Spring 10 - When Should Income Be Reported?
How does your company report taxable income for partially completed work? That might seem to be a highly technical — even arcane — question, but the answer could have a significant impact on your tax liability.
Failure to understand the tax implications of your income reporting method could lead to a large and unexpected tax bill — which is likely to come due when you can least afford it.
Percentage of Completion vs. Completed Contract
Most large contractors (generally speaking, those with annual gross receipts of $10 million or more) are required to use the “percentage-of-completion” method for reporting income on long-term contracts that span more than a single tax year. Using this method, income from the contract is reported in each tax period according to the percentage of costs that were incurred during that period compared to the estimated total cost of the contract.
On the other hand, most small contractors are permitted to use other accounting methods for reporting income; in particular, the “completed contract” method is frequently used. Under this method, all contract revenue is deferred until the contract is completed.
The ability to defer reporting income for tax purposes until the job is completed is obviously appealing, but the completed contract method can cause confusion, especially related to the definition of the term “complete.” A contract is considered complete for tax purposes upon final acceptance by the owner. The IRS defines this as the time when the customer actually begins using the product of the contract and when at least 95 percent of the total contract costs have been incurred.
IRS rules specify that minor unfinished punch list work or the lack of a final certificate of completion is not adequate reason to declare a project incomplete for tax reporting purposes. Neither is unreleased retainage or lack of payment.
Potential Problems and Concerns
While the completed contract method may allow you to postpone the income tax liability for a long-term project, this can be a double-edged sword. For example:
- When several contracts are completed during a single reporting period, the completed contract method may result in your company having to report a substantial spike in income for tax purposes.
- Unless management exercises strong financial discipline, it is easy to spend cash from early billings. Then, when the income is finally reported for tax purposes, there may not be sufficient funds to meet the tax obligation.
- A deferred tax obligation can be particularly dangerous during a prolonged downturn, as the industry is experiencing now. When cash flow is greatly reduced, a large tax liability for work that was done in a prior year could threaten the company’s survival.
- In most instances, alternative minimum tax (AMT) must be calculated using the percentage-of-completion method instead of the completed contract method. Unfortunately, this can partially offset the interim tax savings that might be achieved using the completed contract method.
Determining which income reporting method to use for tax purposes can be a complicated decision, and there are costs incurred in switching methods. Under certain circumstances, however, a change in method could provide an interim benefit that could help your business survive a challenging economy.
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The Construction Advisor is produced quarterly by Bober Markey Fedorovich. For more information, please contact our Construction Services team leader Dale A. Ruther, CPA, CIT, partner, at (330) 762-9785 or by email.