The tax reporting options for long term construction contracts can be perplexing. The rules are complex, sometimes counter-intuitive, and a bad decision or poor advice can lead to some negative tax consequences.
First off, what is a long term contract? A long term construction contract is any contract written for the purpose of manufacturing, building, installing, or constructing a property that spans more than one tax year. In other words, if a calendar-year taxpayer begins a construction job on December 31st and finishes it on January 1st, the contract would be deemed “long-term” since it spans two tax years.
Percentage of Completion Option
Long-term contracts are subject to the percentage of completion method for reporting taxable income (IRC Section 460(b)(1)); however, there are exceptions discussed later. Percentage completion is a method of allocating the taxable income generated from a contract based on how much of the work has been completed. Generally, the overall cost of the contract is used as the basis for allocation. For example, if a contract is estimated to generate $30,000 in income and will cost $75,000 to complete, when $50,000 or 2/3 of the total contract costs have been incurred, $20,000 or 2/3 of the estimated contract net income would be recognized.
There are exceptions to the requirement of using the percentage of completion method:
- Small contractors, defined as having less than an average of $10 million in gross receipts over the prior three tax years, are exempt from the percentage of completion requirement and can elect an alternative method (e.g. completed contract, accrual).
- Home construction contracts that are not subject to the first exception are required to capitalize costs (IRC 460(e)(1)(B)) using IRC section 263A.
Completed Contract Option
As mentioned above, small contractors are exempt from the requirement of reporting long-term contract income using the percentage of completion method and can elect to use an alternative method. One popular choice is the completed contract method; whereby, long-term contract net income is recognized and reported when the contract is completed. Therefore, this approach defers recognition of income that would otherwise be taxed using the percentage completion method. However, there is one major drawback to the completed contract method. Individuals must report the income from long-term contracts under percentage of completion for the calculation of their alternative minimum taxable income. Thus, under certain circumstances, the deferral of income under the completed contract method can be negated by an increase in alternative minimum tax.
What is the best option for your company? It’s definitely a question worth pursuing. Contact a tax professional at PBMares to determine which method provides the greatest tax advantage for your team.