Masonry Magazine August 2000 Page. 29
Tax Court OK's
ACCOUNTING
FOR PROFITS
The U.S. Tax Court recently ruled that the Internal Revenue Service exceeded its authority in requiring a contractor to use the accrual method of accounting. As a result, if this case is upheld on appeal, many building contractors and subcontractors will be allowed to defer the recognition of accounts receivable until they actually receive the funds.
For the record, the cash basis is the method of accounting used by most individuals and many masonry contractors. Income is generally reported in the year that it is actually or constructively received. Deductions and credits are generally taken for the year in which the related expenditures were actually paid.
Under the accrual method, on the other hand, income is accounted for when the right to receive it comes into being. It is not the actual receipt but the "right" to receive that counts.
Thus, under the accrual method, many masonry contractors have taxable income when they bill for a job rather than when they receive payment. Expenses are deductible on the accrual basis in the year incurred - i.e., when all the events have occurred that fix the amount of the item and determine the liability of the taxpayer to pay it.
Every masonry contractor operating as a corporation or partnership is required by our tax laws to use the accrual method of accounting - unless they can meet the $5 million or less gross receipts test for all prior years. Those contractors that are required to use inventories must use the accrual method of accounting with no exceptions.
Now, a sharply divided U.S. Tax Court has ruled that a concrete contractor did not have to use the accrual method because the materials that it used in providing its services are not "merchandise" held for sale and, so, don't have to be inventoried. Instead, according to the Tax Court, the materials are an indispensable and inseparable part of the provision of its services and lose their separate identity to become part of a building or other real property.
RACMP Enterprises is a construction contractor that builds concrete foundations, driveways and walkways for real estate developers. When bidding on a job, RACMP calculates its bid price by figuring the cost of labor and materials required to perform the work plus a margin for profit based on the cost of the labor, the quantity of materials and the complexity of the job.
The contact requires RACMP to furnish sufficient labor, materials, tools, equipment and services and to properly perform the work in a sound workmanlike and substantial manner. RACMP constructs concrete foundation forms on-site using lumber and other supplies in accordance with the developer's blueprints. It then uses fill sand and drain rock with the forms in place and wire mesh and rebar and other hardware in the forms. When this work is approved, RACMP orders ready-mix concrete from a supplier who delivers it to the construction site. RACMP does not manufacture, deliver or store this concrete.
"Under our tax rules, material may be either merchandise or supplies depending upon whether it is held for sale or consumed in performing a service."
The supplier pours the concrete directly into the form. RACMP then installs anchor bolts and performs other finishing work. RACMP is not left with any concrete on hand at the end of the day. It submits a single invoice for the completed work to the developer for payment, along with each supplier's invoice and lien release form. The developer issues a check payable to RACMP and each supplier for the cost of materials as stated on the suppliers' invoices and lien releases. RACMP endorses each joint check and forwards it to the appropriate supplier without depositing or otherwise cashing them. The developer pays for the construction work in a two part process. The developer also issues a check payable only to RACMP for the balance of its invoice.
ACCOUNTING METHODS
RACMP uses the cash method of accounting, recognizing income as it is received and expensing the cost of concrete and other materials when paid. The IRS determined that the concrete, sand and other materials that RACMP used in its business should have been classed as "merchandise," requiring RACMP to use inventories