Watch for pitfalls with the cash basis and completed contract method
Published February 12, 2019
Small construction contractors have expanded tax strategies under tax reform, but it is important to consider some crucial pitfalls.
While the 2018 calendar year has come and gone, there are still a few tax planning decisions that can greatly impact contractor tax liability and cash flow for tax year 2018. Last year’s tax reform resulted in sweeping changes affecting a broad swath of the economy. The construction industry was particularly impacted by the small contractor revenue exemption increase from $10 million to $25 million, beginning on January 1, 2018.
Before tax reform, the law defined a ‘small contractor’ as having average gross receipts from the preceding three years under $10 million. Contractors under this threshold qualified to use a method of accounting for long-term contractors other than percentage-of-completion. A long-term contract is defined as any contract to manufacture, build, or install or construct property that is not completed within the tax year the contract is entered into. This exemption allowed those qualifying small contractors to use other exempt methods to account for their long-term contracts, specifically providing the ability to use the cash or completed-contract method of accounting. This flexibility provided small contractors with the ability to defer taxable income from the slowing of revenue recognition, thus improving cash flow.
An applicable taxpayer can still automatically elect to change its method of accounting in 2019, for tax year 2018, using Form 3115, if filed by the due date, including extensions, of the 2018 entity tax return.
While the $10 million gross receipts threshold had been in existence since 1986, with practically no change, the increase to $25 million opens up a nice opportunity for existing contractors with revenue levels in this space, as well as those who, due to the health of the market, may have found themselves growing over the original $10 million threshold. However, despite its benefits, below are three pitfalls that should not be overlooked when considering converting to a cash or completed contract method for tax reporting purposes.
Alternative Minimum Tax (AMT)
While tax reform eliminated the alternative minimum tax (AMT) for C corporations, it is still required for owners of pass-through entities. Despite the ability to convert to cash and/or completed contract method for regular tax purposes, a contractor may still be liable for AMT. A contractor is still required to recognize revenue under the percentage-of-completion method for AMT for long-term contracts in progress (and are not a home-construction contract), regardless of a contractor’s revenue size. From reviewing prospective construction clients’ income tax returns, we typically see two underlying issues in this area:
- The AMT adjustment is not properly planned for, therefore the long-term contract adjustment for AMT purposes results in unexpected tax liabilities, and subsequent underpayment penalties. This could particularly apply in the current year for those planning during the course of 2018 on the method change without consideration for AMT. While the good news is AMT exemptions and phase-out at the owner level have significantly increased under tax reform, the long-term contract adjustment, specifically in a cash basis position, can be so significant it still results in potential liability.
- The AMT adjustment is fully omitted, which is a glaring red flag on a small contractor tax return, and this carries a heavy potential of accuracy-related penalties.
In determining whether the $25 million gross receipts threshold is met, it is important to remember the gross receipts of all commonly controlled trades, businesses or all members of a controlled group of corporations must be considered. A controlled group of corporations includes structures such as a parent-subsidiary group, a brother-sister corporate group, and a combined group under common control. In determining whether corporations make up a parent-subsidiary controlled group, more than 50 percent of the voting power or value of the stock of a corporation must be commonly held or owned, and family attribution within the voting power or value of the stock will also come into play. In addition, the proportionate share of construction-related gross receipts of any person that a contractor has a 5 percent or greater interest in must also be included. Overall, while a stand-alone construction entity may appear to be under the $25M small contractor threshold, in fact they may exceed due to aggregation and be disqualified to use a method of accounting for long-term contractors other than percentage-of-completion.
Despite some pitfalls, cash basis and completed contract can be a significant tax deferral and cash flow strategy for the small contractor. While the resulting tax deferral is temporary in nature, the benefit can turn out somewhat ‘quasi-permanent’ as it extends and fluctuates over many years. However, because of this it is essential that the contractor at both the CFO/controller and owner level are continuously aware of the ongoing planning and considerations necessary for the long-term. Without this, it becomes easier for management to lose sight of the timing and margins of current ongoing work, versus the immediate tax liability and cash needs related to earnings on prior work. It is therefore important that management develops a consistent way to monitor this off-balance sheet deferred liability as a step in their ongoing process. Finally, long-term consideration for future company operations, and the current tax rate environment should be factored into the timing and decision if cash and/or completed contract are the right methods for a contractor.
For more information about how these changes may affect you and your construction business, please reach out to your MCM tax professional or contact Tax Partner Matt Neely, CPA, via email or phone (812.670.3434).