Would you rather pay taxes now or a year from now? With the new Tax Cuts and Jobs Act passed in December 2017, small to medium-size contractors have a huge opportunity to defer paying taxes on the income earned on projects that are in progress as of the end of the year. Who wouldn’t want to hold onto their money as long as they can and invest that money into business operations to grow their business? How can this be accomplished? It is as easy as selecting the completed contract method for tax treatment of your long-term contracts. Under the new tax laws, many more construction contractors are eligible to use this method.
In order to be eligible, the taxpayer must have less than $25 million in annual gross receipts averaged over the last three tax years (up from $10 million previously). For instance, if a company had $22 million (2015), $24 million (2016), and $26 million (2017) in gross receipts, the taxpayer is still eligible to use the completed contract method for 2018, as the average annual gross receipts is $24 million.
When recognizing income under the completed contract method, the taxpayer does not need to include the earnings (revenues less expenses) attributed to those projects that are to be completed within two years from the date work begins and also are not “substantially complete” – the stage of completion where the project is fit for occupancy and use for its intended purpose. However, under the percentage of completion method, you would have to pay tax on earnings on all contracts in progress during the year.
For example, a contractor with $9 million in costs associated with projects in progress at the end of the year with estimated earnings to date of $1 million would pay tax of $370,000 (assuming flow-through entity in the highest tax bracket). Under the completed contract method, this income and tax recognition would be deferred for tax purposes, along with the resulting tax, until the contract is substantially complete the following year.
While deferring income and tax is a great opportunity, it also comes with its own challenges and all aspects and effects should be considered. For instance, while deferring payment of $370,000 in tax and investing in the business operations is a huge advantage for cash flow purposes, having the funds necessary to pay that tax the following year is something that needs to be planned for. Under this method, the cash flow and operation cycle of completion of the project does not always match the tax cycle, which can lead to issues with having the necessary funds to pay the tax associated with the earnings. The completed contract method can also lead to large swings from year to year depending on the size of contracts completed carried from one year to the next and completed the following year, resulting in a low tax liability one year and a very large tax liability the following year when the contracts are completed.
With the proper planning and awareness of both the advantages and disadvantages of this method, this tax strategy can be properly implemented to take advantage of holding onto your tax dollars as long as possible to invest in your business. For help with planning for the changes in 2018 and guidance on the impact of the new tax laws on your business, please reach out to me or another member of Yeo & Yeo’s Construction Services Group.