Like many industries, the construction industry is governed by many special tax and accounting rules. For example, special tax rules apply for “large contactors.” IRS regulations identify large contractors as those with average gross receipts in excess of $25 million for the three prior tax years. Large contractors must use the percentage of completion method (PCM) to determine income with respect to long-term contracts. The PCM first measures the amount of progress on a contract by comparing the total costs incurred in a taxable year to the total estimated contract costs. This ratio, known as the cost ratio, is then multiplied by the contract price to arrive at the amount of taxable revenue to be reported.
By its nature, the PCM may lead to either underpayment or overpayment of taxes for any given situation. An underpayment of taxes occurs when estimated total costs for the contract are overestimated while an overpayment of taxes occurs when estimated total costs are underestimated. The overpayment of taxes results in the taxpayer being entitled to interest from the IRS on the overpayment amount. However, an underpayment of tax results in the taxpayer owing interest to the IRS. Referred to as the look-back interest calculation, this is often overlooked by taxpayers.
A construction contractor may also overlook an advantageous tax deferral election when utilizing PCM. The tax deferral is often referred to as the 10% rule. If the taxpayer elects the PCM, revenue recognition calculation can be deferred on a contract until the tax year in which 10% of the estimated total contract costs have been incurred. The 10% rule is one of the reasons separate book and tax PCM revenue recognition computations need to be performed.
Construction companies can thrive when they are able to focus on what they do best–helping their clients build their futures. P&N’s experienced tax team understands the specific accounting and tax rules that apply within the construction industry. Contact us to discuss how we can help you navigate the calculations and identify opportunities for your business.