Over the past several years, the construction industry has been going strong with plentiful amounts of work available.

Picture 1But with this growth comes the routine challenges of personnel, infrastructure, cash flow, etc. While all of these challenges are items you see and face everyday, another challenge may be arising that you need to be aware of as well: The day your deferred taxes are due!

With a large number of construction companies operating as S Corporations, the deferred tax liability is not accounted for on the balance sheet. As a result, this potential liability can be easily disregarded. Without being informed of this liability, the impact of this payment due could cause a significant impact on business activities.

Operating as a C Corporation takes a measure of this risk out of the equation because the building liability is shown on the balance sheet. Cash flow still should be available at the time payment is due, but at least the dollar figure is known.

Not only do you need to track the dollar liability that is growing, but you also need to understand when deferred taxes are due. For S Corporations, construction companies can account for taxes using the cash, completed or the accrual method of accounting to pay taxes until such time as your three-year average revenues on your tax returns exceed $10 million. At that time, your deferred taxes are due and future taxes are paid on the percentage of completion method of accounting.

For C Corporations, you can pay taxes on the cash method as long as your three-year average revenue on your tax return is under $5 million. At this level, your deferred taxes are due and you can then elect to use the completed or accrual method until such time as your three-year average revenue on your tax return exceeds $10 million. Again, at that time when your deferred taxes are due, you pay future taxes on the percentage of completion method of accounting.

Clearly, the impact of this mounting tax liability could be disastrous. Working with a knowledgeable construction oriented CPA can help you manage this risk and stay on top of the building liability.

You can always use the percentage of completion method of accounting at any size, but there are advantages to using other methods while you can. However, you need to stay on top conversion occurrences and how much you owe.

It is also important that your surety partner know your accumulating liability and is comfortable knowing you have a plan to deal with the taxes. If left to the surety company, they will estimate your deferred tax liability. Typically, this is a conservative estimate meaning they will add a liability to your balance sheet that is larger than what is realistic. This will result in a reduction of both your equity and potentially working capital depending on whether your surety considers this liability a current or long-term liability.

Without information from you and your CPA an easy way for your surety to account for this liability is to take your 1120S tax return and compare the retained earnings shown to what is shown on your CPA percentage of completion year-end financial statement. They can then take that difference and multiply it by 40 percent to come up with a conservative deferred tax liability.

There are a couple easy ways to counteract this conservative approach to estimating deferred tax liabilities. Your CPA can put a note in your financial statements showing what your deferred tax liability would be if you were a C Corporation. If you don't want to do that you can have your surety either talk to your CPA or have your CPA provide a letter detailing the deferred tax amount and when it may be due.

Communication is critical with your surety company. Keep them informed with your plan to deal with this deferral. It will give them a higher degree of confidence in your business management abilities and provide a higher level of comfort moving forward.

Michael R. Strahan, CCIFP, CRIS, is president of KPS Insurance Services, Inc.   KPS assists construction companies with establishing and maintaining bond programs. He may be reached at 858.538.8822 or visit www.kpsinsuranceservices.com.

Construction Business Owner, May 2008