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Real property businesses may benefit from applying different accounting methods to the various contracts used for their businesses.

Real Property Businesses: Which Accounting Methods Are Best for You?

  • 8/29/2013

Real Property Businesses: Which Accounting Methods Are Best for You?

by Perry McGowan

Remember when you were a child, and your teacher showed you how prisms took the stream of sunlight and converted it into a range of hues? “Wavelength,” the teacher said, “it makes all the difference.” Sunlight may be a long way from the zeros and ones of your business’s accounting system, but somehow that stream of data needs to be converted into something that can be understood and used. Accounting methods are like that prism. They reform the patterns of business information and they produce many hues, particularly with respect to real property businesses like construction, development, design, and engineering.

The cash method and accrual method, for example, are two common methods used by businesses, and the tax law allows both methods to be used simultaneously by one taxpayer if there are different trades or businesses involved.

Many prefer the cash method to keep reported profits in line with available cash. However, some businesses get paid early in the transaction process, perhaps before costs are incurred. They may prefer the accrual method in tax planning, to better align accruable costs (like wages or materials) with the revenue. The differences in reported income can be dramatic, potentially shifting future tax bills for months or years.

A few months of deferring taxes may not seem significant, but consider this: deferring one month of gross sales on a business with $12 million of revenue shifts about $1 million from the last month of the year to the next tax period. If the business has a healthy 8 percent net profit ($12 million x 8 percent = $960,000), that one-month shift represents a deferral of all of the taxable income for the year. Bingo, no tax due!

Special methods of accounting specific to certain industries are also used. Many construction contractors, for example, have a combination of choices and requirements for the reporting of income, and often the method is tied to the individual job. The tax law requires construction contracts, for example, that extend beyond the end of a tax year to follow special methods for income recognition. The “percent complete method” allocates income across time as costs of performance are incurred. A sometimes more favorable alternative, the “completed contract method”, allocates income to the period of completion.

These and other forms of accounting methods can be evaluated and selections made to best represent the taxable income in compliance with the varied tax law requirements. A taxpayer may benefit from income deferrals of a cash or a completed contract method, but only on qualified business lines or qualified jobs. Making the right choices as the business grows and changes is key to minimizing taxes.

Different methods for a variety of businesses

Repair, inspection, and cleaning, companies are purely “service” businesses. These generally qualify for the cash method of accounting and, since payment is normally the last step in the transaction cycle, cash is often the preferred method in tax planning for these activities.

There are many construction contractors who use an accrual method, which is typical for large construction jobs. However, when the components of their business are taken apart, we often find varied service contracts, such as revenues for inspection services, demolition, abatement, painting, finishing, polishing, waste management, testing, cleaning, and similar non-construction activities.

When they are all broken out, a company may not primarily be a construction contractor at all — although it may still be the largest single part of the business. If the tax accounting methods were tailored to the individual characteristics of contract requirements, millions in income could be deferred by applying more advantageous tax accounting methods. Often this can be done without a change in internal bookkeeping systems and without compromising financial statement income.

Missed opportunities

Construction businesses often think of themselves as only engaged in “construction.” But that oversimplifies their world. They are usually opportunistic job-seekers that understand how customer demands vary, and how to profit from those differences. Like the beam of sunlight, those varied jobs can be broken apart and examined in their different tax reporting hues.

Real estate developers have similar issues, since projects typically have many unique characteristics, each with its own accounting method implications. Architects and engineers are typically service businesses that can (and usually do) employ the cash method, but some design contracts may be better served through accrual methods. These opportunities are often overlooked.

Perhaps it is time to evaluate the many contracts that make your business successful and assess if there are opportunities for enhanced cash flow with new accounting methods. Understanding your core strengths is key to your success, and no one is better at that than you. But understanding the hues and shades from behind the prism of the tax law may bring you some bright rewards. With the economy rebounding and tax rates rising, another look at tax method planning might offer a new and brilliant vision. 

Perry McGowan, Director, Construction and Real Estate or 612-376-4632