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Construction Industry Audit Technique Guide (ATG) - Chapter 2

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.


Table of Contents
Chapter 1 / Chapter 3


Chapter 2: Long Term Contracts

Background

Before the enactment of the Tax Reform Act of 1986, construction contractors could choose an accounting method from various alternatives with few restrictions. Contractors would recognize income and expense from construction contracts under the cash method, accrual method, completed contract method, or percentage of completion method. Many contractors adopted the completed contract method for tax purposes because they could defer taxes until the completion of the contract.

Internal Revenue Code (IRC) Section 460 (effective for contracts entered into after February 28, 1986) generally requires the use of the percentage of completion method. Additionally, IRC Section 460 introduced the "Look-back Method." A discussion on the “Look-back Method” is provided in this guide.

A long-term contract method of accounting (completed contract or percentage of completion) is only available to taxpayers that have long-term contracts. Therefore, whether or not a long-term contract exists and the classification of the contract must be determined prior to electing a proper method of accounting. This chapter is designed to bring out the various factors involved in making this determination.

Long Term Contract Defined

The term "long-term" tends to indicate a contract that lasts a long period of time, but the duration of the contract is irrelevant in order for it to be classified as a long term construction contract. IRC Section 460(f) (1) generally defines a long-term contract as one that is not complete at the end of the tax year.

The long-term contract must also be for the manufacture, building, installation, or construction of property.

IRC Section 460(f)(1): In general, the term "long-term contract" means any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into.

Example:

A calendar-year taxpayer begins a construction job on December 31 and completes the job on January 1 of the subsequent year. The contract is considered a long-term contract even though the job was only two days in duration.

Contracts Subject to IRC Section 460

Under IRC Section 460(b)(1), taxpayers must use the percentage of completion method to report taxable income from long-term contracts. The degree of completion is generally determined by comparing the total allocated contract costs incurred to date with the total estimated contract costs, otherwise known as the “cost-to-cost method.”

Engineering estimates or other approaches to determine the degree of completion may not be used if the contractor is subject to the PCM under IRC Section 460. If a contractor is able to meet the exemptions of IRC Section 460(e), the use of the engineering estimates (or any other recognized output methods) or any appropriate method, meeting the definition of section 460, is allowed. See the chapter on Large Contractors for additional information regarding contracts subject to IRC Section 460.

Contracts Exempt from IRC Section 460

IRC Section 460(e) provides two exceptions for long-term construction contracts to the required use of the percentage of completion rules and the application of look-back:

  1. Any home construction contract (defined in IRC Section 460(e) (6)(A)) entered into after June 20, 1988. Home construction contractors not meeting the small contractor exception discussed below are required, under IRC Section 460(e) (1) (B), to capitalize costs using IRC Section 263A. See the chapter on Home Builders and Land Developers for additional information regarding these home construction contracts.
  2. Small construction contracts, as defined in IRC Section 460(e)(1)(B), require that at the time the contract was entered into, it was estimated that such contract would be completed within a 2-year period beginning on the commencement date of such contract; and the contractor's average annual taxable gross receipts for the 3 taxable years preceding the year in which such contract was entered into did not exceed $10 million. See the chapter on Small Contractors for additional information regarding these types of contracts.

Example:

A contractor enters into two long-term contracts during the taxable year. Neither of which are home construction contracts. The average annual taxable gross receipts for the prior 3 taxable years are $9,000,000.

Job 1 is expected to be completed within 18 months. Job 1 is exempt from the percentage of completion and look-back requirements of IRC Section 460 and may be accounted for under the taxpayer’s elected method of accounting for long-term contracts (e.g. completed contract, accrual).

Job 2 is expected to be completed within 30 months. However, Job 2 must be accounted for using the percentage of completion method and look-back may be required upon the completion of the job. Even though the average annual taxable gross receipts for the prior 3 years is less than $10,000,000, the contract is not estimated to be completed within the 2-year period.

In this example, two methods of accounting for long-term contracts are proper. The two exceptions provided under IRC Section 460(e) do not apply to long-term manufacturing contracts.

Construction and Manufacturing Contracts

IRC Section 460 makes a distinction between the two categories of long-term contracts a construction contract and certain manufacturing contracts. A construction contract pertains to real property. A manufacturing contract pertains to personal property. This guide is written primarily for use with construction contracts as opposed to manufacturing contracts. Treas. Reg. Section 1.460-1(b) (1) further distinguishes a long-term construction contract from a long-term manufacturing contract.

Long-term Contract

A long-term contract generally is any contract for the manufacture, building, installation, or construction of property if the contract is not completed within the contracting year, as defined in Regulation Section 1.460-1(b)(5). However, a contract for the manufacture of property is a long-term contract only if it also satisfies either the unique-item or 12-month requirements described in Section 1.460-2. A contract for the manufacture of personal property is a manufacturing contract. In contrast, a contract for the building, installation, or construction of real property is a construction contract. See Treasury Regulation Section 1.460-1(b) (1).

Construction Contract

For purposes of this subsection, the term "construction contract" means any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property. See IRC Section 460(e) (4).

Manufacturing Contract

IRC Section 460(f) (2) provides a special rule for manufacturing contracts. A contract for the manufacture of property shall not be treated as a long-term contract unless such contract involves the manufacture of:

  1. Any unique item of a type which is not normally included in the finished goods inventory of the taxpayer, or
  2. Any item which normally requires more than 12 calendar months to complete (without regard to the period of the contract).

Integral Components of Real Property

A contract not completed in the year the contract is entered into is a long-term construction contract if it involves the building, construction, reconstruction, or rehabilitation of real property; the installation of an integral component to real property; or the improvement of real property. These are collectively referred to as construction. Treas. Reg. Section 1.460-3(a).

Real property means land, buildings, and inherently permanent structures, as defined in section 1.263A-8(c) (3), such as roadways, dams, and bridges. Real property does not include vessels, offshore drilling platforms, or natural products of land that have not been severed.

An integral component to real property includes property not produced at the site of the real property but is intended to be permanently affixed to the real property, such as elevators and central heating and cooling systems.

Example:

A contract to install an elevator in a building is a construction contract because a building is real property, but a contract to install an elevator in a ship is not a construction contract because a ship is not real property.

Example:

A taxpayer enters into a contract to manufacture an elevator. However, an unrelated party will install it. The contract for the manufacture of the elevator is not a construction contract even though the elevator is considered an integral component to real property. The regulations define a construction contract as one that involves the installation of the integral component.

Contract Classifications

Contracts are determined on a contract-by-contract basis and categorized into one of the following classifications:

  1. Long-term construction contract;
  2. Long-term manufacturing contract; or
  3. Non-long-term contract.

Treasury Regulation Section 1.460-1(b)(2)(i) clarifies that a contract's classification should be based on the performance required of the taxpayer under the contract regardless of whether the contract would be classified as a sales contract or a construction contract. It’s not relevant that title in the property constructed under the contract is delivered to the customer.

Treasury Regulation Section 1.460-1(b) (2) provides that (i) In general. A contract is a contract for the manufacture, building, installation, or construction of property if the manufacture, building, installation, or construction of property is necessary for the taxpayer's contractual obligations to be fulfilled and if the manufacture, building, installation, or construction of that property has not been completed when the parties enter into the contract.

If a taxpayer has to manufacture or construct an item to fulfill his obligations under the contract, the fact that the taxpayer is not required to deliver that item to the customer is not relevant. Whether the customer has title to, control over, or bears the risk of loss from, the property manufactured or constructed by the taxpayer also are not relevant. Furthermore, how the parties characterize their agreement (e.g., as a contract for the sale of property) is not relevant.

Example:

A developer, whose taxable year ends December 31, owns 5,000 acres of undeveloped land. To obtain permission from the local county government to improve this land, a service road must be constructed on this land to benefit all 5,000 acres. In 2000, the developer enters into a contract to sell a 1,000-acre parcel of undeveloped land to a residential developer, for its fair market value. In this “sales” contract, the developer agrees to construct a service road running through the land that it is selling to the residential developer. The construction of the service road is estimated to be completed in 2002. The “sales” contract is a construction contract because the construction of an item (the service road) is necessary for the developer to fulfill its contractual obligations. De minimis construction activities must also be considered in classification of the contract if entered into after January 10, 2001.

Hybrid Contracts

A hybrid contract is a single long-term contract that requires a taxpayer to perform both manufacturing and construction activities. Generally, the regulations classify a hybrid contract as two contracts, a manufacturing contract and a construction contract. Treas. Reg. Section 1.460-1(f) (2) permits a taxpayer to elect, on a contract-by-contract basis, to do one of the following:

  1. Treat the entire contract as a long-term construction contract if at least 95% of the estimated total allocable contract costs are reasonably allocable to construction activities; or
  2. Treat the entire contract as a long-term manufacturing contract subject to the percentage of completion method of accounting. Note that there is no 95% rule as with the election to treat a hybrid contract as a construction contract.

Treasury Regulation Section 1.460-1(f)(2) provides that (i) In general, a long-term contract that requires a taxpayer to perform both manufacturing and construction activities (hybrid contract) generally must be classified as two contracts--a manufacturing contract and a construction contract.

A taxpayer may elect, on a contract-by-contract basis, to classify a hybrid contract as a long-term construction contract if at least 95% of the estimated total allocable contract costs are reasonably allocable to construction activities.

In addition, a taxpayer may elect, on a contract-by-contract basis, to classify a hybrid contract as a long-term manufacturing contract subject to the percentage of completion method (PCM).

De minimis Construction Activities

A contract with de minimis construction activities is not a construction contract under IRC Section 460 if the contract includes the provision of land by the taxpayer and the estimated total contract costs attributable to the construction activities are less than 10% of the contract's total contract price.

For purposes of the 10% test, the cost of the land provided to the customer is not included in the allocable contract costs. See Treasury Regulation Section 1.460-1(b) (2) (ii).

This 10% threshold provides a "bright-line" test. Prior to enactment of the regulation, Notice 89-15 provided that a contract was a construction contract if the construction activity required by the contract was necessary for the taxpayer to fulfill its contractual obligations.

Example:

A developer, whose taxable year ends December 31, owns 5,000 acres of undeveloped land with a cost basis of $5,000,000. To obtain permission from a local county government to improve this land, a service road must be constructed on this land to benefit all 5,000 acres.

In 2005, the developer enters into a contract to sell a 1000-acre parcel of undeveloped land to a residential developer for $10,000,000. In the sales contract, there is a provision that commits the taxpayer to construct the portion of the service road that benefits the acreage sold, as required by the local county government. The portion of the cost of the service road attributable to the 1000-acre parcel is estimated to be $10,000. The service road is not completed until 2006.

Because the estimated total allocable contract costs attributable to the construction activities is $10,000 and these costs are less than 10% of the total contract price of $10,000,000, the contract is not considered a construction contract and is not to be accounted for under a long-term contract method. Prior to January 10, 2001, this same contract would have been accounted for under a long-term contract method.

Non Long-Term Contract Activities

Long-term contract methods of accounting apply only to the gross receipts and costs attributable to long-term contract activities. Non-long-term contract activities are defined in Treasury Regulation Section 1.460-1(d) (2).

Non-long-term contract activity means the performance of an activity other than manufacturing, building, installation, or construction, such as the provision of architectural, design, engineering, and construction management services, and the development or implementation of computer software.

In addition, performance under a guaranty, warranty, or maintenance agreement is a non-long-term contract activity that is never incidental to or necessary for the manufacture or construction of property under a long-term contract.

Several revenue rulings have held that contracts for services cannot use a long-term method of accounting:

  1. An architect is not entitled to report income from contracts extending over more than one year on the completed contract method because the work is in the nature of personal service. Revenue Ruling 70-67, 1970-1 C.B. 117.
  2. Engineering services and construction management, unrelated to the construction contractor, are not entitled to use either the completed contract method or percentage of completion method because the contract does not require the taxpayer to construct or build anything, even though the services are functionally related. Revenue Ruling 82-134, 1982-2 C.B. 88 and Rev. Ruling. 80-18, 1980-1 C.B. 103.
  3. A painting contractor cannot use the completed contract method because he provides only painting services. Revenue Ruling 84-32, 1984-1 C.B. 129.

However, if the performance of a non-long-term contract activity is incident to or necessary for the manufacture, building, installation, or construction of the subject matter of one or more of the taxpayer's long-term contracts, the gross receipts and costs attributable to that activity must be allocated to the long-term contract. Treas. Reg. Section 1.460-1(d) requires allocation of the contract’s gross receipts and costs among the activities.

Treasury Regulation Section 1.460-1(d) provides that (i) In general, long-term contract methods of accounting apply only to the gross receipts and costs attributable to long-term contract activities.

Gross receipts and costs attributable to long-term contract activities means amounts included in the total contract price or gross contract price, whichever is applicable, as determined under Section 1.460-4, and costs allocable to the contract, as determined under Section 1.460-5.

Gross receipts and costs attributable to non-long-term contract activities as defined in paragraph (d)(2) of Section 1.460-1, must generally be taken into account using a permissible method of accounting other than a long-term contract method. See IRC Section 446 (c) and Section 1.446-1(c).

However, if the performance of a non-long-term contract activity is incidental to or necessary for the manufacture, building, installation, or construction of the subject matter of one or more of the taxpayer's long-term contracts, the gross receipts and costs attributable to that activity must be allocated to the long-term contract(s) benefited as provided in Section 1.460-4(b) (4)(i) and 1.460-5(f)(2), respectively.

Similarly, if a single long-term contract requires a taxpayer to perform a non-long-term contract activity that is not incident to or necessary for the manufacture, building, installation, or construction of the subject matter of the long-term contract, the gross receipts and costs attributable to that non-long-term contract activity must be separated from the contract and accounted for using a permissible method of accounting other than a long-term contract method. But see Section 1.460-1(g) for related party rules.

Example:

A general contractor is hired to design and construct a building for a customer. The design portion of the contract is considered a non-long-term contract activity. However, it is incidental to the construction of the building because it could not be built without the design so the entire contract is accounted for under a long-term contract method of accounting.

Related Party Contract

Treasury Regulation Section 1.460-1(g) extends the reporting of the percentage of completion method to related parties that may not generally be required to report their income on the percentage of completion method. A taxpayer who performs an activity that would normally be considered a non-long term contract activity (e.g., architectural services) must report income on the percentage of completion method if it is incidental to or necessary to a related party's long-term contract that must be reported using the percentage of completion method (PCM).

Treasury Regulation Section 1.460-1(g) provides that (i) In general, except as provided in Treasury Regulation Section 1.460(g)(1)(ii), if a related party and its customer enter into a long-term contract subject to the PCM, and a taxpayer performs any activity that is incidental to or necessary for the related party's long-term contract, the taxpayer must account for the gross receipts and costs attributable to this activity using the PCM, even if this activity is not otherwise subject to section 460(a).

This type of activity may include, for example, the performance of engineering and design services, and the production of components and subassemblies that are reasonably expected to be used in the production of the subject matter of the related party's contract.

Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate, Treasury Regulation Section 1.460-1(b)(4) define a related party as a person whose relationship to a taxpayer is described in IRC Section 707(b) or Section 267(b) that includes:

  1. A partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership;
  2. Two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests;
  3. Members of a family, including only brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants;
  4. An individual and a corporation, more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual;
  5. Two corporations which are members of the same controlled group;
  6. A grantor and a fiduciary of any trust;
  7. A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;
  8. A fiduciary of a trust and a beneficiary of such trust;
  9. A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;
  10. A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;
  11. A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;
  12. A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership;
  13. An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or
  14. An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation.

Example:

An architectural firm enters into a contract with a customer to design an office building. Since the contract is for the performance of services it is not a long-term construction contract. However, if the architect's related construction company enters into a contract with the same customer to build the "designed" building and the construction company is required to account for the long-term construction contract under the PCM, the architect must account for the design services under PCM because the services are incidental to the related construction company's contract.

Severing and Aggregating Contracts

Under IRC Section 460(f) (3), contractors are permitted and may be required to sever or aggregate contracts. Severance treats one agreement as two or more contracts. Aggregation treats two or more agreements as one contract. Whether an agreement should be severed or two or more agreements should be aggregated, depends on the following factors (with certain exceptions) as provided in Treasury Regulation Section 1.460-1(e):

  1. Pricing: Independent pricing of items in an agreement is necessary for the agreement to be severed into two or more contracts.
  2. Separate delivery or acceptance: An agreement may not be severed into two or more contracts unless it provides for separate delivery or separate acceptance of items that are the subject matter of the agreement. The separate delivery or separate acceptance of items by itself does not, however, necessarily require an agreement to be severed.
  3. Reasonable business person: Two or more agreements to perform manufacturing or construction activities may not be aggregated into one contract unless a reasonable business person would not have entered into one of the agreements for the terms agreed upon without also entering into the other agreement(s).

Exceptions under Treasury Regulation Section 1.460-1(e) (3) provide that (i) A taxpayer may not sever under this paragraph (e) a long-term contract that would be subject to the PCM without obtaining the Commissioner's prior written consent.

In the case of options and change orders, subject to the above Treasury Regulation, a taxpayer must sever an agreement that increases the number of units to be supplied to the customer such as through the exercise of an option or the acceptance of a change order if the agreement provides for separate delivery or separate acceptance of the additional units.

Example 1:

This situation illustrates the concept of severance. On January 1, 2005, a construction contractor enters into an agreement to build two office buildings in different areas of a large city. The agreement provides that the two office buildings will be completed and accepted by the customer in 2006 and 2007 respectively. The contractor will be paid $1 million and $1.5 million for the two office buildings respectively.

The agreement will provide a reasonable profit from the construction of each building. Unless the contractor is required to use the PCM to account for the contract, the contractor is required to sever this contract because the buildings are independently priced and the agreement provides for separate delivery and acceptance of the buildings. As each building will generate a reasonable profit, a reasonable businessperson would have entered into separate agreements for the terms agreed upon for each building.

Example 2:

This situation illustrates the concept of allocation. In 2005, a contractor enters into two separate contracts as the result of a single negotiation to construct two identical special use buildings (i.e. nuclear plant).

Because the contractor has never constructed this type of building before, the contractor anticipates that it will incur substantially higher costs to construct the first building.

If the agreements are treated as separate contracts, the first contract probably will produce a substantial loss while the second contract probably will produce substantial profit.

Based upon these facts, aggregation is required because the buildings are interdependently priced and a reasonable businessperson would not have entered the first agreement without also entering into the second.

Example 3:

This situation illustrates the concept of contract options. A contractor enters into a contract with a developer to construct 10 homes on land owned by the developer to be built in Year 1. The contract provides an option in which the contractor is to build an additional 10 homes. In Year 2, the option is exercised and the additional homes are built. The option would be severed from the original contract.

Conclusion

The construction industry is both unique and complex with respect to the number of available tax methods of accounting. The proper method of accounting for a long-term construction contract is determined contract-by-contract based on the type and terms of the contract, along with related party considerations.

Page Last Reviewed or Updated: 15-Nov-2013