Many contractors don’t understand that there’s specific rules regarding how income and expenses are reported in accounting, so this is an explanation of how the Completed Contract Method works for small businesses.
When you have a contract in place, that’s when you need to make sure that the revenue and expenses related to the job are recognized at its completion. This does not include overhead expenses such as rent, utilities, etc. so you need to make sure that everything is tracked separately. Also be aware that multiple jobs need to be treated as such following the same rules if you’re using this method.
Why is this method used? It makes sense when you’re unsure about when you’ll receive customer funds and that can wreak havoc for what you’re trying to accomplish in tax planning. It helps benefit you, the contractor, because you have greater control to determine completion when all monies and expenses have been received and paid.
The easiest way to protect yourself is making sure that you have accounting procedures in place to make sure you not only have a reference point for anyone who is handling your finances but also the ability to provide the information to outside sources which may question your processes during an audit.
If you’re not sure if this is an option for you, the IRS states the following rules:
- Income and expenses are recognized the year the CONTRACT is completed with at least 95% of the allocable contract costs have been incurred or final completion and acceptance of the subject matter of the contract
- Available for home construction contracts
- Contracts must be completed within 2 years, with the exception of home construction contracts
- Residential buildings with 4 or fewer apartments with at least 80% of the estimated cost is related to the dwellings directly
- For tax years beginning after December 31, 2017, a gross receipts test of requires having average annual gross receipts in the three prior years not exceeding $25 million