Figuring Out Contractor Tax Breaks
The IRS has rules for everything — contractor contracts included. Those in the contractor industry would do well to review IRS guidance and make sure they're in full compliance, and understand that they have choices in how they address the requirements.
To start with, you have to choose an accounting method for your contractor business. Your choice depends on three criteria, according to the IRS:
- The type of contracts you have.
- Your contracts' completion status at the end of your tax year.
- Your average annual gross receipts.
And you're not limited to one method — there may be reasons for two. The IRS notes that many companies use one method for long-term contracts and another for everything else — a "long-term" contract is defined as any project started in one year and completed in another. The two most common methods of accounting that are used are the cash method and the accrual method.
The Cash Method
One method that some contractors can use for all contracts is the cash method. However, not every company can use it.
Basically, a contractor using the cash method of accounting reports cash receipts as income when received, according to the IRS, and deducts expenses when paid. If an expense benefits you for more than one tax year, it must be spread out over the period the benefit is received.
It's pretty straightforward, but in order to qualify for using the cash method your business must be considered a small business taxpayer. A small business taxpayer is a taxpayer that:
- has average annual gross receipts of $25 million or less for the 3 prior tax years and
- is not a tax shelter (as defined in section 448(d)(3)).
There is also a more subtle limitation: you may be prohibited from using the cash method if your merchandise purchases are substantial compared to your gross income. How are "merchandise" and "substantial" defined? That's a complicated question — be sure to discuss this with us before making a decision.
The IRS explains that if you can't use the cash method, you have to choose an accrual method, and some companies have several specialized accrual methods available, each with its own rules and limitations. "In general, all accrual methods attempt to match the expenses that relate to a specific contract to the income from that contract," according to the IRS.
These aren't as straightforward as the cash method, and before you even decide which accrual method to use, you have to do a lot of paperwork:
- Classify all contracts as either short term or long term.
- Classify all long-term contracts as either home construction or general construction contracts.
- Classify yourself as either a small or large contractor.
Once you have taken these steps, you may consider the right kind of accrual method. Large companies usually must use the percentage of completion method (PCM), while small companies have a choice of the PCM, standard accrual, exempt percentage of completion or completed contract method.
It sounds complex, but we can help you get through it. Give us a call today and we'll let you know what's best for your business.