Small construction firm owners and contractors can find it especially difficult to comply with the strict letter of the law when it comes to filing their income tax returns.
The IRS recognizes the potential problems and wants to lend a helping hand. The tax agency periodically updates several publications geared to contractors, most notably Publication 3780, Tax Information for Small Construction Businesses.
This publication identifies common tax pitfalls facing small construction firms and explains how to avoid them. The three main issues addressed are:
- Accounting methods,
- Indirect cost issues, and
- Worker classification.
The accounting method you choose will set the rules for determining how and when income is reported. The choices include the cash method, accrual method, and combinations of these. The method must clearly reflect your income.
Contractors, however, cannot always choose. For tax purposes, there are rules that control whether you must use the cash or accrual method. Cases where the cash method cannot be used include:
- Corporations or partnerships with a C corporation as a partner whose average annual gross receipts exceed $5 million. There is no exception to this limitation.
- Firms that must use an inventory method because merchandise or materials is an income-producing factor. These firms generally must use an accrual method for purchases and sales. Small businesses may qualify for an exception to this rule, and may still use the cash method if their average annual gross receipts is $10 million or less. Firms required to use accrual accounting don’t qualify for this exemption.
For long-term contracts, contractors may be required to use the percentage-of-completion method, which realizes revenues and profit over time as a percentage of the work completed during a year. Home construction contracts, however, are not subject to this method. Moreover, general construction contracts are not subject to it if they meet certain time and gross receipts tests. For additional information on these, talk to your accountant.
Indirect Cost Issues
As a contractor, you must allocate indirect job costs to long-term contracts every year, unless the tax code or regulations provide exemptions. Whether you can capitalize or deduct these costs depends on how you account for long-term contracts.
In general, contractors using the percentage of completion method must allocate indirect job costs to their long-term contracts. Contractors using the completed contract method of accounting must capitalize those costs until the contract is completed. Failing to capitalize can result in overstated deductions.
Allocable job costs include expenses incurred for a project, including repairs, equipment maintenance and rentals, depreciation on equipment and workers’ compensation insurance, among others.
Non-allocable job costs are exempt from cost allocation. They include expenses for unsuccessful bids and proposals, marketing, selling and advertising.
It is important to classify payments to your workers correctly. The treatment of payments for services depends on the business relationship you have with the person performing the job. That person may be classified either as an independent contractor or an employee.
Generally, workers are not treated as independent contractors if you control the services they perform. Factors indicating the degree of control typically fall into these three categories:
- Behavioral. Do you control, or have the right to control, what the workers do and how they do their jobs? For example, providing training indicates that you expect the workers to follow company guidelines. This may mean they should be classified as employees.
- Financial. Do you control the business aspects of the workers’ jobs? This includes how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, etc. In addition, only independent contractors can realize a profit or incur a financial loss from the work.
- Relationship. Are there written contracts or employee benefits, and will the relationship continue after the project is completed? The closer the relationship, the more likely the individual is an employee.
By recognizing the significance of these and other issues, small construction business owners can avoid costly problems on their federal and state tax returns. Your tax adviser can help you get it right.[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]