By Richard Higgins of McCarthy & Company, PC
Changes related to the COVID-19 crisis and the construction and surety industries are still occurring; some data in this article may have changed from the time of article submission and the publication date.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act includes tax provisions to help businesses preserve and increase cash flow. Accounting method planning and taking advantage of tax credits can provide companies with various ways to manage their cash during the COVID-19 pandemic. Contractors should consider accounting method changes that can help to accelerate deductions or defer income. The following are some suggested accounting method changes to help achieve such results.
Accelerate deductions for property taxes
Contractors may be able to accelerate deductions for property taxes paid after year end but before the tax return is filed by adopting the lien-date method.
Accounting methods related to inventory
Small business taxpayers meeting the $25 million gross receipts threshold may be eligible to use simplified methods of accounting for inventories under the Tax Cuts and Jobs Act (TCJA). Certain small businesses are not required to account for inventories under section 471. Inventories may instead be accounted for as non-incidental materials and supplies or treated consistent with the method of accounting used in the taxpayer’s financial statements or books and records.
Eligible taxpayers may also be exempt from the provisions under section 263A, Uniform Capitalization rules (UNICAP). For taxpayers in compliance with section 263A, these new rules could result in an acceleration of deductions in the year of adoption. The final regulations were effective in 2019.
Many taxpayers reverse the financial statement bad debt expense for tax purposes without analyzing the underlying debts for worthlessness. Contractors may claim a deduction for wholly worthless debts in the tax year they become wholly worthless and a deduction for partially worthless debts in the tax year they are properly charged off. Companies may also encounter disputes with customers regarding the amounts billed. If the dispute is made prior to the end of the taxable year in which the sale was made, taxpayers can exclude the disputed amounts from taxable income. Taxable income would then be recognized in the year the dispute is settled.
Deduct prepaid expenses
Contractors should consider accelerating the deduction for certain prepaid expenses such as insurance, ratable service contracts performed within 3½ months of payment, rebates, refunds, and dues and subscriptions. Prepaid expenditures and intangibles are currently deductible under the 12-month rule for cash and accrual basis taxpayers.
Deduct software development expenditures
Software development costs that are capitalized and amortized for financial accounting purposes can be deductible for tax purposes by requesting a change in method of accounting.
Deferment of advance payments
An accrual basis taxpayer is generally required to recognize income upon receipt for advance payments for goods or services to be provided in the future. For financial reporting purposes, revenue is typically recognized in the period the costs are incurred. Section 451(c) codified a one-year deferral rule. If a taxpayer is not optimizing the deferral method, this is a good time to consider this alternative method.
The Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) on June 3, 2020, granting a one-year effective date delay for certain companies and organizations applying the revenue recognition standard. Private companies and not-for-profit organizations that have not yet applied the revenue recognition standard should do so for annual reporting periods beginning after December 15, 2019, and interim reporting periods within annual reporting periods beginning after December 15, 2020. The ASU requires that revenue is recognized when the good or service is transferred or as control over the good or service is transferred. Revenue can be recognized over time (services) or at a point in time (goods). As a result, some businesses will have accelerated income; while others will have an income deferral, or a mixture of both. An accounting method change is normally required to be filed for tax purposes.
Impact of the revenue recognition standard
The revenue recognition standard will significantly affect the current revenue recognition practices of most contractors. It could also impact the timing and amount of revenue reported, key performance indicators (KPIs), debt covenant ratios, bond programs, contract negotiations, performance agreements, business activities, and budgets. It is important for sureties to look at the capitalization of costs associated with deferred revenue and its impact on the balance sheet.
The timing of contract-related costs will have a significant impact on a contractor’s balance sheet. It could change how contract accounts are organized and the presentation of contract-related assets and liabilities on the balance sheet. These include the cost to obtain and fulfill the contract.
Contractors are required to maintain the financial metrics outlined in the terms of a loan or bond agreement. This can include everything from minimum working capital ratio to maximum debt-to-equity ratio requirements. Lenders and sureties use this information to determine if the contractor is financially healthy.
Financial ratios and KPIs may be negatively impacted by an increase in liabilities on the balance sheet. It is important for contractors to have a conversation with their banker and surety to explain why and develop a pro forma of what the balance sheet will look like once revenue is recognized to demonstrate the impact.
Other examples of how contractors can benefit from an accounting method change include the following:
⦁ Accelerating certain deductions under the recurring item exception of section 461(h).
⦁ Accelerating deductions for self-insured medical expenses.
⦁ Conducting cost segregation studies, class-life reviews, and other means of accelerating cost recovery or permitting immediate deductions.
⦁ Deferring income that is recognized on the books but remains contingent for tax purposes.
⦁ Evaluating the use of the cash or accrual method of accounting for small business taxpayers.
⦁ Evaluating fixed asset costs for potential acceleration through bonus depreciation.
⦁ Increasing the “de minimis” threshold for expensing certain acquisition costs.
⦁ Making charitable donations of food or inventory.
⦁ Maximizing the section 179 deduction.
⦁ Triggering unrealized losses through sales or dispositions of property.
Temporary Procedure for Filing for a Change in Accounting Method
The IRS is implementing the temporary procedure described below in response to the coronavirus pandemic. Starting on July 31, 2020, the IRS will accept the duplicate copy of Form 3115, Application for Change in Accounting Method, via fax to 844.249.8134. This change applies only to taxpayers requesting consent to make a change in accounting method under the automatic change procedure. This temporary procedure is in effect until further notice.
Find Out More
Richard Higgins, CPA, is the Managing Principal—New Jersey office for McCarthy & Company, PC. Contractors trust Higgins to assist them with a strategy to achieve their goals by looking at key indicators such as productivity, job costing, profit margins, and cash flow. Higgins helps contractors to establish realistic benchmarks to assess how well they are doing or to alert them to issues that need to be addressed. He can be contacted at 732.341.3893 or [email protected].