A deep dive into construction tax accounting methods and the "small contractor exemption" from percentage of completion method of accounting.

AGC previously reported about certain tax provisions, included in the 2017 Tax Cuts and Jobs Act (TCJA), that are important to the construction industry which are set to expire. The past two weeks we have discussed the Section 199A “qualified business income deduction” and the ability of businesses to fully deduct the cost of equipment in the year that it is purchased. Today's section will focus on construction tax accounting methods, and the "small contractor exemption" from percentage of completion method of accounting.

The Tax Reform Act of 1986 introduced significant revisions to the long-term contract accounting rules, specifically under Section 460 of the Internal Revenue Code. This legislation established new requirements for long-term contracts, which are defined as contracts for manufacturing, building, installation, or construction that extend beyond the tax year in which they were initiated. Unless exempted, contactors are required to use the percentage of completion method (PCM) of accounting on long-term contracts.

For tax purposes, PCM accounting requires that contractors calculate the percentage of a contract that is complete in a given tax year, thereby requiring them to pay taxes on that percentage of income. This system imposes significant administrative burdens and cash flow challenges, particularly for smaller contractors, as PCM is more complicated due to its need for continuous financial tracking and estimating.

Before the changes brought about by the 1986 Act, contractors had the option to utilize the completed-contract method (CCM), which allows them to defer tax payments until the contract is fully completed, or other recognition methods like the cash method to account for long-term contracts. Recognizing the difficulties PCM accounting presented to smaller businesses, Congress established an exemption (commonly called the “small contractor exemption”) for contractors with less than $10 million in average annual gross receipts for the previous three years. “Small contractors” can utilize CCM accounting or other simplified accounting methods. Additionally, contracts that are completed in less than one tax year are also exempt from PCM accounting. Unfortunately, the 1986 Tax Reform Act did not index the small contractor exemption to inflation, so for the next 31 years, more and more contractors were forced to use PCM accounting for tax purposes due to inflation.

While AGC advocated for raising the small contractor exemption to $40 million—which would have accounted for inflation since 1986—AGC strongly supported the provisions in TCJA that raised the small contractor exemption from $10 million to $25 million, and permanently indexed it to inflation.

Unfortunately, while the corporate alternative minimum tax (AMT) was repealed in TCJA, the individual AMT was not. And for pass-through businesses calculating AMT income, long-term contracts must be calculated (or recalculated) using PCM accounting. Because of this AMT provision, small contractors that use accounting methods other than PCM, like CCM or cash method—are required to recalculate their long-term contracts using PCM to determine AMT income. This has the effect of nullifying many of the positive effects of tax simplification for small contractors that was achieved by increasing the small contractor exemption to $25 million. Because of this additional complexity, AGC is advocating for removing long-term contracts as an “add back” for the individual AMT.

PCM accounting has an additional pernicious complication for contractors. Under Section 460, during the life of a long-term contract, estimated revenues may differ from actual amounts, necessitating a “look-back” calculation to adjust for any prior income misreporting. If gross profit was overestimated, the IRS owes interest on overpaid taxes; conversely, if it was understated, the taxpayer owes interest on underpaid taxes. This method is applied in the year the contract is completed and in any subsequent year with adjustments to contract price or costs, without changing the total taxes paid over the contract's duration. These “look-back returns” have poor compliance rates, are incredibly complicated, and are poorly understood by the IRS. Doing away with look-back calculations entirely would be a significant simplification measure for the construction industry and would likely have very little impact on tax revenue.

For additional information please contact Matthew Turkstra.