How to (Legally) Defer Taxes Using Your Accounting Method

We’ve never met a contractor who liked paying taxes, but there’s a difference between tax avoidance and tax deferral. This week, let’s talk about some strategies to legally defer your taxes without creating bigger problems down the road for your business.

Topics we cover in this episode include:

  • What tax deferral really means
  • The four main tax methods and how tax deferral works with each
  • Strategies that involve delayed billing or paying expenses at year-end
  • Common pitfalls that contractors encounter when trying to avoid taxes

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com

TRANSCRIPT

[00:00:00] Wade Carpenter: Welcome to the Contractor Success Forum. In this episode, we are talking about how to legally defer your taxes using your accounting method. Now, I’ve never met a Contractor that liked paying taxes, but there is a big difference between tax avoidance and tax deferrals. So if you’re a business owner, listen to me here.

I always say running a business is like walking through a cow pasture. If you know where you stand, you tend to stand in a better place. So while you think about that for a minute, let’s get into it.

I’m Wade Carpenter with Carpenter Company CPAs. Stephen Brown, my co-host, had an unexpected setback and unfortunately, will be out a little bit longer. He’s okay, but we miss him and look forward to having him back very soon and wish him a continued speedy recovery.

So let’s dive in.

Let me start off with a bit of a disclaimer. You know, we’ve been doing this podcast, at least our 126th episode by the time this comes out, and we haven’t missed one yet. But in the last six months we’ve started getting a following on YouTube. So I’ve actually been paying attention to YouTube a little more than I ever really have, and it’s amazing to me a lot of the bad advice I see out there on the internet. Some from people with CPAs or other letters behind their name, but I would recommend that you go to your tax advisor before putting any of these strategies we talk about today into place.

Now again, if they’re not a construction oriented CPA maybe they may not know some of these rules that we’re going to talk about today. Knowing the rules is half the game.

What is tax deferral?

[00:01:46] Wade Carpenter: So let’s talk about the tax deferral part. What is tax deferral? Stated simply, the idea that you can put off paying taxes until the future. A simple example that you may be doing right now is maybe you’re earning money at a job and putting it away in your 401(k or maybe an IRA, and you’ve earned that money this year, but you don’t have to pay taxes on it until you take it out in retirement Presumably, you’re going to take that money out in retirement when your income is lower and presumably your tax rate will be lower.

It makes a lot of sense to defer money to a time when it’s not going to cost you as much. Let me give you another common example you may never have thought about from the tax world. Many people have heard about the concept of a like-kind exchange, or you may have heard of a 1031 exchange where you can defer capital gains in what they refer to as a tax-free exchange.

Tax-free exchange is somewhat of a misnomer. It’s really a tax deferred exchange. I think this is a great analogy here because I have many people that are going to sell a piece of real estate and they want to defer the gain, and they call me on the day that they’re about to close that property and they say, how can I do this so that I don’t pay taxes on it?

Well, on the day that you’re about to close, it’s too late to do that. In fact, a lot of people don’t realize that if you’ve already drawn up a contract, you’re probably already too late to do this because you’ve gotta set up a qualified intermediary before you actually even set up the contract. Otherwise, you’re not going to get that tax-free deferral. That’s just the way the, rules work. You have to set up and do certain things ahead of time.

Now. As I said, if we are deferring taxes on the gain and rolling it into a property. So at some point we are going to have to pay taxes on it in the future. So you’re bringing over the basis of that property at a probably a very low rate. And at some point there are taxes that’s going to be paid on it. And you can do it legally, but you can’t wait till the last minute to do it.

 I have built my practice around knowing where you stand. And I’m recording this in August. It’s a little early for starting the year end tax planning, but it’s really never too early to start planning.

What I’m hoping for you today is that you’ll take what you hear and go back and see your construction oriented CPA, use the knowledge you’ve gained here. Again, don’t do this on your own without knowing what you’re doing. But do that now. Don’t wait until December 31st. What a lot of people don’t realize is assuming you’re a December year-end, if you wait until January 2nd to do something about your taxes, 99% of the options you have are gone.

The tax methods and how they work

[00:04:43] Wade Carpenter: You may have A CPA or accountant that does your taxes and you may not even know what tax method you’re on. You can find out simply by going to your tax return, and whether you’re a corporation or S corporation, partnership, or sole proprietor, there is a box on there that actually says what your tax method is. And if you don’t know, go ask your tax professional.

In the world of construction, there are four main methods and a couple of hybrids of each.

There’s the cash method, there’s accrual method, there’s a completed contract method, and there’s a percentage of completion method. Let’s talk about how we deal with each one of them.

Cash Basis Method

[00:05:23] Wade Carpenter: With the cash basis, essentially what we’re talking about here is if you receive money in cash before the end of the year, it’s income for that year. By the same token, if you pay an expense by the end of the year, that’s an expense for that particular year. And that’s the simple definition of what cash basis is.

In the Tax Cuts and Jobs Act of 2017, that expanded the use of the cash basis. At that point, it was up to $25 million of annual revenue on an average gross receipts basis. So if you fell above 25 million, then you didn’t have to do it. And I believe as I’m recording this, in 2023, the number has risen to 29 million.

But even before that, there were rules on this that a lot of CPAs didn’t know. For a contractor that qualified, you could actually do cash basis up to $10,000,000 in revenue. And there’s a lot of CPAs that didn’t know that rule, simply because there was a rule that also said that if you got over $5,000,000 in revenue, you had to use the accrual basis.

It’s amazing to me that even CPAs, a lot of them did not know this rule about the cash basis exception. They put people on their accrual basis without knowing that they didn’t have to.

I like the cash basis when we can use it. On this one you generally know the rules. If you receive the money by December 31, assuming you’re a December year end, you gotta pay tax on that money.

Delaying billing at the end of the year

[00:06:50] Wade Carpenter: Perhaps you can delay your billing and not receive your money until next year. Some people take that to extreme. You know, if you delay all your billing and you aren’t able to collect your cash until February or March, you can run outta cash pretty quickly.

There’s also people that receive the money and don’t put it in the bank. if the IRS finds out, they will reclassify that income to the proper year.

Unfortunately, I see people carrying this to an extreme That could be a red flag where you don’t put any money in in November and December, but on January 2nd you put $2 million in the bank. That’s where you’re going to get in trouble if the IRS audits you.

Paying expenses before the end of the year

[00:07:32] Wade Carpenter: Let’s talk about paying expenses. Same kind of deal. If you’ve got some legitimate expenses that you can pay before the end of the year, then if you’ve got the cash, go ahead and pay them. Where people go wrong here is that they will write a bunch of checks on December 31, and that’s okay if you are legitimately writing it and put it in the mail.

Where people get in trouble is they will write a ton of checks and they won’t clear until April. And they’re trying to game the system. They had no money in the bank to do that. And you know, if the IRS saw that, they could very easily also reclassify those things. The idea is, let’s play this game, but don’t wait until the last minute because that way, you can kind of plan for this. You also probably need to remember that other contractors, they probably want to pay these things before to the end of the year. So they’re going to try to give you revenue before the end of the year.

Now, there is another piece of this, where we said paying expenses, but what if you don’t have the cash? There is a rule in tax circles. It’s referred to as the credit card rule. If you’ve got a legitimate expense that you pay on a credit card before the end of the year, then it is going to count as an expense whether you’ve paid that credit card or not.

I had a situation several years back where a contractor that, we, we did some great tax planning, but she was actually going to be out of town the week between Christmas and New Year’s. And she had a great neighbor that she trusted and took care of her, and she asked them to check their mail. I don’t really know the situation, but they must obviously be very good friends.

But they didn’t plan to take in some revenue before the end of the year, we had it all planned out before they went out of town. And on December 30th this check showed up in the mail. And I don’t know that I trust my neighbors with my bank accounts, but they ended up opening this check and taking it to the bank for them because it was like a $200,000 check that they weren’t planning on getting this particular year.

And they were trying to do it right, but unfortunately, it’s hard to say that this is not revenue when your bank is showing it on their bank statement. They had to actually pay money on that bank deposit and they had to do a little scrambling to cover it.

Again, most of the time, it’s the other way around. You know, people will hold off on all these things, and I actually had one where last year they didn’t deposit a $2 million check until January 2nd. And legitimately on the cash basis, it’s not revenue until they put it in there, but I suspect that they got this check prior to the end of the year. And if the IRS catches you, that’s where we’re talking about them reclassifying income. Just like that lifetime exchange, you want to avoid the appearance that you’re doing something wrong.

Same in estate planning. A lot of people wait until the last minute you know, somebody’s on their deathbed or whatever. And they wait till the last minute and then they put stuff in a trust or try to move assets and that’s when the court’s going to come back and get you for, you know, reclassify those assets.

Accrual Basis

[00:10:56] Wade Carpenter: Alright, let’s talk about the accrual basis. If you’re on the accrual basis of accounting, it’s just a little different planning game you have to play. So let’s define accrual first.

Basically, If you bill an invoice before December 31, assuming you’re on a calendar year end, it is income for that year whether you’ve received it in cash or not. But by the same token, if you’ve got an invoice from your supplier, your subcontractor or whoever you got that invoice from that is dated before December 31, that is something that counts as accounts payable.

That accounts payable is an expense, even if you haven’t paid it before the end of the year. So a lot of people will ask their suppliers all to get their bills in and date them before December 31. You put it on the books and count it in the year that you’ve got the expense.

The idea here with accrual basis is we’re going to hold off on our billing. There are some consequences to this. Obviously if you bill and don’t collect the money, you can wreck your cashflow in January and February. You also have a contractor that’s doing formal financial statement and they do long-term contracts, they really need to be on percentage of completion basis for financial statement purposes. And if you hold off on your billing, that can also look like you have this huge underbilling on your contracts if you’ve done a bunch of work at the end of the year, but you haven’t billed it.

And there may be legitimate reasons you’re doing that for tax purposes, but if you’re dealing with a bonding company, they’re not going to understand why you’re so far underbilled. They could think that you have problems with billing and collecting.

Completed Contract Method

[00:12:30] Wade Carpenter: Let’s talk about the completed contract method now. In simple terms, If you don’t complete the contract, you’re not going to pick up the revenue or the expenses until you complete the project. There are a lot of people out there that treat the completed contract method wrong. So let’s talk about that for a minute.

Even tax professionals that apply this improperly, they end up doing things like taking those expenses in the year that they pay them but they don’t pick up on the revenue until they collect their money. So you’ve already expensed these expenses, but all of a sudden something closes and you don’t have the expenses to follow it. That’s when It can result in a huge profit dump in one year. So let’s talk about how you plan for that.

In planning for completed contract method, well, obviously if you don’t complete the job, then you don’t have to pick up the income. If you’re really done with that job, then that can be a problem.

Now you can tell your accountant that this job is not done, but if the IRS looks at it, and if you’re 98% done with that job, you’ve got like $2,000 worth of punch list items and so just because of that, you didn’t call it complete. Or if you say it’s not complete because you didn’t build a retainage yet, whether you’ve gotten that money or not, that doesn’t necessarily define whether it’s a completed job.

So The IRS could look at this as a completed job and move the revenue. So the idea is let’s plan for this, and you may have to move some things around to where you defer completing some things on the project to actually make this work, but you at least know where you are on it and what’s going to come in. And if you do have a bunch of money coming in, then at least you need to plan for the taxes.

I actually just took over this year as an outsourced CFO a very large contractor that also did development work. And completed contract is very common when you’re doing development. There’s also some different rules I won’t get into right now. But they had been showing losses for many years, and now they’ve got this construction division. And even though this division was on the completed contract method, all of a sudden $20 million worth of contracts closed in one year, and it threw off about $6 million in profit. They had never planned for this, so now they’re scrambling to pay taxes.

So that explains one of the pitfalls of the completed contract method. Situations like that, where all of a sudden you’ve got all these jobs coming to a completion all at the same time. Another one where we saw examples of this during the recession, if a contractor comes to a sudden stop or say a contractor suddenly dies and the business sort of stops for a little bit, it can be a disaster. Here’s a couple of examples of how that happened.

So during the recession, I had a contractor that had played these deferral games. They bought trucks every single year they were on this completed contract method and all of a sudden they ran out of work, and they had to lay a bunch of people off.

And with all their deductions up front, they had all this profit come in on these jobs that they had finished, but there was no justifying having more trucks because there was nobody to drive it.

What happened? All this came in and there was no money left over to pay these taxes and it was a huge profit dump. Unfortunately, they were essentially bankrupt for many years. They did eventually come back because they had a great name, but you know, everything the guy had worked for, from basically his whole life was lost. He had to pay all these taxes. So it’s a sad thing to see.

We see that again when the owner of a company dies, you know, it was all tied to one particular person. They went and got all the work. And all of a sudden there’s no work to follow it. And you’ve played all these expense games and there’s no cash to continue playing those games. They have to dig in their savings to pay these taxes and sometimes it can wipe them out.

When they played these deferral games to extreme, it can sometimes be a disaster. That’s not to say you shouldn’t use a completed contract method. When it works, it works, well, but. you also need to remember, you’ve gotta pay for those taxes when they come due.

Percentage of completion method

[00:16:54] Wade Carpenter: So let’s talk about the percentage of completion method. So let me define that really quickly. Let me give you a little example. So say we got a million dollar job and that job will take us $800,000 in costs. So at December 31, we have $400,000 in costs of that 800,000 in place. In the percentage of completion method, they look at the percentage that you’re done on the cost basis. So In that example, 400,000 out of the 800 is 50% done.

It doesn’t matter whether you’ve billed 400,000, 600,000 or all million dollars, you’re going to pick up 50% of that revenue. In this simple example, that 50% of revenue on a million dollar contract is 500,000. So you’re going to pick up 500,000 in revenue, and that’s the percentage of completion in a nutshell.

Back to the topic of today being the deferring the taxes on the percentage of completion, that can be a very tough thing to do because essentially you are where you are, but the problem lies in where people don’t know where they really are. They really run their business around the cash method, but they look at the revenue, say, by accrual method because that’s what they billed. But what the percentage of completion says is that it could be higher or lower than what you’ve billed. And if you’re not planning for it and you don’t have the cash, that’s when it can backfire.

Another thing you may not be aware of is that for financial statement purposes, under Generally Accepted Accounting Principles, or GAAP, the rules state that you should be taking your losses as soon as you recognize you’re going to have one, whether you’ve completed it or not. You need to take the whole loss immediately.

That would be great for tax purposes, but unfortunately the IRS doesn’t allow you to do that. There’s a lot of misconceptions out there. In my former life, a very large CPA firm I could not believe, did not understand these rules and how to apply them, and I’ll leave it at that, but unfortunately knowing the rules is half the battle to knowing how to play the game.

So let me change direction a little bit now that we’ve talked about the four main methods. From from the standpoint of planning, it really doesn’t matter what tax method you’re on. You just have to know which rules you’re playing by to properly defer taxes. Many contractors, they’re worried about their bonding and their banks, and they need to pay attention to their financial statements and how they’re going to look. And it’s very common that for a contractor, you’re going to have a different method of accounting for tax purposes versus financial statement purposes if you’ve got long-term contracts. There’s nothing at all illegal about that, even though it sounds like we’ve got two sets of books.

Let’s talk about that. Now going back to the cash method of accounting, I still like to use that a lot. A lot of CPAs are out there, they just think that it has to be accrual basis and they just don’t know the rules. So let’s say you’re on accrual basis or one of these other methods that probably could qualify for cash method. Can you change the rules?

Depending on your situation and your particular tax method, you can change the rules, but you have to get IRS approval. You can’t just do it and say this is what you’re doing. And with that Tax Cuts and Jobs Act of 2017, they did allow a lot of these method changes with IRS to be automatic, especially with the cash basis. Again, you still have to file for and ask for the change. Even though I say automatic, change, you have to get approval to do that.

So there are also situations where people unknowingly get put on a method such as percentage-of-completion when they really weren’t supposed to. A contractor that didn’t even come close to really having to do that. And there could be situations where you could possibly change that. Unfortunately, some of these changes are not automatic.

Let’s talk about some of the points. Number one, knowing what accounting methods you’re on for tax purposes is the first step in playing the game. You’ve gotta know what rules you’re dealing with before you can figure out how to defer taxes and plan for it. But once you do, then you know what rules to play by and you can use that to your advantage. And again, I hope I’ve given you some ideas to do this legally.

Now point number two is don’t do this last minute, as we said. I truly believe if you stay on top of your books, and I still also believe that contractors should be doing job costing, you know, if you stay on top of your books where you know you can start looking at this in October, November and making those moves, not December 29th or January 2nd, when it’s too late, that’s when you stay out of trouble, assuming you follow the rules correctly.

Point number three is that if you’re doing financial statements, You need to understand the financial statement method you’re on. And If you’re doing long-term contract, that means you should be doing a percentage of completion method. So if we hold off on our billings in December, you’re not going to get paid until February or March. That can wreck your cashflow, but it also can be something you’re going to have to explain to your bonding or your banker.

Personally, I’ve built my business on making sure contractors are more successful by knowing where they are and minimizing the taxes. One very big key component that most people want to talk about. But also look at that in long term. Don’t be so shortsighted that you defer the taxes, perhaps you see a huge tax bill coming next year, you defer all your income to this year, sometimes that’s not the right play. Sometimes you should pay a little bit of tax this year and keep it in a lower bracket than have it all dump in one year, and then you dealing with the higher tax brackets.

So I’ve hope I’ve given you some things to think about today and again, go see your own construction oriented CPA. Know the rules. Don’t wait till the last minute to do these things. That’s when you get in trouble.

I’m going to put a little guide to this in the show notes if you want to check those out, about some more in depth on these rules, that you can get for free.

But let me wrap this up. Thank you for listening to the Contractor Success Forum. Check out the show notes at Contractor Success Forum dot com or on the CarpenterCPAs YouTube channel for more information on this topic. Consider subscribing to this channel and follow each episode every week as we post it. Thanks for listening. We will look forward to seeing you on the next show.

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