Construction Industry Audit Technique Guide (ATG) - Chapter 3
Publication Date - May 2009
NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
- Exceptions to Percentage of Completion Methods & Look-Back Interest
- Production Period Interest
- $10 Million Gross Receipts Test
- Proper Method of Accounting for Small Contractors
- General Rule of Accounting Methods
- Methods of Accounting
- Selecting an Accounting Method
- Cash Method of Accounting
- Accrual Method of Accounting
- Completed Contract Method (CCM)
- Completion of a Long-Term Contract
- Subcontracts and Completion
- Exempt-contract Percentage-of-Completion Method (EPCM)
- Alternative Minimum Tax (AMT)
- Small Contractors Becoming Large Contractors
- Pros and Cons of Long-Term Accounting Methods
IRC Section 460 was enacted as part of the Tax Reform Act of 1986 and requires the use of percentage of completion method for long-term construction contracts. However, there are exceptions to the required use of the percentage of completion accounting method and to the application of “look-back” interest rules. The exceptions are home construction contracts and small construction contracts.
This chapter will provide an overview of the methods of accounting that are available to small construction contractors such as cash, accrual, completed contract, and exempt percentage of completion.
Specific accounting methods for home construction contracts and large construction contracts such as contracts that do not meet one of the two exceptions of IRC Section 460 will be discussed in other chapters.
IRC Section 460(e) provides two exceptions to the required use of the percentage of completion accounting method and application of the look-back interest rules applicable to certain construction contracts. These exceptions do not apply to long-term manufacturing contracts.
- The home construction contract; and
- The small contractor contract exception contained in IRC Section 460(e)(1)(B) requires the following conditions to be met:
- At the time the contract was entered, it was estimated that the contract would be completed within a 2-year period beginning on the commencement date of the contract; and
- The contractor’s average annual gross receipts for the 3 taxable years preceding the year in which the contract was entered did not exceed $10 million.
The exception for certain construction contracts is provided for under IRC Section 460(e). IRC Section 460(e) (1) provides that subsections (a), (b), and (c) (1) and (2) shall not apply to the following:
- IRC Section 460(e)(1)(B): Any other construction contract entered into by a taxpayer;
- IRC Section 460 (e)(1)(B)(i): Construction contracts that are estimated to be completed within the 2-year period beginning on the contract commencement date; and
- IRC Section 460 (e)(1)(B)(ii): A taxpayer having an average annual gross receipts not exceeding $10,000,000 for the 3 taxable years preceding the taxable year in which such contract is entered into.
- In the case of a home construction contract with respect to which the requirements of clauses (i) and (ii) of subparagraph (B) are not met, IRC Section 263A shall apply notwithstanding subsection (c) (4).
This situation illustrates the concept where the 2-year requirement is not met: The taxpayer’s average annual gross receipts are less than $10,000,000 for the prior 3 taxable years. The taxpayer enters into two different jobs that are not home construction contracts.
Job 1 is expected to last 18 months. The taxpayer would account for Job 1 under its normal method of accounting for long-term contracts (accrual, completed contract, or percentage of completion) because the 2-year requirement is met.
Job 2 is expected to last 3 years. The taxpayer must account for Job 2 using the percentage of completion method as required by IRC Section 460 because the 2-year requirement is not met.
Even though small contractors are exempt from the requirements of IRC Section 460 such as reporting using PCM and applying the look-back interest rules, the interest capitalization rules of IRC Section 460(c)(3) are applicable to all contractors. IRC Section 460(e) (1) only exempts the small contractor from subsections (a), (b), and (c) (1).
Incomes from all trades or businesses whether or not incorporated that are under the common control with the taxpayer are considered in determining the gross receipts test. This is an area that is often overlooked with small construction contractors.
Each return of a related group of tax returns may appear to qualify for the small contractor’s exception. However, once the gross receipts of all related entities are aggregated, the exception is not met.
Therefore, the IRC Section 460 requirements of the use of the percentage of completion method and application of “look-back” may apply to each “small contractor”.
IRC Section 460(e)(2) provides that for purposes of paragraph (1), the determination of taxpayer’s gross receipts shall include::
- IRC Section 460 (e)(2)(A): All trades or businesses (whether or not incorporated) which are under common control with the taxpayer within the meaning of section 52(b);
- IRC Section 460(e)(2)(B): All members of any controlled group of corporations of which the taxpayer is a member; and
- IRC Section 460 (e) (2) (C): Any predecessor of the taxpayer or a person described in subparagraph (A) or (B), for the 3 taxable years of such persons preceding the taxable year in which the contract described in paragraph (1) is entered into shall be included in the gross receipts of the taxpayer for the period described in paragraph (1) (B).
- The Secretary shall prescribe regulations, which provide attribution rules that take into account, in addition to the persons and entities described in the preceding sentence, taxpayers who engage in construction contracts through partnerships, joint ventures, and corporations.
The gross receipts test looks to the prior 3 taxable years rather than including the tax year during which the contract was entered. This enables the contractor at the commencement of the contract to know whether or not it must be reported using the percentage of completion method, and can adjust the accounting system accordingly.
If a taxpayer has been in existence for less than the three taxable years, the taxpayer determines its average annual gross receipts for the number of taxable years (including short taxable years) that the taxpayer (or its predecessor) has been in existence.
Treasury Regulation Section 1.460-3(b) (3) directs the taxpayer to Treasury Regulation Section1.263A-3(b) to determine what items are included for this gross receipts test. Gross receipts are the total amount, as determined under the taxpayer’s method of accounting, derived from all trades or businesses. Gross receipts does not include (not all inclusive):
- Returns or allowances;
- Interest, dividends, rents, royalties, or annuities, not derived in the ordinary course of a trade or business; or
- Receipts from the sale or exchange of capital assets.
Two or more corporations whose stock is substantially held by five or fewer persons are a “controlled group”. These groups include “brother-sister” controlled groups, parent-subsidiary groups, combined groups, and insurance companies. Members of a controlled group are subject to related party transaction rules such as income or deduction matching and loss deferrals on sales between members.Example 1:
This situation illustrates the concept of a controlled group. The Building Corporation has four unrelated shareholders each owning 25% of the stock. The same four shareholders also own 25% each of the Bridge Corporation. The Building and Bridge corporations are related parties.Example 2:
This situation illustrates the concept of aggregation of gross receipts for a controlled group. Mr. A is the sole shareholder of two corporations.
Corporation A operates a roof installation business. Corporation B operates a grocery store.
The gross receipts from both businesses are considered when determining the $10,000,000 average gross receipts test per IRC Section 460(e) (1) (B) (ii).Attribution of Gross Receipts of Less than Controlling Interest
A contractor that has less than 50% ownership but more than 5% ownership must aggregate a proportionate share of the construction-related receipts in determination of the $10,000,000 test.
Treasury Regulation Section 1.460-3(b) (3) provides that except as otherwise provided in paragraphs (b) (3) (ii) and (iii) of this section, the $10,000,000 gross receipts test is satisfied if a taxpayer’s or predecessor’s average annual gross receipts for the 3 taxable years preceding the contracting year do not exceed $10,000,000, as determined using the principles of the gross receipts test for small resellers under Treasury Regulation Section1.263A-3(b).
To apply the gross receipts test, a taxpayer is not required to aggregate the gross receipts of persons treated as a single employer solely under IRC Section 414(m) and any related regulations.
A taxpayer must aggregate a proportionate share of the construction-related gross receipts of any person that has a five percent or greater interest in the taxpayer. In addition, a taxpayer must aggregate a proportionate share of the construction-related gross receipts of any person in which the taxpayer has a five percent or greater interest.
For this purpose, a taxpayer must determine ownership interests as of the first day of the taxpayer’s contracting year and must include indirect interests in any corporation, partnership, estate, trust, or sole proprietorship according to principles similar to the constructive ownership rules under IRC Sections 1563(e), (f)(2), and (f)(3)(A).
However, a taxpayer is not required to aggregate under paragraph (b) (3) (iii) any construction-related gross receipts required to be aggregated under paragraph (b) (3) (i) of this section.Example:
This situation illustrates the concept of the $10,000,000 test for attribution of gross receipts. Bob owns 100% of the Building Corporation. The Building Corporation has average annual gross receipts of $8,000,000. Bob also owns 10% of the Construction Corporation. The Construction Corporation has average annual gross receipts of $25,000,000. The aggregate gross receipts for IRC Section 460 purposes of the Building Corporation are $10,500,000 ($8,000,000 + $2,500,000 (25,000,000 x 10%)). Therefore, the Building Corporation would be required to account for its long-term construction contracts under the percentage of completion method.
It is important to note that within the construction industry, a contractor will normally have a minimum of at least two methods of accounting. It will have an overall method of accounting such as cash, accrual, or hybrid and one or more methods for its long-term contracts such as completed contract, percentage of completion, and percentage of completion capitalized cost method. The small contractor’s exception is determined on a contract-by-contract basis.Example:
This situation illustrates the concept of where several methods of accounting are used by one contractor. A small contractor uses the accrual method of accounting as its overall method to account for short-term contracts and the income and expenses not related to long-term contracts. In addition, the contractor uses the completed contract method for its exempt contracts and must use the percentage of completion method for the contracts that are estimated to exceed 2 years.
IRC Section 460(e)(1), Revenue Ruling 92-28, and Internal Revenue Bulletin (IRB) 1992-15,41 (April 13, 1992) permits a taxpayer to use different methods of accounting for exempt and nonexempt contracts within the same trade or business.
IRC Section 446 provides for general rules for the methods of accounting that are available to the taxpayer. The general rule under IRC Section 446(a) provides that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.
Exceptions under IRC Section 446 (b) provide that if the taxpayer has regularly used no method of accounting or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method, in the opinion of the Secretary that does clearly reflect income.
In addition, permissible methods under IRC Section 446(c) provide that subject to the provisions of subsections (a) and (b), a taxpayer may compute taxable income under any of the following methods of accounting:
- IRC Section 446 (c) (1): The cash receipts and disbursements method;
- IRC Section 446 (c) (2): An accrual method;
- IRC Section 446 (c) (3): Any other method permitted by this chapter; or
- IRC Section 446 (c) (4): Any combination of the foregoing methods permitted under regulations prescribed by the Secretary.
IRC Section 446 allows the cash method of accounting and the accrual method of accounting. The other methods that IRC Section 446(c) (3) references for construction contracts are namely the completed contract method and the percentage of completion method.
Because long-term methods of accounting are determined on a contract-by-contract basis, a taxpayer potentially could be reporting long-term contracts under several methods of accounting. The choice of a proper method of accounting for long-term contracts is complex. The methods available to a contractor to account for the income and expenses of a long-term contract are as follows:
- Accrual with Deferred Retainages
- Completed Contract Method (CCM)
- Exempt-Contract Percentage of Completion Method (EPCM)
- Percentage of Completion Method (PCM) or Cost-to-Cost as required by IRC Section 460
- Percentage of Completion Simplified Cost Method
- Percentage of Completion 10% Method
- Percentage of Completion Capitalized Cost Method (PCCM)
The percentage of completion or cost-to-cost as required by IRC Section 460, the percentage of completion simplified cost, the percentage of completion 10%, and the percentage of completion capitalized cost methods of accounting are discussed in the chapter on large construction contractors.
If a contractor is exempt from the percentage-of-completion method under IRC Section 460, the contractor may adopt a method of accounting for its long-term contracts on the initial income tax return, or in the first tax year there are long-term contracts.
Once a method of accounting is adopted, this method must be used for all long-term contracts in the same trade or business. A change is not generally permitted without obtaining prior permission from the Commissioner.
Generally, the cash method of accounting is an acceptable method for small contractors. However, there are limitations on the use of the cash method.
IRC Section 448 prohibits the use of the cash method by "C" corporations and partnerships with a "C" corporation partner unless such entities have annual gross receipts not exceeding $5 million. IRC Section 448 also prohibits use of the cash method by all tax shelters. IRC Section 448 does not allow the use of the cash method but it limits the use of the cash method for certain entities.Example:
An S Corporation that files a Form 1102-S is not subject to the $5 million gross receipts limitation of IRC Section 448. An S corporation that has gross receipts of $5 million may use the cash method of accounting as long as there are no other sections prohibiting it such as a taxpayer who is required to use accrual method to account for inventory or IRC Section 460 that requires the use of PCM for long-term contracts.Cash vs. Accrual Issue
In prior years, the IRS won many cases supporting the change from cash to accrual when merchandise was considered an income-producing factor. Treasury Regulation Section 1.446-1(c)(2)(i) requires the use an accrual method of accounting if the taxpayer is required to account for inventories per IRC Section 471. Treasury Regulation Section1.471-1 requires an accounting of inventory in every case in which the production, purchase, or sale of merchandise is an income-producing factor.
After much litigation in this area, a safe harbor provided by Revenue Procedure 2001-10 and Revenue Procedure 2002-28 allows the use of the cash method accounting to taxpayers who would otherwise have been required to use the accrual method of accounting.Exception to the Accrual Method under Revenue Procedure 2001-10
Revenue Procedure 2001-10 was issued on January 8, 2001 and permits eligible small businesses with average gross receipts equal to or less than $1 million to use the cash method when IRC Section 471 would otherwise require an accrual method because of inventory.
The Commissioner provided administrative relief from the requirements of IRC Section 471 and Treasury Regulation Section 1.446-1(c) (2) (i) to certain small taxpayers. This revenue procedure allows qualifying taxpayers (including those that provide goods and services to their customers) with average annual gross receipts of $1 million or less to use the cash method.
However, contractors that qualify under this revenue procedure must treat certain property as non-incidental materials and supplies as defined under Treasury Regulation Section 1.162-3. The taxpayer cannot deduct these expenses until the year in which payment for them was made or the year in which the materials and supplies are actually used or consumed in the taxpayer's business.
Even though the cash method is an acceptable method, the contractor is still required to account for inventories. This is discussed later in this chapter regarding non-incidental materials and supplies.Qualifying Taxpayer under Revenue Procedure 2002-28
The average annual gross receipts for the 3 prior years must be $10,000,000 or less and the taxpayer’s principal business activity must be a North American Industry Classification System (NAICS) code other than one of the ineligible NAICS codes listed in Revenue Procedure 2002-28:
- Mining: NAICS 211 and 212
- Manufacturing: NAICS 31 through 33
- Wholesale Trade: NAICS 42
- Retail Trade: NAICS 44 and 45
- Information Industries: NAICS 5111 and 5122
Revenue Procedure 2002-28 does not override IRC Section 448 that prohibits C corporations or partnerships with a C corporate partner with average annual gross receipts greater than $5 million from using the cash method of accounting.
Revenue Procedure also does not override IRC Section 460 requiring long-term construction contracts such as contracts expected to require more than 2 years that are not home construction contracts to be accounted for by using the percentage of completion method.
An additional qualifying factor is that the taxpayer cannot have previously changed from the cash method to the accrual method after becoming ineligible under Revenue Procedure 2002-28.Qualifying Small Business Taxpayer under Revenue Procedure 2002-28
Revenue Procedure 2002-28 was issued on May 6, 2002. It allows a “qualifying” small business taxpayer with average annual gross receipts of $10 million or less to use the cash receipts and disbursements method of accounting with respect to an eligible trade or business.Qualifying Small Business Taxpayer under Revenue Procedure 2002-28 Section 4.01 (1)
A qualifying small business taxpayer may use the cash method as described in this revenue procedure for all of its trades or businesses if the taxpayer satisfies any one of the following three tests and did not previously change (and was not previously required to have changed) from the cash method to an accrual method for any trade or business as a result of becoming ineligible to use the cash method under this revenue procedure.Gross Receipts Tests under Revenue Procedure 2001-10 and Revenue Procedure 2002-28
As with IRC Section 460, the gross receipts test uses the average annual taxable gross receipts for the prior three taxable years. However, the definition of gross receipts under Revenue Procedure 2001-10 and Revenue Procedure 2002-28 is different from IRC Section 460.
Gross receipts under Revenue Procedure 2001-10 and Revenue Procedure 2002-28 include total sales (net of returns and allowances) and, all amounts received from services, interest, dividends, and rents. Whereas, gross receipts under IRC Section 460 do not include returns and allowances, interest, dividends and rents.Inventory under Revenue Procedure 2002-28
A taxpayer who is required to account for inventories under IRC Section 471 has three options:
- A taxpayer can use overall cash method and account for inventories under IRC Section 471;
- Can use overall cash method and account for inventory the same as materials and supplies that are not incidental under Treasury Regulation Section 1.162-3; or
- A taxpayer can use an overall accrual method and account for inventory as materials and supplies that are not incidental under Treasury Regulation Section 1.162-3 and thus not deductible until used or consumed in business.
If the taxpayer chooses to treat materials under Treasury Regulation Section 1.162-3, they are not subject to IRC Section 263A.Non-Incidental Material and Supplies under Revenue Procedure 2002-28
An inventory item is any item that is either purchased for resale to customers or used as a raw material in producing finished goods. Inventory items that are treated as non-incidental material and supplies under Revenue Procedure 2002-28 are deductible in either the tax year that payment for them is made or in the tax year that they are actually used and consumed, whichever is later. Guidance on the timing of deductions for Inventory items treated as non-incidental materials and supplies is provided for under Treasury Regulation Section 1.162-3.Example:
Revenue Procedure 2002-28; Section 6; Example 15: Taxpayer is a roofing contractor that is eligible to use the cash method under this revenue procedure. Taxpayer chooses to use the cash method and to account for inventory items as non-incidental materials and supplies under Treasury Regulation Section1.162-3.
Taxpayer enters into a contract with a homeowner in December 2001 to replace the homeowner’s roof. Taxpayer purchases roofing shingles from a local supplier and has them delivered to the homeowner’s residence. Taxpayer pays the supplier $5,000 for the shingles upon their delivery later that month. Taxpayer replaces the homeowner’s roof in December 2001, and gives the homeowner a bill for $15,000 at that time. Taxpayer receives a check from the homeowner in January 2002.
The shingles are non-incidental materials and supplies. The cost of the shingles is deductible in the year taxpayer uses and consumes the shingles or actually pays for the shingles whichever is later.
In this case, a taxpayer both pays for the shingles and uses the shingles (by providing the shingles to the customer in connection with the performance of roofing services) in 2001. Thus, the taxpayer deducts the $5,000 cost of the shingles on its 2001 federal income tax return. The taxpayer includes the $15,000 in income in 2002 when it receives the check from the homeowner.Example:
Revenue Procedure 2002-28; Section 6; Example 16: Same as in Example 15, except that the taxpayer does not replace the roof until January 2002 and is not paid until March 2002. Because the shingles are not used until 2002, the cost of the shingles can only be deducted on the taxpayer’s 2002 federal income tax return notwithstanding that the taxpayer paid for the shingles in 2001. Thus, on its 2002 return, the taxpayer must report $15,000 of income and $5,000 of deductions.Contractors Building Property to Sell on Land They Own and Revenue Procedure 2002-28
A contractor who meets the requirements of Revenue Procedure 2001-10 or Revenue Procedure 2002-28 is permitted to use the cash method of accounting. However, these revenue procedures do not apply to a contractor to the extent it enhances the value of land it owns by building structures it intends to sell. Such contractors are not permitted to immediately deduct the costs of this construction. These costs must be capitalized and will eventually be offset against the sales price of the land and its improvements that becomes real property as they are completed.
IRC Section 263(a) (1) and Treasury Regulation Section 1.263(a)-1 prohibits deductions for any amount that a taxpayer pays for new buildings or for permanent improvements or betterments that increase the property’s value. Treasury Regulation Section 1.263(a)-2 sets forth examples of capital expenditures, including the cost of acquisition, construction, or erection of buildings. Consequently, the taxpayer-contractor must capitalize expenses in connection with real property construction on its own land, including construction of property that it intends to sell.
The purpose of Revenue Procedure 2001-10 and Revenue Procedure 2002-28 is to provide qualifying small taxpayers an exception to the required accrual method under IRC Section 446 when the taxpayer is otherwise required to account for inventory under IRC Section 471. However, a taxpayer-contractor building on his own land for the purpose of selling the property constructed is producing or constructing a real property asset that it cannot inventory. See W.C. and A.N. Miller Development Company v. Commissioner 81 T.C. 619 (1983); Pierce v. Commissioner, T.C. Memo. 1997-411 (1997); and Revenue Ruling 86-149, 1986-2 C.B. 67.
Revenue Procedure 2002-28, section 4.02, and Revenue Procedure 2001-10, section 4, provide inventory options that do not apply to expenses related to construction of taxpayer-owned real property. If the taxpayer has expenses related to inventory items that are not required to be capitalized and are not related to construction of taxpayer-owned real property, it can choose from the applicable revenue procedure’s inventory options.
The taxpayer can still use the overall cash method of accounting so long as it meets the definitions of a qualifying small taxpayer. Under the cash method of accounting, the taxpayer can deduct business expenses that are not required to be capitalized, when it pays them, sells the expense items, or uses the items for the customer regardless of when they are accrued. Similarly, the taxpayer would recognize income upon receipt subject to applicable special rules such as IRC Section 1001 regardless of when it is accrued.Example:
Revenue Procedure 2002-28; Section 6; Example 17 illustrates when a taxpayer-contractor must capitalize building costs that occur on its own land and are attributable to property that it holds for sale, rather than deducting or inventorying them. The taxpayer is eligible to use the cash method as described in this revenue procedure. The taxpayer is a speculative builder of houses that are built on land it owns. In 2001, the taxpayer builds a house using various items such as lumber, piping, and metal fixtures that it had paid for in 2000. In 2002, the taxpayer sells the house to a buyer. Because the house is real property held for sale by the taxpayer, the house and the material used to build the house are not inventory items under this revenue procedure. Thus, the taxpayer may not account for the items used to build the house as non-incidental materials and supplies under Section 1.162-3. Rather, the taxpayer must capitalize the costs of the lumber, piping, metal fixtures and other goods used by the taxpayer to build the house under IRC Section 263. Upon the sale of the house in 2002, the costs capitalized by the taxpayer will be offset against the house sales price to determine the taxpayer’s gain or loss from the sale.Example:
Guidance on the timing of deductions for inventory items treated as non-incidental materials and supplies is provided under Revenue Procedure 2002-28; Section 6; Example 18 emphasizes the importance of determining the ownership of the property that the taxpayer builds.
Same as in Example 17, except that (1) the taxpayer builds houses on land its customers own, and (2) the houses are built in three months with payment due at completion. Because the taxpayer does not own the house, the lumber, piping, metal fixtures and other goods used by the taxpayer in the provision of construction services are inventory items, not real property held for sale. The taxpayer elects to treat the goods used to build the house as non-incidental materials and supplies under Section 1.162-3. The taxpayer must deduct the cost of the lumber, piping, metal fixtures and other non-incidental materials and supplies that are used by it to build the house in 2001 the year those items were used by the taxpayer to build the house notwithstanding that Taxpayer had paid for the items in 2000. Taxpayer will report income it receives from its customer as the income is actually or constructively received.Summary of Accounting Methods for Construction Contractors
Average annual gross receipts are equal to or less than $1 million:
Revenue Procedure 2001-10 and Revenue Procedure 2002-28 allows the use of the Cash Method but the taxpayer must account for inventories pursuant to IRC Section 471 or as non-incidental materials and supplies under Treasury Regulation 1.162-3.
All entities except C corporations and partnerships with C corporation partners and gross receipts greater than $1 million and less than or equal to $10 million:
Revenue Procedure 2002-28 allows Cash Method but must account for inventories per IRC Section 471 or as non-incidental materials and supplies under Treasury Regulation 1.162-3.
C corporations and partnerships with C corporation partners and gross receipts less than $5 million:
IRC Section 448 prohibits use of Cash Method.
Entities with gross receipts of less than or equal to $10 million but with a non home construction contract that is expected to last less than 2 years:
IRC Section 460 requires the use of PCM for long-term contracts that are not exempt per IRC Section 460(e).
All Entities with long-term contracts and gross receipts of less than or equal to $10 million:
IRC Section 460 requires use of PCM for long-term contracts with the exception of home construction contracts.
Note: Revenue Procedure 2002-28 can apply to taxpayers with average annual gross receipts of $10 million or less but excludes certain types of businesses. Whereas, Revenue Procedure 2001-10 can only apply to taxpayers with average annual gross receipts of $1 million dollars or less but includes many types of businesses that Revenue Procedure 2002-28 excludes.
Cash Method of Accounting
Treasury Regulation, Section 1.446-1(c)(1)(i)) requires the taxpayer to report income when received and to deduct expenses when paid. Income may be actually or constructively received. Constructive receipt occurs when the taxpayer has unrestricted access to income that has been earned.
As a general rule, Treasury Regulation 1.461-1(a)(1) provides that a cash basis taxpayer shall deduct expenses in the year of payment. It further provides that where an expenditure results in the creation of an asset having a useful life extending “substantially” beyond the close of the taxable year such an expenditure may not be deductible or may be deductible only in part for the taxable year in which made.
In Zaninovich, 616 F.2d 429, the appellate court adopted the “one-year rule” on a cash basis taxpayer distinguishing between currently deductible expenses and capital expenditures having a useful life extending “substantially beyond” the taxable year. The court allowed a full deduction for prepaid rent in the year of payment and did not require it to be deducted on a prorated basis.Example:
This situation illustrates the concept of constructive receipt. A general contractor contacted a subcontractor and offered payment for a job recently completed in December of Year 1. The subcontractor did not pick up the check until January of Year 2. The subcontractor would be required to report the income in Year 1 because it had been constructively received.
For book purposes, the contractor generally includes revenue in gross income when it is billable under the contract. However, for tax purposes the general principle is that income is included upon the first event fixing the taxpayer's right to receive income under IRC Section 451 and must be determined under the terms of each particular contract. The relevant test is commonly called the "all-events test”. All events that fix the right to receive income occur at the earliest of the following:
- When the required performance occurs;
- When payment is due; or
- When payment is made.
See Revenue Ruling 2003-10; Revenue Ruling 84-31; Revenue Ruling 83-106; Revenue Ruling 81-176; Revenue Ruling 80-308; Revenue Ruling 79-292; and Revenue Ruling 79-195.
In Boise-Cascade Corporation, 530 F.2d 1367, cert denied, 429 US 867, the Court of Claims permitted the accrual of income based on the work performed and not upon billing entitlement.Advance Payments
Advance payments or front-loading billings are common in the construction industry. The taxpayer may require payment of 30 percent “up front” before the contract begins to cover the cost of the materials needed at the job site. Under the accrual method the 30 percent is income when it is received under the contract even though no performance of the job has been incurred. Thus, this principle requires an accrual basis taxpayer to include advance payments received from construction contracts in gross income in the taxable year in which they are actually or constructively received rather than when earned at a later time under accrual accounting principles. See Treasury Regulation Sections 1.451-1(a) and 1.451-2(a).
Advance payments have traditionally been considered gross income in the year of receipt. Revenue Ruling 60-85, 1960-1 D.B. 181 states that Service will continue its general policy of taxing prepaid income in the year of receipt. This policy applies to income from contracts to furnish services and to other types of prepaid income regardless of whether the period for prorating is definite or indefinite unless a different treatment is specifically provided in the Internal Revenue Code or the regulations.Exception to Reporting Advance Payments in Year of Receipt
It should be noted that the Service recognizes a limited exception that allows an accrual basis taxpayer to defer including all or part of advance payments in gross income until the year after the year the payment is received. See Revenue Procedure 2004-34, 2004 C.B. 991 which modified and superseded Revenue Procedure 71-21 generally for taxable years ending on or after May 6, 2004.
Revenue Procedure 2004-34 does not restrict a taxpayer’s ability to use the methods provided in Treasury Regulation Section 1.451-5. Treasury Regulation Section 1.451-5 generally allows accrual method taxpayers to defer the advance payments for goods until the taxable year in which they are properly accruable under the taxpayers method of accounting for federal income tax purposes if that method results in the advance payments being included in gross income no later than when the advance payments are recognized in revenues under the taxpayers method of accounting for financial reporting purposes.
Revenue Procedure 2004-34 like its predecessor Revenue Procedure 71-21 allows a one-year deferral for advance payments of services. However, Revenue Procedure 2004-34 expanded the scope of Revenue Procedure 71-21 to include advance payment for certain non-services and combinations of services and non-services. Additionally, Revenue Procedure 2004-34 expanded the scope of Revenue Procedure 71-21 to include advance payments received in connection with an agreement or series of agreements with a term or terms extending beyond the end of the next succeeding taxable year.
For the advance payment to be deferred until the next tax year for federal income tax purposes, the advance payment must also be deferred until a subsequent year for financial purposes. See Section 4.01(2) of Revenue Procedure 2004-34.Deducting Expenses under the Accrual Method of Accounting
Under the accrual method of accounting, expenses are deductible when all events have occurred that establish the fact of the liability, the amount can be determined with reasonable accuracy, and economic performance has occurred.
Treasury Regulation Section1.446-1(c)(1)(ii)(A): Generally, under an accrual method, income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy. Under such a method, a liability is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
Treasury Regulation Section1.461-4(d) (2) provides that except as otherwise provided in Treasury Regulation Section1.461-4(d) (5), economic performance occurs when the liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person.Accrual Method and Retainages
Retainages withheld from a contractor are included in income when the right to receive the income becomes fixed and determinable. Generally, retainages are withheld from a contractor to ensure that the contractor satisfactorily completes their contractual obligations. If the contractual terms state the contractor will be paid the retainages withheld upon final completion and acceptance, the contractor does not have a fixed right to the retainages until that event occurs.
Revenue Ruling 69-314 allows an accrual-basis taxpayer to elect to defer the retainages withheld until they are billable under the terms of the contract, which is normally when the contractor has the right to receive the retention. If the contractor defers retainages receivable they must also defer retainages payable.
“Pay when paid” and “pay if paid” clauses generally do not defer recognition of retainages receivable to the time of receipt. They only provide a reasonable timeframe for when the contractor/subcontractor can expect payment. Many states have declared these clauses to be against public policy; thus the contractor has legal recourse to request payment of the retainages when they’ve performed the work as contractually required.
If the taxpayer is not currently deferring the retainages and wants to elect this provision under Revenue Ruling 69-314, it is a change in method of accounting that requires the Commissioner’s permission.
In turn, retainage the contractor withholds on subcontractors is not deductible until the “all-events” test is met. Therefore, even though economic performance has occurred (i.e. the subcontractor has completed a portion of the work) the all events test with respect to the retainage may not be established if the contract requires full acceptance and completion.Example:
This situation illustrates the concept of retainages payable. A contractor hires a subcontractor and the contract requires a $1,500,000 total payment and a 10% retainage. The retainage is not payable until full acceptance and completion of the job. The subcontractor completes one-third of the job and bills the contractor for $500,000.
The contractor withholds 10% and pays the subcontractor $ 450,000. The contractor can only deduct $450,000 because all events that establish the fact of the liability in regards to the $50,000 have not occurred. If the subcontractor fails to complete the job or completes the job unsatisfactorily the $50,000 does not have to be paid pursuant to the terms of the contract.
Taxpayers may elect the CCM to account for their exempt contracts. The general rule is that all contract income and contract related expenses (both direct and indirect) are deferred until the taxable year that the contract is completed. Because of this tax deferral, this is the method preferred by most taxpayers.
Treasury Regulation Section 1.460-4(d): provides that except as otherwise provided in paragraph (d)(4) of this section, a taxpayer using the CCM to account for a long-term contract must take into account in the contract's completion year, as defined in Section 1.460-1(b)(6), the gross contract price, and all allocable contract costs incurred by the completion year. A taxpayer may not treat the cost of any materials and supplies that are allocated to a contract, but actually remain on hand when the contract is completed, as an allocable contract cost.
Prior to the issuance of the final regulations, facts and circumstances determined whether there was final completion and acceptance. See Ball, Ball and Brosamer, Incorporated v. Commissioner 964 F.2d 890 (9th Cir. 1992) (aff'g T.C. Memo. 1990-454). For contracts entered into after January 10, 2001, the new regulations further define completion by providing a "bright-line" test that explicitly differs from Ball, Ball, and Brosamer Incorporated. A contract is deemed complete when the customer uses the primary subject matter of that contract and the taxpayer has incurred at least 95% of the total allocable costs.
Treasury Regulation Section1.460-1(c)(3) provides (i) In general, a taxpayer's contract is completed upon the earlier of (A) use of the subject matter of the contract by the customer for its intended purpose (other than for testing) and at least 95% of the total allocable contract costs attributable to the subject matter have been incurred by the taxpayer, or (B) final completion and acceptance of the subject matter of the contract.Example 1:
This situation illustrates the concept of completion using the customer-use rule. In 2002, a calendar year-end construction contractor enters into a contract to construct a building for a customer. In November 2003, the building is completed in every respect necessary for its intended use and the customer occupies the building.
In early December of 2003, the customer notifies the contractor of some minor deficiencies that need to be corrected and the contractor agrees to correct them in January 2004. Reasonable estimates of the costs to correct these deficiencies will be less than 5% of the total allocable contract costs.
The contract is complete in 2003 because in that year the customer used the building and at least 95% of the total allocable contract costs attributable to the building had been incurred. The contractor would then use a permissible method of accounting for any deficiency-related costs incurred after 2003.Example 2:
This situation illustrates the concept of completion using the customer-use rule. In 2001, a calendar year-end construction contractor agrees to construct a shopping center that includes an adjoining parking lot. By October 2002, the contractor has finished constructing the retail portion of the shopping center. By December 2002, the contractor has graded the entire parking lot but has paved only one-fourth of it because inclement weather conditions prevented the contractor from laying asphalt on the remaining three-fourths. In December 2002, the customer opens the retail portion of the shopping center and the paved portion of the parking lot to the general public.
The contractor reasonably estimates that the cost of paving the remaining three-fourths of the parking lot when weather permits will exceed 5% of the total allocable contract costs. Even though the customer is using the subject matter of the contract, the contract is not completed in December 2002 because the contractor has not incurred at least 95% of the total allocable contract costs attributable to the subject matter.Post Completion Expenses
When the contract is considered complete under the 95% completion rule under Treasury Regulation Section 1.460-1(c)(3), the remaining contract costs incurred after the completion year are deductible under the taxpayer’s permissible method of accounting such as the accrual method.
The completed contract method (CCM) requires that the taxpayer include all income in the gross contract price in the completion year and account for all costs incurred after the completion year in the normal manner for such expenses.
Treasury Regulation Section 1.460-4(d) (2) provides that if a taxpayer incurs an allocable contract cost after the completion year, the taxpayer must account for that cost using a permissible method of accounting.Example:
This situation illustrates the concept of post completion expenses on CCM. As of Dec 31, 2001, a contract entered into after January 10, 2001 was determined to be 97% complete. The total contract price is reported as income in 2001 as well as the related contract costs that have been incurred to date. The remaining contract costs (approximately 3% of total contract costs) incurred during 2002 is deductible in 2002.Allocation of Indirect Costs
All contract costs are deferred until the contract is deemed complete. The non-allocation of indirect costs that must be allocated can result in a substantial mismatching of income and expenses. The non-allocated costs are deducted as period expenses rather than being capitalized to the long-term contract that they benefit. Taxpayers electing the CCM have the option of allocating all direct and indirect costs as defined in Section1.263A-1(e) or as provided in Treasury Regulation Section1.460-5(d).
Treasury Regulation Section 1.460-5(d) lists the various indirect costs that are allocable to the contract. A taxpayer allocating costs under this paragraph (d)(2) must allocate the following costs to an exempt construction contract, other than a contract described in paragraph (d)(3) of this section, to the extent incurred in the performance of that contract:
Treasury Regulation Section 1.460-5(d) (2) provides that indirect costs allocable to exempt construction contracts.
- Repair of equipment or facilities;
- Maintenance of equipment or facilities;
- Utilities, such as heat, light, and power, allocable to equipment or facilities;
- Rent of equipment or facilities;
- Indirect labor and contract supervisory wages, including basic compensation, overtime pay, vacation and holiday pay, sick leave pay (other than payments pursuant to a wage continuation plan under section 105(d) as it existed prior to its repeal in 1983), shift differential, payroll taxes, and contributions to a supplemental unemployment benefits plan;
- Indirect materials and supplies;
- Non-capitalized tools and equipment;
- Quality control and inspection;
- Taxes otherwise allowable as a deduction under section 164, other than state, local, and foreign income taxes, to the extent attributable to labor, materials, supplies, equipment, or facilities;
- Depreciation, amortization, and cost-recovery allowances reported for the taxable year for financial purposes on equipment and facilities to the extent allowable as deductions under chapter 1 of the Internal Revenue Code;
- Cost depletion;
- Administrative costs other than the cost of selling or any return on capital;
- Compensation paid to officers other than for incidental or occasional services;
- Insurance, such as liability insurance on machinery and equipment; and
- Interest, as required under paragraph (b) (2) (v) of this section.
Treasury Regulation Section1.460-5(d) (2) also provides that (ii) Indirect costs not allocable to exempt construction contracts. A taxpayer allocating costs under this paragraph (d) (2) is not required to allocate the following costs to an exempt construction contract reported using the CCM:
- Marketing and selling expenses, including bidding expenses;
- Advertising expenses;
- Other distribution expenses;
- General and administrative expenses attributable to the performance of services that benefit the taxpayer’s activities as a whole such as payroll expenses, legal and accounting expenses;
- Research and experimental expenses as described in IRC Section 174 and the regulations;
- Losses under IRC Section 165 and the regulations;
- Percentage of depletion in excess of cost depletion;
- Depreciation, amortization, and cost recovery allowances on equipment and facilities that have been placed in service but are temporarily idle (for this purpose, an asset is not considered to be temporarily idle on nonworking days, and an asset used in construction is considered to be idle when it is neither en route to nor located at a job-site), and depreciation, amortization and cost recovery allowances under chapter 1 of the Internal Revenue Code in excess of depreciation, amortization, and cost recovery allowances reported by the taxpayer in the taxpayer’s financial reports;
- Income taxes attributable to income received from long-term contracts;
- Contributions paid to or under a stock bonus, pension, profit-sharing, or annuity plan or other plan deferring the receipt of compensation whether or not the plan qualifies under section 401(a), and other employee benefit expenses paid or accrued on behalf of labor, to the extent the contributions or expenses are otherwise allowable as deductions under chapter 1 of the Internal Revenue Code. Other employee benefit expenses include (but are not limited to): worker’s compensation; amounts deductible or for whose payment reduction in earnings and profits is allowed under section 404A and the regulations there under; payments pursuant to a wage continuation plan under section 105(d) as it existed prior to its repeal in 1983; amounts includible in the gross income of employees under a method or arrangement of employer contributions or compensation which has the effect of a stock bonus, pension, profit-sharing, or annuity plan, or other plan deferring the receipt of compensation or providing deferred benefits; premiums on life and health insurance; and miscellaneous benefits provided for employees such as safety, medical treatment, recreational and eating facilities, and membership dues;
- Cost attributable to strikes, rework labor, scrap and spoilage; and
- Compensation paid to officers attributable to the performance of services that benefit the taxpayer’s activities as a whole.
- Determining an in-process contract to be complete if over 95% complete;
- Allocation of Indirect Costs when all costs are not allocated to the contract; and
- Alternative Minimum Tax on non-home construction contracts or subject to alternative minimum tax discussed later in this chapter.
Treasury Regulation Section1.460-1(c) (3) (iii) clarifies that a subcontractor's customer is the general contractor. Thus, the subject matter of the subcontract is the relevant subject matter in determining a contract's completion.
Treasury Regulation Section1.460-1(c) (3) (iii) provides that in the case of a subcontract, a subcontractor's customer is the general contractor. Thus, the subject matter of the subcontract is the relevant subject matter under paragraph (c) (3) (i) of this section.Example:
In 2001, a customer hires a general contractor to construct an office building. The building will not be completed until 2003. The general contractor in turn hires a subcontractor to pour the concrete foundation. The subcontractor pours the concrete foundation and the general contractor accepts it in 2002. The subcontractor's contract is considered complete in 2002 and not in 2003 because the customer's use of and/or acceptance of the building occurred in 2002.
A taxpayer who is exempt from the requirement to use the percentage of completion under IRC Section 460 (using the cost-to-cost method) still may elect a PCM. The percentage of completion may be determined by using any method of cost comparisons such as the following:
- Direct labor costs to estimate total labor costs;
- Work performed (e.g., units of production) the criteria used to compare the work performed on a contract must clearly reflect the earning of income with respect to the contract; or
- Treasury Regulation Section 1.460-4(c) (2) Exempt-contract percentage-of-completion method.
Treasury Regulation Section1.460-4(c) (2) provides that (i) In general. Similar to the PCM described in paragraph (b) of this section, a taxpayer using the EPCM generally must include in income the portion of the total contract price, as described in paragraph (b)(4) of this section, that corresponds to the percentage of the entire contract that the taxpayer has completed during the taxable year. Under the EPCM, the percentage of completion may be determined at of the end of the taxable year by using any method of cost comparison (such as comparing direct labor costs incurred to date to estimated total direct labor costs) or by comparing the work performed on the contract with the estimated total work to be performed, rather than by using the cost-to-cost comparison required by paragraphs (b)(2)(i) and (5) of this section, provided such method is used consistently and clearly reflects income. In addition, paragraph (b) (3) of this section (regarding post-completion-year income), paragraph (b) (6) of this section (regarding the 10% method) and Section1.460-6 (regarding the look-back method) do not apply to the EPCM.
Treasury Regulation Section1.460-4(c)(2) also provides that a determination of work performed, for purposes of the EPCM, the criteria used to compare the work performed on a contract as of the end of the taxable year with the estimated total work to be performed must clearly reflect the earning of income with respect to the contract. For example, in the case of a road builder, a standard of completion solely based on miles of roadway completed, in a case where the terrain is substantially different, may not clearly reflect the earning of income with respect to the contract.Example:
This situation illustrates the concept of an exempt-contract percentage-of-completion method (EPCM). An exempt contract requires the taxpayer to install 50 miles of utility lines. The entire 50 miles is on comparable terrain meaning no particular area will require additional costs to install the utility lines. The taxpayer elects the percentage of completion based on units (e.g., miles). At the end of the tax year, 10 miles have been installed. Thus, 20% of the contract is determined to be complete.
Generally contractors meeting the “small contractor exemption” under IRC section 460 (e) (1) are not required to use PCM for regular tax purposes. However, I.R.C. Section 56 requires that long-term contracts shall be determined under the percentage of completion method of accounting for alternative minimum tax. Alternative minimum tax is a separate tax system designed to ensure that taxpayers pay a minimum amount of tax on the true economic income when the income may not yet be taxable for regular income tax purposes. Therefore, small contractors that elect a method other than PCM may be required to compute alternative minimum taxable income.
IRC Section 56 provides guidance on adjustments that are applicable to all taxpayers. IRC Section 56 (a) (3 provide guidance on the treatment of certain long-term contacts:
In the case of any long-term contract entered into by the taxpayer on or after March 1, 1986, the taxable income from such contract shall be determined under the percentage of completion method of accounting (as modified by section 460(b)). For purposes of the preceding sentence, in the case of a contract described in section 460 (e)(1), the percentage of the contract completed shall be determined under section 460(b)(1) by using the simplified procedures for allocation of costs prescribed under section 460(b)(3). The first sentence of this paragraph shall not apply to any home construction contract (as defined in section 460(e) (6)).
There are two exceptions to the percentage of completion method for alternative minimum tax. The first exception is home construction contracts. The last sentence in IRC Section 56(a) (3) states that the alternative minimum tax adjustment for PCM does not apply to home construction contracts.
IRC Section 460(e) (6) (A) defines a home construction contract: The term “home construction contract” means any construction contract if 80 percent of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to activities referred to in paragraph (4) with respect to:
- IRC Section 460(e)(6)(A)(i) provides that dwelling units as defined in section 168(e)(2)(A)(ii) in buildings containing 4 or fewer dwelling units, and
- IRC Section 460 (e)(6)(A)(ii) provides that improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
For purposes of clause (i), each townhouse or row house shall be treated as a separate building.
The second exception to the percentage of completion method for alternative minimum tax is for “small corporations”. Small corporations are exempt from alternative minimum tax for years beginning after 1997 under IRC Section 55(e). The definition of a “small corporation” for purposes of the exemption, the corporation must:
- Be a C corporation. S Corporations, partnerships, and individual entities (Schedule C) are not exempt per IRC Section 55(e);
- For the first tax year beginning after 1996, the average gross receipts for the prior 3 years must be $5 million or less; and
- A C corporation that meets the initial average gross receipts of $5 million will continue to be exempt from AMT as long as the average gross receipts do not exceed $7.5 million.
IRC Section 55 imposes an alternative minimum tax. There is an exception for small corporations:
- $7,500,000 Gross Receipts Test: The tentative minimum tax of a corporation shall be zero for any taxable year if the corporation’s average annual gross receipts for all 3-taxable-year periods ending before such taxable year do not exceed $7,500,000. For purposes of the preceding sentence, only taxable years beginning after December 31, 1993 shall be taken into account.
- $5,000,000 Gross Receipts Test for First 3-Year Period: Subparagraph (A) shall be applied by substituting “$5,000,000” for “$7,500,000” for the first 3-taxable-year period (or portion thereof) of the corporation which is taken into account under subparagraph (A).
- First Taxable Year Corporation in Existence: If such taxable year is the first taxable year that such corporation is in existence, the tentative minimum tax of such corporation for such year shall be zero.
- Special Rules: For purposes of this paragraph, the rules of paragraphs (2) and (3) of section 448(c) shall apply.
If a small corporation later exceeds the $7.5 million average, the corporation becomes subject to AMT but only for those contracts entered into after the average was exceeded. C Corporation contractors (other than home construction contracts) with average gross receipts between $7.5 million and $10 million would be subject to the long-term AMT adjustment. Contractors exceeding the $10 million average would be required to use PCM for regular tax purposes and no AMT adjustment would be necessary.Example:
Assume a calendar-year corporation was in existence on January 1, 1994. In order to qualify as a small corporation for 1998 (the first year the exemption is available), the corporation’s average gross receipts for the three-taxable year period 1994 through 1996 must be $5 million or less and the corporation’s average gross receipts for the 1995 through 1997 period must be $7.5 million or less. If the corporation qualifies for 1998, the corporation will qualify for 1999 if its average gross receipts for the three-taxable year period 1996 through 1998 are $7.5 million or less. If the corporation does not qualify for 1998, the corporation cannot qualify for 1999 or any subsequent year.Example:
Assume a calendar-year corporation is first incorporated in 1999 and is neither aggregated with a related existing corporation under IRC Section 448(c) (2) nor treated as having a predecessor corporation under IRC Section 448(c)(3)(D). The corporation will qualify as a small corporation for 1999 regardless of its gross receipts for such year.
In order to qualify as a small corporation for 2000, the corporation’s gross receipts for 1999 must be $5 million or less. If the corporation qualifies for 2000, the corporation also will qualify for 2001 if its average gross receipts for the two-taxable year period 1999 through 2000 are $7.5 million or less. If the corporation qualifies for 2001, the corporation will qualify for 2002, if its average gross receipts for the three taxable year period 1999 through 2001 are $7.5 million or less. If the corporation does not qualify for 2000, the corporation cannot qualify for 2001 or any subsequent year.
Sole proprietorships (1040 Schedule C), S corporations (1120-S), and partnerships (1065) do not have a gross receipts exception. Therefore, the percentage of completion for alternative minimum tax purposes is required for non-home construction contracts.Long-Term Contract Adjustment for Alternative Minimum Tax
The AMT adjustment is computed by taking the difference between the two gross profits. The gross profit using the taxpayer’s accounting method for regular tax purposes and the gross profit computed under PCM (using the simplified method or the alternative method to determine percent complete).
PCM is required to be used for financial statements under SOP 81-1 (Statement of Position) and many companies are required to have financial statements for bonding or lending purposes. Thus, this information is usually readily available.Example:
This situation illustrates the concept of the AMT Adjustment. A Schedule C contractor reports income and expenses from long-term contracts on the completed contract method. The contracts are not home construction contracts. The AMT adjustment for the job below would be as follows (only one job-in-process used for simplification purposes):
PCM Gross Profit
CCM Gross Profit
For the tax years 2000 and 2001, the contractor would pay alternative minimum tax since no regular income tax is paid. However, in 2002, the negative AMT adjustment would most likely result in no alternative minimum tax and the contractor would receive an AMT credit on the prior AMT paid. The 2002 AMT adjustment is shown on the line 21 (Long-Term Contracts) on Form 6251, Alternative Minimum Tax - Individuals and line 2f of Form 4626, Alternative Minimum Tax - Corporations.S Corporations, Partnerships, and Alternative Minimum Tax
The alternative minimum tax adjustment for long-term contracts is determined at the entity level. Each shareholder then reports the AMT adjustment on his or her pro-rata ownership. This amount should be reported on the Schedule K-1 provided to the partner or shareholder which would then be reported on the appropriate line on the Form 6251 if the shareholder/partner is an individual or Form 4626 if the shareholder or partner is a corporation.Look-Back and Alternative Minimum Tax
Even though small contractors are exempt from the requirement to report long-term contracts on PCM and apply look-back to completed contracts; the look-back applies to those small contractors that must compute PCM for alternative minimum tax purposes. See the look-back module for more detailed information on the computation of look back.
Small contractors those were exempt from the IRC Section460 PCM reporting requirements due to the average annual gross receipts being less than $10,000,000 become large contractors when the average annual gross receipts exceed $10,000,000.
During this converting year, any contracts previously in progress are still accounted for under the method they have been using (e.g., completed contract method). Any new contracts started are computed on the percentage of completion method. This is known as the “cut-off” method. Because this is a statutory change, the change in accounting method procedures (i.e., filing Form 3115) does not apply.
If, in a subsequent year, the average annual taxable gross receipts go below $10,000,000 the taxpayer will compute any new contracts under its “exempt” contract method such as the completed contract and continue to report previous contracts using to PCM.Example:
The contractor has been in business since 1990 and properly elected the completed contract method for reporting its long-term construction contracts. The year 2000 is the first taxable year that the average annual gross receipts for the prior three taxable years exceeded $10,000,000. In 2002, the average annual gross receipts dropped below $10,000,000:
Job 1 - In Process in 1999
CCM Job Completed
Job 2 - Started in 2000
PCM Job Completed
Job 3 - Started in 2001
Job 4 - Started in 2002
- Defer gross profits and income tax on contracts until the job is completed.
- Several contracts completed within one year may require substantial income recognition in a single year.
- Contractors may spend cash received from early billings and not have sufficient funds to pay income tax in year of completion.
- Alternative minimum tax must be calculated using the percentage of completion method, unless taxpayer meets one of the exceptions.
- Allows recognition of income as work is performed, rather than recognizing substantial amounts when several contracts are completed in one year. This enables taxpayers to take advantage of the graduated tax rates.
- Allows for the deferral of income from front-loading, which, under the accrual method, is recognized when received or billed.
- There may not be any difference in reporting for financial statement purposes and the tax return. This reduces burden of record keeping.
Small construction contractors have more flexibility in electing methods of accounting for their long-term contracts. However, the small contractor may be subject to alternative minimum tax for those contracts that are not computed on the percentage of completion method. The choice of a proper accounting method, the proper computation of each accounting method, and the alternative minimum tax consequences are complex concepts that must be considered by each contractor.