Small construction firm owners and contractors can find it especially difficult to comply with the strict letter of the law when it comes to filing their income tax returns. The IRS recognizes the potential problems and wants to lend a helping hand. The tax agency periodically updates several publications geared to contractors, most notably Publication 3780, Tax Information for Small Construction Businesses. This publication identifies common tax pitfalls facing small construction firms and explains how to avoid them.
The three main issues addressed are:
- Accounting methods,
- Indirect cost issues, and
- Worker classification.
Accounting methods set the rules for determining when and how income taxes are reported. The methods include cash receipts and disbursements, accrual, and combinations of such methods. The method must clearly reflect income. Contractors, however, can’t always choose. There are tax rules that control whether you must use the cash or accrual method.
The choice depends on:
- Type of business entity,
- Business activity,
- Level of gross receipts, and
- Existence or absence or merchandise as an income-producing factor in the business.
Cases where the cash method can’t be used include:
- Corporations or partnerships with a C corporation as a partner whose average annual gross receipts exceed $5 million. There is no exception to this limitation.
- Firms that must use an inventory method because merchandise or materials is an income-producing factor. These firms generally must use an accrual method for purchases and sales.
Most small businesses with average annual gross receipts of $10 million or less, however, may use the cash method. Firms required to use accrual accounting don’t qualify for this exemption. For long-term contracts, the percentage-of-completion method is generally required. With this method, revenues and profit are realized over time as a percentage of the work completed during a year.
Home construction contracts, however, aren’t subject to this method. Moreover, general construction contracts aren’t subject to it if they meet certain time and gross receipts tests. In these cases, you may use the one of the allowable exempt contract methods. For additional information on these, talk to your accountant.
Indirect Cost Issues
As a contractor, you must allocate indirect job costs to long-term contracts every year, unless the tax code or regulations provide exemptions. Whether you can capitalize or deduct these costs depends on how you account for long-term contracts.
In general, contractors using the percentage of completion method must allocate indirect job costs to their long-term contracts. Contractors using the completed contract method of accounting must capitalize those costs until the contract is completed. Failing to capitalize can result in overstated deductions.
Allocable job costs include expenses incurred for a project, including repairs, equipment maintenance and rentals, depreciation on equipment and workers’ compensation insurance, among others.
Non-allocable job costs are exempt from cost allocation. They include expenses for unsuccessful bids and proposals, marketing, selling and advertising.
The treatment of payments for services depends on the business relationship you have with the person performing the job. That person may be classified either as an independent contractor or an employee.
Generally, workers aren’t treated as independent contractors if you control the services they perform. Factors indicating the degree of control typically fall into these three categories:
- Behavioral. Do you control, or have the right to control, what the workers do and how they do their jobs? For example, providing training indicates that you expect the workers to follow company guidelines. This may mean they should be classified as employees.
- Financial. Do you control the business aspects of the workers’ jobs? This includes how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, etc. In addition, only independent contractors can realize a profit or incur a financial loss from the work.
- Relationship. Are there written contracts or employee benefits, and will the relationship continue after the project is completed? The closer the relationship, the more likely the individual is an employee.
By recognizing the significance of these and other issues, small construction business owners can avoid costly problems on their federal and state tax returns.
How We Can Help
One of the areas I assist my construction and contractor clients with most frequently is capturing overhead and burden (Indirect Costs) into their job costing system – as mentioned above. Not only does that provide management with a more accurate picture of a job’s profitability, but it also ensures compliance with tax laws. If you have questions related to setting up or evaluating your job cost reporting system, accounting methods for tax filing, or worker classification issues, please contact us to discuss your unique situation.