Tax Reform Creates Considerations for Construction Companies with Less than $25 Million in Gross Receipts
By R.L. Widmer
Among the many opportunities for small businesses created by tax reform is the expansion and simplification of rules for businesses with less than $25 million in average annual gross receipts. For construction companies, this change in accounting method creates an opportunity to defer income on contracts they likely would have recognized in the past.
Deciphering the implications of this method change is complex. Here’s what construction companies need to know as they assess their method of accounting.
Prior to tax reform, construction companies with average annual gross receipts over $10 million generally had to use the percentage-of-completion method to recognize revenue on long-term contracts. Additionally, these contractors weren’t able to automatically switch to the cash method. Doing so required an application to change their accounting method under advance consent procedures, making it subject to IRS review and incurring significant user fees. With tax reform, the revenue threshold has now increased to $25 million, and there are some potential method changes to consider.
Overall Accounting Method
Contractors under the new threshold can switch their overall method from the accrual method to the cash method, which could provide an opportunity to defer revenue, especially if receivables are greater than payables. The benefit of this is the potential to take a “catch-up adjustment” – normally a negative adjustment to income – in one year.
Long-Term Contract Accounting Method
Contractors under the new threshold can choose to switch back to their previous exempt method, which could include the cash method, completed contract method, accrual method, or accrual excluding retentions, or elect to move to another permissible method not previously used. Each method offers unique ways to recognize revenue at different times and provide for deferral opportunities. Companies should work with their tax professionals to determine which method to use and any procedural requirements to effect the change.
Companies with less than $25 million in average annual gross receipts are potentially eligible, but there’s one important distinction. The threshold is determined on a controlled group basis, so if there are several companies with common ownership, businesses will need to analyze whether those controlled group rules apply.
As companies work with sureties, banks, and consultants, there are some considerations and key questions they may want to ask.
Sureties & Banks
Choosing to use these simplified methods likely won’t impact how a construction company works with its surety or bank, provided there’s adequate communication. Typically, sureties and banks are analyzing audited or reviewed financial statements, which won’t be affected because these methods are specific to tax purposes only.
However, if a surety is comparing financial statements to tax returns, there will be a change in how and when taxable income is reported, and any method changes should be clearly communicated.
Here are some questions to consider as construction companies work with their accounting consultants.
Approaching the Threshold
Contractors utilizing one of the allowed methods need to work with their consultants to determine planning opportunities. Once over the threshold, there are many variations of the percentage-of-completion method that contractors can use depending on what type of work they do and the duration of their contracts. Even the largest contractors can utilize deferral strategies that will allow them to keep more cash in their companies.
Tax reform created several considerations for companies looking to switch accounting methods. For instance, financial statement revenue recognition standards have changed for nearly every industry, which could impact the way revenue is recognized. Companies should consider how their book-to-tax differences might change with the new revenue recognition standards, especially if they are making a method change.
Net Operating Loss Limitations
Another change from tax reform was the limitation of net operating losses (NOLs) and carry forward rules. NOLs can no longer be carried back, and NOL carry forward amounts can only offset 80% of income in a given year under the new rules. Companies that are potentially creating a large loss by choosing this accounting method may want to consider these new NOL rules and potential basis limitations. Opportunities also exist in the form of a new 20% pass-through deduction, so understanding and weighing the options is important to avoid unintended consequences.
Contractors under the $25 million threshold could potentially realize significant tax benefits from these method changes and should work closely with their advisors to determine their best path forward.