For construction contractors, having the ability to manage and preserve working capital is critical. One of the many ways a contractor can successfully do this is to incorporate thoughtful tax planning strategies which impact the timing of income tax obligations for the business and its owners.
This article will focus on a tax planning strategy involving the application of pay-if-paid language in a contract to defer taxes and maximize working capital. This planning tool offers perhaps one, if not the only, benefit of being subject to a pay-if-paid provision in a contract.
A new option related to pay-if-paid arrangements has been confirmed by the IRS and allows contractors to exclude certain costs associated with subcontractors’ accounts payable from the job cost for tax reporting purposes. As will be explained below, there are some criteria both from a legal and a tax law perspective that will need to apply in order to utilize this strategy. However, the end result is the opportunity to create a significant deferral on the recognition of revenue for tax reporting purposes and, thereby, defer the recognition of tax into the future.
How the Pay-if-Paid Tax Strategy Works
Generally, contractors with gross receipts greater than $25 million are required to recognize revenue on long-term contracts using the percentage of completion method (PCM). The percentage of completion is determined by applying a ratio of the cost allocated to the contract and incurred before the close of the taxable year with the estimated total contract cost to the total contract value. Under the PCM methodology, the higher the numerator, the higher the amount of income that gets recognized in the current year on such contracts. Conversely, lowering the numerator will reduce the amount of revenue that would otherwise be recognized.
Under the tax regulations and case law, contract expenses are allocated to the contract using the accrual basis of accounting. A contractor can’t deduct an expense for which the contractor has yet to incur a legal obligation. Generally, an obligation that is yet to become fixed and certain will not meet necessary conditions to give rise to a deduction. In states where the legal obligation to pay subcontractors is subject to conditions, a contractor cannot include the related account payable arising from the subcontractor’s invoicing to the contractor until the contract conditions are met.
An example of when this might occur is for states that enforce pay-if-paid clauses in construction contracts. Assume a contractor receives an invoice from a subcontractor at year-end that is subject to the pay-if-paid clause and the owner has yet to pay the contractor before the end of the year. Since the legal obligation to pay the subcontractor’s invoice does not arise unless the contractor is paid, the contractor can’t deduct the liability for tax purposes, even though the contractor would include the invoice amount in the job cost for GAAP purposes. Therefore, this invoice cost would not be included in the numerator of the PCM fraction for tax purposes. This results in a deferral of income, since the percentage of completion fraction will be lower for tax reporting.
Even though this may create a short-term timing difference, it becomes somewhat permanent as the contractor continues to start new contracts. Contractors that have jobs in pay-if-paid states and wish to report their percentage of completion by excluding subcontractor payables may be required to file for an Application for Change in Accounting Method with the IRS by the end of the tax year to incorporate this tax deferral strategy. After some internal discussions, IRS officials have recently begun accepting and approving this accounting method change.
Ensuring the Pay-if-Paid Contract Language is Valid
The pay-if-paid provision is a term contractors often seek to avoid because it shifts significant non-payment risk to the down-stream contractor. However, contractors dealing with such provisions in their contracts may find the revenue recognition strategy discussed in this article to be one of the few – if not the only – benefits of being subject to a valid pay-if-paid provision. The operative term here, though, is “valid.”
A two-step analysis is required to determine whether a pay-if-paid provision is valid.
Step 1: Determine whether the provision is properly drafted.
To ensure that a pay-if-paid provision is properly drafted, it must:
- Include language that clearly and unambiguously shifts the risk of non-payment to a down-stream contractor or supplier and is expressly conditioned upon the upstream contractor’s receiving payment first. Terms such as “express condition precedent,” “unless and until,” or “if and only if” are generally used to create a valid pay-if-paid provision.
- Be consistent with language in the rest of the contract. If there are other provisions that may be inconsistent with the condition precedent, or create ambiguity, the provision may not enjoy pay-if-paid treatment.
Step 2: Determine whether the work was performed in a jurisdiction that authorizes the use of pay-if-paid provisions in construction contracts.
In some states, pay-if-paid provisions have been deemed contrary to public policy. These jurisdictions have passed statutes rendering pay-if-paid provisions void and unenforceable. States barring the use of pay-if-paid provisions in this region include New York, Massachusetts, and Delaware.
Even if a contractor is based in a state authorizing the use of pay-if-paid provisions, the state where the work was performed should be considered to determine if the pay-if-paid provision is enforceable.
Finally, care should also be taken to ensure that you are, in fact, dealing with a rock solid pay-if-paid provision if you elect to use the revenue recognition strategy in this article, as electing to use the strategy could be treated as an admission that the contract includes a valid pay-if-paid clause. Therefore, you may be legally unable to take a contrary position as to the provision’s validity in a subsequent payment dispute. The analysis of pay-if-paid provisions is complex and should not be taken lightly.
For construction contractors, having the ability to defer significant income taxes into future years can create a competitive advantage and help to improve the working capital of the business. Collaboration from your tax and legal professionals would be required to determine whether this strategy will apply in states that enforce the pay-if-paid contract clause and how best to calculate and report this change to the IRS. Once this is established, it can create a long-term tax planning strategy for your business.
Interested in learning more about the pay-if-paid tax strategy? Plan to join construction industry experts from Kreischer Miller and Davis Bucco Makara & Dorsey on January 21, 2020 for a seminar on this topic. Click here for more details and to register.
Contact the authors:
Carlo R. Ferri, Director, Tax Strategies and Construction Industry Group Co-Leader, Kreischer Miller
John Dorsey, Partner, Davis Bucco Makara & Dorsey
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.