Construction accounting pitfalls
Milton Zall is president of Zall Enterprises, an editorial consulting firm based in Silver Spring, Md. He writes on taxes, investments, technology, the Internet, and HR/business issues. He is a Certified Internal Auditor and a Registered Investment Advisor. He can be reached via email at milt.zall@verizon.net .
April 7, 2004 -Whether you're just starting out or have been in business for awhile, it is important to understand and comply with tax laws that affect your business. Recently, the IRS identified common problem areas for owners of small construction businesses, including accounting methods and capitalization of indirect costs to long-term contracts. A review of these issues will help you properly file your tax returns and avoid costly mistakes.
Accounting methods
Common Problem #1: Contractors, especially those who operate using cash, may not have a choice when it comes to the accounting method they use. Rather, these contractors may be required to use the accrual method of accounting.
An accounting method is a set of rules to determine when and how income and expenses are reported. It includes not only the overall method but also the accounting treatment of any material item. Examples of accounting methods are: 1) cash receipts and disbursements; 2) accrual; and 3) combinations of these methods. Whichever method is elected, it must clearly reflect a business' income. If your business operates as a regular (C) corporation with annual gross receipts in excess of $5 million, you generally are required to use an accrual method of accounting. If an inventory method is required because merchandise (or materials) is an income producing factor in your business, generally, an accrual method of accounting must be used for purchases and sales.
An exception to the requirements to use an accrual method to account for inventories is found in IRS Revenue Procedure 2002-28, which permits most small businesses with "average annual gross receipts" of $10 million or less to use the cash method of accounting. However, if you are required to use the accrual method for some other reason covered by IRS rules, you cannot qualify for this exception.
The accounting for inventory items is simplified by an IRS Revenue Procedure that allows their cost to be deducted in the year the merchandise is sold or paid for, whichever is later. Generally the percentage of completion accounting method is required for long-term contracts. A long-term contract is one that is still in process at the end of your taxable year. For example, if work on a contract to construct a building begins in November 2004, and ends in January 2005, and the contractor used the calendar tax year, the contract is a long-term contract.
Home construction contracts are not subject to the percentage-of-completion accounting method. In addition, general construction contracts are not subject to the percentage of completion method if certain completion time and gross receipts tests are satisfied. Whether an accounting method is permissible depends on a number of factors, such as the type of business entity, business activity, level of gross receipts, and existence or absence or merchandise as an income-producing factor in the business.
Capitalization of indirect costs to long-term contracts
Common Problem #2: Many contractors utilizing the completed contract method of accounting overstate their deductions because they are not properly allocating costs to long-term contracts.
Contractors are required to annually allocate indirect job costs to their long-term contracts unless the tax code or IRS regulations provide otherwise. Whether contractors are required to capitalize these "Allocable" job costs, or are permitted to deduct these "Allocable" job costs as current expenses, depends on the contractor's method of accounting for long-term contracts.
Allocable job costs include costs that are incurred because of the contractor's construction projects, such as repairs, equipment maintenance and rentals, utilities at the job site, depreciation on construction equipment, officer's compensation, and workers' compensation insurance.
Non-allocable job costs included expenses for unsuccessful bids and proposals and expenses for marketing, selling, and advertising. These costs are exempted from the cost allocation requirement.
In general, contractors using the percentage of completion method are required to allocate indirect job costs to their long-term contracts. Contractors using the completed contract method of accounting are required to capitalize indirect job costs allocated to long-term contracts until the contract is completed.
Under the completed contract method, income or loss is reported in the year in which the contract is completed. In addition to direct materials and labor costs, all indirect costs incurred for reason of a long-term contract or that directly benefit the long-term contract, must be allocated, or capitalized to that contract. As long as that contract has not been completed and accepted, these costs must not be deducted as current period costs.
Some indirect costs may benefit both the long-term contract and other business activities. These costs will require a reasonable allocation between the other business activities and the long-term contract. Suggested methods are specific identification method or the use of ratios based on direct costs, hours, or other units of measure.
Resources
IRS Audit Technique Guides contain examination techniques, common and unique industry issues, business practices, industry terminology, and other information. There are several of these guides specific to construction, which may help you better understand your industry. They can be found at the IRS website: www.irs.gov/smallbiz. Click on Industries/Professions, and then click on Construction.
Further information can be found in the Employer's Supplemental Tax Guide, Publication 15-A.
