Construction contractor

[natiro]

Anyone out there with expertise in this area?

Client is a residential home builder. In 2006, revenues were 2,000,000. All contracts were home construction contracts. Client is an LLC filing Form 1065.

Can client use the cash basis for tax reporting?

Many thanks.

[outwest]

Under rev proc 2002-28..

Yes.

Until he reaches $10 million.

Assuming there are no C Corp partners.

[Bees Knees]

The NAICS code for a home construction contractor is 236110. Accorcing to TheTaxBook, page 8-22, that code does not fall within the list of activities that are not allowed to use Rev. Proc. 2002-28. Therefore, they can use Rev. Proc. 2002-28 and since gross receipts is under $10 million, they can use the cash method.

[OldJack]

However, the cash method does not mean the contractor can just expense construction costs in the year of payment. Included with cash basis accounting is the concept of inventory, completed contract accounting method, and percentage of completion method of accounting (normally an accrual method).

[natiro]

Construction contractor

Old Jack,

Can you explain, perhaps by example, how the cash basis of reporting integrates with the completed contract and percentage of completion method? This is the part that's confusing me.

Thanks.

[OldJack]

Well its like different methods of inventory. Completed contract method holds all construction costs until the job is finished and matches all income recognized (ie: the last nail driven). Percentage of completion is costs held in inventory but a percent of profit recognized as the job is partially finished. Percent complete is not normally used with cash basis accounting. In both cases the costs are held in an asset account much the same as inventory but with a different titled account that better describes the method of accounting. When on the cash basis other operating expenses are deducted when paid.

[glgillis]

Look at

the IRS information for "Home Construction Contracts". The accrual, percentage of completion, and completed contract methods are listed, but no mention is made of the cash method of accounting.

[glgillis]

Just looked back

at Old Jack's posts. He is correct. While the company may technically be on the cash basis, it has to use one of the other methods to account for actual construction projects.

[natiro]

Still confused

Thanks for all of the responses so far.

I guess I'm still confused. To me, there is a big difference between cash basis and completed contract of percentage of completion reporting. So when we say the client can use cash basis but must use percent of completion or CC method, this seems to be contradictory.

Let's say client has one job and bills on cost plus basis. Invoices are sent out monthly and reflect the actual costs each month, plus a % for P & O.

At the end of Dec 2006, be pays subs and material costs of 1,000 and invoices his client 1,100 (cost plus 10%). The client pays the invoice in Jan 2007. Under cash basis reporting, he would deduct expenses of 1,000 in 2006 and would report the revenue in 2007. Under CC method, he would not deduct anything in 2006, but would deduct all costs, and report all income, when contract is complete. Under % completion, (let's assume job is 10% complete at 12/06), he would report 1,000 of expenses and 1,100 of income in 2006.

These are all very different outcomes and I'm still very confused about how a taxpayer who seems to be allowed to use the cash basis method, really has to use another method which gives such different outcomes.

Any insight or guidance on this would be greatly appreciated, as always.

Thanks.

[Snaggletooth]

Hybrids

Natiro, I believe if you separate "expense" from "cost" the picture becomes clearer.
Even though cash basis is allowed for expenses, and receivables/payables don't have to be recognized, the matching concept for inventoriable-type costs must still be observed in certain industries.

What if a client bought $35,000 in capital equipment and said he could deduct it as a cash expense? Immediately you recognize that capital equipment is not a part of the accrual-vs-cash basis question. Were it not for the special s.179 treatment, you would not be able to deduct it all in one year.

Used car dealers who carry notes are forbidden to elect cash basis treatment on their notes, but ARE allowed a reserve for bad debts based on experience.

Contractors are much the same way, as cash-in, cash-out is so distortive of their real profits that I believe the Code/Regulations single them out as having to use percentage-of-completion method. I don't even allow cash-in, cash-out for schedule C for homebuilders,
but do allow cash basis for operating expenses.

[Bees Knees]

A home construction contractor is not required to use completed contract method or percentage of completion method provided gross receipts are not more than $10 million. Code Section 460(e)(1), TTB, page 8-14.

What you do is use the cash method, with inventories.

All costs going into the home go into an inventory account until the home is sold, at which time you take a COGS deduction. The difference between this and accrual is you do not have to accrue expenses or income. In other words, you only record the expense in the inventory account when a check is actually written out for the expense. And you only record income from the sale when you get the check in hand. You don’t have to accrue income that is held in escrow for something the contractor has to do six months later, such as landscaping. That income is not recorded as income until they actually get paid for it.