Percentage of Completion or Completed Contract: Which Is Better for Long-Term Contract Tax Reporting?

In December 2017, The Tax Cuts and Jobs Act raised the percentage of completion requirement threshold for long-term contract reporting from $10 million to $25 million. The IRS defines a long-term contract as any contract for the manufacture, building, installation or construction of property if such contract is not completed in the taxable year in which such contract is entered.

Contractors with three-year annual average revenues of $25 million or greater, or large contractors, are required to report long-term contract activity on the percentage of completion method. Conversely, contractors with three-year annual average revenues of under $25 million, or small contractors, have the option to report their long-term contract activity using the percentage of completion method or the completed contract method. Homebuilders are exempt from the percentage of completion requirement, regardless of size.

For small contractors, the best method for reporting long-term contract activity is specific to the business strategy of individual entities. To make sure tax strategy aligns with business and personal goals, it is vital for contractors to explore their reporting options. Delaying the payment of income taxes is a common tool used by contractors to improve cash flow.

There are a few things small contractors should consider when choosing how to report long-term contracts. Understanding the difference between the percentage of completion method and the completed contract method is a good place to start.

Percentage of completion method

Under this reporting method, revenue is recognized and reported for tax purposes as it is earned. A common misconception is that revenue is reported as it is received. In actuality, revenue is recognized using either an input or output measure of performance. The majority of contractors use the costs-to-costs input method, whereby the costs incurred through the taxable year are compared to the estimated total costs of the long-term contract. Once the percentage of completion is calculated through the costs-to-costs method, the earned revenue for the long-term contract can be determined. The revenue is determined by applying the percentage of completion percent to the total estimated revenues of the contract in question.

For example, if 75% of the estimated costs are incurred on a long-term contract through the end of the taxable year, then 75% of the estimated revenues must also be reported. For reporting purposes, revenue is adjusted by any amount greater or less than 75% of the calculated contract progress. The balance is booked to an over/underbillings account.

Some contractors use the output measure of performance when they have a readily measurable unit of production (e.g.: the number of feet of a curbed gutter installed for a specialty concrete contractor). Similar to the costs-to-costs method, once the percentage of completion is determined, the percent complete is applied to the total estimated revenues of the contract.

Completed contract method

Under this reporting method, revenue and related expenses are recognized and reported for tax purposes only when a long-term contract is complete. According to the IRS, in general, a taxpayer’s contract is completed upon the earlier of:

• use of the subject matter of the contract by the customer for its intended purpose (other than for testing) and at least 95% of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer; or
• final completion and acceptance of the subject matter of the contract.

In most cases, the completed contract method is more advantageous for small contractors. This method gives small contractors the ability to defer taxes on long-term contracts until the job is complete. The deferral can be substantial. At year-end, a contract can be 90% complete, but if it is not deemed complete by IRS standards, the contractor does not have to pay tax on any of the contract profit and proceeds received through the tax-reporting year.

Nevertheless, the completed contract method can create consequential cash flow problems if not monitored closely and appropriate tax planning is neglected. Trouble occurs when a cluster of long-term contracts are completed and all the revenue must be reported in the same taxable year. A contractor might have several long-term contracts open in one fiscal year and defer all of the tax due on the open contracts until year two. In year two, the contractor might have a strong fourth quarter and close out most of their contracts that they started in the second year. In this scenario, the contractor could and up paying two years of tax in one year because they closed out all of year one contracts in progress AND closed out most of their contracts started in year two. The completed contract method can be back-breaking for an entity that didn’t plan accordingly.

The cash flow crunch of the completed contract method is especially tough for new or growing companies that are reinvesting large portions of cash back into their businesses. With the cash increase from the completed contract tax deferral, the contractor might invest in some new equipment or trucks, add another crew, or distribute some cash to the owners. This is sustainable until several jobs close at once and no cash is available when it’s time to pay Uncle Sam.

The roller-coaster of the completed contract method is why some small contractors report their long-term contracts on the percentage of completion method. Under this method, the contractor pays tax when profits are earned, no matter when the contract is deemed complete. The percentage of completion method is easier to plan for and stabilizes company cash flow.

In conclusion, the completed contract method is more advantageous for tax purposes. Not many business owners want to pay tax sooner than required. Nevertheless, reporting long-term contracts on the completed contract method takes considerable foresight and a cash flow discipline. Not covered in this article are the many nuances of completed contract reporting. To insure compliance with IRS regulations, contractors should contact their tax advisor if considering a change in accounting method for long-term contracts.