The implementation of ASC 606, Revenue from Contractors with Customers, comes with a host of considerations for construction contractors and their revenue recognition policies. ASC 606 became effective for nonpublic contractors for the first annual reporting period beginning subsequent to December 15, 2018.
One of the key items that construction contractors have been faced with is the tax impact of these new standards. While the financial statements are critical in order for construction companies to obtain bank financing and bonding capacity, minimizing the owners’ income tax liability is also key. Finding the right balance under the new revenue recognition standards when taking tax into consideration is crucial.
Below are three major tax considerations for construction contractors to consider as they evaluate the impact of the new revenue recognition standards on their financial statements and tax returns.
- Variable Consideration. Many construction contracts include a variable consideration component. A construction contractor may be eligible for an additional bonus if the contract is completed ahead of schedule, or conversely, a penalty may be imposed if the contract falls behind schedule. Under ASC 606, a contractor is required to recognize variable consideration when it is probable that there will not be a significant reversal of the revenue in the future.
For tax purposes, variable consideration must be recognized in the total contract value when the contractor can reasonably predict that the amount will be earned. The regulations do not define a guideline for predicting; therefore, judgment is required by the contractor. However, variable consideration should be recognized no later than when it is recognized for financial statement purposes. This treatment could result in an acceleration of income on the contract prior to when the award or incentive is officially achieved.
- Claim Revenue. Under ASC 606, claim revenue and the associated profit are recognized for financial statement purposes when there is high probability that the claim will not be significantly reversed in the future. A review of past claim collection history could assist in determining the likelihood of these assumptions.
For tax purposes, claim revenue must be included in the total contract revenue at the time the contractor can reasonably predict that the matter will be resolved in the contractor’s favor. The recognition is not contingent on when the contractor could receive payment of the claim. The Internal Revenue Service has historically included claim revenue as part of the taxable contract value no later than when recognized for financial statement purposes.
- Uninstalled Materials. Under ASC 606 revenue is recognized up to the cost of the materials when certain criteria are met. To recognize revenue, control of the material must transfer to the customer and the material should not be distinct as defined in the standard. If the specific criteria are not met, costs may need to be capitalized and recognized as revenue, resulting in the need to track the cost of the material by separate job numbers.
For tax purposes, the concept of uninstalled materials has always been in existence. However, the focus is shifting to the pre-purchasing of materials for a contract, specifically, the timing of when those materials are purchased and whether the costs should be recognized in the percentage of completion factor.
Uninstalled materials are recognized in taxable income when the materials are dedicated to the job, not when the materials are installed. Dedication to a job occurs when material has been delivered to a job site, the material is ordered for a specific contract, and the material is unique and distinct to the contract. This can result in a significant acceleration of revenue for tax purposes, as opposed to what is reported under GAAP.
These three key tax areas should be considered during implementation of the new revenue recognition standard. However, this list is not all encompassing. Having a thoughtful discussion regarding the impact of both the financial statements and tax returns is critical when implementing the new standards, as this can lead to unintended consequences. Kreischer Miller can assist you with other tax implications for contractors as a result of adopting ASC 606.
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