The media has focused attention on high profile builders who successfully use tax planning strategies to reduce taxable income. Some builders are able to reduce or completely eliminate the need to pay federal income tax. While it may be legal and within the letter of the tax law, the public frowns on profitable builders who do not pay their fair share of income tax.

While there are many tax credits and deductions available to contractors, the timing and method of reporting income and losses is important. Contractors need to understand that a small change can make a big difference.

Income and Expense Recognition and Tax Reporting Methods

Generally, it is best to defer income to the next year and accelerate deductions in the current year. Even so, if a contractor anticipates that the company will be more profitable in 2021, it may be better to do the opposite—accelerate income in 2020 and defer deductions to 2021. It is important to consider realistic opportunities for near-term growth, as well as industry and economic trends before implementing this type of tax planning strategy.

A contractor’s accounting method determines when revenue is recognized for tax purposes and when expenses are deductible. Construction contractors whose average gross receipts for the prior three years exceed $25 million are required to use the percentage-of-completion accounting method for long-term contracts. A long-term contract is one that starts in one tax year and ends in another. There are several exemptions that apply to this requirement that contractors should consider. Contractors whose average gross receipts for the prior three years are under $25 million can elect to use the completed contract method, cash or accrual basis instead.

Under completed contract, revenue and expenses related to a job are reported on the income statement when the contract is completed. Taxable income can therefore be deferred. Companies on a cash-basis report revenue as it is received and expenses when they are paid in cash. Under an accrual-basis method of accounting, revenue is recognized when it is earned and expenses when incurred. Typically, companies on a cash-basis have more opportunities to defer income or prepay certain expenses. For example, a company on a cash method could delay billing for services rendered so that the payment is received in 2021. Companies on an accrual method would have to delay the performance of certain services until after year-end to defer income. Payments received in 2020 for services or goods that will be delivered in 2021 may also qualify to be deferred.

Change in Accounting Methods

The accounting method used by a contractor can impact its tax liability. It may be advantageous to change accounting methods by filing an Application for Change in Accounting Method (Form 3115). The IRS requires advance consent change for an accounting method change. Form 3115 must be filed by the end of the tax year for the change to be effective for the year. Accounting method changes are generally effective for contracts beginning on the first day of the tax year of the year of change.

Commercial contractors who build residential projects can use the completed-contract method (CCM) method instead of percentage of completion method (PCM). Builders, GCs and specialty contractors qualify if 80% or more of the estimated total contract costs for the year the contract was entered are attributable to the building, construction, reconstruction, or rehabilitation of units contained in buildings with four or fewer dwelling units. Improvements to real property that are directly related to such dwelling units (homes, townhouses, assisted living facilities, etc.) may qualify as well.

The percentage of completion capitalized cost method (PCCM) might be better if a contractor builds more than four dwelling units (apartments, dorms, condos, prisons, nursing, assisted living, retirement facilities, etc.). PCCM allows 30% of the contract to be accounted for under CCM, with the other 70% under PCM. It is possible to defer 30% of gross profit until the year the project is completed. Builders, GCs and specialty contractors may qualify.

If a contractor is below the PCM threshold ($25 million average annual gross receipts for the prior three years), they should consider using a cash method of accounting instead of the accrual method.

The retainage exclusion can be used if the contractor is on PCM and their accounts payable retainage balance is significant.

Net Operating Losses

The Tax Cuts and Jobs Act (TCJA) of 2017 changed how net operating losses (NOL) are reported. Under the TCJA, the NOL deduction for a tax year is equal to the lesser of:

• the aggregate of the NOL carryovers to such year, plus the NOL carry-backs to such year; or
• 80% of taxable income (determined without regard to the deduction).

Generally, NOLs can no longer be carried back but are allowed to be carried forward indefinitely. Other rules apply.

Deferring loss recognition to future years, will typically increase the present value of total federal income taxes owed. Contractors should take into account the time value of money. Companies with intermittent loss years and startup companies with initial years of losses may not do as well as under previous law, all other factors being equal.

Changes to the NOL rule require taxpayers to understand the timing of their income and deductions on future tax liabilities. The NOL carryforward provisions may no longer result in eliminating federal tax liability in years of low taxable income relative to prior loss years.

There is a lot to take into consideration when reporting income and losses. The timing of reporting income or deferring costs can have a significant impact on a contractor’s income tax liability. While most contractors want to reduce taxable income as much as possible to pay less taxes, NOL limitations and other provisions imposed by TCJA may make it difficult. Implementing tax planning strategies will generally make a big difference.