Small Contractor Exemption
You’ve been recognizing revenue for tax purposes on the percentage of completion method because you have long-term construction contracts. But are you sure that’s your only option?
The Tax Cuts and Jobs Act increased the gross receipts threshold to be deemed a “small contractor” from 10 million to 25 million (adjusted annually for inflation), which made a lot of contractors eligible for the small contractor exemption who were previously ineligible. Why is that important you ask?
Small contractors have more flexibility with the method they use to account for long-term contracts. They can use the percentage of completion method (PCM), the percentage of completion/ capitalized-cost method (PCCM), the exempt contract percentage of completion method (EPCM), or the completed contract method (CCM), where normally they would be required to use percentage of completion.
Breakdown of the various methods
Percentage-of-completion method (PCM) – taxpayer generally has to include in income the portion of the total contract price that corresponds to the percentage of the contract that was completed during the tax year
Percentage-of-completion/ capitalized-cost method (PCCM) – taxpayers can determine income from a long-term contract using the PCM for the “applicable percentage” of the contract, and the exempt contract method for the “remaining percentage.” The PCCM applies to residential construction contracts, qualified ship contracts, and qualified naval ship contracts
Completed contract method (CCM) – revenue and costs of contracts are not recognized for tax purposes until the contract is completed (over 95% complete)
Exempt-contract percentage-of-completion (EPCM) – Similar to the PCM, under EPCM a taxpayer generally has to include in income the portion of the total contract price that corresponds to the percentage of the entire contract that is completed during the tax year. However, there is flexibility in calculating the percentage of completion. Taxpayers can 1) use any method of cost comparison or 2) compare the work performed on the contract with the estimated total work to be performed.
Why do we care?
Using a method other than percentage of completion can allow for significant tax deferrals. Completed contract (CCM) is probably the most popular method for long-term contracts exempt from percentage of completion and generally results in a large deferral for tax purposes.
So, how do you qualify as a “small contractor”?
The exemption applies to construction contracts entered into by a taxpayer (after December 31, 2017) that:
- Are estimated to be completed within two years
- Taxpayer meets the $25 million gross receipts test
The aggregation rules apply for the gross receipts test so be careful if you have a consolidated group or controlled group.
How do you switch methods?
The change is made on a cut-off basis and a Form 3115 would be filed with the year’s tax return.
If you would like to talk to one of our professionals in our Construction Segment on this topic or any other business-related topic, please do not hesitate to contact us.