threemenatcomputer-600x405As you know, the IRS takes great interest in your construction company’s revenue — and particularly how and when it’s received. If you encounter unanticipated income, also known as “claim revenue,” you might find yourself in hot water with the taxing authorities. So, the question is: Are you at risk?

Know the rules to avoid problems

Generally, long-term contracts (those stretching more than one tax year) require percentage-of-completion accounting, under which you determine gross income for each taxable year of the contract and then, when the job is done, calculate any look-back interest owed to or due from the IRS for each year.

An exception: If your gross receipts were less than $10 million for the three years preceding the contract, and the contract will be completed within two years, you may opt for the completed-contract method, under which you recognize both expenses and income in the year in which they’re incurred or received. Be advised: The IRS won’t look kindly at switching back and forth between methods — even if your volume fluctuates around the $10 million mark.

With the percentage-of-completion approach, you report income over the life of the contract based on the total amount of revenue you expect to receive, and you deduct expenses in the year in which they’re incurred. Your revenue estimates are likely to change as the job evolves, but the total contract price should always reflect the amount you expect to bring in.

Under IRS regulations, total contract price must include claim revenue as soon as you can reasonably predict you’ll earn it. Even if a claim is being disputed, you must adjust the total contract price to include the revenue you expect to receive from it.

Like claims, any early completion bonuses should also be included in the total contract price as soon as you’re reasonably sure you’ll get them. If the bonus, or any other contingent revenue (such as a claim), doesn’t materialize, you can deduct that amount in another tax year.

Note that requirements for financial statements generated under Generally Accepted Accounting Principles (GAAP) differ slightly when it comes to recognizing contingent assets. GAAP typically requires that the contingent asset be more certain before recognition.

Look back to move forward

In deciding what to include each year, gather objective, verifiable evidence supporting each claim. If you don’t include the right amount of claim revenue in the year in which you do the work, you may be liable for underpaid taxes as well as penalties and interest.

How will you know one way or the other? As mentioned, when you complete a long-term contract, you’ll use the look-back method to determine whether you’ve over- or underpaid taxes or interest. Ask your CPA for help: IRS regulations in this area are complex, and many contractors calculate look-back interest incorrectly, don’t calculate it at all or fail to properly file the results.

In simplest terms, when a contract is completed, you must reallocate income to reflect actual (rather than estimated) results for each year of the contract. Based on that reallocation, you can determine whether you’ve over- or underpaid taxes. If the former, you can receive interest. If the latter, you’ll owe interest.

Work with a pro to stay out of hot water

Accounting for claim revenue can be downright tricky — especially if you’re relatively new to the construction trade. But seasoned veterans understand that, when it comes to ascertaining claim revenue for their construction companies, it’s best to leave it to the pros. Your CPA understands the ins and outs of accounting for claim revenue — so much so that he or she can keep you out of that hot water we mentioned earlier.