methods
Contractors considering a change in accounting method should be aware of Form 3115 requirements, and any change made is on a cut-off basis.
Compliance and Tax Adjustments
Additionally, the Alternative Minimum Tax (AMT) may require adjustments if a method other than Percentage-of-Completion is elected for income tax purposes.
Strategic Evaluation
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.
Insights from McKinsey Insights and Accounting Today further highlight how strategic financial management and method selection can significantly impact business performance.
FAQ
Below are common questions to help clarify how these accounting methods apply to construction contractors.
What changed under the TCJA for contractors?
The TCJA increased the gross receipts threshold from $10 million to $25 million, allowing more contractors to use alternative accounting methods.
What is the benefit of the Completed Contract Method?
It allows contractors to defer recognizing income and expenses until a project is nearly or fully complete, often providing tax deferral benefits.
When is the cash method most useful?
The cash method is most beneficial when a contractor has high receivables and lower payables, as income is recognized only when received.
What is the 10% election?
It allows contractors to delay recognizing income and expenses until a contract reaches at least 10% completion.
Do contractors need approval to change accounting methods?
Yes, contractors must file Form 3115 and follow IRS procedures when changing accounting methods.
Why should contractors evaluate different methods?
Different methods can improve cash flow, align revenue with expenses, and support better financial management depending on the contractor’s situation.