The new Tax Cuts and Jobs Act (TCJA) has brought many changes to the tax law. However, there is one area not drawing a lot of attention that is worth discussing: the change to a $25 million average gross receipts threshold. The new $25 million average gross receipts threshold will have a huge impact on construction businesses.
Most construction companies use two different accounting methods on their balance sheet: one overall method (cash or accrual) and one long-term method (percentage of completion or completed contract). For GAAP purposes, taxpayers are typically required to use percentage of completion for all long-term contracts no matter what size the company is.
Cash vs. Accrual for overall accounting
Under cash method of accounting, the small contractor will recognize income when the payment is received and deduct expenses when they are paid. Under the accrual method, the contractor will recognize income when it is earned and deduct the expense when it is incurred.
Hybrid Method for overall accounting
When selecting accounting methods, the IRS permits mixing the best of both worlds. A contractor may use the cash method for receipts and disbursements, while at the same time use the accrual method for inventory and payables related to the inventory. A small contractor can use this method as long as the specific methods of accounting have been disclosed to the IRS or adopted with an initial tax return.
Percentage of Completion vs Completed Contract for long term contracts
Under the percentage of completion method, revenue and expenses are recognized according to the percentage of completion on the particular contract during the tax year. The percentage is determined by calculating costs allocated to the contract and incurred during the tax year and dividing the cost by the estimated contract cost. Under the completed contract method, income and expense is not reported until the contract is substantially complete, which is typically 95%.
Before TCJA, if a contractor’s average gross receipts were $5 million or more they were required to use the accrual method of accounting. Also, if the contractor’s average gross receipts were $10 million or more, they were required to use the percentage of completion for their long term contracts, in addition to the overall accrual method.
The TCJA increased the gross receipts threshold from $5/$10 million to $25 million resulting in more construction companies eligible to use the cash and completed contract methods.
For many construction companies, this creates an opportunity to use favorable methods. For example, if your accrued income (receivables) tends to be higher than your accrued expenses (payables), then switching to the cash method would likely allow you to defer income, and as a result, generally, reduce your current tax bill. However, if your accrued expenses tend to be higher than your accrued income, switching to cash method may accelerate your income, resulting in a higher current tax bill. For contract accounting, either using cash or the completed contract method of accounting will allow taxpayers to recognize income when cash is received or contracts are complete, vs. using estimated contract costs to determine income. It also allows the contractor to discontinue calculating lookback interest if the estimated contract revenue was incorrect in prior years.
Keep in mind, if a contractor chooses to change their accounting methods for long-term contracts or from accrual to cash method, they will be required to file form 3115 “Application for Change in Accounting Method.”
If you have questions about which of these methods are best for your business, please contact your local Blue & Co. advisor.