Aronson Partner Chavon Wilcox, CPA, CCIFP, has over 15 years of experience in the construction and real estate industry. Wilcox provides accounting and assurance, business and personal taxation and consulting services to construction and real estate companies. Wilcox is a published author and local presenter on accounting, tax and management issues. Visit aronsonllc.com.
Do your business practices expose your construction company to potential IRS penalties? The implications of how you report revenue or account for your labor force can vary from year to year and change when certain financial milestones are achieved. Does your CPA keep you informed of the benefits available to your business? The following are some common tax reporting issues that can impact construction contractors.
1. Methods of Accounting
There are multiple methods of tax accounting, which include cash, accrual (with variations), completed contract, percentage of completion (with variations) and a hybrid of these methods. Reaching certain revenue thresholds determines what method you will use each year. You will likely use at least two methods of accounting, one for your overall method and one for your long-term contracts. Once a contractor reaches or exceeds revenue over $10 million in average gross receipts for the previous 3 tax years, long-term contracts must be reported using the percentage of completion method under Internal Revenue Code (IRC) Section 460. The intricacies of IRC Section 460 and other rules of the IRC can complicate which method you use. Think carefully; once a method of accounting is adopted, it must be used as your overall method going forward, unless a method change is requested from the IRS Commissioner. Work closely with your accountant throughout the year to avoid surprises at tax time.
When IRC Section 460 was enacted in 1986, the IRS determined that it was possible for contractors to abuse the new reporting requirements and intentionally underreport taxable income by manipulating the percentage of completion on a contract. To combat this, they incorporated a lookback provision, which states that, in the year a contract is completed, the taxpayer must look back to the prior tax years the contract was in process and recompute the gross profit for those years using the final contract values at completion. If the recomputed gross profit in those years is more than your gross profit originally reported, you could owe the IRS money. If the gross profit in those years is less than the amount originally reported, you are likely to receive a refund. The lookback requirements can be burdensome, and lookback compliance remains a hot topic for the IRS. You should re-evaluate your situation to determine whether your accounting method requires you to compute the lookback and what contracts are subject to the provisions.
3. Long-term Contract Adjustment (LTCA)
This adjustment comes into play with the Alternative Minimum Tax (AMT). LTCAs are adjustments that must be computed on contracts that do not use the percentage of completion method. You must compute the gross profit earned on these contracts as if you were using the percentage of completion method, and then compare it to your normal method. The difference between the two gross profits is the LTCA (positive or negative) used to determine your AMT. There are two exceptions that exempt a contractor from computing this adjustment. The first is if the contract qualifies as a home construction contract, and the second is if the company is deemed a small corporation. Compliance in this area is often overlooked or computations are performed incorrectly. You should determine if you are subject to the LTCA provisions each year by considering your method of accounting and revenue threshold.
4. Domestic Production Activities Deduction
This deduction, created by the American Jobs Creation Act of 2004, is equal to 9 percent of qualified production activities income (QPAI), and limited to 50 percent of qualified W-2 wages paid for the year. Qualified deduction activities include residential and commercial construction, infrastructure improvements, land preparation activities and architectural and engineering services. To calculate the deduction allowed, 9 percent is applied to the lesser of QPAI or taxable income for the tax year after the utilization of any net operating loss (NOL) carryforwards. There are strict rules as to what is considered QPAI versus noneligible activities. However, the IRS has permitted a de minimis calculation that can be beneficial to many contractors, allowing 100 percent of their activities to qualify for the deduction. The deduction flows through to the stockholders and members of pass-through entities as well. There are many situations where eligible contractors have not taken advantage of this valuable deduction. Be sure that you have.
5. Tangible Property Regulations
These regulations became effective for tax years on or after January 2014. They provide guidelines covering materials and supplies, capitalized costs and costs to acquire, produce, improve and dispose of tangible property. Generally, taxpayers must capitalize amounts paid to acquire, produce or improve tangible property. However, the IRS has provided a de minimis safe harbor election that can be filed on an annual basis to expense all items under a certain dollar amount or with a useful life of less than 12 months. The de minimis amount is $5,000 if you have an applicable financial statement and a written accounting policy. If you do not have these items in place, the safe harbor amount drops to $2,500. Filing these elections annually, regardless of your policy, will protect you if ever questioned by the IRS.
6. Independent Contractor Versus Employee
Hiring a worker as an employee has costs beyond their wages, such as hard costs, compliance with the regulatory requirements of having an employee and the added administrative burdens. In a perceived cost-savings measure, some business owners are tempted to hire workers and treat them as independent contractors. Nonetheless, the decision to classify someone as an independent contractor versus an employee demands careful consideration for both federal and state purposes in order to avoid unnecessary and costly consequences. This has been a contentious issue for contractors of all sizes, but especially for small contractors. The degree of control the owner has over a worker is one element evaluated by the IRS to determine proper worker classification. If the worker is subject to strict supervision by the business owner with regard to time, place and how, the worker is more likely an employee for whom wage withholding, unemployment taxes, insurance, etc., are required. If the worker is only responsible for a completed service or product without strict supervision, the worker is more likely to be considered an independent contractor. This is one of many criteria used to determine worker classification. Additionally, workers are often aware of the classification issue. It only takes one former independent contractor to file for unemployment or classification determination to wreak havoc on your business. If you have any doubt about worker classification, don’t wait to determine if you have properly classified your workforce.
Proactive tax planning at the beginning of each year should help you avoid the common tax reporting issues to which contractors can fall victim. Schedule a meeting with your CPA to make sure you are covering key areas of concern before you receive a letter from the IRS.