Sessions@ Berman Hopkins Presents:

Tax Topics for Contractors

The Tax Department of Berman Hopkins

Hierarchy of Contractor Masters-Pass #1

1. The Auditor- aka the quarterback- it all starts here

2. The Bondsman- Our bonds are paid up front

3. The Banker- We like lots of loan covenants

4. The IRS- We know where you are

1. The IRS – Ultimate Power

2. The Bondsman – No bond, no work

3. The Banker – We think you may have violated a loan

covenant

4. The Auditor – We’re on your team

Hierarchy of Contractor Masters-Pass #2

Your Defense Team (same for Pass #1)

1. Your Accounting Firm and Auditor-Objective

with Class & Credibility

2. Your Tax Advocate

Hierarchy of Contractor Masters

Generally Accepted Accounting Principles (GAAP) – Percentage of Completion (POC) (603-35-25-51)

1. The POC method recognizes income as work on the contract progresses.

2. Income recognized shall be the percentage of total income, that incurred costs to date bear to estimated total costs based on current estimates of costs to complete (i.e. a moving target) For example: Total Contract Price is $500,000, costs incurred to date are $300,000 with an estimate to complete of $100,000. You would recognize $375,000 of the contract (300/400x500), less expenses of 300,000 for a current period net profit of $75,000.

What are Contract Costs (605-35-25-34)

Contract costs generally include all direct costs, such as materials, direct labor, and subcontracts, and indirect costs identifiable with or allocable to the contracts. However, practice varies for certain types of indirect costs considered allocable to contracts (for example, support costs such as central preparation and processing of payrolls, billing and collection costs, and bidding and estimating costs).

Best Option- Completed Contract Method IRC Section 460(e)

1. Best option is to report for tax purposes under the completed contract method. Pay no tax until contract is completed.

2. Must be under $10 million in average annual revenue for past 3 years For example: 2014 - $12million in revenue, 2013 - $10million in revenue, 2012 - $7 million in revenue – results in a 3 year average of $9.66 million, so you could still report on the completed contract method for 2015

3. Be absolutely aware of the Alternative Minimum Tax (AMT). The difference between the completed contract method and the percentage of completion method is a factor in the AMT calculation.

Percentage of Completion for Tax Purposes

IRC Section 460

1. The percentage of completion shall be comparing costs allocated to the contract incurred before the close of the taxable year over estimated total contract costs – IRC Section 460(a).

2. All costs which directly benefit the long-term contract activities of the taxpayer shall be allocated to such contracts.

3. Research and development expenses, unsuccessful bid expenses, and marketing, selling and advertising expenses are not contract expenses.

The Tax Method seems like it is the same as the GAAP, Percentage of Completion Method, and the answer is yes and no.

Percentage of Completion

Options for Tax

• No Fuss No Muss Option Just follow the financial statement method of POC – You do not want any confusion or complexity.

• The Regular & AMT Tax Deferral Method – You have the right to set up your own POC method

of accounting for tax purposes using our Section 460 tax grid. We defer income by a use of inflation factors and other overhead factors for long-term contracts. This is a tax favorable method but does add some confusion. It will result in a deferral of income taxes over time.

Home Construction Contractors- Sec 460(d)(6)

1. Home construction is defined as constructing buildings with 4 or fewer dwelling units including townhomes.

2. As long as 80% or more of the contract costs are attributable to such dwelling units, the contract qualifies as a home contract.

3. In practice this effectively means you are on the completed contract method, recognizing income and costs at closing.

Other POC Tax Tricks

Election to Exclude 10% Contracts IRC Sec. 460(b)(5) We can elect to not report any POC income on a contract that is not at least 10% complete. Special Rules for Residential Contractors 1. A residential contractor can report for tax purposes under the

Percentage of Completion/Capitalized Cost Method (PCCM). 2. PCCM allows residential contractors to report 70% of the

contract under POC and 30% under the Completed Contract Method. Thank goodness for accountants.

3. Residential contractors are those building “dwelling units” with more than 4 units, such as apartments, condos, nursing homes, retirement homes, college dormitories, and prisons. Hotels do not qualify.

Look Back Method-Sec. 460(b)(2)

1. The look back method simply changes your interest if you under reported your income from the contact. In other words, the contract ended up better than the estimates (a good thing).

2. In the event you over reported your income because the contract underperformed the estimates, the IRS will pay you interest.

3. The interest rate currently is 3%.

Watch Out for the Alternative

Minimum Tax (AMT)

1. We refer to this as the “Pearl Harbor” provision – it can sneak up on you and do some real damage.

2. For AMT purposes, you must report all of your income on the POC method. So if you are using the Completed Contract Method or the Residential Contractor Method (PCCM), you must make an adjustment for the tax deferral for AMT purposes.

3. The AMT tax in this case is not a permanent tax, as it is a refundable credit in future years as the contracts turn around. Your claim the credit on Form 8801.

Illustrative Tax Calculations-REAL CASE

Per Books Per Reg Tax Per AMT

Net Income $1,874,229 $1,317,576 $1,874,229

Income Taxes $684,037 $463,603 $521,171 *

Blended Tax Rate 36.5% 24.8% 27.8%

* In general, timing difference (like long-term contract adjustments) that create AMT are refundable in future years, when the contract timing difference turns around. In this example, $57,568 ($521,171-$463,603) would be a credit carry forward to future years to offset future regular tax.

Joys of Owning Your Own Business

1. Business expenses are deducted right off the top 2. Vehicle deductions 3. Conference/quasi vacation travel 4. Laptops, IPads, internet, cell phones and other

business gadgets 5. Family on payroll 6. Publications and office supplies 7. First class business travel 8. Employee holiday and other functions 9. Business lunches, dinners and entertainment