Construction businesses have had their share of challenges recently. Is your business looking to preserve precious cash and working capital going into an uncertain year? If your company is like most, the answer is a resounding yes. But there are two powerful tax planning opportunities you can take advantage of if you’re willing to invest some time, review your contracts, and plan ahead.
These tax-deferral strategies center on nonautomatic accounting method changes that must be submitted to the IRS before December 31 of the year that the change goes into effect. For this year, for example, the change would need to be submitted to the IRS by Dec. 31, 2020, for the 2020 tax year. Both methods require user fees and extensive planning but can result in significant benefits.
Pay-if-paid method for long-term contracts
This method gives construction businesses an opportunity to create a tax deferral by excluding their subcontractor payables as part of their IRC Section 460 percentage of completion (POC) calculation if certain conditions are met. It’s most useful for long-term contracts and can generate large cash savings by deferring revenue.
Typically, general contractors or large-contract manufacturers are the most common beneficiaries of the pay-if-paid accounting method. If you have a large, healthy subcontractor payable balance at the end of the year, this method will be beneficial. Combining it with other Section 460 planning, such as the exempt contract methods that include residential or home contracts can also yield favorable results.
How the pay-if-paid method generates tax benefits
In a nutshell, the pay-if-paid accounting method allows contractors to remove their subcontractor costs from the IRC Section 460 calculation under certain circumstances. This process creates a new tax job-to-date cost, which directly changes the percentage of completion of that contract and slows revenue recognition.
Contractual conditions for making a pay-if-paid accounting method change
In order to use the pay-if-paid accounting method, your standard contracts with subcontractors must meet two conditions:
- They must have “pay-if-paid” language in them.
- They must be in a state/local jurisdiction that allows “pay-if-paid” language in contracts.
Note that this applies to pay-IF-paid language, not pay-WHEN-paid. The easiest way to distinguish between the two can be boiled down to one specific concept: the condition precedent. Pay-if-paid contracts create a “contingent” payment structure and shift the financial risk of a given contract to the subcontractor. This contingency is what creates the opportunity from a tax perspective to defer this payable, rather than to recognize the expense under IRC Section 461(h) and the court ruling in United States v. General Dynamics Corp.
Pay-when-paid contracts, on the other hand, are simply a timing mechanism that means once the general contractor has been paid, he will pay the subcontractor. It doesn’t absolve general contractors from paying if the deal goes sour.
Planning for the pay-if-paid accounting method change
This method requires planning and continuous monitoring for the benefits to outweigh the initial investment. To start:
- Talk with your attorney about your current subcontracts to determine whether or not they contain the proper pay-if-paid language.
- Consult with legal counsel and assess the current footprint of your business, and identify the states in which a majority of your work is being performed. Do these states allow pay-if-paid language in their subcontracts?
- Ensure you can provide relevant schedules and documentation, such as calculating payables by job, aggregating jobs properly, and other accounting capabilities.
- Plan properly to ensure the maximum deduction.
- File IRS Form 3115 by the end of the year the change is to go into effect.
- Pay the IRS user fee of $10,800, adjusted annually for inflation, for the filing of Form 3115
With proper planning, the pay-if-paid method can improve cash flow and help mitigate longer-term federal, state, and local tax burdens, and can be used as a year-end planning strategy to manage your tax positions.
Cash method for short-term contracts
Electing the cash method gives companies with over $26,000,000 average annual gross receipts, adjusted annually for inflation, an opportunity for tax deferral that mainly applies to short-term contracts, although it also combines nicely with other long-term-contract accounting methods.
The method change to cash accounting can result in an immediate and semipermanent deferral, since it enables revenue recognition when the cash is actually received rather than when it’s earned. In recent years, we’ve helped several contractors elect this method, with significant first-year income deferrals.
Planning for the cash accounting method change
For the benefits to outweigh the initial investment, the cash accounting method also requires significant initial planning and ongoing. To start:
- Assess your balance sheet. Most likely to benefit are subcontractors who typically incur costs and have shorter vendor payment terms of 30-45 days but receive payment from owners or general contractors in a longer time frame of 60-90 days.
- Perform proper planning to determine cash flow needs.
- Ensure you can provide relevant schedules and documentation, such as calculating payables by job, aggregating jobs properly, and other accounting capabilities.
- Note that any long-term contracts — defined as “any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into” — would still be accounted for using the POC method.
- File Form 3115 by the end of the year you want the change to go into effect.
- Pay the IRS user fee of $10,800, adjusted annually for inflation, for the filing of Form 3115.
If you plan carefully, the cash accounting method can result in more cash in your pocket in the first year and continue year-over-year if your balance sheet stays stable.
In conclusion
Don’t miss out on these tax-deferral opportunities, especially now as we face increased uncertainty. Both the pay-if-paid and cash method changes require planning and some upfront investment, but the upside — in both short- and long-term benefit — can outweigh the cost for many construction businesses.
Have questions? Feel free to give us a call.
