Tax Planning for Small Contractors Under the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (the “Act”) was passed by the House and Senate and signed by the President in December of 2017 with many provisions effective January 1, 2018. One provision is a huge win for construction contractors, particularly those with average revenues between $10,000,000 and $25,000,000. Tax planning just got a lot more interesting and complex for those in that window. The Act changed the definition of a small contractor exempt from the requirement to use the percentage-of-completion method (PCM) for long-term contracts from the pre-Act law, which provided an exception for construction companies with average annual gross receipts of $10 million or less in the preceding three years.
For contracts entered into after Dec. 31, 2017, the exception for small construction contracts from the requirement to use the PCM is expanded to apply to contracts for the construction or improvement of real property if the contract:
- is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract and
- is performed by a taxpayer that (for the tax year in which the contract was entered into) meets the $25 million gross receipts test.
This is a benefit for those contractors that exceeded the $10,000,000 threshold previously and lost the ability to utilize a more beneficial method of recognizing revenues. Some of the available options for small contractors, include:
- Cash Method – The cash method of accounting can be used as an overall method of accounting and to account for long-term contracts. Income is recognized when cash is actually or constructively received, and expenses are generally deductible when paid.
- Accrual Method – The accrual method can be used for both an overall method of accounting and for long-term contracts. Income under the accrual method is generally recognized when the payment is received, payment is due, or payment is earned, whichever occurs first.
- Retentions under the Accrual Method – As a variation to the accrual method of accounting, a contractor can elect to exclude this retention from income until received or billable under the contract.
- Completed Contract Method – The completed contract method of accounting suspends both revenue and job costs until the completion of the job. The effect is to defer the contracts gross profit from inception until the contract is completed.
- Percentage of Completion Method (PCM) – Although not required, the small contractor has the option, like a large contractor, to use the percentage-of-completion method (PCM) of accounting for long-term contracts under §460(b).
For contractors between $10,000,000 and $25,000,000, the first step is to communicate with the tax preparer to determine the best available accounting method for long term contracts. The change in the threshold provides a unique opportunity for construction contractors to revert to a method utilized prior to becoming a large contractor, as previously defined. It also provides an opportunity to elect to utilize a different method of accounting if that is more beneficial currently.
Once the best method is determined, contractors should review prior tax filings to determine if any Form 3115 (“Application for Change in Accounting Method”) was previously filed. Specifically, contractors should review the tax year in which their average revenues first exceeded $10,000,000 and they were no longer a small contractor. While Form 3115 was not required to change to the percentage of completion method in that year, many construction contractors filed one. If this was the case, Form 3115 will be required again in 2018 in order to change the method of accounting for exempt long-term contracts. If Form 3115 was not filed previously to change the method of accounting for long-term contracts, then the method of exempt long-term contracts will revert to the method in place before becoming a large contractor, and Form 3115 will not be required. It is important to note the use of this PCM exception for small construction contracts is applied on a cutoff basis for all similarly classified contracts. This means the change in method of accounting applies only to contracts entered into after the effective date of the change.
The third step would be to review each of the contracts, both short term and long term, before year end to effectively utilize the accounting methods in place. With the additional flexibility that the Act provides to an increased pool of small contractors, profitable contractors will have the ability to defer significant taxable income to future years. Proper planning can help cash flow by avoiding a large tax burden currently. The 2018 tax year is the year to take advantage of the opportunity!
It is highly recommended that each construction contractor review their financial situation to determine the best accounting method suitable for the specific needs of the company. Each contractor will also need to review prior filings to determine if a change in accounting method was filed in the year $10,000,000 of gross receipts was exceeded. This will be an indicator of whether additional filings will be required for 2018.
If you have questions regarding tax planning under the new Tax Cuts and Jobs Act, contact Nicholas L. Shires, CPA.