Construction contractors are taxed on the amount that net assets (less liabilities) increased from the same period 12 months prior. This is different from what most contractors think of when being taxed which is "income." However, the tax code allows income to be defined numerous different ways - some of which can be used to the advantage of a growing contractor.

There are numerous bases of accounting (or different definitions of income) allowed for construction contractors. They are cash basis, accrual basis, completed contract basis, and percentage of completion basis. Each of these methods calculate income based on the accumulation of certain assets and excluding others.

The cash basis, as its name implies, calculates income based on the accumulation of cash over the previous twelve-month period. Therefore, under the cash basis, accounts receivable, retainage, work in progress, and prepaid assets are not considered to be a part of income for tax purposes. Because of the nonrecognition of so many assets, it is common for a contractor to show a significant income for financial statement purposes and to show a loss for tax purposes. For this reason, the cash basis is a very attractive method for those contractors that can qualify to use it.

To qualify for use of the cash method, the contractor cannot maintain significant inventory, cannot have more than $5,000,000 in gross revenues, and the use of the cash method cannot significantly distort income. There is a safe harbor rule for contractors who gross under $1,000,000; they can use the cash method regardless of maintaining inventories. If a contractor qualifies for this method, in almost all situations, it will result in lower taxes than other methods.

For contractors who do not qualify for the cash basis, usually their next best alternative is either the accrual method or the completed contract method. To determine which of these options is better, the individual circumstances and industry of the particular contractor must be analyzed.

The accrual method taxes the net increase in cash, accounts receivable, and other types of prepaid assets to calculate taxable income. This method excludes retainage and work in progress. Like the cash method, excluding the accumulation of retainage and work in progress can result in a situation where the contractor is able to show significant income for book purposes while minimizing taxable income.

The completed contract method taxes projects only upon completion of the project. Thus all work in progress, including all billings and expenses, are excluded from taxable income. This method is generally preferable to the accrual method for contractors who do not carry large retainage balances.

Percentage of completion method of accounting is the same method of accounting that is used for financial statement purposes. All increases in net assets are included in the calculation of income for tax purposes. Thus, it is very difficult to have a year where the taxable income is much lower than the income shown on the financial statements. Because this method of accounting does not exclude any type of asset, contractors generally do not use it if they have a choice. The percentage of completion method of accounting is required for contractors who gross in excess of $10,000,000 for a three-year average.

Construction contracting is a very equipment intensive business. There are a couple of rules relating to the depreciation of equipment that contractors generally can use to their advantage.

Section 179 Expense is an equipment investment incentive provided by Congress to stipulate small businesses to invest in equipment. This rule allows a contractor to immediately deduct the first $24,000 of the purchase price of an asset when it is purchased. This applies regardless of whether cash or debt is used to pay for the asset. On December 31st, a contractor may simply sign a note for a new piece of equipment and immediately create an additional $24,000 of expense deductions for his company.

There are a few limitations for use of this rule. This rule applies only to small contractors who purchase less than $200,000 in equipment per year. The deduction cannot create a loss for the contractor. If there is no income, the deduction will be carried forward until there is sufficient income to utilize the full loss. Additionally, the equipment purchased must meet certain qualifications. Generally all construction equipment will qualify, along with vehicles that weigh over 6,000 pounds.

For contractors who have heavy machinery, such as excavators, asphalt pavers, etc., the timing of repairs can result in tax savings. If the contractor is having a high tax year, one in which the contractor may be paying higher tax rates such at 35%, the contractor should look to replace worn out parts, and undertake other repairs during that year. The tax savings could cut the "real" repairs expense by a third.

There have been a lot of changes to the tax code in the past few years. Most of these changes will keep your tax professional busy and really don't affect the day-to-day operations of a construction contractor. However, the following are a few of the new changes that will affect a contractor:

• The 2001 tax act makes the $5,250 exclusion for employer provided educational assistance applicable to graduate education.
• The §529 plan has become attractive because now donors can contribute $10,000 per year or $50,000 up front to a plan that can grow tax free and be withdrawn tax free to pay for qualified tuition and living expenses. Additionally, the donor can change the beneficiary of the plan.
• The exemption for the estate tax has changed, but it is a hollow change. Starting in 2002, the estate tax exemption is $1,000,000. In 2004 the exemption rises to $1,500,000. In 2006 the exemption rises to $2,000,000. In 2009, the exemption rises to $3,500,000. There is no estate tax for 2010. And the exemption drops to $1,000,000 starting in 2011.

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