How a construction contractor records taxable income and deductible expenses is determined by your choice of accounting method. Most construction companies use the accrual accounting method. Accounting methods are based on the size of the company and the term of the contracts. A construction contractor must first identify costs as two basic categories: labor costs, and general and administrative (G & A) costs.
General and administrative costs (G & A)
G & A costs are the ordinary daily administrative operating expenses of businesses that cannot be attributed to specific jobs. They include items such as office expenses and utilities.
However, certain administrative expenses are sometimes treated as indirect labor costs rather than as G & A costs. These are the operating costs that may be tied to a particular contract. For example, advertising expenses to sell a specific property can be treated as an indirect cost of employment. Other advertising expenses are still classified as G & A costs.
Labor costs are expenses related either directly or indirectly to a particular construction project. Payments for subcontractors, direct labor, and materials are the direct costs.
Indirect labor costs are the administrative costs necessary for the performance of a contract. Whether a contractor counts these costs as indirect labor costs or includes them with G & A costs depends on the size of the contractor and the sophistication of the accounting system.
Small construction companies often use the cash accounting method. Under this method, cash income is recorded as income when payments are received. Expenses are deducted when paid.
A construction contractor is not authorized to use the cash method if the business is a corporation or a partnership with a corporate partner. The cash method is also not allowed for a construction contractor with annual gross revenues exceeding $ 10 million. There is no exception to this limitation.
In addition, a construction contractor may be rejected from using the cash method if total purchases of “merchandise” for the year are “substantial” compared to annual gross income. Merchandise is any item that is physically incorporated into a product for customers. For the construction industry, the commodity is commonly called materials, such as wood or concrete. Merchandise is generally considered to be substantial when at least 10 to 15% of gross revenue is found for the year. This percentage has not been established by law, but has been applied in some judicial cases.
Method of accumulation
If a construction contractor cannot use the cash method, you must select a build method. The expenses will be deducted later when a cost has been incurred and an invoice has been received. The accumulation method tries to match the expenses for a specific contract to the income of that work. Under this method, revenue is usually recorded when the work is completed and billed to a customer. Therefore, income is often recorded before any money is actually received as payment.
Special types of accumulation methods
By separating the costs of each job, a contractor could record the revenue using the percentage of completion or the completed contract method. These could be more advantageous than the basic method of accumulation.
The percentage of progress is a method that only affects how earnings are reported. Under this method, all G & A and labor costs are deducted using the basic accumulation method rule. However, the income is declared as the work progresses. This is particularly useful for contracts that have not been completed in the same year they are started. Revenues are reported each year from a long-term contract. To determine gross income for the current year from a long-term contract, the percentage of advance is multiplied by the total price of the contract and the amount of gross income previously recorded is subtracted.
With the contract method completed, all contract revenue is recorded when the job is completed. In addition, all labor costs are deducted on completion of the project. The completed contract is the method commonly used by small contractors in the construction of custom homes.