Chapter 11 Construction Industry Tax IssuesAfter completing this session, participants will be able to do the following: 1. Explain how to account for long-term construction contracts2. Understand the deductions for business transportation

• Determine the deduction for an employer provided vehicle • Determine portion that is included in the employee’s income

3. Know when to deduct meal and entertainment expenses4. Employee vs. Independent Contractor Classification

Issue 1: Accounting for long-Term Contracts

Who/What Is Your Taxpayer (small business)pg. 416

• TCJA redefied small taxpayers for purposes of accounting methods• Taxpayers with average gross receipts that do not exceed $26M (for

2021) for the 3 prior tax years (small construction contracts)• Cash method of accounting• Accrual method of accounting• Exempt from uniform capitalization rules IRC 263A • Exempt from keeping inventory• Exempt from percentage-of-completion method under IRC 460

Construction Industry Accounting Methods NIB

• IRC 446(a) provides that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes income in keeping books

Except under IRC 446(b) provides:• If the taxpayer has regularly used no method of accounting or if the

method does not clearly reflect income, the computation of taxable income shall be made under such method, in the opinion of the Secretary that does clearly reflect income

IRC 446(a) Provides Permissible Methods NIB

• Cash receipts and disbursements method• Accrual method• Any other permissible method, or• Any combination of the foregoing methods permitted under the

regulations

If No Exceptions pg. 416

Such as…..• Home construction exception, or• Small construction contractor exceptions do not apply:

• IRC 460 generally require the Percentage-of-Completion method(revenue recognition throughout the term of the contract)

Long-term construction Contracts pg. 417• Any contract for the manufacture, building, installation, or

construction of property, if the contract is not completed within the tax year in which the contract is entered into

Contract dates –Start when it’s binding on both the contractor and customerEnds earlier of

use for intended purpose and 95% costs incurred, orcomplete and customer accepts

Example 11.1 (completed contract) pg. 417

• 2019 Casey contracted to build an office building• Average gross receipts of $30,000,000• November 2020 contract completed enough for tenants to move in• Some minor details still to be completed (less than 5% costs)• 2021 Casey completed punch list (Jan. 2021)• In what year was the contract completed?• Is this a long-term contract?

IRS Audit Technique Guide NIB• Long Term Contract "long-term" tends to indicate a contract that lasts a

long period of time, but the duration of the contract is irrelevant in order for it to be classified as a long-term construction contract.

• IRC Section 460(f) (1) generally defines a long-term contract as one that is not complete at the end of the tax year. The long-term contract must also be for the manufacture, building, installation, or construction of property. IRC Section 460(f)(1): In general, the term "long-term contract" means any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into.

IRS Audit Technique Guide NIB

• 1. Cash, 2. Accrual, 3. Hybrid • 4. Accrual with Deferred Retainages • 5. Completed Contract Method (CCM) • 6. Exempt-Contract Percentage of Completion Method (EPCM) • 7. Percentage of Completion Method (PCM) or Cost-to-Cost as

required by IRC Section 460 • 8. Percentage of Completion Simplified Cost Method • 9. Percentage of Completion 10% Method • 10. Percentage of Completion Capitalized Cost Method (PCCM

Selecting an Accounting Method ATG

• If a contractor is exempt from the percentage-of-completion method under IRC Section 460, the contractor may adopt a method of accounting for its long-term contracts on the initial income tax return, or in the first tax year there are long-term contracts

• Once a method of accounting is adopted, this method must be used for all long-term contracts in the same trade or business

• A change is not generally permitted without obtaining prior permission from the Commissioner

Example of Multiple Contracts NIB

• Small contractor uses accrual method of accounting for short term contracts (income & expenses not related to long term contracts).

• Uses the completed contract method for its exempt contracts, and• POC for contracts that are not exempt (contracts not expected to be

completed within 2 years)

Example – Small Contractor NIB

• Contract 1: Expected to last 18 months – allowed to use its normal method of accounting for long-term contracts (cash, accrual, CCM)

• Contract 2: Expected to last 3 years – Must use the PCM as required by IRC 460 as the two-year requirement is not met

• Exception to using PCM – Home Construction Contracts (any size contract) if,…………..

Home Construction contract pg. 419 - 420

Exception to requirement to use the PCM:

80% or more of allocable costs for construction of:Dwelling units (4 or fewer), orImprovements to dwelling units

Residential construction contracts (more than 4 dwelling units) must use PCM or PCCM

Percentage of Completion Method pg. 417

• Report a portion of the total contract price that corresponds to the percentage of the entire contract that was completed during the year

• Gross revenue reported each year is determined in three steps:1. Determine completion factor - cumulative allocable contract costs

(costs for year)/estimated total allocable costs = % ratio2. Ratio from 1 above X total contract price3. Current yr. gross receipts = difference between cumulative gross

receipts for current yr. from step 2 & the amount of cumulative gross receipts for the immediately preceding yr.

PCM Calculation of Current Year Gross Receipts pg. 418

PCM Calculation Example 11.2 & 11.3 pg. 418 • 1-1-2020 Blue Construction $100M contract, $62,500,000

estimated costs. • In 2020 $7M incurred. Gross receipts are $11,200,000 and net

contract income is $4,200,000.• $7M/$62.5M X $100M = $11,200,000 Blue Construction Year 2. Same calculation but use cumulative costs

($7M+ $35M = $42M) 1. $42M/$62.5M X $100M = $67.2M - $11.2M = $56M2. $56M current gross receipts - $35M current costs = $21M net

income

Allocable Contract Costs pg. 419

• Direct and indirect costs that must be capitalized under IRC 263A, or• Election to use the simplified cost-to-cost method to allocate costs

• Completion factor using only direct materials, direct labor, depreciation, and cost recovery allowances on equipment and facilities directly used

• In either case you must apply the lookback method upon completion of each contract

• Looks at each year to see if you under or over reported income based on actual costs. Could result in interest due, not tax due

Small Contractor Exemption pg. 420

• Taxpayer may use the PCM and any other permissible method• Applies to a construction contract:Entered into after 12/31/2017 or later, other than a tax shelter

prohibited from using the cash method of accounting, andwho estimates at the time the contract is entered into that the

contract will be completed within a 2-year period From the contract commencement date

Completed Contract Method Example pg. 422

• 2020, Brent Builders contracted to build a single-family home• The contract price is $500,000 (home was finished in 2021) • Brent incurred $350,000 in costs in 2020• Brent reports no income or expenses in 2020 • Brent reports $150,000 of income in 2021 ($500,000 - $350,000)• Does this reflect what actually occurred in 2020?

Exempt contract methods pg. 421 -422

May elect to use: PCM, Exempt Contract PCM, CCM, or any other permissible method

Exempt Contract PCM – use any method of cost comparison

CCM – Include all in completion year

Issue 3: Transportation Expenses

Allowable expenses pg. 423Commuting expenses – not deductibleDeduct if from one business location to anotherDeduct if from residence to temporary workplace (outside metropolitan area or regular place of business away from residence)Temporary – 1 year or lessDeduct if residence is principal place of business

Example 11.7 pg. 423

• JS is a construction contractor• She has an office where she regularly meets with customers and

manages all her project activities • JS drives from her residence to her office and back each day • While driving she often makes calls to schedule subcontractors and

order materials • JS is working while she is in the car • Is any of her travel to her office and back deductible?

Deducting expenses pg. 424

May deduct cost based on Standard Mileage Rate (SMR) or Actual costs SMR:Used in lieu of actual expenses (owned or leased) Elect in first year vehicle used in business 2021 rate = $.56 per mileNot allowed for fleet (> 5 vehicles)

SMR – Additional expenses pg. 425• Expenses allowed in addition to SMR:

• Parking fees & tolls• Interest paid on vehicle loan• State/local property taxes

SMR Depreciation component pg. 425Basis adjustment for SMR depreciation component - a portion of SMR each year is considered depreciation• Figure 11.3 table• In 2021 = $.26/mile• Ex. 11.10 Amy paid $34,000 and sold for $15,000. 87,700 miles

using SMR = $22,653 depreciation (Figure 11.4). Reduces basis, and $3,653 gain.

Actual costs pg. 426Deductible expenses include: Gas and oil Maintenance and repairs Tires Registration fees and taxes Licenses Vehicle loan interest Insurance Rental or lease payments Depreciation Interest on purchase Taxes

PN – SMR or actual can deduct parking fees and tolls for business use

Depreciation deductionsMost autos MACRS 5 year (eligible for 179 & bonus) Figure 11.5 – Section 280F depreciation limits (under TCJA) Placed in service 2019 - 2021 (no bonus depreciation) Year 1: $10,200 Year 2: $16,400 Year 3: $9,800 Later Years: $5,860

P. 427

Example 11.11 pg. 428

• On June 1, 2020, Frank purchased an SUV with a 5,800-pound GVW for $60,000

• He used it 100% business and wants to deduct actual expenses • He did not elect the section 179 deduction and elected out of bonus

depreciation• His MACRS 2020 depreciation deduction is $12,000 ($60,000 × 20%) • Francisco’s depreciation is limited by section 280F to $10,100

Substantiation pg. 428 -431SMR – KEEP A LOGDateDestinationMileageBusiness purposeACTUAL EXPENSES – KEEP RECEIPTSSee Figure 11.7

Passenger Auto Bonus Depreciation pg. 428• Generally, qualify for bonus depreciation• Taxpayer must elect out (by asset class all MACRS 5-yr. property)• TCJA bonus depreciation was increased to $8,000 per year

IRC 179 (Passenger Autos) pg. 429

• 2021 - $1,050,000 cost of qualifying property placed in service • Phase out $1 for $1• Limited to taxable income• Unused is carried forward (does not expire)• Calculated before Bonus depreciation (reduces basis)• After IRC 179 & Bonus depreciation – recalculate basis• IRC 280F still limits passenger autos to $18,200 for 2021• IRC 179 election will prevent future deduction until year 7

SUVs Over 6,000 Lbs. GVW pg. 429

• Exempt from IRC 280F limits • Must be less than 14,000 lbs. GVW• An SUV is not a bus, van, pickup, cargo van* • 2021 IRC 179 is limited to $26,200 • TP may claim 100% bonus depreciation

* Most full-size pickup trucks and cargo vans are also exempt form IRC 280F limits

IRC 179 vs. Bonus Depreciation pg. 429

• The limit on the section 179 deduction may be irrelevant for many taxpayers because 100% bonus depreciation is allowed on both new and used vehicles.

• However, the bonus depreciation decision applies to all assets within any given recovery class placed in service that year by the taxpayer.

• The section 179 decision is made on an asset-by-asset basis rather than a class-by-class basis.

Employee use of employer vehicleValue of personal use included in income

• Cents-per-mile method – SMR x personal use miles• Annual lease value method – use tables in the regulations (Figure

11.8)• Commuting value rule - $1.50 x each one-way commute

PP. 431- 434

Issue 4: Meal and Entertainment expenses

General rules pg. 435 - 436

Food or beverage expenses 274(k) limit – not lavish 274(n) limit – 50%

Restaurant meals 100% deductible in 2021 and 2022 Exceptions to the limitations may applyNo deduction for entertainment (with exceptions)

Work site mealsMeals on the job site

May be excluded from employee’s incomeFor the convenience of employer50% deduction Ex. 11.12 Remote construction site outside Jackson Hole. Big

Bend construction can deduct 50% (100% if restaurant), excluded from employees’ income.

P. 436

Business Meals & entertainmentBusiness meals with customer, client, employee, etc.

deduct 50% (100% restaurant)Not lavish or extravagant, taxpayer or employee presentNo deduction for entertainment – even if for businessMeals during entertainment must be separately stated

P. 437

Recreational meals Employee party – deduction limits don’t apply Can’t discriminate in favor of HCEs Ex. 11.13 – Employee holiday party deduct 100% Ex. 11.14 – Only HCEs deduction limited to 50% (100% if

restaurant) Ex. 11.15 – Business dinner w/client and employee limited to 50%

(100% if restaurant)

PP. 437-438

Example 11.13 pg. 438

• Ambient Electric hosts a holiday party for its employees in a hotel ballroom.

• There is a buffet dinner and an open bar. • The cost of the party, including food and beverage expenses, is not

subject to the deduction limitations because the holiday party is a recreational, social, or similar activity primarily for the benefit of non–highly compensated employees.

• Thus, Ambient may deduct 100% of the cost of the party

Ex 11.15 pg. 438

• OJ is a landscape designer • Invited an employee and client to dine at a restaurant (business meal)• Ordered a special dessert for employee birthday• Employee recreation expense exception does not apply• Dinner is deductible at 50% (100% for 2021 & 2022)

Meals treated as compensationFully deductible if expenses treated as compensation Ex. 11.16 – Work site meals included in compensation –

deduct 100% Ex. 11.17- Employee pays part – deduct 100% Ex. 11.18 – Meals excluded – deduct 50%

P. 439

Example 11.16 pg. 439• Gator Builders Inc. provides meals to employees at construction site

(free to employees)• The meals do not meet the exception of a de minimis fringe benefits

at the convenience of the employer• Not excluded from employee income• Compensation/wages and deductible to employer at 100% • If employees are charged $8 & FMV is $10 per day (cost is $9)• $2 is treated as compensation • Gator deducts 100% ($9 per day)

Meals For The Convenience of Employer pg. 439 (ex 11.18)• Meals provided to employees at remotes site• No charge to employee• Meals are excluded from employee compensation (IRC 119)• Employer is limited to 50% deduction • *If they at a restaurant it would be 100%

Issue 5: EMPLOYEE or INDEPENDENT CONTRACTOR Classification

Common law factors

• Behavioral control: Right to direct how work is performed – instructions/training

• Financial control: Purchase equipment, pay expenses, opportunity for profit

• Relationships of parties: Fringe benefits and exclusive services indicate employee

PP. 441-442

Independent contractor case lawWorkers controlled hours/methods, construction job was of short

duration, free to accept other jobs [ Kurio v United States]

Workers controlled manner and method of work, were free to accept other work, had own tools & equipment, employed own workers, paid upon completion [Tristate Developers v United States]

PP. 442-444

Case Law pg. 444-445

Workers had own equipment, set own hours, no instruction other than the work order[Beyer v United States]

Worker chose means/methods and worked for other companies [Jones v. Commissioner]

Employee case law Company paid holiday bonuses and carried worker’s comp and liability

insurance, workers worked almost exclusively for the company, and no retained right to discharge [Chase Mfg. v. United States] Employer provided materials and supervised workers. No opportunity

for profit [Ramirez v. Commissioner] Employer provided most tools and equipment, trained and supervised

workers, and provided liability insurance[Klingler v. United States] Employer provided materials and loaned tools, workers wore uniforms,

and on-site supervisors. Employer paid health insurance premiums and vacation pay [McCombs v. United States]

PP. 444-445

independent contractor Reporting

Form 1099-NEC Nonemployee Compensation

PP. 445-446

Questions?