As the corporate tax deadline for returns on extensions comes and goes, some contractors can start to take advantage of recent changes to the tax codes.

The last tax reform in 1986 negatively impacted contractors as it introduced a small contractor’s exemption that a taxpayer must use to be exempt from using percentage of completion for income tax reporting on long-term contracts. This was a negative impact for tax reporting because contractors could no longer pick what method they wanted to report taxable income—instead they had to see what methods were available. To qualify for the small contractor exemption, the taxpayer needed to satisfy two tests:

1. The length of the contract: To satisfy the length of the contract test, the taxpayer needed to estimate the contract could be completed within 24 months from the day the contract actually started.
2. Average annual gross receipts: The second test for the small contractor’s exemption was the Average Annual Gross Receipts Test (AAGRT). To satisfy the AAGRT, the taxpayer’s average annual gross receipts from the previous three years must have been less than $10,000,000.

Why is the small contractor’s exemption important to a contractor?

For taxpayers who are not required to use percentage of completion (POC) for tax reporting, they have an opportunity to use other methods available to defer paying taxes. A tax deferral postpones tax payments to a later date, leaving more cash on-hand for day-to-day operations, large purchases and steady business operations.

From 1986 to 2016, the $10 million AAGRT was never adjusted for inflation until the Tax Cuts and Jobs Act (TCJA) of 2017. The TCJA changed the AAGRT to $25 million.

If a contractor has AAGR under $25 million, they may be exempt from reporting income on the POC method for tax purposes. In doing so, two accounting method options should be considered:

1. Completed contract method: Under the completed contract method, revenue and cost on contracts is not recognized until the job is completed, or more than 95 percent complete, and used for its intended purpose. This method usually creates the maximum tax deferral.
2. Cash method: When using the cash method, accounts receivables are not recognized as income and accounts payables are not deducted. This method helps postpone taxpayers from paying taxes on large receivables until the cash is actually received and available to pay the taxes.

Since the tax filing season for 2017 is just about over, information is available for taxpayers to calculate the AAGRT for the past three years using tax returns that have been filed.

Doing this calculation sooner rather than later will help with tax planning because contractors will be able to determine if they can use an accounting method that can defer amounts to a future date.

It’s important to note that if a new method is chosen, there may be filing requirements to elect the method. In addition, contracts started before 2018 must stay on the original method, which is known as the cut-off method of an accounting method change.

Contracts can also be recorded on a contract-by-contract basis, meaning contractors’ tax returns can be on more than one method: one for exempt contracts and one for non-exempt contracts.

Several other elections and tax incentives are available to contractors that should also be considered, but the new AAGRT is an important starting point for 2018 planning.