This article is going to explain how to properly document cash transactions in construction. Prior to explaining the documentation procedures I am going to explain when and why you would want to conduct cash transactions.
Advantages of Cash Transactions
For some strange reason unbeknownst to me, contractors think that paying with cash reduces their income tax liability. HUH?
If you wrote a check, isn’t that the same as paying in cash?
This thought process stems from the thinking that the Internal Revenue Service (IRS) can’t track cash. First off, they can indeed track cash simply by reviewing your bank withdrawals. Secondly it doesn’t matter to them. Without a receipt for your cash payment you are not allowed the deduction. Therefore your profit is higher and YOU pay the income tax.
Doesn’t seem fair does it?
With the most basic transaction between a contractor and his subcontractor, the sub desires to get paid in cash. Why? Well it is difficult for the IRS to track cash revenue in this industry. So the subcontractor desires cash as payment to reduce his overall tax liability.
His reduced liability shifts that responsibility back to the contractor. Let’s use a very basic example with a $5,000 transaction with a sub:
Undocumented payment to sub $5,000
Disallowed by the IRS 5,000
Change in costs of construction -0-
No deduction, profit increases by 5,000
Income tax @ 15% 750
Self Employment Tax @ 15.3% 765
Total additional tax liability assumed by contractor $1,515
Actually the tax is a little less due to the self-employment tax formula; but you get the idea. So technically, your $5,000 cash payment actually costs you $6,515. Where is the advantage here? So how do you take advantage of paying with cash? If your sub wants cash as his form of payment then you need two requirements from him.
First he should provide a cash payment discount on his invoice to you (the bill you receive for his work). In this industry cash is worth about 5 to 7%. On that same $5,000 transaction, you should demand at least $250 to as much as $350 depending on how quickly you pay the bill. Almost every subcontractor will yield to this discount.
The second requirement: proper documentation satisfies the IRS documentation regulations.
The IRS scrutinizes contractor transactions in more detail as they know that it is easier to commit fraud in this industry than many other industries. Fro costs of construction they are going to grade your overall bookkeeping prior to digging into the details. So first off have a well-organized set of books and ledgers. I have written several article within the construction industry section related to proper accounting structure and organization.
Next is the proper use of cash disbursements. This is where cash payments begin. To pay cash, you’ll need to go to the bank to cash a large check. Via cash disbursements write a check to the owner and in the memo section write ‘Cash Advance – YR/Month/Day’ and debit a cash account with a title ‘Owner’s Vendor Payments’. This clearly identifies the purpose of the cash.
Now with the physical cash in hand, it is time to pay your subcontractors. Before heading out purchase a cash receipts book from your local office supplies store. You’ll need the 3 part type whereby two of the copies are a result of carbon paper.
At the point of payment fill out the receipt and make sure you have the following information:
2) The subcontractor’s invoice # (bill #)
3) A short description such as ‘Plumbing’ or ‘Forming’
4) The dollar value paid
5) Discount amount
6) Invoice amount
7) Your signature
8) The sub’s signature confirming receipt
You keep the primary copy, hand him the second copy and retain the third copy in the book. Now staple the primary copy (usually white) to the vendor’s/subcontractor’s bill (his invoice to you). Turn the bill with the attached receipt back into the bookkeeper. She will simply credit the owner’s payments and debit the correct accounts payable related to that vendor. In addition she will debit purchase discounts for the appropriate savings.
Now you have complied with the required documentation procedures for audit purposes. It is that simply. Notice now how you are not only in compliance but you save money too.
Summary – Using Cash in Construction
Using cash in the construction industry is not illegal as long as you use proper documentation. If you are going to pay for materials or subcontractor work take advantage and demand a discount for payment with cash. Otherwise pay with the traditional check disbursement method. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.