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Construction Industry Audit Technique Guide (ATG) - Chapter 4

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 3 / Chapter 5


Chapter 4: Large Construction Contractors

Introduction

This chapter discusses the taxation of large construction contractors that are defined as contractors not meeting the exceptions under IRC Section 460(e). Contractors meeting the exceptions of IRC Section 460(e) are discussed in separate chapters involving small construction contractors and home construction contracts.

Methods of Accounting for Contracts Subject to IRC Section 460 Percentage of Completion Method (PCM)

Large construction contractors are required to account for long-term contracts on the percentage of completion method. The amount of revenue reported each year under the contract using the percentage of completion method is determined by multiplying the total estimated contract price times the percentage of completion at the end of the taxable year (completion factor) less any gross receipts reported in the prior tax years of the contract. See Treasury Regulation Section 1.460-4(b)(2). IRC Section 460 provides two methods of determining the degree of contract completion. They are the “cost-to-cost method” and the “simplified cost-to-cost method.”

Cost-to-Cost Method

IRC Section 460(b) (1) (A) generally requires that the percentage of completion method (PCM) be computed utilizing the cost-to-cost method. Treasury Regulation Section 1.460-4(b) describes the “cost-to-cost” computation as follows:

Cost to Cost Computation
Total Allocable Contract Costs Incurred To Date
Divided By
Total Estimated Allocable Contract Costs
Times Total Estimated Prior Years’ Reported Gross Receipts Contract Price Equals Gross Receipts To Be Reported For The Taxable Year

Treasury Regulation Section1.460-4(b) provides guidance on the percentage of completion method. In general, under the PCM, a taxpayer generally must include in income the portion of the total contract price, as defined in Regulation Section 1.460-4(b)(4)(i) that corresponds to the percentage of the entire contract that the taxpayer has completed during the taxable year. The percentage of completion must be determined by comparing allocable contract costs incurred with estimated total allocable contract costs. Thus, the taxpayer includes a portion of the total contract price in gross income as the taxpayer incurs allocable contract costs. The following computations may be required for a taxpayer to determine the income from a long-term contract:

  1. Computes the completion factor for the contract, which is the ratio of the cumulative allocable contract costs that the taxpayer has incurred through the end of the taxable year, to the estimated total allocable contract costs that the taxpayer reasonably expects to incur under the contract;
  2. Computes the amount of cumulative gross receipts from the contract by multiplying the completion factor by the total contract price;
  3. Computes the amount of current-year gross receipts, which is the difference between the amount of cumulative gross receipts for the current taxable year and the amount of cumulative gross receipts for the immediately preceding taxable year (the difference can be a positive or negative number); and
  4. Takes both the current-year gross receipts and the allocable contract costs incurred during the current year into account in computing taxable income.

Example:

B enters into a construction contract in 2001 for $10 million. B estimates that its total costs under the contract will be $8 million. At the end of 2002, B has incurred $4 million of its estimated costs on this project. If using the formula above, B includes $3 million of the contract price as gross receipts in 2001. B must include $2 million as gross receipts for 2002 computed as follows: ($4,000,000 ÷ $8,000,000) x ($10,000,000) - ($3,000,000) = $2,000,000

Allocable Contract Costs

The allocable contract costs that are used in determining the cost-to-cost method are provided in Treasury Regulation Section 1.460-5(b), which has a direct link to IRC Section 263A costs.

Treasury Regulation Section 1.460-5(b) provides the cost allocation method for contracts subject to PCM. In general, except as otherwise provided in paragraph (b)(2) of this section, a taxpayer must allocate costs to each long-term contract subject to the PCM in the same manner that direct and indirect costs are capitalized to property produced by a taxpayer under section 1.263A-1(e) through (h). Thus, a taxpayer must allocate to each long-term contract subject to the PCM all direct costs and certain indirect costs properly allocable to the long-term contract (i.e., all costs that directly benefit or are incurred by reason of the performance of the long-term contract). However, see paragraph (c) of this section concerning an election to allocate contract costs using the simplified cost-to-cost method. As in section 263A, the use of the practical capacity concept is not permitted. See section 1.263A-2(a) (4).

Direct costs listed under Treasury Regulation Section 1.263A-1(e) (2) include:

  1. Direct material costs
  2. Direct labor costs

Indirect costs listed under Treasury Regulation Section 1.263A-1(e) (3) include:

  1. Indirect labor costs
  2. Officers’ compensation
  3. Pension and other related costs
  4. Employee benefit expenses
  5. Indirect material costs
  6. Purchasing costs
  7. Handling costs
  8. Storage costs
  9. Cost recovery
  10. Depletion
  11. Rent
  12. Taxes
  13. Insurance
  14. Utilities
  15. Repairs and maintenance
  16. Engineering and design costs
  17. Spoilage
  18. Tools and equipment
  19. Quality control
  20. Bidding costs
  21. Licensing and franchise costs
  22. Interest
  23. Capitalized service costs

Subject to PCM, direct material and labor costs, are properly allocable to the long-term contract are all costs that directly benefit or are incurred through the contract’s performance. See Treasury Regulation Section 1.460-5(b) (1).

Similarly, indirect costs are properly allocable to property produced or property acquired for resale when the costs directly benefit or are incurred by reason of the performance of production or resale activities. See Treasury Regulation Section 1.263A-1(e) (3) (i).

Some indirect costs, on the other hand, may benefit both the long-term contract and other business activities of the taxpayer and are not always specifically identified to a particular long-term contract. This allocation may be a specific “facts-and-circumstances” method, including the specific identification (or tracing) method, burden rate method (i.e., ratios based on direct costs, direct labor, etc.), standard cost method, a “simplified method” provided in Treasury Regulation Section 1.263A-2 (b) and Treasury Regulation Section 1.263A-3(d) or any other reasonable method (as defined under Treasury Regulation Section 1.263A-1(f)(4)). See Treasury Regulation Section 1.263A-1(f) and Treasury Regulation Section 1.263A-1(g) (3).

Direct Material Costs

Direct material costs include the costs of those materials that become an integral part of specific property produced and those materials that are consumed in the ordinary course of production that can be identified or associated with particular units or groups of units of property produced. See Treasury Regulation Section 1.263A-1(e) (2) (i) (A). Direct material costs must be allocated to a long-term contract when “dedicated” to the contract. Thus, a taxpayer dedicates direct materials by associating them with a specific contract, including by purchase order, entry on books and records, or shipping instructions. See Treasury Regulation Section 1.460-5(b) (2) (i). Therefore, uninstalled materials that are dedicated to a contract become an allocable job cost.

Direct Labor Costs

Direct labor costs include the costs of labor that can be identified or associated with the long-term contract. For this purpose, labor encompasses full-time and part-time employees, as well as contract employees and independent contractors. Direct labor costs include all elements of compensation other than employee benefit costs described in Treasury Regulation Section 1.263A-1(e) (3) (ii) (D). Elements of direct labor costs include basic compensation, overtime pay, vacation pay, 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 payments to a supplemental unemployment benefit plan. See Treasury Regulation Section 1.263A-1(e) (2) (i) (B).

Bidding Costs

Bidding expenses are those costs incurred by a contractor in the solicitation of a long-term contract. The taxpayer must defer all bidding costs paid or incurred in the solicitation of a particular contract until the contract is awarded. If the contract is awarded to the taxpayer, the bidding costs become part of the indirect costs allocated to the subject matter of the contract. If the contract is not awarded to the taxpayer, bidding costs are deductible in the taxable year that the contract is awarded to another party, or in the taxable year that the taxpayer is notified in writing that no contract will be awarded and that the contract (or a similar or related contract) will not be re-bid, or in the taxable year that the taxpayer abandons its bid or proposal, whichever occurs first. See Treasury Regulation Section 1.263A-1(e) (3) (ii) (T).

Indirect Costs Not Generally Allocable To a Contract

Subject to the exception in IRC Section 460(c)(2) (costs identified under cost-plus and certain federal contracts), costs not allocable to the contract are independent research and development expenses, expenses for unsuccessful bids and proposals, and marketing, selling, and advertising expenses. See IRC Section 460(c) (4).

Treasury Regulation Section 1.263A-1 (e) (3) (iii) provides a list of additional indirect costs not allocable to the long-term contract under Treasury Regulation Section 1.460-5(b). These indirect costs include “deductible service costs,” which generally include costs incurred by reason of the taxpayer’s overall management or policy guidance functions, such costs from the board of directors, chief executive, financial, accounting, and legal officers. See Treasury Regulation Section 1.263A-1(e)(3)(iii)(K) and Treasury Regulation Section 1.263A-1 (e)(4)(ii)(B) and Treasury Regulation Section 1.263A-1 (e)(4)(iv)(A).

Even though a service cost is classified as “general and administrative,” however, it is allocable to the long-term contract if it directly benefits or is incurred by reason of the taxpayer’s performance of the production or resale activities. Examples are costs from data processing, personnel operations, security services, and legal services. See Treasury Regulation Section 1.263A-1 (e)(4)(i)(A) and Treasury Regulation Section 1.263A-1 (e)(4)(i)(B) and Treasury Regulation Section 1.263A-1 (e)(4)(i)(e)(4)(ii) -(iii).

Nondeductible Costs

Costs that would normally be allocable to a contract but are nondeductible by the Internal Revenue Code is not an allocable contract cost. A common example would be the nondeductible portion of meals per IRC Section 274. The amount incurred as well as the total estimated amount of the nondeductible cost must be removed from the percentage of completion computation.

Treasury Regulation Section 1.460-5(f) provides special rules applicable to costs allocated under this section. It states that a taxpayer may not allocate any otherwise allocable contract cost to a long-term contract if any section of the Internal Revenue Code disallows a deduction for that type of payment or expenditure (e.g., an illegal bribe described in section 162(c)).

Impact of Cost Allocation on the Percentage of Completion Computation

Unlike the percentage of completion method, a taxpayer using the completed contract method must defer the deduction of all allocable contract costs until the contract is completed. See Treasury Regulation Section 1.460-4(d) (1). Under the percentage of completion method, however, the taxpayer deducts the allocable contract costs in the year incurred, but the allocable contract cost’s exclusion from the percentage of completion computation (also known as “completion factor”) may affect the gross receipts amount reported in each taxable year of the contract. The key is to know what costs the percentage of completion taxpayer included in the completion computation.

The scenarios below point out the effect that allocation of indirect costs could have on the gross receipts reported by a taxpayer using the percentage of completion:

At the end of Year 1, the taxpayer’s estimated completion is 20% is determined as follows:

$100,000 Total Allocable Contract Costs Incurred To Date
Divided By
$500,000 Total Estimated Costs Allocable Contract Costs

Scenario 1:

An indirect allocable contract cost was included in the total estimated allocable contract costs in the denominator, but the cost, which was incurred during the taxable year, was erroneously not included in the numerator. This incurred cost was deducted on the tax return. The amount is still deductible as an expense; however, it should also be added to the numerator and, as such, impacts the amount of gross receipts to be reported on this contract.

$100,000 + $10,000
Divided By
$500,000
Equals
22% Complete

Scenario 2:

An indirect allocable contract cost, which is not incurred pro-rata over the life of the contract (e.g., architect fee and building permits which are incurred early in the contract), was improperly excluded from both the numerator and denominator of the PCM computation. The amount incurred during the tax year is the same as the total estimated cost of this expense - no additional amount of this indirect cost is to be incurred on this contract. Again, as mentioned in scenario 1, the deductibility of this expense is proper, only the gross receipts amount to be reported under this contract is impacted.

$100,000 + $10,000
Divided By
$500,000 + $10,000
Equals
21.57% Complete

Under PCM, the reference to the regulations under section 263A applies only to what costs to allocate and how. Allocable contract costs under PCM, however, are still deductible in the year incurred when computing taxable income. See Treasury Regulation Section 1.460-4(b)(2)(iv) and (h); Example 2, Treasury Regulation Section 1.460-5(b)(1).

Scenario 3:

An indirect allocable contract cost is incurred pro-rata over the life of the contract (e.g., indirect labor and officer’s salary that are incurred throughout the duration of the contract), and improperly excluded from both the numerator and denominator of the PCM computation. The cost incurred during the taxable year is included in the numerator and the total estimated cost, which must be determined, is included in the denominator.

$100,000 + $10,000
Divided By
$500,000 + $50,000
Equals
20% Complete

As Scenario 3 indicates, theoretically, if a pro-rata cost is not included in the numerator and denominator of the percentage of completion computation it may not have a material impact on the gross receipts to be reported. Thus, the exclusion of a common, everyday indirect cost from the PCM computation will probably have no effect on the income recognition of the contract.

Cost-Plus Contracts and Federal Long-Term Contracts

Cost-plus fee contracts are common in the construction industry. With this type of contract, the owner agrees to pay the contractor a fee in addition to the costs the contractor incurs to complete the project. This fee may be fixed or based on a percentage of the costs. This type of contract shifts much of the risk to the owner; however, the owner can reduce the risk by establishing a Guaranteed Maximum Price (GMP). The GMP establishes a maximum cost that the owner will pay and may contain a clause for the owner and contractor to share in any savings if the project is completed at less than the maximum price. In cost-plus contracts, the contract will detail which costs are to be reimbursed by the owner. For percentage of completion purposes, if any of these “contract costs” would not normally be allocated to the long-term contract, IRC Section 460(c)(2) requires those costs be allocated. See also Treasury Regulation Section 1.460-5 (b) (2) (iv):

Treasury Regulation Section 1.460-5(b)(2)(iv) provides that costs identified under cost-plus long-term contracts and federal long-term contracts, to the extent not otherwise allocated to the contract under this paragraph (b), a taxpayer must allocate any identified costs to a cost-plus long-term contract or federal long-term contract (as defined in section 460(d)). Identified cost means any cost, including a charge representing the time-value of money, identified by the taxpayer or related person as being attributable to the taxpayer’s cost-plus long-term contract or federal long-term contract under the terms of the contract itself or under federal, state, or local law or regulation.

Example:

A cost-plus contract lists some marketing expenses, which are not normally considered an allocable contract cost per IRC Section 460(c) (4). However, per IRC Section 460(c) (2) these costs are allocated to the long-term contract.

Simplified Cost-to-Cost Method

IRC Section 460(b) (1) (A) generally requires the cost-to-cost method to determine completion. However, IRC Section 460(b) (3) (A) provides an elective simplified cost-to-cost method for determining the degree of contract completion for taxpayers using the PCM. Under the simplified cost-to-cost method, only the following costs are used in determining the percentage-of-completion:

  1. Direct material costs;
  2. Direct labor costs; and
  3. Depreciation, amortization, and cost recovery allowances on equipment and facilities directly used to construct or produce the subject matter of the long-term contract.

Subcontracted costs represent either direct material or direct labor costs which must be allocated to a contract. See Treasury Regulation Section 1.460-5(c) (1).

Treasury Regulation Section 1.460-5(c) provides that simplified cost-to-cost method for contracts subject to the PCM. In general, instead of using the cost-allocation method prescribed in Treasury Regulation Section 1.460-5(b), a taxpayer may elect to use the simplified cost-to-cost method, which is authorized under section 460(b)(3)(A), to allocate costs to a long-term contract subject to the PCM.

Under the simplified cost-to-cost method, a taxpayer determines a contract's completion factor based upon only direct material costs; direct labor costs; and depreciation, amortization, and cost recovery allowances on equipment and facilities directly used to manufacture or construct the subject matter of the contract. For this purpose, the costs associated with any manufacturing or construction activities performed by a subcontractor are considered either direct material or direct labor costs, as appropriate, and therefore must be allocated to the contract under the simplified cost-to-cost method.

An electing taxpayer must use the simplified cost-to-cost method to apply the look-back method under Section 1.460-6 and to determine alternative minimum taxable income under Section 1.460-4(f). A taxpayer using the simplified cost-to-cost method must also utilize the costs described above in determining both the costs allocated to the contract and incurred before the close of the taxable year, and the estimated total contract cost.

Percentage-of-Completion (10 Percent Method)

Under IRC Section 460(b)(5) and Treasury Regulation Section 1.460-4(b)(6), the taxpayer may elect to defer recognition of revenue under PCM until 10% of the total estimated allocable contract costs are incurred. Accordingly, the costs incurred before the 10% year are considered pre-contracting year costs and thus are not deductible until the 10% year. This method of accounting is an election and applies to all long-term contracts entered into during, and all taxable years after, the electing year. Once elected, the taxpayer would be required to obtain the Commissioner's permission to change to another method. This election is unavailable if the taxpayer elected to use the simplified method for allocation of costs under IRC Section 460(b)(3)(A) or is exempt under IRC Section 460(e).

Example:

A contractor, C, whose taxable year ends December 31 determines the income from long-term contracts using the 10 Percent Method. For each of the taxable years, C's income from the contract is computed as follows:

10 Percent Method
  2001 2002 2003
Cumulative Incurred Costs

$40,000

$300,000

$600,000

Total Estimated Costs

$600,000

$600,000

$600,000

Percentage Complete

6.67%

50.00%

100.00%

Total Contract Price

$11,000,000

$11,000,000

$11,000,000

Gross Revenue Reported

0

$500,000

$500,000

Expenses Deducted

0

$300,000

$300,000

Percentage-of-Completion or Capitalized-Cost Method (PCCM)

A taxpayer may determine the income from a long-term construction contract that is a residential construction contract using either the PCM or the PCCM. The PCCM allows the residential construction contractor to report 70 percent of the contract under PCM (as required by IRC Section 460) and the remaining 30 percent to be reported under an exempt method (e.g., completed contract method). A residential construction contract differs from a home construction contract in that a home construction contract involves buildings with four or fewer dwelling units; whereas, a residential construction contract involves buildings with more than four dwelling units (e.g., apartment buildings or condominiums with five or more units in each building). See IRC Section 460(e) (6).

Treasury Regulation Section 1.460-3(b) (2) (I) (A) turns to IRC Section 168(e) (2) (A) (ii) (I) for the definition of “dwelling unit,” which defines “dwelling unit” as a house or apartment used to provide living accommodations in a building or structure but does not include a unit in a hotel, motel, or other establishment more than one-half of the units in which are used on a transient basis.

In issuing the former regulation to the predecessor of IRC Section 168(e)(2)(A)(ii)(I), the Regulations Policy Committee deleted a proposed reference that a dwelling unit must be self-contained with facilities generally found in a principal place of residence such as a kitchen. Deleting this reference indicates the intent to expand the scope of “dwelling unit” to include other living accommodations such as nursing homes, retirement homes, prisons, and college dormitories.

The former regulation defined “transient basis” as occupancy for less than 30 days. See IRC Section 167(k)(3)(C)(repealed in 1990); Treasury Regulation Section 1.167(k)-3(c)(1) and (2) (removed in 1993) (T.D. 8474, 1993-1 C.B. 242).

Because nursing homes, retirement homes, prisons, and dormitories provide “living accommodations in a building or structure,” they are dwelling units for purposes of a residential construction contract under the PCCM only if no more than one-half of the units are used for less than 30 days by the same tenant. For example, a prison is not a dwelling unit if it is a holding cell in a courthouse or a police station. The final regulations explain the PCCM.

Treasury Regulation Section 1.460-4(e) provides for the percentage of completion capitalized cost method. Under the PCCM, a taxpayer must determine the income from a long-term contract using the PCM for the applicable percentage of the contract and its exempt contract method, as defined in paragraph (c) of this section, for the remaining percentage of the contract. For residential construction contracts described in Section 1.460-3(c), the applicable percentage is 70 percent, and the remaining percentage is 30 percent. For qualified ship contracts described in Section 1.460-2(d), the applicable percentage is 40 percent, and the remaining percentage is 60 percent.

Even though the residential construction contracts are allowed the 70/30-hybrid method for reporting income for regular tax, the entire contract must be reported under PCM for alternative minimum tax purposes. See Treasury Regulation Section 1.460-4(f).

Total Estimated Contract Price and Claim Income

The total estimated contract price is the amount the contractor reasonably expects to receive from the owner under the long-term contract. Total estimated contract price includes: the original contract price, “retainages,” “holdbacks,” and approved contract change orders. In addition, contractors must include, in the estimated contract price, contingent compensation such as awards, incentive payments, unapproved contract change orders, and amounts relating to claims when there is a reasonable expectation the contractor will receive these amounts. See Appendix 5 for definitions of award, bonus, change order, claims, holdback, and retainage.

Treasury Regulation Section 1.460-4(b)(4) provides that the total contract price means the amount that a taxpayer reasonably expects to receive under a long-term contract, including holdbacks, retainages, and cost reimbursements. See Section 1.460-6(c) (1) (ii) and (2) (vi) for application of the lookback method as a result of changes in total contract price.

Contingent compensation (i.e., bonus, award, incentive payment, and amount in dispute) is included in total contract price as soon as the taxpayer can reasonably predict that the amount will be earned, even if the all-events test has not yet been met.

The portion of the contract price that is in dispute is includible in the total contract price at the time and to the extent that the taxpayer can reasonably predict that the dispute will be resolved in the taxpayer's favor, regardless of when the taxpayer actually receives payment or when the dispute is resolved. See Treasury Regulation Section 1.460-4 (b)(4)(i)(B); Tutor-Saliba Corp. v. Commissioner, 115 T.C. 1 (2000).

This regulation also provides that contingent income is includible in the total contract price not later than when it is included in income for financial reporting purposes under generally accepted accounting principles (GAAP).

Treasury Regulation Section 1.460-4(b) (4) (i) (B) provides that contingent compensation is any amount related to a contingent right under a contract, such as a bonus, award, incentive payment, and amount in dispute, is included in total contract price as soon as the taxpayer can reasonably predict that the amount will be earned, even if the all events test has not yet been met. For example, if a bonus is payable to a taxpayer for meeting an early completion date, the bonus is includible in total contract price at the time and to the extent that the taxpayer can reasonably predict the achievement of the corresponding objective.

Similarly, a portion of the contract price that is in dispute is includible in total contract price at the time and to the extent that the taxpayer can reasonably predict that the dispute will be resolved in the taxpayer's favor (regardless of when the taxpayer actually receives payment or when the dispute is finally resolved).

Total contract price does not include compensation that might be earned under any other agreement that the taxpayer expects to obtain from the same customer (e.g., exercised option or follow-on contract) if that other agreement is not aggregated under Section 1.460-1(e).

For the purposes of paragraph (b) (4) (i) (B), a taxpayer can reasonably predict that an amount of contingent income will be earned not later than when the taxpayer includes that amount in income for financial reporting purposes under generally accepted accounting principles. If a taxpayer has not included an amount of contingent compensation in total contract price under paragraph (b)(4)(i) by the taxable year following the completion year, the taxpayer must account for that amount of contingent compensation using a permissible method of accounting. If it is determined after the taxable year following the completion year that an amount included in total contract price will not be earned, the taxpayer should deduct that amount in the year of the determination.

Example 1:

This situation illustrates the concept of contingent compensation. In 2002, a contractor reports $10 million of disputed income as income on the financial statements, which are prepared in accordance with GAAP. Treasury Regulation Section1.460-4 (b) (4) (i) (B) provides that this amount is to be included in the total contract price in 2002.

Example 2:

This situation illustrates the concept of bonuses. A contract specifies that the contractor will receive a bonus for meeting an early completion date. At the end of the 2001 taxable year, the contractor is ahead of schedule and anticipates meeting the early completion date; therefore, the bonus would be included in the total contract price.

Additional Considerations for PCM

Each component of the PCM computation needs to be analyzed to ensure the proper gross income amount is reported each year under the contract.

Total Allocable Contract Costs Incurred To Date
Divided By
Total Estimated Allocable Contract Costs
Equals
Total Estimated Contract Price

Obtain a detailed accounting of all the costs included in the numerator and denominator. The factors shown below should be considered in determining the numerator for the total allocable contract costs incurred to date and the denominator for the total estimated allocable contract costs.

  1. Verify that the direct and indirect allocable contract costs under Treasury Regulation Section 1.460-5(b) are included in both the numerator and the denominator as the cost is incurred. See Treasury Regulation Section 1.460-4(b).
  2. For example, the denominator includes the total estimated allocable cost of equipment rental. However, it must also be included as this cost is incurred in the numerator of the PCM computation. If these costs are not included in the numerator, the completion of the contract is understated and results in the understatement of gross income for the taxable year.
  3. However, if the taxpayer has not included an allocable contract cost in either the numerator or the denominator, consider the potential impact as previously discussed earlier in this chapter under “Impact of Cost Allocation on the Percentage of Completion Computation”.
  4. Year-end bonuses paid to employees may not be allocable to the PCM computation of in-process jobs if they are generally paid on the basis of the profitability of the completed jobs. However, if the taxpayer reasonably expects to pay bonuses in a subsequent year on the jobs currently in-process, they would be included in the denominator as a total estimated cost of the contract.
  5. Verify that warranty expenses are not included in the PCM computation. See Treasury Regulation Section 1.460-1(d)(2) and Treasury Regulation Section 1.263A-1(e)(3)(iii)(H).
  6. A taxpayer may not allocate any otherwise allocable contract cost to a long-term contract if any section of the Internal Revenue Code disallows a deduction for that cost or expenditure (e.g., an illegal bribe described in section 162(c), nondeductible portion or meals and entertainment per section 274). See Treasury Regulation Section 1.460-5(f) (1).

Obtain a detailed accounting of all the costs included in the total estimated contract price. The factors shown below should be considered in determining the total estimated contract price:

  1. Retainages, holdbacks, and cost reimbursements are included in the total estimated contract price because the taxpayer reasonably expects to receive these amounts under the long-term contract. See Treasury Regulation Section 1.460-4(b) (4) (i) (A).
  2. Contingent compensation such as a bonus, award, incentive payment, and amount in dispute, is included in total contract price as soon as the taxpayer can reasonably predict that the amount will be earned, even if the all events test has not yet been met. Additionally, if the contingent amount is included in income for financial reporting per generally accepted accounting principles, the amount is also included in the total contract price. See Treasury Regulation Section 1.460-4(b) (4) (i) (B).

Reversal of Income on Terminated Contract

If a long-term contract (under PCM) is terminated before completion and, as a result, the taxpayer retains ownership of the property, the taxpayer must reverse the transaction in the taxable year of termination. The taxpayer reports a loss (or gain) equal to the cumulative allocable contract costs reported under the contract in all prior taxable years less the cumulative gross receipts reported under the contract in all prior taxable years.

As a result of reversing the transaction, a taxpayer will have an adjusted basis in the retained property equal to the cumulative allocable contract costs reported under the contract. If the taxpayer received and retains any consideration or compensation from the customer, however, the taxpayer must reduce the adjusted basis in the retained property (but not below zero) by the fair market value of that consideration or compensation. To the extent that the amount of the consideration or compensation described in the preceding sentence exceeds the adjusted basis in the retained property, the taxpayer must include the excess in gross income for the taxable year of termination. The look-back method does not apply to a terminated contract.

Treasury Regulation Section 1.460-4(b) (7) provides that if a long-term contract is terminated before completion and, as a result, the taxpayer retains ownership of the property that is the subject matter of that contract, the taxpayer must reverse the transaction in the taxable year of termination. To reverse the transaction, the taxpayer reports a loss (or gain) equal to the cumulative allocable contract costs reported under the contract in all prior taxable years less the cumulative gross receipts reported under the contract in all prior taxable years.

As a result of reversing the transaction under Treasury Regulation Section 1.460-4(b)(7)(i), a taxpayer will have an adjusted basis in the retained property equal to the cumulative allocable contract costs reported under the contract in all prior taxable years. However, if the taxpayer received and retains any consideration or compensation from the customer, the taxpayer must reduce the adjusted basis in the retained property (but not below zero) by the fair market value of that consideration or compensation. To the extent that the amount of the consideration or compensation described in the preceding sentence exceeds the adjusted basis in the retained property, the taxpayer must include the excess in gross income for the taxable year of termination. The look-back method does not apply to a terminated contract that is subject to this paragraph (b) (7).

Example:

A contractor-taxpayer buys a parcel of land. In 2002, the contractor enters into a contract to construct an office building on that parcel of land and reports on this contract under the percentage of completion method as follows:

Gross Receipts and Allocable Contract Costs
  2002
Gross Receipts

$2,000,000

Allocable Contract Costs

$1,500,000

Gross Profit on Contract

$500,000

In 2003, the customer defaults on the contract due to bankruptcy. The unfinished office building remains with the contractor.

In 2003, the contractor will report a loss of $500,000 in relation to this terminated contract computed by deducting the prior taxable years' reported cumulative gross receipts of $2 million from the prior taxable years' reported cumulative allocable contract costs of $1.5 million.

As of termination, provided there were no additional expenses incurred on this office building in 2003 and the contractor does not receive or retain consideration or compensation from the customer, the contractor will have an adjusted basis of $1.5 million equivalent to the cumulative allocable contract costs reported under the contract in all prior taxable years.

However, if the contractor had billed and received $1.8 million from the customer in 2002 of which none of the proceeds are due back to the customer, the contractor will report $300,000 in gross income in 2003 (year of termination) because the $1.8 million compensation exceeds the adjusted basis of $1.5 million. The adjusted basis of the property would be zero.

Conclusion

Large construction contractors must use the percentage of completion method to report income from long-term contracts. They do not have the flexibility of selecting among several methods as the small construction contractors.

Page Last Reviewed or Updated: 29-Nov-2013