If you withhold retainage (known as a portion of a contract’s final payment withheld by a principal — client or owner — until the project is complete in all respects), from subcontractors, you may be able to defer some of your taxable income to future years. This opportunity stems from the way retainage payable is treated under the percentage-of-completion method (PCM) of accounting.
For tax purposes, large contractors generally use the PCM to report income on long-term contracts — that is, contracts that span two or more tax years. Large contractors are those whose average annual gross receipts for the preceding three years exceed $10 million.
Under the PCM, in a given tax year the contractor applies a “completion factor” to the contract price when calculating profits. Typically, the completion factor is the ratio of costs incurred during the tax year to total estimated contract costs. In certain circumstances, retainage can be excluded from the completion factor, which defers tax to future years.
Percentage-of-completion Method Illustrations
Illustration A: Completion and taxable profit
CCC Construction won a $10 million contract to build an office building at an estimated cost of $9 million over three years, beginning construction on the first day of its tax year. At the end of the tax year, CCC has incurred costs totaling $3 million, and its original $9 million total cost estimate remains accurate.
The project’s completion factor is $3 million / $9 million, or 33.33%. CCC’s revenue for year one, therefore, is 33.33% of the $10 million contract price, or $3,333,000. After deducting its $3 million in costs, CCC’s first-year profit on the job is $333,000.
Illustration B: Retainage exclusion and deferring taxable income
Assume that, of CCC’s $3 million in year-one costs, $2.8 million consists of payments to subcontractors for which CCC withholds 10% retainages totaling $280,000. If CCC can exclude retainage from the numerator of the completion factor, the percentage complete is reduced to 30.22% ($2,720,000 / $9,000,000). This reduces first-year revenue to $3,022,000 and first-year profits to $302,000 ($3,022,000 – $2,720,000).
By excluding retainage, therefore, CCC reduces its taxable income in the first year by $31,000 ($333,000 – $302,000). This may not seem like a significant amount, but when you multiply it across all of your jobs, the current-year tax savings can really add up.
When can you exclude retainage from the PCM calculation? You can do so until it becomes a “fixed and determinable” liability and, therefore, must be treated as an incurred cost.
Under IRS rules, a liability must be recognized by an accrual-basis taxpayer when:
- All events have occurred to establish the fact of the liability,
- The amount of the liability can be determined with reasonable accuracy, and
- Economic performance has occurred.
Generally, the third bullet occurs when a subcontractor completes its work or, if earlier, when it’s paid. Even if a subcontractor has completed its work or been paid, however, your liability for withheld retainage may not meet the first two parts of the test. This may be the case if, for example, the contract provides that retainage isn’t payable until full acceptance and completion of the job.
As long as there’s a possibility that the sub will forfeit some or all of the retainage, your liability is not yet “fixed and determinable” and retainage should be excludable from the numerator of the completion factor.
So to take advantage of this tax-deferral strategy, make sure your contracts with subcontractors are clear that retainage isn’t payable until the job is fully complete and accepted. The contracts should also spell out the circumstances under which you’re entitled to withhold retainage, such as incomplete or defective work, or failure to pay suppliers or other subs.
Application for Change in Accounting Method
If you haven’t excluded retainage payable from the PCM calculation in the past but would like to do so in the future, you’ll need to apply to the IRS for permission to change your accounting method. This means filing Form 3115 — “Application for Change in Accounting Method” — together with supporting documentation that illustrates how the new method will more accurately reflect your income. The IRS will likely request copies of existing or master contracts you’ve entered into with subs to make sure the language is compliant with requirements.
Changing your accounting treatment of retainage payable can generate substantial tax benefits at a relatively low cost. Obtaining IRS approval to change your accounting method can take several months, however, so the earlier you apply, the better. Your tax advisors can help you determine whether such a change would benefit your company and, if so, guide you through the process.