Construction Companies

Hello all, I hope all is well with you and your families.

I’m beginning to take on some construction companies, that are small (under $5MM gross receipts) that either build out for tenant improvements in commercial spaces and a new client that does both TI work and ground up work (construct a budiling from the ground up).

The new TCJA has me a bit purplexed as to what method of accounting is best for companies such as these listed above. I like the Cash Method; Income isn’t recognized until received until you get to the end of the year and the client receives a deposit from the client (draw against future billing) of a large amount. If I have this right, Cash Basis says this is Income. Accrual, maybe this is Income but maybe not if work isn’t yet completed. CCM (Completed Contract Method), which is now available to companies with a 3 year average of less than $25MM, says this income is only recognized when the building is competed and the client pays in full.

But, to keep things simple for the client, I still like the Cash Method. But, for WIP (construction in progress), are we still required to capitalize these costs until the project is completed? If so, I think the CCM is the winner because a Cash Basis taxpayer is paying taxes with every draw received, and at a disadvantage if the draw is received at year end unless they can quickly pay their incurred expenses before the year ends. If capitalization is not required, then it’s a toss up.

I’m just here for some guidance. For those of you with construction clients under the $25MM, what Method has suited them best over the years? Thanks for not throwing tomatoes at me!!! Like I said, this is new territory for me, but very interesting work. TIA!

Dave, have a tomato…don’t confuse overall method with long-term contracting method.

Alright, you threw the first one so I’ll bite. You’re right, I am a bit confused. I think the majority of the construction folks I will run across will have projects lasting less than 2 years. In the past, only companies with less than $10MM in gross receipts could use the completed contract method and left the percentage of completion method to the bigger boys, employing the Cash Basis of accounting.

So, Jeff, with the new loosening of the rules (Gross Receipts less than $25MM), I think most construction companies will benefit from using the Cash Basis. But, my confusion lies in incomplete work at year end. Would a Cash Basis taxpayer be required to capitalize WIP? And if so, is this simply a taxpayer that is using the CCM method? Or, do I have it wrong and a Cash Basis taxpayer is not required to capitalize WIP if the project runs into the following year? To clarify, I am referring to a construction company that is hired to build a structure. Meaning, this is not a developer; they don’t own the land, they are merely charged with building a building.

Am I overthinking this? Or am I underthinking this? Is it too late for a brain transplant??

https://www.accountingtools.com/article ... act-method

When i did the books for a small local contractor, i recorded all draws or invoices as revenue when received.
Cash basis, but accrual for debts, as the owner owed the IRS over $100k

Am I overthinking this?

No. Your questions are good ones. Let’s start with the idea that there’s two types of construction: (1) construction performed pursuant to a customer contract and (2) construction performed that is not pursuant to a customer contract. Our focus is on the first type. What fits this second mold is something like a spec home, because there is no customer and hence, no customer contract. Another thing that would fit this mold is construction undertaken where the end product is for self-use, like I build a building that I will own (and maybe use for my business, or maybe use personally, or maybe rent out). Sec 263A would cover costs associated with non-contract construction, sometime referred to as “self-construction.”

Now let’s go back to construction undertaken pursuant to a contract. The second “C” in “CCM” stands for “Contract.” As per the Regulation, CCM works like this:
(d) Completed-contract method.

(1) In general. Except as otherwise provided in paragraph (d)(4) of this section, a taxpayer using the CCM to account for a long-term contract must take into account in the contract's completion year, as defined in §1.460-1(b)(6), the gross contract price and all allocable contract costs incurred by the completion year. A taxpayer may not treat the cost of any materials and supplies that are allocated to a contract, but actually remain on hand when the contract is completed, as an allocable contract cost.

That first sentence is chock full of stuff. It basically forces a unique accounting method upon us. It talks about timing (i.e. “in the contract’s completion year”) and tells us we must “take into account” the gross contract price and contract costs “incurred” by the completion year. This language sure implies that it doesn’t matter what our overall accounting method is, hence it being a unique accounting method unto itself. And also note that if it’s saying we must take into account these things “in the contract’s completion year,” that means we don’t take these things into account in any prior (or future) tax year.

Now take your example: Client signs a contract to build a building for a customer. Construction starts in Year1 and concludes in Year2.

If we are on the cash basis, that’s fine. Whatever revenue we have received as of 12/31/Year1, that goes to the Balance Sheet as a liability. And the costs paid in Year1 go to the Balance Sheet too, as an asset (call it CIP, or construction in progress). Net P&L effect for Year1 is $0, because $0 revenue and $0 costs have hit the P&L. If we are on accrual, our 12/31/Year1 numbers [i.e. revenue and costs] might be different when compared to our cash basis numbers, but they end up on the Balance Sheet all the same.

Now, let’s say were using the cash method and 12/31/Year2 rolls around. As of that date, assume we haven’t paid all costs and we haven’t collected all money from the customer. Further assume all costs have been incurred (i.e. we’re not closing the job under the 95% rule). We have to record our unpaid costs with a journal entry (debit COGS, credit Payable). And we have to record additional revenue to get us up to the gross contract price (debit Receivable, credit Revenue). Basically, as of 12/31Year2, we have to account for all revenue and all costs (to the extent incurred), that have not yet been booked, on the accrual method (if you will). And, of course, whatever was on the Balance Sheet at the end of Year1 gets moved to the P&L in Year2. At the end of Year2, no matter our overall method, all revenue and all costs are on the P&L and none remain on the Balance Sheet.

So to answer your questions:

Would a Cash Basis taxpayer be required to capitalize WIP?

Absolutely.

And if so, is this simply a taxpayer that is using the CCM method?

Yes, that is the impact of CCM – It requires us to push our revenue (i.e. gross contract price) and our costs (to the extent incurred by the end of the completion year) into the completion year, regardless of the overall method. So, if we have paid some costs in a year before the contract is complete, they go to the Balance Sheet until the contract is complete.

Or, do I have it wrong and a Cash Basis taxpayer is not required to capitalize WIP if the project runs into the following year?

You have it wrong. If a contract spans more than one year, a long-term contract accounting method is required to be used.

Other things to talk about are (1) the AMT and (2) admin expenses.

Jeff, excellent summary sir, you should do this for a living!

This puts it all together for me now and I really appreciate your time and efforts explaining this to me. I’ve been doing a lot of reading on this subject and everything you describe lined up with my research. I suppose I just get brain bogged at times.

Regarding the AMT, I’ll go out on a limb here and say most of my clients won’t have this worry (most aren’t C Corps, but S Corps and Partnerships).

Regarding the admin expenses, I’ll go out on another limb and say these should be included as operating expenses, deductible when occurred, and not capitalized. But, I’ve been wrong before...

Regarding the AMT, I’ll go out on a limb here and say most of my clients won’t have this worry (most aren’t C Corps, but S Corps and Partnerships).

AMT was repealed for C corps beginning 1-1-18. All non C-corp taxpayers must calculate an AMT adjustment which shows the difference between regular tax method and percentage of completion (reported on Sch K). This adjustment is ultimately reported on individual's 6251, line 22. So, no matter what method is used for regular tax purposes, you must always calculate percentage of completion for long-term contracts.

Sounds like this is going to be a collocation nightmare! Might be a good time to consider the C Corp Election.

Thank you for the information. Lots of number crunching to do.

Dave,

Check out Example 22 of Rev. Proc. 2002-28. If the taxpayer has only exempt construction contracts, it would be eligible to use both the overall cash receipts and disbursements and the cash method for its exempt contracts. Generally speaking, the only reason to choose this method is if the taxpayer pays expenses throughout the construction contract and bills in arrears to the point where this is generally a better answer than the CCM.

Thank you for taking the time to respond Brian, I appreciate the reference.

I have some reading to do, should be a hoot.

I do have a general question to those that care to carry on the conversation. I’ve read G&A expenses are deductible in the year incurred (Cash Basis). Would the taxpayer be required to capitalize his own wages if he is the super on the exempt jobs?

Meaning, he is the guy that supervises the jobs, gets the subs paid, orders materials, etc. Can we somehow bifurcate his wages by identifying how much time is spent on the job and how much is spent as a desk jockey (opening mail, running errands) so we can deduct a portion of his payroll as an admin expense? Or, is his salary incidental to completing the contract and therefore must be capitalized to the job? Thanks for any input.

Generally speaking, the only reason to choose this method is if the taxpayer pays expenses throughout the construction contract and bills in arrears to the point where this is generally a better answer than the CCM.

While I agree, I don’t think it’s all that practical.

Would the taxpayer be required to capitalize his own wages if he is the super on the exempt jobs?

Yup, to some degree, assuming we’re talking about a corp. And this is what I meant about having to talk about Admin…

I’ve read there is no way around this AMT adjustment, whether the CCM or the Cash Method is used, unless, the client opts for the C Corp Election, which would avoid AMT altogether beginning in 2018.

C Corp taxation may work well because they shareholders will take high salaries (they have quite a bit of experience in the business), but I’ll have to weigh the flat 21% on the dividends they will expect, in addition to the salaries vs an S Corp with AMTI flowing to the partners vs an AMT credit carryover, etc, etc.

I need a mile long spreadsheet for this one!!