The Current Contractor Tax Method Environment and Possible Alternatives
Just about every contractor and their CPA tax return preparer believe that large contractors must only employ the accrual method matched to the percentage-of-completion method (PCM) for all their contract revenues. That rule had been true for many years however it is not true today. Since 2014, the IRS has been accepting and approving PCM tax method change applications away from the strict accrual/PCM. As a result, all profitable contractors should now be aware of this significant change. Tax methods that enable the consistent deferral of revenues will enable a contractor to keep more cash on its balance sheet or allow more profits to be released to its owners. If the contractor has reasonable consistency in its profitability, types of contracts employed, and in its balance sheet contract-related accounts, the tax deferrals essentially become permanent like deferrals.
Here’s an example – a large mechanical contractor with revenues well in excess of $100MM per year, wanted a change in its current CPA firm. The CPA firm did both its audit and tax return and did a good job. The contractor decided to put its CPA services out to bid. Ten CPA firms submitted proposals. The contractor narrowed its decision down to three firms. One of the firms asked us to look at the financials and tax returns to see if we could provide any suggestions that would distinguish that CPA firm from the others. Once we reviewed the client data, and understood the nature of the type of contractor, we used our experience in filing tax method changes to quickly discern that the contractor could be employing tax methods other than the accrual/PCM. We estimated the initial potential tax deferral to be approximately $20MM.
The contractor was a sophisticated client. Its owner had a legal education, and its CFO and controller were from Big-4 tax practices. The contractor asked if we would explain to them why we believed we could provide them with tax deferrals when none of the ten CPA firms even noticed that possibility. Once we explained our expertise in this area, we obtained an engagement letter and got to work. We read well over a hundred of their contracts, organized their WIP schedules, prepared the method change legal arguments, attached examples of supporting documents, and completed the tax method change filings for the contractor. There were three new tax methods submitted for approval. Once those were signed and submitted to the IRS, we waited for the IRS chief counsel office to review those applications for approval.
Fast forward to nine months after that call, the contractor received the IRS Private Letter Rulings and Consent Letters approving the proposed tax methods. Those letters provided audit protection, security, and confidence to the contractor. It helped him understand that the accrual/PCM tax method was not the only tax method possible. Those tax method deferrals saved the contractor millions of dollars.
There is no book or training on how to identify potential tax methods that a contractor can employ. It takes years of tax experience including the road map learned from submission of hundreds of method change applications to the IRS.
What we can provide: In order to file potential tax method changes for a contractor, one must know
- what alternative tax methods the IRS will approve
- whether the contractor has the underling facts and circumstances that would enable the employment of such methods
- how to read contracts to obtain the supporting facts and circumstances
- what the range of the potential tax deferrals are going to be
- the legal arguments/narratives and exhibits that must be submitted to the IRS, and
- how to defend the application(s) when the IRS attorney(s) working on them wishes to disagree.
A large profitable GC in the mid-west was considering changing its entity structure to an ESOP, but before doing so wanted to make sure all issues were considered. This company, doing approximately $2 billion in revenues, submitted its financials and tax returns to us for review.
During our process we reviewed underlying contracts employed with its owners and subcontractors. We determined that no less than four tax method changes could be implemented. Those tax method changes collectively resulted in the deferral of over $30 million in taxable income. If the GC decided to move to an ESOP entity, that deferral would become a permanent deferral.
General Process Overview, Documents, and Data Needed:
In order to determine if a tax method change is possible, the contractor may have to supply data not limited to the following items: (i) two years of financials and tax returns with details of tax adjustments; (ii) several examples of actual contracts with owners and subcontractors for each different contract type (such as fixed price, construction management (CM), CM with GMP (gross max price), service agreement, time and material, design build, and any master service agreements related to these contract types etc.); (iii) billing examples for each type of contracts employed (iv) work in process (WIP) schedules for the current and prior tax year; (v) accounts and retentions receivable and accounts payable matched to the open contracts; and (vi) the states in which the contract language is performed and/or governed by.
IRS Tax Method Change Filing Process:
The steps that are employed in a tax method change filing process typically are the following: (a) estimate the potential for tax method change benefit by reviewing the financials and tax return and provide an estimated range of tax deductions possible; (b) obtain an engagement letter to move forward; (c) obtain the underlying data to calculate the actual expected tax deductions; (d) decide what underlying actual contractor documents would best support the particular method change application; (e) prepare the supporting legal arguments for the method change application; (f) prepare the IRS Form(s) 3115; (g) assemble the IRS filing package consisting of the IRS form, the supporting legal arguments, answers to the IRS form questions, details of the contractor’s entity and related legal structure, exhibits, and so forth; (h) sign the 3115, obtain the contractor’s signature and submit the applications to the IRS along with the IRS filing fee; (i) await any IRS subsequent inquiries and provide answers or supporting information; (j) obtain the final IRS Private Letter Ruling and Consent Letter(s); (k) work with the CPA to ensure the incorporation of the method changes in the income tax returns.
10 Examples of Recent Contractor Tax Method Change Filings
Contractor Type: GC
Tax Deferral: $30MM
Contractor Type: Underground Utility
Tax Deferral: $14.3MM
Contractor Type: Glazing
Tax Deferral: $2.5MM
Contractor Type: Drywall
Tax Deferral: $7.5MM
Contractor Type: Concrete
Location: Chicago, IL
Tax Deferral: $2.4MM
Contractor Type: HVAC
Location: Eastern US
Tax Deferral: $20MM
Contractor Type: Electrical
Location: New Jersey
Tax Deferral: $6.3MM
Contractor Type: Guiderail
Tax Deferral: $3.1MM
Contractor Type: Sprinkler
Tax Deferral: $5.7MM
Contractor Type: Heavy Highway
Tax Deferral: $11MM
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