Don’t let an auditor come along and “deconstruct” your construction business! Take a moment to look at your business through the eyes of an auditor and save yourself some heartache. The purpose of an auditor is to really delve into tax returns and make sure the government gets every dollar of individual and business revenue it’s due.
Auditors use a hefty tax code for reference and are trained to examine filings to determine if returns are complete and in compliance. This code is 70,000 pages of complexity and detail; not to mention the addition of different specs for each specific build-out. Below, you’ll get a glimpse into an auditor’s challenge.
THE AUDITOR’S TOOLS
To aid agents, the IRS keeps a series of Audit Technique Guides (ATGs) covering certain laws and industries, including construction. Think of these guides as a Cliff’s Notes version of tax code portions most applicable to a respective taxpayer segment. Still, even this abbreviated version that auditors study before opening the books of a construction business is 11 chapters and more than 250 pages long. Yikes!
The same differing aspects that make construction a challenging field make accounting for construction businesses anything but “the usual”. Every job has its own unique set of issues that differ from project to project, region to region and day to day. Such things might include: weather, jobsite conditions, labor issues, performance of suppliers and subcontractors, change orders and environmental factors. Additionally, unlike owners of retail stores or manufacturing plants, most contractors bills and are paid on an incremental basis, with no definitive point of sale. The use of the percentage-of-completion accounting method causes construction businesses to pay taxes even on income they haven’t billed, much less collected.
Just as auditors do themselves a favor by brushing up before they begin a job, construction owners, contractors and any in-house accounting or bookkeeping personnel would do well to study the IRS’s Construction ATG too. The introductory chapters that tell how the construction sector is structured and how contractors and subcontractors interact may seem like basic, no brainer stuff, but the subsequent content should be required reading to stay in line with the tax laws and to comprehend issues that could cause problems.
Check out five of the main topics covered by the current edition of the Construction ATG:
ACCOUNTING FOR LONG-TERM CONTRACTS
How to account for the revenue from long-term construction contracts has been a huge area of confusion for the industry. The size of the business usually determines whether a contractor must use the percentage-of-completion method of accounting for revenues and apply the look-back rules. Companies with revenues averaging more than $10 million in gross receipts during the prior three years are classified as large contractors and therefore are generally subject to these provisions. Small contractors (with less than $10 million in revenues) may choose other methods of accounting for revenue on their income tax returns. However, both large and small contractors may be required to use the percentage-of-completion method for alternative minimum tax (AMT) purposes.
The definition of “large contractor” has not been changed since 1986. Associated Builders and Contractors’ Tax Advisory Group is working hard to change that, as well as gain exemption from AMT for all small contractors. Too many contractors and practitioners either do not understand the look-back rules or choose to ignore them. The IRS doesn’t like the look-back rules either, but a legislative change is needed to get rid of them.
COST ALLOCATION AND CAPITALIZATION
The ATG also deals with how to decide what costs must be allocated and maybe even capitalized as part of the construction costs. Agents typically find that contractors may be charging direct costs to jobs, but often they neglect to include overhead costs that should be allocated to jobs as part of the costing process.
Some small contractors might use the cash method of accounting. Even so, they might not be able to deduct the cost of certain materials and supplies until they’re paid for or within the tax year in which they’re actually used. Depending on the type of entity and the method of accounting for unused materials and supplies, a gross receipt threshold of $1 million, $5 million or $10 million might apply.
The ATG points to improperly deferred income due to delayed billings. One example is waiting until the entire job is complete—not just the specific subcontractor’s portion—to recognize income. Related-party transactions are carefully examined to uncover income-shifting schemes or deductions generated that are not at arms-length. To look for red flags, agents are told to perform minimum-income probes to determine whether income may have been diverted to owners.
The ATG instructs agents to apply certain techniques when auditing a contractor. For instance, it specifies that “special attention needs to be given to the possibility of unreported income.” Auditors are told to discuss with their managers any omitted income item in excess of $10,000. If something like this should be found during an audit could lead to a criminal investigation of the contractor.
INCOME FOR PERSONAL USE
Deducting costs of items on the income tax return that are for personal use raises another red flag. A high percentage of audit changes are made to gross receipts, cost of goods sold, meals and entertainment, car and truck expenses, insurance expenses and officer compensation. The ATG provides a breakdown according to type of entity.
The Construction ATG is a great help for contractors and IRS agents, so if you’re a contractor, use it to help yourself and keep your business safe.