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Accounting for Construction Contracts - Construction Tax Tips

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How Do I Choose a (accounting) Method?

There are special tax rules that control the accounting method you must use for your construction business. Generally, you choose your tax accounting method when you file your first tax return for the business.

Your choice of accounting method depends on:

  1. The type of contracts you have,
  2. Your contracts' completion status at the end of your tax year, and
  3. Your average annual gross receipts.

Most construction businesses use two different tax accounting methods; one for their long-term contracts and one overall method for everything else. A long-term contract is any contract that is not completed in the same year it's started.

Most construction businesses use the Accrual Method for their overall method of accounting.

Cash Method of Accounting

One method that some construction contractors can use for both their overall method and for their long-term contracts is the cash method. However, there are significant limitations on who can and cannot use this method.

How Does the Cash Method of Accounting Work?

A contractor using the cash method of accounting reports cash receipts as income when received and deducts expenses when paid. If you pay an expense that benefits you for more than one tax year, you must spread the cost over the period you receive the benefit.

What are the Limitations on the Use of the Cash Method?

There are two situations in which your use of the cash method of accounting can be limited. First, you are not allowed to use the cash method if your business is a corporation or a partnership with a C corporation as a partner, whose average annual gross receipts exceed $5 million. There is no exception to this limitation.

Second, depending on what type of business you have, you may not be allowed to use the cash method if your total purchases of "merchandise" for the year are "substantial" compared to your gross income for the year.

So, what do the terms "merchandise" and "substantial" mean?

Merchandise includes any item physically incorporated in a product you transfer to your customers. In the construction industry, merchandise is commonly called materials. For example, the lumber used to frame a building is merchandise for tax purposes.

Merchandise is generally considered to be substantial when it is at least 10% - 15% of your gross income for the year. This percentage is not a hard and fast rule, but a guideline used in some court cases.

Accrual Methods of Accounting

If you can't use the cash method, you must choose an accrual method of accounting. In the construction industry, there are several specialized accrual methods available, each of which has its own set of rules and limitations. In general, all accrual methods attempt to match the expenses that relate to a specific contract to the income from that contract.

The rest of this tax tip concentrates on helping you choose the correct accrual method for your construction business and assumes that you use a calendar tax year, from the 1st of January to the 31st of December.

Choosing an Accrual Method

Choosing a permissible method of accounting for tax purposes involves the four steps discussed below. As your business grows and changes, you might have to use a different method of accounting. You should review the following four steps every year to ensure that you are using a permissible method of accounting for your construction contracts.

Types of Costs

Before you can understand how the different accrual methods work, it's important to know about the different types of costs your construction business will have.

The two basic categories of costs your construction business will have are job costs and general and administrative (or G&A) costs.

Job Costs are the expenses related, either directly or indirectly, to the construction job, like construction wages, materials, and allocated indirect costs. G&A Expenses are the day-to-day expenses of running the business, like office expenses and utilities. However, certain administrative costs are sometimes treated like indirect job costs to figure the income earned on a contract.

General and Administrative Expenses

General and administrative (G&A) expenses are indirect costs of operating a construction business that cannot be traced to specific jobs. However, certain administrative costs may be treated like indirect job costs.

For example, the wage paid to the person in the office who keeps track of the costs for each job is a G&A type expense that would be treated as an indirect job cost. On the other hand, selling and advertising costs are G&A expenses that would not be treated like indirect job costs.

Generally, your G&A expenses will be deductible under the accrual rules, as explained later.

Job Costs

Job costs are divided into two groups. Direct job costs such as labor, materials, and subcontractor expenses can be traced directly to the construction project. The wage paid to a site manger is an example of a direct labor cost. Similarly, direct materials would include lumber for framing a house or concrete for the foundation of a shopping center.

Direct costs also include amounts paid to subcontractors. Subcontractors work for and are paid by the general contractor on a project. Subcontractors may also provide the raw materials for the job. Labor and materials provided by a subcontractor are generally treated as direct costs.

Indirect job costs are all the costs necessary for the performance of the contract other than direct materials, direct labor, and subcontractors. The expenses included in indirect job costs differ depending on whether you are a small or large contractor.

Allocating Indirect Costs

You have learned that indirect job costs benefit the project but are not tied as clearly to it as direct costs are. Indirect job costs often involve expenses that benefit more than one job and must be allocated among all the jobs that received benefit.

Source: Internal Revenue Service IRS.GOV

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