Speaker: Misconceptions Often Mean Contractors Leave Money on Table

By:
Chris Gaetano
Published Date:
Oct 19, 2017
TaxWorry

James Lundy Jr., a partner with Marcum LLP's Construction Industry Practice group and a speaker at the Foundation for Accounting Educations Oct. 19 Construction Contractors Conference, said that many contractors miss opportunities to lower their tax bills because of misconceptions about how certain programs can apply to their industry, particularly where it concerns deferred taxation. 

The "number one" mistake he said he sees construction contractors make? They don't take advantage of home or residential construction exemptions for Section 460. Under this section, the IRS says that long-term contracts must use the percentage-of-completion method (whereby revenues and expenses of long-term contracts are recognized yearly as a percentage of the work completed during that year). Lundy said that a lot of contractors just interpreted that as saying all contractors must use this method. But this is a mistake. The literature actually says that contractors with annual gross receipts of $10 million or more over three years must use that method, meaning that Congress was only really concerned with the largest contractors. While the number of contractors below that threshold has shrunk since it was first implemented in 1986 because of inflation, it's still about 60 percent of them. 

"I bring that up to say the code section is designed to exempt more contractors than it impacts. So if you read it that way, you start understanding that Congress put loopholes in the rules to try to allow contractors to not to have to use percentage of completion. Why do I want to use something other than that? Main reason: I'm assuming if the IRS says I have to use a method, it's a bad method for me. They're not going to say, 'Let's use the method where you have to pay the least taxes.' They want the method that makes me pay the most," he said. 

Beyond the threshold, Lundy also pointed out that home construction contracts are  exempt from having to use the percentage-of-completion method. Got clients who are homebuilders? Then that they do not need to use percentage of completion. The clients can use whatever method they want, be it cash, accrual, or some other way. However, he noted that it is important to make sure that a taxpayer is not claiming a home construction exemption when the contract is, in fact, a residential construction contract, which has its own exemption criteria.

Anything with fewer than four dwelling units is considered home construction, which carries a total exemption from the percentage-of-completion method, he said. Anything with more than four is considered residential construction, which carries a 30 percent exemption from the percentage-of-completion method, so long as the average stay is 30 days or more. That means that if a project is considered a residential construction contract, 70 percent of the job is completed using the percentage-of-completion method and 30 percent is calculated using any other appropriate method. 

He noted that many contractors miss out on even this 30 percent exemption because they don't think what they're building would count as residential. For instance, prisons. 

"Nowhere in the rules does it say you want to be there! So we have clients who built prisons. ... So [average stay] has to be more than 30 days. Well, how about life? And [the IRS] said that will pull the average up, sure. But then we need to calculate and split out the mixed-service costs," he said. 

So what his firm did with this client was to separate out all the elements that were not necessary to the residential aspects of the prison or that were required to be there by contract or law. So, he said, they took the cost of the administrative offices out of the calculation, but added in the cafeteria, the laundry and even the walls as part of the residential contract. 

Other things that could qualify, he said, include school dorm rooms (pointing out that, ideally, the average stay there is well over 30 days), nursing homes and army barracks. 

He also noted that other contracts can be exempted from the percentage-of-completion rules based on their timing. In most accounting literature, "long term" means "more than a year," but he said that in tax terms it means "two tax years." The way this timing works can paradoxically mean that contracts that may seem rather short term could actually be counted as long term. For instance, if a contract begins Dec. 30 and ends Jan. 2, that means it covers two tax terms and would therefore be counted as a long-term contract. and must use the percentage-of-completion method Conversely, he said, a contract running from January to December may seem long, but it only counts as one term and so the taxpayer can use other methods. 

Another common mistake he said clients make is overestimating the significance of the alternative minimum tax (AMT) compared to their regular tax rate. People, he said, really don't want to pay AMT. However, he said, this sometimes represents the best of several bad options. 

"I'd rather not pay AMT, but if I'm going to have to pay a tax, what kind of tax would I like to pay? What's the C Corp AMT for a company? Twenty percent. So what's the regular rate for a C Corp? The maximum regular rate? Thirty-four percent, plus [NYS taxes]; that rate is, like, a billion percent," he said. 

This situation can take some careful framing when it is being explained to clients, he said. If a client, through exemptions, is expecting to pay zero tax and instead needs to pay $60,000 in AMT, they client is going to get angry.

"Your taxes would be $120,000 but because of these methods we're using, you'll only owe $60,000, and that $60,000 will be credited against future tax--we have a party! But if they think zero and now you go in there and say it wasn't zero, it would have been $120,000 but now it's $60,000, I would think you would get killed. ... I think a lot of people hate AMT, so in my office it's a fireable offense to not calculate AMT on every contractor," he said. 

Lundy also lamented that too few contractors do look-back tax returns, i.e., looking in retrospect at the jobs completed versus what the client told the IRS each year, something that will likely result in a refund. Doing a look-back return, the clients look back four years and see costs incurred to date and then recalculate what the clients would have paid in those years. If they owe tax, they pay interest but if they overpaid tax, they get interest. Lundy said that contractors tend to overestimate their taxes owed, so they often get money back. 

"So this is something we find people aren't doing. As we go around, people say, 'We don't do look-back because we don't understand it, we don't think the IRS understands it, and our clients don't want to pay us to prepare it," he said. 

These are the sorts of mistakes that lead contractors to leave money on the table that could help them in the future, and even when informed that they can get more from the IRS, clients can still be hesitant, something he felt was unfortunate. 

"If you [have] a pile of money across the street, you would go get that pile of money," he said. 

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