The Upside Down
If you are a fan of the popular Netflix science fiction horror series Stranger Things, then you are familiar with The Upside Down. For those who are not acquainted with the series, The Upside Down could be described as an alternate parallel dimension that is not too human friendly, to say the least.
The world of construction accounting is viewed by many as somewhat of an upside-down, with a strange language consisting of such terms as POC, under billings, overbillings, ASC 606, phase codes, related parties and, worst of all, though certainly not unfamiliar, income tax.
The first U.S. income tax was passed in 1861 and signed into law by Abraham Lincoln to fund the war against the southern states. It began as a flat tax of 3% on incomes above $800 and because the war lasted longer than expected by the Union, was later modified to a progressive tax structure. It was repealed in 1872. Our present income tax system was set in place in 1913 with the ratification of the 16th amendment to the U.S. Constitution.
The history of U.S. income taxation began with a national struggle, and to this day continues to be a struggle. The federal tax code and regulations are complicated and confusing. Convoluted by special interest lobbying, made difficult with programs to correct economic and social issues, replete with governmental spending disguised as tax cuts, and made more incomprehensible by well-meaning attempts to infuse fairness into the code, it has increasingly become not too human friendly.
However, when the fog lifts just a bit, one thing is clear: it is better to legally push the payment of income taxes as far as you can to the future. And then push it some more. The more distant the tax horizon, the better. There are exceptions, of course, but in most cases, you want to pay later, not now. Fortunately, construction contractors have several powerful tools available to defer income tax liabilities. The result of a skillful use of these tools creates a liability on your balance sheet called deferred income tax liability (“DTL”). A DTL is one of those rare “good liabilities”.
It is true that most privately-held construction companies elect to be taxed as a flow-through entity for federal income tax purposes. Therefore, income, expense, and credits will not be taxed to the company directly, but instead, will pass through and be taxed to the owners of the company. This includes companies organized as S-Corporations, partnerships, limited liability companies, and proprietorships. Many states also permit this flow-through treatment. Therefore, when we describe a DTL on the balance sheet, the liability may, instead, be at the owner level, not the company level. However, most construction companies will make tax distributions to the owners to fund their current income tax liability. Accordingly, income tax deferral strategies at the company level have a direct bearing on the size of the company’s tax distribution and its cash flow.
So, what tools are available to a construction contractor to defer income tax? You look for tools that create taxable temporary differences. Taxable temporary differences produce deferred tax liabilities for financial reporting, and that means you pay later, not now. Without getting too deep into the weeds, here are some of those tools available to contractors under the Internal Revenue Code (“IRC”):
- Method of accounting. Contractors can select more than one method of accounting under the IRC. Selecting the correct methods will make a significant difference in tax deferral. The contractor may have an overall method of accounting, such as the accrual method, and different methods specific to non-exempt and exempt contracts. (Non-exempt contracts are those required under IRC Section 460 to account for revenue recognition using tax cost-to-cost percentage of completion (“POC”) method – generally not to the taxpayer’s advantage. Exempt contracts are those exempted from tax POC under IRC Section 460, permitting the taxpayer to select more favorable income recognition methods). Methods of accounting include:
- Cash method. This can be an overall method of accounting but is limited to certain eligible entities based on average annual gross receipts.
- Accrual method. This can be an overall method of accounting, including any exempt construction contracts. This is generally the worst method for contractors because taxation of overbilling is accelerated.
- Completed contract method. For qualifying contractors, this is often the best method to elect because it produces the greatest deferral of income.
- Exempt-contract POC method. This method can be elected for contracts that are exempt from POC under IRC section 460 and permits the percentage of completion methods other than the Section 460 cost-to-cost method.
- Contracts potentially exempt from tax POC under IRC Section 460. Additional tax deferral opportunities exist for contractors with exempt contracts under IRC Section 460.
- Ten percent method. This election excludes from tax any contract that is less than 10% complete at year end. In other words, revenue and cost from contracts less than 10% complete are deferred from taxation until the tax year its percentage of completion is greater than 10%.
- Small contractors. Contracts of small contractors, as defined in the code, may be exempted from tax POC under IRC Section 460. Other methods may be elected. Under the Tax Cuts and Job Act, contracts entered into after December 31, 2017, meet the exception for small construction contracts if the contract is expected to be completed within two years and the taxpayer meets the $25 million gross receipts test for the year the contract is entered into.
- Home construction contracts. If certain requirements are met, the primary one being that at least 80% of the estimated total contract cost is expected to pertain to the construction of four or fewer dwelling units in the building, then that contract may be exempt from POC treatment under IRC Section 460. Another method may be elected.
- Percentage of completion / capitalized cost method. This method exempts 30% of the contract from tax POC treatment and applies to residential construction contracts with more than 4 dwelling units with an average stay of more than 30 days. The 30% exempted portion is accounted for under the company’s normal method as elected.
The tax code does provide benefits to the construction industry, mostly through tax deferrals. The deferred income tax liability is the result of those tax deferrals and is a sign of savvy tax planning. Consider discussing your DTL with your tax professional to see what elections have been made and how those elections benefit the company and its owners.