it is dealing with labor shortages, collecting retainage or preparing for the ever-changing
regulatory landscape, those in the construction industry never seem to have a
lull in the action. This audit and accounting resource guide supplies insights
and reference material for your construction business and reviews some of the
recent changes in the industry.
Revenue recognition is finally here!
After years of threats and changes to the standard, revenue recognition is now in effect. For construction companies issuing Generally Accepted Accounting Principles (GAAP) basis financial statements, this new accounting standard will change their financial statement presentation and possibly the timing of revenue recognition. This standard introduces a five-step approach to recognizing revenue and requires construction companies to make more estimates, examine contracts for variable consideration and revisit change orders to determine if they should be a new contract or modification of an existing contract. The new standard completely replaces the existing standards.
After revenue recognition, construction companies still have leases to contend with in 2021. Many off-balance sheet lease agreements will be added to balance sheets, which will result in an increase in both debt and asset balances. Construction companies need to be aware of the ramifications this will have on their total financial health and bank or bonding covenants.
Current liabilities will increase and if banks opt not to remove this new liability from covenant calculations or change the benchmark, a historically easy ratio to obtain may become an impossible hurdle. The lease standard will also require estimates of how many extensions of a lease will be exercised and, based on wording in the lease, expenses like operating costs and real estate taxes may be included in the newly recorded liability. Construction companies should review their lease agreements and current footnotes to determine the impact of this change, prior to implementation.
Assess the need to continue using GAAP reporting
GAAP has been the gold standard for accounting basis, some would argue, forever. However, with the recent changes occurring or pending, including the above mentioned revenue recognition and lease standards, GAAP may no longer be the answer for many small or privately held construction companies. When a reporting framework becomes too difficult to maintain or not beneficial to the users of the financial statements, it may be time to change. Construction companies could shift to tax or cash basis of accounting or a similar version of either and instantly simplify this function. Another option, as developed by the American Institute of Certified Public Accountant, is the Financial Reporting Framework for Small and Medium Sized Entities (FRF for SME). This framework was very similar to GAAP 10-15 years ago and has removed many of the larger changes (revenue recognition, leases and fair value reporting) that has made current GAAP so complex. Any switch in accounting basis cannot be made lightly and needs to be discussed and understood by the users of the financial statements, including banks, owners, bonding companies and future users of the financial statements. Although these alternatives are valid and widely used, there are exceptions.
1: If a construction company’s
goal is to sell to a large, publicly traded company, switching away from GAAP
is not the solution.
Example 2: If obtaining bank financing is an issue or switching banks is being planned, it may not be the best time to transition. Discuss options with your bank prior to making a transition away from GAAP.
When the U.S. Supreme Court changed course on nexus determination and no longer required a physical presence for sales tax remittance, the online retail industry was not the only one affected. States quickly reacted to the ruling and have implemented a variety of different laws. Before taking a contract of shipping goods out of state, be sure to review the possible sales tax implications.
Technology drives the construction industry
The 2019 Construction Technology Report by JBKnowledge offers insights into the market and allows you to compare your company to others in the industry in terms of technology usage, IT expenses and research and development costs. As in most industries, technology drives efficiency, improves productivity and is constantly changing. The report is driven by a survey of industry members.
Although not an industry specific problem, the construction industry has been hit hard by a shortage of qualified employees. Union benches are empty and accepting under-motivated or under-qualified applicants is the new normal as projects and proposals are still available. If this continues, construction companies will need to look at expanding benefits to keep or attract employees. Companies need to look at production and backlog and consider if higher production, at the expense of overtime and other additional costs, is worth the margin gained on the work. This is especially important if contracts require specific deliverables or have a specific date for completion. Most construction companies have a difficult time passing on a proposal, but increasing margin or extending dues dates when responding to the proposal could improve workflow and counteract the effects of overtime.
Note: Interested in learning benchmarks and key performance indicators for your specific industry? Reach out to a Smith Schafer professional. We work with over 800 Minnesota construction and real estate entities and have access to industry reports.
Tax law changes offer opportunities
Tax reform simplified some aspects of the tax code, but also made it much more complicated. Construction company owners need to ensure they have fully examined the opportunities allowed within tax reform, including, maximizing the tax benefits of their basis of accounting and increasing the 199A deduction. These decisions cannot be made without a full review of both the ownership group and the company in general.
Industry knowledge and close collaboration are instrumental in providing our construction clients with the insight and awareness to make the best business decisions and seize growth opportunities. Smith Schafer is a recognized leader in providing accounting and consulting services to the construction industry since 1971. We have a team of experts, focused on working with the construction industry, and committed to helping our clients succeed. If you have questions about improving your business model, implementing an accounting practice or tax planning strategies to improve operations, Smith Schafer can help. For additional information, click here to contact us.
The Internal Revenue Code Section 199A Qualified Business Income
(QBI) Deduction allows a deduction equal to 20% of business income for owners
of pass-through entities. When the law was passed, there was confusion about whether
owners of rental real estate businesses would be eligible for the deduction.
When the regulations were finalized, the IRS released Revenue Procedure
2019-38, which was intended to help these rental real estate businesses assess
whether they are eligible for the QBI Deduction. This helps to clarify
confusion by allowing a “safe harbor” for rental businesses who do not
necessarily qualified as a trade or business, to qualify for the deduction.
What types of entities qualify for the safe harbor?
The safe harbor rules define a rental real estate enterprise as
an interest in real property existing for generating rents. If the taxpayer
owns several different real estate enterprises, they have the choice to either
treat each one of the rental properties individually or as a group. Properties
would be divided into groups for residential real estate and commercial real
estate if a grouping election is made.
What are the requirements to qualify for the safe harbor?
The taxpayer, their employees, agents or independent contractors must perform at least 250 hours of rental services annually with respect to the enterprise.
Items qualifying as rental services:
Advertising for the rental of the properties
Performing repairs and maintenance
Supervision of employees or contractors
Processing tenant applications
Negotiation or execution of leases
Items not qualifying as rental services:
Making investment or financing decisions
Managing long-term capital improvements of the property
Hours spent traveling to or from the rental properties
Separate books and records must be maintained to track income and expenses of each rental real estate enterprise, either individually or by group if electing to form a multiple property enterprise.
Taxpayer must maintain records proving who performed the services, hours of all service performed, description of the services performed and the dates on which the services were performed.
What could disqualify a taxpayer from the safe harbor?
A taxpayer cannot use the safe harbor if they use the real estate property as a residence at any point during the year.
Real estate property leased using a triple net lease would not qualify for the safe harbor.
The safe harbor rule is not the only way to qualify for the
Section 199A deduction. This deduction can be quite powerful so contact us today
to discuss how to qualify. It is important to review your tax strategies to
ensure you are in the best position possible.
Smith Schafer is a recognized leader in providing accounting, auditing and consulting services to the construction and real estate industry. Our Construction Group, comprised of numerous professionals, is committed to serving over 800 Minnesota construction and real estate entities. Click below to schedule a free 30-minute consultation.
Smith Schafer is proud of our clients. Our success is the direct result of our client’s success. We are an award-winning public accounting and business consulting firm offering a proactive advisory relationship to business clients.
Industry knowledge and close collaboration are instrumental in providing construction companies with the insight and awareness to make the best business decisions and seize growth opportunities. We demonstrate our value by anticipating client needs rather than reacting to their requests. The following construction industry client case study is just a sample of Smith Schafer’s results. For more information about our approach to client solutions, visit our services pages.
Below is a case study of how we have helped one of our Twin Cities construction clients – Steve Kucera, CFO, Schoenfelder Renovations.
Q: How long have you worked with Smith Schafer?
A: Schoenfelder Renovations has worked with Smith Schafer for five years.
Q: What services does Smith Schafer provide for Schoenfelder Renovations?
A: The Smith Schafer Team helps us with audited financials, Sage 50 and all-around accounting support. Having our financials audited annually and Tim Pass, a Smith Schafer Audit Principal, as a member of our Board, brings immense knowledge and industry expertise to the conversation.
Q: Can you describe a time when Smith Schafer really came through for Schoenfelder Renovations?
A: A few years ago, we changed our accounting staff. Smith Schafer Principal, Tim Pass, and Smith Schafer IT Advisor, Tim Jewell, reviewed our accounting system and assisted us in creating best practices going forward to help grow the company.
Q: What are the most important reasons you stay with Smith Schafer?
A: Their willingness to help the company grow and the team’s knowledge and expertise.
Schoenfelder Renovations is a nationwide general contractor offering hotel, multi-housing and box store renovations. With years of experience in commercial work, they can help property reach its fullest potential. Check out their website for more details: www.schoenfelderrenovations.com
The main goal of Accounting Standard Codification (ASC) 606 is to create a similar revenue recognition policy and calculation across all industries. The construction industry, which has historically had its own guidance and industry practices, is no exception. Below are the first four steps as required by ASC 606:
Identifying the contracts
Identifying the performance obligations
Determining the transaction price
Allocating the transaction price to the performance obligations
Once you have completed the above, please continued reading for items that may affect the construction industry when finally recognizing revenue in step five:
1. Timing of Recognition
ASC 606 has two basic options for recognizing revenue once control has been transferred:
over time or
at a point in time.
In order to recognize revenue over time, one of the following criteria needs to be met:
The customer receives and consumes the benefits provided by the seller’s performance as they perform.
The seller’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. For example, you are constructing a building on the customer’s land, even if construction is stopped half way through the project, the customer’s asset (land) has received value.
The seller’s performance does not create an asset with an alternative use to the seller, and the seller has an enforceable right to payment for performance completed to date. For example, pre-fabricated wall panels are customized for a specific project and the contract stipulates once production starts costs are the customer responsibilities.
Before determining if a contract meets one of the above requirements, construction companies will need to understand when transferring control of the asset, as defined within ASC 606, occurs. It is not until control is transferred that revenue can be recognized. ASC 606 defines “control of an asset” as the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. Control includes the ability to prevent other entities from directing the use of, and obtaining the benefits from an asset.
Examples of indicators that transfer of control has occurred include:
An entity has a present right to payment for an asset.
Customer has legal title to the asset.
Physical possession of the asset has transferred.
Customer has accepted the asset.
These concepts are easier to conceptualize when the end product is a tangible item, but when considered in relation to the construction of a building, parking lot, house or any component within a larger construction project it becomes more difficult. Often in these projects, the customer will not accept the asset until all punch list items have been completed.
Percentage of completion and completed contract methods, in name, no longer exists. In essence, “billings in excess of costs” and “costs in excess of billings” will shift to the concepts of “contract liability” and “contract asset.” Instead of percentage of completion, contractors will use a cost “input method” as described in ASC 606 when calculating the contract liability/asset. Although the actual math using the new input method will be nearly identical to the calculation used for over and under billings, the path to this point will be different.
3. Change orders
Under ASC 606, the scope of a change order determines if it should be considered a separate contract or should be combined with the original contract. The determining factors in that decision is based on if the change order results in an addition of a distinct good or service and if that good or service reflects the standalone selling price.
4. Wasted materials
The accounting for wasted material was emphasized within ASC 606. If a construction company has wasted costs (purchased the wrong materials, had re-work due to error, poor job management, etc.) those costs are recognized immediately and not taken into account as a job cost. Therefore, this is not part of the cost input calculation when recognizing revenue over time.
5. High material costs
Based on the type of construction project, material costs can be the majority of the total job costs. ASC 606 requires construction companies to consider the realistic progress made on a job when determining if the material costs can be included in the cost input method calculation.
Example – If a $500,000 job includes a $300,000 generator and on day one of the job the generator is purchased, the calculation would exclude the $300,000 in costs and in contract value when completing the cost input calculation.
Even with nearly a decade of warnings, revenue recognition has arrived quickly, and is now requiring the attention of construction companies. Without careful planning and reviewing of contracts, revenue streams could unintentionally change.
Do you understand the impact of the new accounting standard on your construction company? Revenue recognition has been around since 2010, when the first draft of the new standard was released. Three exposure drafts and numerous accounting standards later, it will be required to recognize income under the five step approach beginning December 15, 2018.
Tariff – a tax on imports or exports, typically between two countries. It is a form of regulation of foreign trade and a policy that taxes foreign products to encourage or safeguard the domestic industry.
In recent years, governments have used tariffs as a form of protectionism. In 2018, the United States government began imposing tariffs on steel, aluminum and lumber from a number of countries. These tariffs were imposed in order to try to protect the United States manufacturing industry. However, these tariffs may lead to negative effects for industries, such as construction, because it relies heavily on these products. Construction businesses need to be:
• aware of these tariffs • the challenges they could bring • have strategies in place to address these challenges
Impact of Tariffs on Construction Businesses
• Increases in material costs. As tariffs are an additional tax on the imported materials, the cost of these materials will increase, leading to increased job costs for your construction business. If they cannot be passed to the customer, they will go directly to the bottom line. • Volatility in pricing. As the government is in control of the tariff policies, at any time there may be changes to the rate or it may be removed completely. Being unable to accurately predict this pricing, may have a negative impact on contracts and budgets, which were completed under different scenarios. • Delays in receipt of materials and project completion. Tariffs often lead to delays in receipt of materials as processing times at ports of entry typically become longer. Large projects, which had their scheduling completed prior to the tariffs, may face difficulties in reaching completion. • Changes in supply chain or lack of materials. Tariffs may lead to your vendor’s prices increasing to where you cannot afford. You may need to shop around for the best price. This could lead to difficulties working with a new vendor, decreased reliability in receiving materials or having to settle for the increased costs. Tariffs may also affect the number or type of choices for material specifications for a project, as there may only be a few types of materials in the desired price range.
4 Strategies to Mitigate Challenges
Escalation Clauses An escalation clause is a provision in a contract calling for adjustments in fees, wages, or other payments to account for fluctuations in the costs of raw materials or labor. As it relates to tariffs, an escalation clause may be included in a contract to shift the burden of increased material costs from the contractor to the customer.
Supply Bonds Supply bonds are used to provide a guarantee that a supplier will deliver the promised materials on time. Securing supply bonds upfront, will mitigate the risk of materials not being delivered if a large tariff is imposed on the vendor in between the time of the signing of the contract and the time of delivery.
Subcontractor Default Insurance Subcontractor Default Insurance may be used to recoup costs incurred from a default in performance by a subcontractor. If tariffs affect a subcontractor to a point where they are unable to fulfil their performance requirements, this will help to protect the contractor.
Stay Up-to-Date Keep track of current and future proposed tariffs. This will help your construction businesses improve planning and allow you to get in front of the challenges discussed above.
Our Construction & Real Estate Group, comprised of numerous professionals, is committed to serving over 800 Minnesota construction and real estate entities. Contact us today to learn business strategies that will help you grow and save you money.
Success in the construction industry requires the ability to cost effectively create a building envelope, structure or support system and virtually every financial decision regarding your construction company, has a tax consequence. The summary outlined below covers the most common sales tax implications for construction contractors.
Materials & Supplies
Contractors must pay sales tax on the cost of all materials, supplies, and equipment to complete a construction contract.
Tax Tip: You may pass this tax onto your customers as part of the materials cost. Do not itemize it separately on customer invoices.
If you sell repair
parts or materials to your customers WITHOUT installation, you have made a
Tax Tip: Charge sales tax on the total selling price of retail sales and itemize on your customer’s invoice.
If you are a
contractor and also make retail sales, the rules for when and how you pay tax
on your purchases depend on:
Whether you know how the items will be used when you buy them
Whether they will be used in a construction contract or sold at retail
In some cases, whether you are “primarily a retailer” or “primarily a contractor”
You are primarily a contractor if at least 50
percent of your business purchases are used for construction activity
Pay sales tax on all purchases.
If you sell any items at retail, deduct cost of materials you already paid sales tax on.
You are primarily a retailer if at least 50
percent of your business purchases are for retail sales.
Do not pay sales tax on your purchase.
Give supplier completed Certificate of Exemption.
Contracts with Exempt Organizations
You owe sales tax when you contract with exempt organizations such as churches, schools, and government agencies. In order to buy materials tax exempt, the exempt organization must designate you as its purchasing agent. The written contact must include all of the following:
The appointment has been made.
The exempt organization takes title to all materials and supplies at the point of delivery.
The risk of loss for all materials and supplies is that of the exempt organization.
The exempt organization has responsibility for all defective materials and supplies including those incorporated into realty.
You are responsible to keep documentation to show the purchasing agent relationship exists, such as a letter indicating the above information, copies of written contract including all four items noted above, and evidence of the organization’s exempt status. You must also keep records of all materials and supplies purchased for the exempt project.
An exempt organization
cannot appoint a contractor as its purchasing agent for the purchase or lease
of equipment used by the contractor in completing the construction contraction.
The exemption only applies to building materials, equipment, and supplies that
become part of the improvement to real property.
Aggregate & Concrete Sales
If an aggregate seller delivers and spreads aggregate material so no further leveling or movement is required by the purchaser, the sale is considered an improvement to real property and not taxable. The aggregate seller is required to pay sales or use tax on their cost of any taxable products or services used to complete the contract.
An aggregate seller
must charge sales tax on both the material and delivery charges when they dump
aggregate material in a pile and/or when the construction contract does not
require them to deposit the material so that no further leveling or movement is
Ready-mixed concrete sold from a ready-mixed concrete truck, without installation, is taxable, including transportation, delivery, or other service charges.
The U.S. Supreme Court struck down the physical present nexus standard established in the 1992 decision Quill Corp v. North Dakota in the landmark South Dakota v. Wayfair, Inc. case. States can now require certain retailers, with no physical presence, to collect and remit the applicable sales or use tax on sales delivered to locations within their state.
October 1, 2019, Minnesota’s Small Seller Exception does not require remote
sellers to collect sales tax until their sales during a period of 12
consecutive months total either:
or more retail sales shipped to Minnesota
or more in retail sales shipped to Minnesota
Note: When calculating this exception, do not include any sales where the purchaser is buying for resale. Purchaser should give you a completed Form ST3, Certificate of Exemption claiming an exemption for resale. August 2017 is the earliest month to include to calculate if the business qualifies for the Small Seller Exception.
What Does This Mean?
The biggest impact of the Wayfair case on the construction industry is the requirement of all Minnesota sellers, regardless of their location, to collect state and local sales taxes based on where your customer receives the taxable product or service. Construction businesses tend to operate in multiple locations and construction sites and it will be important to determine if/when local sales taxes are payable. See examples below detailing how to source the sale and determine which taxes are applicable:
A construction business is physically located in St. Paul, Minnesota. A customer from Rochester, Minnesota visits the store in St. Paul and purchases materials. In this example, the customer takes the materials with them when they leave, so the possession of the items were transferred at the physical location of the store. The tax assessed on the materials is the Minnesota general rate sales tax plus any applicable local taxes for St. Paul.
A construction business is physically located in St. Paul, Minnesota. A customer from Rochester, Minnesota purchases materials online and has them shipped to their home in Rochester. The tax assessed on this sale would be Minnesota General Rate sales tax and any applicable local taxes for Rochester, since possession of the items were transferred when the items were received by the customer at their home. Sourcing would also be Rochester if the customer went in to the physical location and asked for the materials to be shipped to their home. Keep in mind, the cost to ship the materials should be included in the sales price and the entire amount taxed.
You are responsible for researching or contacting each state to determine your sales tax registration and reporting requirements. If you are not up to speed on all the changing and new state tax laws, it may put your construction business at risk for penalties and interest charges on unpaid tax liabilities – potentially in multiple states.