Accounting methods used in the construction industry are unique and typically require a business owner to use two different methods of accounting for their construction activity – one for the bank or bonding company and one for tax filings.
The financial objectives of these methods differ – Banks and bonding agencies expect an accounting method determined under Generally Accepted Accounting Principles (GAAP) that produces a set of financial statements reflecting a clear image of the company’s financial performance. For a construction contractor that means using the Percentage of Completion Method for their financial statements. On the other hand, most taxpayers want to use an accounting method that provides a tax benefit resulting from a delay in income recognition. The tax law allows more than one permissible overall accounting method for contracts for certain taxpayers, but any tax method is subject to review if the government determines it does not clearly reflect income.
For example, a small business may use the Percentage of Completion Method (PCM) in preparing their financial statements and use the Completed Contract Method (CCM) in preparing their income tax returns. This article focuses on how CCM works for tax purposes.
Small business taxpayers should consider adopting the Completed Contract Method (CCM) for tax purposes if the following circumstances exist:
-Average annual revenues for the three preceding years does not exceed $10 million dollars and the subject matter of the contracts involves real property
-Collection of funds is uncertain
-Most, if not all, contracts are short term in nature, meaning that such contracts will be completed within 2 years beginning on the contract commencement date
CCM is an accounting method that enables the small business to defer revenue and expenses until the completion of a project for income tax purposes. All costs incurred for materials and labor allocable to a contract remain on the balance sheet until the contract is complete or substantially complete (generally measured as 95 percent or greater at year-end). The absolute advantage of reporting under CCM for tax purposes is to achieve the maximum deferral of taxes for both current and future periods.
Some disadvantages of electing CCM are:
-The books may not reflect clear information on operations because income and expenses are recognized upon the completion of a contract as opposed to recognizing profits as revenue is collected (PCM).
-Fluctuations in P&L will occur using CCM because revenue is recognized as jobs are completed.
-Once adopted, tax accounting methods cannot be changed without approval from the Internal Revenue Service.
-Use of CCM can produce an adjustment in the computation of Alternative Minimum Tax that can mitigate the effect of the income deferral
Example:
Al’s Construction, Co. is building a five story building under a contract price of $700,000 and plans to start construction on March 15, 2017; the commencement date of the contract. Al’s Construction, Co. expects that the entire facility will be completed by December 31, 2017. The term of the contract is less than one year and the contract will start and is expected to be completed within the same tax year (2017). Al’s Construction, Co. meets the requirements and elects to use the Completed Contract Method (CCM) of accounting for long-term contracts for tax purposes. Upon completion of the contract, Al’s Construction, Co. incurs $580,000 of totals costs for materials and labor. Al’s Construction, Co. will bill the owner for the entire $700,000 and recognize costs of $580,000, leaving $120,000 in profit in 2017. Had the contract been completed after year-end, all of the revenue and expenses would be recognized in 2018 producing a deferral of taxable income of $120,000.
You can see from this example that the timing of completion of the contract is critical in terms of the tax year the profit is reported. This is an area where your CPA can really help you if they are involved in the planning process and understand your business objectives.
Article Contributed by Maribel Loza
Staff Accountant
About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.
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