Revenue Tests for Contractors: Small Contractor?
By Kenneth Padgitt, Senior Manager, Tax & Business Services
All taxpayers strive to determine and use the tax accounting method that results in paying the least amount of tax allowed by law. Because of the many different methods available, contractors should continually review the rules to ensure they are using the most beneficial methods. An understanding of the qualifying tests for each method is essential.
At the core of each method is the test for average annual gross receipts (AAGR), determines which of accounting method a contractor may use. The test also determines the method that can be used on certain qualifying contracts. Because the test is based on an average of prior years, the results will change from one year to the next, resulting in the need to monitor the results annually.
There are several specific dollar limitations that factor into the permissible method of reporting for tax purposes. One is the $10 million test to determine whether a contractor will can qualify for the small contractor exception under Internal Revenue Code Section §460. Below is a summary of how this test operates:
$10 Million Section 460 Test
This test is to determine whether a contractor can qualify for the small contractor exemption or will be required to use the percentage-of-completion method (POC) for non-exempt contracts (note that home construction and 30% of residential construction contracts are exempt from the requirement to use POC). This test pertains to the prior three years. The test for the 2017 calendar year would determine the AAGR for 2014, 2015, and 2016.
It should also be noted that this test is not a “once failed, always failed” test. If a contractor fails the test for 2017, for example, and the same contractor’s AAGR falls below $10 million for 2018, any non-exempt jobs started in 2018 could be reported under the contractor’s normal method of accounting, i.e., accrual, completed contract, cash, etc., assuming the contractor qualifies to use this other method.
Entities included in the Test
Determining which entities have to be included is perhaps the most complicated part of this test. The test deals with entities under “common control,” which also brings into play the rules of attribution (common ownership). The rules of attribution cover areas such as family, parent-subsidiary, and brother-sister ownership. They must be taken into consideration to assure all required entities are included.
Although a complete analysis of these rules is beyond the scope of this article, two are worth mentioning since so many construction companies are family-owned. First, an individual is considered the owner of any interest owned directly or indirectly by or for his or her spouse. Also, a parent is considered the owner of any interest owned either directly or indirectly by minor children (under 21). The reverse is also true. The minor child is considered the owner of the parents’ interest. The results will be the same if the child is 21 or older, but only if one of the parties has effective control (over 50%) before this attribution.
The Internal Revenue Regulations define two groups of entities that must be included in the test to qualify as a small contractor as exempt from POC. The first is all trades and businesses that are under common control. Entities treated as a single employer will be included in this group. This includes all controlled groups whether corporations, partnerships, LLCs, or sole proprietorships.
The second group deals with attribution of gross receipts for those entities not under common control. For this group, a taxpayer has to include a proportionate share of all construction-related gross receipts for any person who has a 5% or greater interest in the taxpayer. In addition, the taxpayer must include its proportionate share of construction-related gross receipts for any person in whom the taxpayer has a 5% or greater interest. Ownership is determined on the first day of the test year. The test includes indirect interests in any corporation, partnership, estate, trust, or sole proprietorship as determined using the principles of constructive ownership.
Receipts Included in the Test
Because this test is to determine whether the income from construction contracts is subject to reporting using POC, included in the test are construction-related receipts from all trades or businesses of the entities included as discussed above. This is determined using the method of reporting that the taxpayer used for tax purposes, i.e., completed contract, cash, etc. It does not include receipts such as interest, dividends, rents, and proceeds from the sale of assets.
Gross receipts include the gross contract price, whether or not it is a long-term contract. It also does not matter whether it is a general or subcontract. It will not include the cost of materials supplied by the person for whom the contract is being performed unless the purpose for this type of arrangement was to reduce the contractor’s gross receipts. Any gross receipts between the related parties are eliminated.
Restrictions on Use
The only restriction on this test is that it is for long-term contracts only. If a contractor fails the test, it will not change the reporting for any income or expense not from long-term contract.
This means that contracts that begin and end in the same tax year, as well as contracts for home construction and 30% of residential contracts will not be subject to POC (unless POC is the contractor’s normal method of accounting). It also excludes construction management contracts since they do not meet the definition of a long-term construction contract.
The benefit to passing this test is that a contractor is not required to use the POC method to account for the income from long-term contracts. This allows the contractor to use either the cash, completed contract, accrual, or accrual excluding retainage methods. These methods may result in an income deferral over the POC method. Any tax planning normally will not affect financial income.
Change in method
A contractor that fails the $10 million test is not required to file a change in accounting method with the IRS. In fact, a change in method should not be filed. Requesting a change would establish POC as the contractor’s normal method and thus eliminate any other method of accounting, even for exempt contracts.
If a contractor goes below the $10 million AAGR threshold, all new jobs started in the following year and any subsequent year will not be required to be reported using the POC method as long as AAGR remains under $10 million. These jobs can be reported under the contractor’s normal method of accounting. If the contractor had requested a change to POC after exceeding the $10 million AAGR, it would have to get IRS approval to use any method other than POC.
Planning for the Tests
As you realize by now, the key to this test is the timing of receipts with the objective of being below the specified dollar limit for that test.
If a contractor properly plans for receipts, it may be able to qualify for the benefits of or avoid the pitfalls associated with passing or failing, respectively.
Since the test determines gross receipts based on the method used for tax reporting, the time for testing is during year-end preliminary planning. At this time, you can determine whether receipts need to be delayed or accelerated. This will depend on the timing of the prior years.
Say, for example, that while planning for 2017, a contractor using the completed contract method has gross receipts for 2015 and 2016 of $9 million and $9.5 million, respectively. If gross receipts for 2017 are in excess of $11.5 million, the contractor will exceed the AAGR for 2018 and will be subject to POC reporting for jobs started in that year. In this situation, the contractor needs to review all jobs estimated to be complete by the 2017 year-end and determine if there is any way to keep jobs open for tax purposes so the receipts will be reported in 2018. Of course, the guidelines regarding when a job is considered complete will have to be taken into account.
The reverse could also be true. A situation could occur where it would be more advantageous to close a job early.
Regardless of whether receipts need to be delayed or accelerated, planning needs to occur prior to year-end. Proper planning can help avoid problems later.
This article is not intended to cover all the possible scenarios that might affect a taxpayer under the $10 million test. It is intended to make the reader aware of the test and what the general guidelines are.
As you can see, a contractor needs to review his or her situation each year in order to take advantage of every tax saving and/or deferral method available. Even if changing methods only defers the timing of when income is reported, it is better to pay later than pay now.