Steps for Choosing an Accrual Method of Construction Accounting

Accrual Methods of Construction Accounting

Choosing a permissible method of accounting for tax purposes for your construction business involves classifying your contracts and business. As your construction business grows and changes, you may benefit from using a different method of accounting.

You should review the following three steps every year to ensure that you are using the right method of accounting for your construction contracts.

The Three Steps

Step 1: Classify all Construction Contracts as either Short-Term or Long-Term

The IRS defines a long-term contract as any contract that spans a year-end. If you have a contract that starts in December but was not complete until January, you have a long-term contract.

A short-term contract, on the other hand, is any contract you start and finish within one taxable year, regardless of the elapsed time of the project (i.e. 3 months versus 9 months). In terms of accounting methods for short-term contracts, use your overall method of choice – accrual or cash.

You must then choose an accounting method for your long-term contracts based on the following steps.

Step 2: Classify all Long-Term Contracts as either Home Construction or General Construction

Are you building homes or other types of buildings?  Not including apartment buildings, these buildings with four or fewer dwelling units are considered home construction contracts:

• Single-family homes
• Duplexes
• Triplexes
• Quadplexes

Additionally, 80% or more of the estimated total contract costs must be for the construction, improvement, or rehabilitations of the units. If the project doesn’t fall under these criteria, it is a general construction contract and should be treated as such.

For long-term general construction contracts, there is one more step to take to choose the correct accounting method.

Step 3:  Classify Yourself as Either a Small or Large Contractor

This is a two-part step.

• The first part is to measure your average annual gross receipts for the last three tax years of your construction business. If the amount is $10 million or less, you are a small contractor.
• If it is more than $10 million, you are a large contractor and do not have to consider the second part of this step.

Large contractors are required to account for long-term contracts using the percentage-of-completion method (PCM) for their general construction contracts. Under PCM, contract income is reported annually according to the percentage of the contract completed in that year. For example, if a contract is 50% complete at the end of the taxable year, 50% of the contract income would be included in taxable income.   

If you are a small contractor, the second part of this step requires that you separate your long-term general construction contracts into two categories.

• The first category is those contracts that are reasonably likely to be completed within two years from the date work begins.
• The second category is long-term general construction contracts that you estimate will take two years or more to complete. For these longer-duration contracts, you must use a large contractor method, even though you are a small contractor.

Wondering about your tax obligations and which accounting method is permissible for your construction business? Contact us for a free consultation!