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Preserve cash: Accounting method changes available for construction businesses

October 6, 2020 / 5 min read

Many construction firms are overlooking two powerful tax planning opportunities. These accounting method changes require you to invest time, review contracts, and plan ahead. We break down the pay-if-paid and cash methods into key action items.

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:

  1. They must have “pay-if-paid” language in them.
  2. 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.

Typically, general contractors or large-contract manufacturers are the most common beneficiaries of the pay-if-paid accounting method.

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:

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.

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:

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.

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