From Cash to Completion: Tax Tactics for Construction Success
In an ever-changing world of complex tax regulations, tailoring a tax strategy for your business and personal tax situation requires acute attention to detail and a deep knowledge of the rules that guide the construction industry. Contractors play in one of the most unique and complex areas of accounting and taxation. Working closely with an accounting service provider that understands the business, including the ins and outs of local, state and federal tax laws, can significantly impact a construction contractor’s financial efficiency.
Construction Tax Methods
The first step to identifying opportunities is to evaluate if you qualify for the small contractor exemption, available to all contractors other than tax shelters with three-year average gross receipts of less than $30M (expected inflation-adjusted exemption amount for 2024). The second step is to identify the types of contracts in play and determine the various tax methods that may apply to your company. For example, contractors engaged in general construction under long-term contracts and service/maintenance work under short-term time and material projects may be able to have different accounting methods for each revenue stream.
Construction companies should consider the following tax methods and the impacts of each:
- Cash Method (open to small contractors): This method allows contractors other than tax shelters to pay taxes based solely on cash inflows and outflows of the company’s long-term contracts. Revenue is recognized when cash is received, and expenses are deductible when cash is paid. This method simplifies accounting and often has the benefit of matching tax liability to cash flow. Additionally, certain types of businesses can also account for service-orientated revenue streams on the cash basis, even if the gross receipts exceed the three-year average threshold for small contractors. This method often leads to an income tax deferral compared to the accrual method of accounting.
- Completed Contract Method (open to small contractors): Under this method, contractors other than tax shelters capitalize revenue and expenses from long-term contracts on the balance sheet and recognize them only when a contract is completed. Completion is defined by the IRS as the time when 95% of all costs (based on the total costs of the contract) are incurred. This approach often leads to an income tax deferral, providing a cash flow advantage, but it requires careful management of ongoing projects as it can also lead to substantial taxable income in periods when several large contracts complete in the same period.
- Accrual Method (open to small contractors): For contractors other than tax shelters, this method refers to recognizing receivables and payables from long-term contracts as taxable income and deductions, respectively, as incurred. This method is often attractive due to its ease of application. However, a significant disadvantage of this method is that it accelerates taxable income if the company operates in an overbilled position, which is very common in the construction industry.
- Percentage of Completion Method (applies to all large contractors and open to small contractors): This method requires contractors to recognize revenue from long-term contracts as expenses are incurred, based on the percentage of estimated total costs (referred to as the cost-to-cost or percentage of completion method) as the project progresses. This method mimics generally accepted accounting principles in the U.S. – matching book and tax methods together. Note: A service revenue exception may apply to large contractors, allowing additional tax methods for other revenue streams.
While many of the methods may or may not be available to you depending on your gross receipts, understanding when to apply them and what exceptions exist allows for additional planning opportunities. Note also that the Percentage of Completion Method must always be used for Alternative Minimum Tax purposes (except for home construction contracts), even when a small contractor may use another method for regular tax purposes. Following a deep dive into construction revenue streams and business structures, our professionals can help discover deductions and credits that are not always easily identifiable upfront.
Year-End Tax Planning and Beyond
Effective tax planning for contractors goes beyond the immediate tax year and includes discussions on not just your corporate entities, but the individuals behind those entities. It involves considering future growth and potential changes in tax laws. Between the upcoming elections and the Tax Cuts and Jobs Act sunsetting Dec. 31, 2025, tax laws are anticipated to change significantly in the near future. Business owners and decision makers should engage in forward-looking discussions with their accountants to identify long-term tax strategies. A few immediate and longer-term considerations include:
- Accelerated Depreciation: Contractors should review their depreciation records and consider accelerating qualified purchases to take advantage of the maximum bonus depreciation allowable (60% in 2024). Each year the allowable percentage of bonus depreciation decreases by 20%. Section 179 expense is also in play in years of taxable income to provide an additional deduction on fixed asset additions (limit of $1,220,000 in 2024). Those with real property on their books in the form of buildings should explore options like cost segregation studies to maximize deductions. We recently helped a client accelerate nearly half a million dollars in deductions utilizing this strategy on a new $2M building and land purchase.
- Retirement Planning: Proper succession planning, ideally initiated three to five years before a business owner’s retirement or business transition, can maximize tax benefits and ensure a smooth transition. Exploring options such as cash balance pension plans can help contractors save for the future while reducing current tax liabilities. If you are considering a large gift soon that might utilize the lifetime estate tax exemption, be aware that current estate and gift tax exemptions are set to decrease by 50% in 2026, which will have major implications for corporate succession and personal wealth transfer planning.
- Inflation Reduction Act: While many of the 70 separate credits included with the Inflation Reduction Act (IRA) are not targeted toward the construction industry, there are still several opportunities that contractors should be aware of, including Section 179D, Section 45L, Section 45W, and Sections 48 and 48E. Understanding how to maximize these sections of the IRA to work for your business is paramount to effectively meeting your organization’s ESG goals or effectively meeting your customers’ ESG goals by delivering lower-cost solutions that are more energy efficient.
Connect with a team member today to discover how to take better advantage of construction-related incentives and credits now or in the future.