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The Internal Revenue Service hasidentified several issues that maycause problems for the owners ofsmall construction businesses.This document is intended to makeyou aware of these issues and toprovide you with information, whichwill help you avoid pitfalls along theway.These issues include: Accounting Methods Capitalization of Indirect Costs

to Long-Term Contracts

 Independent Contractor or

Employee Classification

Whether you have an existing business or just starting one, we want tohelp you understand and complywith the tax laws that affect yourbusiness.By recognizing the significance ofthese issues, small constructionbusiness owners can properly filetheir tax returns and avoid costlyproblems.

 Accounting Method Issues

Accounting methods are not always acontractor’s choice in the construction trade.Some contractors who use the cash method ofaccounting may be required to use an accrualmethod.What are Accounting Methods?An accounting method is a set of rules to

determine when and how income andexpenses are reported. It includes notonly the overall method but also theaccounting treatment of any material item.Examples of accounting methods are cashreceipts and disbursements, accrual, andcombinations of such methods. Whichevermethod is elected, it must clearly reflectincome.

If your business operates as a C corporation with gross receipts in excess of $5

million, you generally are required to usean accrual method of accounting.

If an inventory method is required because

merchandise (or materials) is an incomeproducing factor in the business, generally,an accrual method must be used forpurchases and sales.

An exception to the requirements to use

an accrual method and to account forinventories is found in Revenue Procedure2002-28, which permits most smallbusinesses with “average annual gross receipts” of $10 million or less to use thecash method of accounting. However, ataxpayer otherwise required to use theaccrual method cannot qualify for thisexception. In addition, a business whoseprincipal activity is mining, manufacturing,wholesale trade, retail trade or informationindustries will generally be ineligible to usethis exception. (See Rev. Proc. 2001-10).The accounting of inventory items issimplified by The Revenue Procedureallowing their cost to be deducted in the

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Publication 3780 (Rev. 11-2003)Catalog Number 31997W
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the long-term contract, must be allocated, orcapitalized to that contract. As long as thatcontract has not been completed and accepted,these costs must not be deducted as currentperiod costs.Some indirect costs may benefit both the longterm contract and other business activities.These costs will require a reasonable allocationbetween the other business activities and thelong-term contract. Suggested methods arespecific identification method or the use ofratios based on direct costs, hours, or otherunits of measure.

Independent Contractor or

Employee Classification Issues

Before you can know how to treat paymentsyou make for services, you must first know thebusiness relationship that exists between youand the person performing the services. Theperson performing the services may be anemployee or an independent contractor.The three factors to consider when making thisdetermination are:Behavioral ControlFinancial ControlRelationship of the Parties

Audit Technique GuidesAudit Technique Guides contain examinationtechniques, common and unique industry issues,business practices, industry terminology, andother information. There are several of theseguides specific to construction, which may helpyou understand your industry. They can befound at www.irs.gov/smallbiz. Click on Industries/Professions, Click on Construction.North American Industry Classification System (NAICS)When preparing your tax return, you should referto the instructions for each return type (i.e., Form1040, Schedule C, Form 1120, 1120S, or 1065)for the proper NAICS code that most accuratelydescribes your particular business activity.General construction codes are provided forBuilding, Developing, General Contracting,Heavy Construction, and Special Trade Contractors:Building, Developing, and General Contracting233110 Land Subdivision and Land Development233210 Single Family General Construction ContractorsHeavy Construction234100 Highway and Street ConstructionSpecial Trade Contractors235110 Plumbing, Heating, & Air Conditioning235210 Painting & Wall Covering Contractors235310 Electrical Contractors235410 Bricklaying Construction Contractors235610 Roofing, Siding, and Sheet Metal

Further information is contained in Treasury

Regulation 1.460 and IRC section 263A for certain

contractors such as large home construction

contracts. Contractors required to use the

percentage of completion method for long-term

contracts should refer to IRC Section 460.

Further information can be found in Employer’s

Supplimental Tax Guide, Publication 15-A.