At Kreischer Miller, we work with numerous government contractors and as part of our due diligence we have reviewed many of their income tax returns. We are frequently surprised by how many contractors aren’t taking full advantage of the existing tax laws.
Here are two questions we recommend asking yourself to determine whether you are making the tax laws work for you.
1.Have You Selected the Correct Accounting Method?
The most common oversight we see—and the one that has the largest impact on how much income tax you pay—is the accounting method you’ve selected. Many contractors believe that the accounting method they use for financial reporting must also be used for their income tax reporting. This is not the case.
For service-related companies, the company can often elect to report income using the cash method of accounting. Under this method, income is not reported until it is collected and expenses are not deductible until paid (with some exceptions). This method typically defers taxes from one period to the next; it is not a permanent savings. When income tax rates are changing, this provides management the ability to move income from a high rate environment in one year to a lower rate in the following year. This can be accomplished in one of two ways—defer billing so the invoices aren’t paid by year-end, or prepay expenses for the following year by December 31. Prepayments typically include rents, general and group insurance, and subcontractors.
If a contractor has inventory, that portion of the business must be accounted on the accrual method of accounting. However, the service piece of the business may qualify for the cash basis. In addition, regular corporations (not S Corporations) with revenues in excess of certain limits, partnerships with C Corporations as partners, and tax shelters and similar entities are all required to report income using the accrual method of accounting.
The accrual method reports income as it is earned and expenditures can be deducted as incurred. Contracts that extend between tax reporting periods generally have to be accounted for under the percentage-of-completion method. This method typically estimates the revenue earned on the contract based on percentage of the costs that have been incurred compared to the total of costs expected to be incurred. If the average gross revenue of the client for the past three years does not exceed $10 million, the contractor may qualify for the completed contract method, which allows the contractor to defer the gain until the project is completed.
All of the above methods are acceptable to the IRS. You may also use a “hybrid” method, in which you apply the above methods to different areas of your business.
2.Are You Taking Full Advantage of Tax Credits and Deductions?
Many government contractors are surprised to learn that they qualify for the Research & Development Tax Credit because they have a misconception that you have to be wearing a lab coat to qualify. If you develop or design new products, enhance existing products, enhance processes, review new technologies, or explore new materials for products, you could be eligible for the credit.
To be eligible, the taxpayer must have financial risk (i.e., it can’t be related to a cost plus contract), be technological in nature, contain some uncertainty about the outcome of the test, and have some process of experimentation. The credit usually amounts to 10 percent of eligible costs (wages, supplies, and some outside costs).
Introduced in 2004, the Domestic Production Activities Deduction (DPAD) provides a nine percent deduction for certain manufacturing and domestic production activities. Such activities include civil engineering and architectural services, if performed in the U.S. for real property construction projects that are also in the U.S.
Eligible engineering services include consultation, investigation, evaluation, planning, design, and supervision of construction. Eligible architectural services include consultation, planning, aesthetic and structural design, and supervision of construction.
You can elect to expense up to $500,000 (with some limitations) of new or used equipment annually that is placed into service during that tax year. In addition, improvements to the interior portion of a building that is nonresidential (with some limited exceptions) can qualify for 50 percent bonus depreciation in the year the property is placed into service.
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