Construction Industry ATG - Chapter 8 Other Tax Issues in Construction
Publication Date - May 2009
NOTE: 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.
The construction industry is so broad and extensive that many issues found in other industries will also appear in construction cases. There are, however, some issues that are more closely identified with the construction industry. This chapter is intended to produce an awareness of those issues. The construction issues discussed do not compose an all-inclusive list.
Accounting Method Issues
Improper Computation of the $10 Million Average Annual Gross Receipts per IRC Section 460
Taxpayers are not aggregating the gross receipts of all the related companies for this computation and, therefore, are improperly electing an exempt, long-term method of accounting, when the percentage of completion method (PCM) is required. The Internal Revenue Code requires the aggregation of the gross receipts from:
- All trades or businesses whether or not incorporated under common control,
- All members of any controlled group of corporations for which the taxpayer is a member, and
- Any predecessor of the taxpayer or of the entities in the prior two groups. IRC Section 460(e)(2).
Gross receipts produced by the all the entities from each of these three groups for each of the three years is considered. Aggregations of all gross receipts from all trades or businesses are considered regardless of whether or not under common control. For this purpose, the following conditions must be met:
- Parent-Subsidiary group when more than 50% ownership by one entity, and
- Brother - Sister group when 5 or fewer owners own more than 50%; and
- If the taxpayer has a 5% to 50% ownership, the taxpayer is requires including its proportionate share of gross receipts according to percentage of ownership. Attribution rules apply to indirect or direct ownership.
A small contractor teams up with a large contractor on a joint venture. The joint venture was set up as a partnership to construct property for a large government job. The small contractor owned 51% of the joint venture, and the large contractor owned 49%. For the gross receipts test, determined at the joint venture level, 100% of the small contractor’s gross receipts, 100% of the joint venture, and 49% of the large contractor’s construction gross receipts exceeded the $10 million. The joint venture was reporting income using the completed contract method, but is required to use the percentage of completion method per IRC Section 460. See IRC Section 460(e)(2), IRC Section 460(e)(3), and Treasury Regulation Section 1.460-3(b)(3).
Improper Computation of the $5 Million Average Annual Gross Receipts under IRC Section 448
Taxpayers may improperly be using the cash method of accounting. As with IRC Section 460 above, the aggregation rules apply to all entities under common control. IRC Section 448 (a) prohibits the use of the cash method by a C corporation, a partnership with a C corporation as a partner, or a tax shelter. According to IRC Section 448(b)(3) and (c), C corporations and partnerships with a corporate partner are allowed to use the cash method of accounting, if the average annual gross receipts of the entity do not exceed $5,000,000.00
Partnerships, sole proprietorship, and S corporations are not subject to the IRC Section 448 limitations. Therefore, they may continue to use the cash method until their average annual gross receipts for the prior three years exceeds $10 million.
The determination of gross receipts under IRC Section 448 includes all gross receipts, while the determination of gross receipts under IRC Section 460 includes only trade or business receipts. For example, gross receipts determined under IRC Section 448 includes dividend income, interest income, rental income, etc., where IRC Section 460 would not include these items of income. See Treasury Regulation Section1.448-1T (f)(2)(iv)(A) and Treasury Regulation Section 1.460-3(b)(3)(i).
Netting Gross Receipts for the $5 million and $10 million Thresholds
The taxpayer may be using an improper method of accounting if gross receipts have already been offset with expenses other than returns and allowances so that only the net amount is reported as gross receipts on the tax return. This netting may improperly reflect average annual gross receipts below the $5 million and $10 million thresholds under IRC Section 448 and IRC Section 460, respectively.
A specified amount is usually withheld from progress billings pending satisfactory completion and final acceptance of the project. The customer will withhold the retainage from the contractor or Retainages Receivable. The contractor will also withhold a retainage on the subcontractors or Retainages Payable.
Recognizing retainages in taxable income depends on the method of accounting used by the taxpayer:
- Cash: Income when received or upon constructive receipt
- Accrual: Income when received, due, or earned, whichever comes first. The retainages are earned as the work is performed. However, the taxpayer may elect to exclude the retainages until billable per Revenue Ruling 69-314.
- Completed Contract: Income when the contract is considered complete.
- Percentage of Completion: Included in the contract price as the job progresses.
Similarly, recognizing retainages as an expense depends on the method of accounting used by the taxpayer:
- Cash: Expense when retainage is paid.
- Accrual: Deductible when all events test has been met per IRC Section 461. However, if the taxpayer has elected to defer the retainages receivable per Revenue Ruling 69-314, it must also defer the retainages payable until payable.
- Completed Contract: Expense when the contract is considered complete.
- Percentage of Completion: Deductible and included in the cost-to-cost PCM computation when the all-events test has been met per IRC Section 461.
Delayed Billings under Accrual Method
Under the accrual method, the taxpayer may delay billings or structure the billing entitlement in the contract in an attempt to defer reporting of gross receipts.
In Boise-Cascade Corp. v. United States,530 F.2d 1367 (Ct. Claims 1976), cert. denied, 429 U.S. 867 (1976), the court determined that the accrual of income is based upon the work performed rather than upon billing entitlement.
Determining Completion under Completed Contract Method (CCM)
Taxpayers using this method may defer completing the contract in an attempt to defer the reporting of the gross profit. Treasury Regulation Section 1.460-1(c)(3) provides a “bright-line” test in determining completion and it is the earlier of the following:
- 95% of contract costs have been incurred and the customer has the intended use of the subject matter of the contract; or
- Final completion and acceptance.
Reviewing the year-end work-in-progress schedule would reveal the percent complete on each job. Any job that is 95% or more complete would require further investigation to determine if the contract meets the completion requirements above. See Treasury Regulation Section 1.460-1(c)(3).
Improper Use of the PCM or Completed Contract Method
In the construction industry, many taxpayers provide construction management, engineering, and architectural professional services that are an essential part of the construction process. However, these contracts do not meet the definition of a long-term construction contract involving the building, construction, reconstruction or rehabilitation of real property.
In contrast, the general contractor and subcontractors are responsible for the actual construction and are usually working under the direction or advice of the construction manager, engineer, or architect. Because construction management, engineering, and architects provide services that do not meet the definition of a construction long-term contract, they cannot report their income under any long-term contract method such as the completed contract or percentage of completion methods. They can only report income under the cash or accrual method.
See IRC Section 460(e)(4), Treasury Regulation Section 1.460-1(d)(2), Revenue Ruling 70-67, Revenue Ruling 80-18, Revenue Ruling 84-32, and General Counsel Memo (GCM) 39803 for additional guidance.
Deferring Costs under Percentage of Completion Method
Costs incurred under IRC Section 461 and under the cost-to-cost percentage of completion method required by IRC Section 460 determine the completion rate of the job. Costs incurred near year-end might not be recorded. This would reduce the percentage of completion, understating the income to be recognized from the job.
Costs of uninstalled materials might also be omitted from the numerator in the percentage of completion method. For generally accepted accounting principles (GAAP), this is appropriate. However, for tax purposes, direct materials are allocated to a long-term contract when dedicated to the contract. A taxpayer dedicates direct materials by associating them with a contract. This is accomplished by purchase order, entry on books and records, or shipping instructions. See Treasury Regulation Section 1.460-1(b)(8) and Treasury Regulation Section 1.460-5(b)(2)(i).
Allocation of Indirect Costs
Sometimes, taxpayers fail to allocate the appropriate indirect costs to jobs. There are four separate IRC Code sections or regulations under which costs should be allocated:
- IRC Section 460 (c)(1) through (c)(5) applies to long-term contracts that do not meet the home construction contract or small contract exception per IRC Section 460(e)(1). Treasury Regulation Section 1.460-5(b) provides a direct link to IRC Section 263A for the appropriate indirect costs to include in the percentage of completion method.
- IRC Section 460(b)(3) allows taxpayers that fall under IRC Section 460 above to elect the simplified production method. See also Treasury Regulation Section 1.460-5(c).
- IRC Section 263A applies to home construction contracts unless they meet the exceptions at IRC Section 460(e). The exceptions pertain to the average annual gross receipts are less than $10 million and the job is expected to last less than 2 years. Speculation homebuilders and land developers must also allocate costs under IRC Section 263A as “producers of property”.
- Treasury Regulation Section 1.460-5(d) applies to small contractors both residential and commercial using the completed contract method.
For all of the situations above, construction period interest is capitalized under IRC Section 460(c)(3) for all long-term contracts and IRC Section 263A(f) for producers of property or land developers and speculative homebuilders.
Failure to allocate all appropriate indirect costs may increase or decrease the income to be reported using the percentage of completion method and will create a larger adjustment for completed contract method users, speculation homebuilders, and land developers because these costs are not deductible until a later year when completion of the long-term contract or when the house or lot is sold.
Production Period Interest
Many contractors meeting one of the two exceptions under IRC Section 460(e)(1) for home construction contracts or small contractors (less than $10 million gross receipts and less than 2-year contract) do not capitalize construction period interest as required by IRC Section 460(c)(3). The exceptions found under IRC Section 460(e) only exempts the taxpayer from IRC Section 460(a), (b), (c)(1), and (c)(2). All other subsections of IRC Section 460 apply.
Production period interest applies to all long-term contracts, land developers, and speculation homebuilders who must also capitalize production period interest because they are required to allocate costs under IRC Section 263A.
Improper Inclusion of Costs in PCM Computations
The cost-to-cost method, required by IRC Section 460, is used to determine the completion percentage of a contract that determines the amount of income to be reported in a taxable year.
The completion percentage is determined by:
Costs Incurred To date
Total Estimated Costs
The taxpayer might improperly include estimates that are overstated, include nondeductible costs, or include allowances for contingencies in the total estimated costs figure that reduces the percentage of completion. This results in the understatement of the corresponding income to be reported on the contract.
Also, costs that are included in the total estimated costs figure may not be included in the numerator such as the costs incurred. This too reduces the amount of income to be reported for a taxable year.
Improper Expense Recognition under the Completed Contract Method
The taxpayer might improperly allocate costs from contracts that are still in progress to completed contracts that accelerates the expense recognition. An unusually low gross profit on a job may be an indication of improper job allocation.
Homebuilder Building for Speculation
This type of taxpayer might improperly deduct costs that are incurred as the house is built. All of these costs, direct and indirect, must be capitalized per IRC Section 263 and IRC Section 263A. The taxpayer is building an asset. Thus, the costs become the basis in the property, and are not recognized until the asset is sold.
Carpenter v. Commissioner, T.C. Memo. 1994-289. A taxpayer building a house on speculation is required to capitalize the costs of building the house under IRC Section 263A.
Common improvements are any real property or improvements to real property that benefit two or more properties that are separately held for sale by a developer such as roads, sidewalks, sewer lines, playground, and pool.
In general, common improvement costs may not be added to the basis of benefited properties until the common improvement costs are incurred within the meaning of IRC Section 461(h).
Taxpayers may improperly deduct common improvements costs as incurred rather than allocating them to the basis in the lots.
Also, if a taxpayer elects the alternative cost method under Revenue Procedure 92-29, it may be deducting estimated costs of common improvements without complying with Revenue Procedure 92-29. See the chapter on homebuilders and land developers for more information regarding Revenue Procedure 92-29.
Front-load billing is common in the construction industry. Many contractors want a percentage of their fee paid in advance before any work is performed in order to buy the materials necessary to perform the job. Under both the cash and accrual methods using the all events test, advance payments are reported in income when received. However, Revenue Procedure 2004-34 permits accrual basis taxpayers to defer the advance payments to the subsequent tax year if they meet the qualifying requirements.
Improper Computation of the Contract Amount under Percentage of Completion Method (PCM)
Once the percentage of completion of a long-term contract has been calculated, it is applied to the total contract price in determining the amount of income to be reported. The contract price includes change orders, retainages, expected bonuses, and claim revenue.
The taxpayer may not include any one of these items as part of the contract price, thereby understating the amount of income reported. The regulations also specify that, if any contingent amount is included in income for financial statement purposes, it is to be included for tax purposes. See Treasury Regulation Section 1.460-4(b)(4)(B).
Claim Income under PCM
Claim income is an amount in excess of the original contract price that the contractor seeks to collect from the owner such as disputed change orders, costs associated with owner delays, errors in specification, and contract termination.
Under the percentage of completion method, the amount that the taxpayer reasonably expects to receive is included in the contract price and is reported in income as the job progresses. Examiners should inspect final progress billing requests, legal files, correspondence, complaints filed with the court, and Schedule M-1 or M-3 for potential issues involving claim income. Disputes under the other methods of accounting are reported in income as follows:
- Cash: When amount is received.
- Accrual: When amount is settled.
- Completed Contract: Depends on the facts of each dispute.
- Taxpayer Assured of a Profit or Loss: See Treasury Regulation Section 1.460-4(d)(4)(ii).
- Taxpayer Unable to Determine a Profit or Loss: See Treasury Regulation Section 1.460-4(d)(4)(iii).
Smaller contractors, not faced with bonding or similar requirements for financial statements and performance verification, might only report income for a portion of their work. For example, the contractor may erroneously report only the income reflected on the Forms 1099. Some contractors may be willing to work for 20% to 25% less on the condition that Form 1099 is not issued or that the payment is made in cash. This has an adverse effect on the industry and voluntary tax compliance in general.
With the proliferation of check-cashing schemes, payment with a check is an insufficient control to validate income using bank deposit records. The examiner should look to some central element of the specialty contractor's business. This should then be compared to another source such as an indirect method to confirm that the reporting of gross income is substantially correct. With a smaller contractor, the examiner can also look at the owner's return, life-style, assets or county records information to gain a reasonable assurance as to the economic reality of reported income.
Other Compensation Income
A contractor may receive an interest in a project for his or her services rather than making an initial investment of capital. Inspecting the contractor's partnership returns will frequently reveal an interest in a construction project. A review of electronic databases for public records on LEXIS or ChoicePoint should be conducted. The contract between the owner and the general contractor will often specify what the general contractor is to receive in lieu of cash payment. See IRC Section 83.
Depending on the method of accounting, the contractor might delay billings or the recording of receivables in an effort to defer the reporting of gross receipts. The auditor might consider selecting a sample of jobs and inspect the job folders to review the contract billing terms, progress-billing applications sent to the owner, and owner payment documents retained by the contractor in order to test income.
Other Omission of Income Issues
- Failure to report interest income earned on funds such as retainages, deposits, funds transferred from other escrow accounts.
- Failure to report income from remote construction projects.
- Failure to report income earned from claims subsequently settled by court decisions or arbitration.
Subcontractor Improperly Deferring Income
Subcontractors hired early in a project such as land clearing, installation of cables or wiring, and laying concrete slabs may improperly defer the recognition of income under the completed contract method, because “final completion and acceptance” does not occur until the total job is complete. However, Treasury Regulation Section 1.460-1(c)(3)(iii) states that final completion and acceptance of a contract with respect to a subcontractor occurs when the subcontractor’s work has been completed and accepted by the party with whom the subcontractor has contracted with. This is usually the general contractor.
The nature of the materials used in plumbing, heating, and air-conditioning, may lead to the issue of scrap sales. For example, copper piping and tubing that are cut for jobs may leave small pieces that cannot be used. The scrap is then sold to metal dealers. Also, excess job materials may be inventoried for a future job, returned to the vendor for credit, or applied to another job.
Built-In Gains Tax
When a C corporation is converted to an S corporation, taxpayers using the completed contract method may be subject to a built-in gains tax. The value of the contracts in progress as of the day of conversion is computed under the percentage of completion method and which would be subject to the built-in gains tax. The income that was earned while a C corporation, but not reported until the following year, is unrealized income at the time of conversion. See Reliable Steel Fabricators, Inc. v. Commissioner, T.C. Memo. 1995-293.
IRC Section 453 provides that dealer dispositions do not qualify for the installment sale calculation of income. Homebuilders and land developers, therefore, cannot use the installment method of accounting. IRC Section 1237 does provide a limited exception in which a disposition of real property subdivided for sale is not be deemed to be held primarily for sale in the ordinary course of trade or business. However, no substantial improvements can be made to the property, and the taxpayer must have held the property for a period of 5 years. See Raymond v. Commissioner, T.C. Memo. 2001-96.
Gain on the Sale and Leaseback Arrangements on Model Homes
Homebuilders sometimes sell a model home and then lease it back for use in their sales activities. The homebuilder sells the model home(s) to an unrelated party for the lower of cost or 80% of the fair market value. The homebuilder reports a loss on this sale.
Then the homebuilder leases the property back from the unrelated party at 10% of the purchase price. The homebuilder retains the right to determine both the time of sale of the model home and the terms of the price and buyer.
The proceeds on the sale are used to repay the loan from an unrelated party and a contractual bonus. Any remaining amount is then used to pay the homebuilder. Title passes but the homebuilder retains many significant rights of ownership.
The essence of the transaction is that of a loan. The title to the unrelated party merely acts as security. Thus, the loss on the “sale” and the lease expenses would not be deductible. See Frank Lyon Co v. United States, 435 U.S. 561 (1978); and Helvering vs. F. & R. Lazarus & Co., 308 U.S. 252 (1939).
Per Diem - 50% Meals Disallowance on Out-Of-Town Travel
Meals paid for out-of-town travel are subject to the 50% travel and entertainment limitation under IRC Section 274(n). Employers may be paying employees out-of-town expenses on a per diem basis with nothing being applied to meals and deducting the total as a “lodging only expense”. Revenue Procedure 2004-60, provides rules for per diem allowances. Generally, a portion of the allowance must be treated as paid-for meals. If the total per diem amount is less than the applicable federal per diem for that locality, 40% of the per diem paid is deemed to be paid-for meals subject to the 50% limitation. See Section 6.05(3) of Revenue Procedure 2004-80.
Depreciation of Automobiles and SUV's
For passenger automobiles, the total depreciation deduction that can be claimed including the IRC Section 179 deduction is limited.
A passenger automobile is any four-wheeled vehicle made primarily for use on public streets, roads, and highways and rated at 6,000 pounds or less of unloaded gross vehicle weight. However, in the case of a truck or van gross vehicle weight is substituted for unloaded gross vehicle weight. It includes any part, component, or other item physically attached to the automobile or usually included in the purchase price of an automobile. IRC Section 280F(d)(5)(A)
Sport Utility Vehicles or SUV’s are commonly used within the construction industry. Revenue Procedure 2003-75 and its successors define the term “trucks and vans” as including passenger automobiles that are built on a truck chassis, including minivans and sport utility vehicles that are built on a truck chassis. If the taxpayer is depreciating SUVs, researching the internet for manufacturer or dealership information on the gross vehicle weight may be necessary to determine if the passenger automobile depreciation is limited.
Personal Use of Business Assets
Contractors in closely held businesses sometimes deduct expenses for improvements to a personal residence. These expenses are frequently deducted through cost of sales, along with other contract costs. If the taxpayer is a C corporation and the expenses are incurred to improve a shareholder's residence, a potential dividend issue exists, and the expenses are not deductible. For an S corporation or a partnership, these expenses would be considered a distribution to the specific shareholder or partner.
An employment tax issue is possible if improvements are made to an employee's residence. A homebuilder may offer to build homes for their employees at a discount. The discount is not included in the employees’ wages as a fringe benefit. IRC Section 132(a)(2) states that gross income shall not include any fringe benefit that is a “qualified employee discount” with respect to qualified property or services. IRC Section 132(c)(4) specifically states that real property is not qualified property and the discounted amount is required to be included in the wages of the employee. See also Treas. Reg. Section 1.132-3(a)(2)(ii).
When conducting an examination of a contractor, it is crucial to fully understand the contractor’s billing and job cost records. Sampling invoices for deliveries to the contractor’s residence or excess building supplies charged to a job are examples of auditing techniques.
Officer and owner compensation fluctuates frequently and the amounts may differ significantly. An argument may be made that the higher than usual present year compensation is a result of artificially low compensation in earlier years. This argument may be valid and will be sustained where the early years of the operation were used to build capital.
However, if the operation is well established and the profits of a high-volume year are being reduced through high compensation, the examiner should seriously consider raising the issue. Industry averages are also available through websites such as Bizstats.com. This issue depends on the facts and circumstances of each case.
Double deductions can occur when the contractor uses a single-entry bookkeeping system. Some job costs may be both capitalized and expensed in the current period. Since the single entry bookkeeping system will allow duplications to occur, the examiner should consider using in-depth investigative techniques.
Cash Method Interest Expense
Interest expense on a construction loan is not deductible until a contractor on the cash method of accounting pays it. A construction loan differs from a conventional loan in that a construction loan usually does not require interim payments. Even the loan origination fees may be financed, these expenses are not deductible until the payments are made. The loan documents should be examined to determine the terms for making principal and interest payments and verifying that actual payments were made during the year. See Heyman v.Commissioner, 70 T.C. 482 (1978), aff'd, 652 F.2d 598 (6th Cir. 1980).
Capitalization of Pre-development Costs
A developer may purchase a parcel of property for future development. Any pre-development costs are not currently deductible and must be capitalized. The following court decisions support this position:
- Reichel v. Commissioner, 112 T.C. 14 (1999): A real estate developer who purchased properties for development was required to capitalize related real estate taxes as indirect production expenses.
- Hustead v. Commissioner, T.C. Memo 1994-374: A developer was required to capitalize costs incurred to challenge the zoning of property.
- Von-Lusk v. Commissioner, 104 T.C. 207 (1995): Property taxes and preliminary costs associated with the contemplated construction were required to be capitalized per IRC Section 263A.
Contributions of Land and Facilities
Land developers and building contractors often donate land, buildings, or other assets to charitable or civic organizations and state or local governments. These assets usually have appreciated in value, due to the passage of time and/or the development activity by the builder. Charitable contribution deductions involving the fair market value of the donated property should be scrutinized.
Examiners should consider the intent of the builder who is donating the land or facility. A common practice is for state or local government agencies that have control of zoning and building permits to require the developer or builder to set aside and donate land and facilities for schools, parks, police and fire stations, government offices, medical facilities, community centers, water and sewer plants, roads, and maintenance buildings.
If the developer or builder donated the asset due to a requirement of a government agency or the facility was used as a promised improvement in selling efforts to customers, then the requisite donating intent for a contribution deduction is missing. Without this intent, the non-deductible donation is a part of the cost of developing lots.
When addressing this issue, examiners should inspect the builder’s correspondence and legal files; zoning and permit documents; minutes of government agency meetings; corporate minutes of the builder; newspaper articles; and the builder’s sales literature.
Examiners should also be aware that developers or builders often only allocate development costs to the properties that will generate sales revenue. Thus, the donated property may only have the cost of raw land charged to it. The allocation of costs usually takes place in the early stages of development and donations of property are usually made in the latter stages of development. Lastly, examiners should ensure that a double recovery of cost is not allowed.
There may be an improper inclusion of the total loss on a contract that is still in progress. Financial reporting (GAAP) requires the contractor to recognize the full amount of any anticipated loss in the current period, regardless of the degree of completion. However, for tax purposes, the loss is not deductible until the job is determined to be complete for taxpayers using the completed contract method. The loss incurred to date (not the total loss) is deductible for taxpayers using the PCM.
If a taxpayer abandons an asset, the loss is generally deductible to the extent of the taxpayer's adjusted basis in the abandoned property. To support an abandonment loss, the taxpayer must establish intent to abandon the asset and must make some affirmative act of abandonment. The loss is deductible in the year the abandonment is sustained with regard to non-depreciable property.
In general, abandonment losses occur with specification homebuilders, real estate developers, and related-party entities more frequently than with other types of contractors. Abandonment losses may result from lack of financing, lack of bonding, disapproval of zoning changes, cost overruns, or possible tax avoidance involving related parties.
In Chevy Chase Land Company v. Commissioner, 72 T.C. 481 (1979), the taxpayer was unsuccessful in getting property rezoned. All the costs that the taxpayer incurred for the rezoning were allowed as an abandonment loss except for the cost of a topographical map because it has a continuing value; it can be used for the taxpayer's new project on the property.
Related Party Transactions
A contractor or subcontractor may incur expenses for improvements to his personal residence or that of a friend or relative. A contractor or subcontractor may also build a home for his personal use or that of a friend or relative. To disguise these costs, the expenses might either be applied to another job or be reported to the job separately but then sell the residence for cost. Potential issues include disallowance of personal expenses or dividend issues if a corporation is involved. The difference between the FMV and the actual sales price to the shareholder would be subject to constructive dividend rules.
Allocation of indirect costs not charged to the taxpayer or relative would also result in a nondeductible loss under IRC Section 267.
For tax purposes, losses are not deductible until incurred. Under the completed contract method, none of the loss may be deducted until the contract is completed. Under the percentage of completion method, the loss is deducted as the job progresses. By improperly severing a contract, the taxpayer is recognizing the loss prematurely. See Treasury Regulation Section 1.460-1(e).
Bad Debts and Cancellation of Debt Income
The typical bad debt issue must be reviewed when related party transactions are involved. If a party has a legitimate bad debt, the other related party should have a cancellation or forgiveness of debt income. Bad debts are deductible under IRC Section 166 and cancellation of debt is income pursuant to IRC Section 108. Bankruptcy or insolvency may impact the recognition of forgiveness of debt income. In addition, net operating losses may have to be reduced if bankruptcy limits the recognition of forgiveness of debt income. Bad debts require an inquiry into the following questions:
- Is it a debt or equity investment?
- Whose debt is it and are there any related parties?
- Is it a business or non-business debt?
- Have only the adjusting journal entries been made or have the funds actually been transferred?
- Has interest on the debt been charged and reported?
- DDo documents exist that support the transactions?
Warranty Reserves or Contingent Liabilities
An accrual basis taxpayer may be deducting estimated warranty costs from a reserve account established to reflect a liability for future services:
- Treasury Regulation Section1.446-1(c)(1)(ii): Under the accrual method a liability is incurred in the taxable year in which all the events have occurred that establish the fact of the liability, the amount can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
- IRC Section 461(h)(1): In determining whether an amount has been incurred, the all events test shall not be met any earlier than when economic performance occurs. Economic performance occurs when the taxpayer provides service or property.
Economic performance has not occurred with respect to estimated warranty costs and contingent liabilities are not deductible. The examiner should be aware that these are reportable under GAAP and the corresponding Schedule M-1 or M-3 adjustments are required.
The taxpayer is in the business of building and selling residential houses. To assist in its sales activity, the taxpayer may temporarily use certain houses as models or sales offices. Such use does not generate any rental income to the taxpayer. Revenue Ruling 75-538 provides that a vehicle is not property used in the business thus subject to depreciation if it is used merely for demonstration purposes or is temporarily withdrawn from stock-in-trade.
Revenue Ruing. 89-25 recognizes that model homes or sales offices are used for a small fraction of their expected useful lives and the taxpayer ultimately expects to sell them. Although the taxpayer may be reluctant or unwilling to sell the models or sales office while they are being used as such, they remain property held primarily for sale to customers and may not be depreciated. See Revenue Ruling 89-25.
Accumulated Earnings Tax
Closely held C corporations are more likely to accumulate earnings and profits beyond the reasonable needs of the business in order to avoid income taxes on its shareholders than are large C corporations. Each accumulated earnings case is unique. No pro forma guide for calculating a taxpayer’s reasonable needs can be prepared. Reasonable needs that would usually be considered in any accumulated earnings case are the need for sufficient net liquid assets to pay reasonably anticipated, normal operating costs through one business cycle and sufficient net liquid assets to pay reasonably anticipated, extraordinary expenses and capital improvement financing.
In addition, the following represents a non-exclusive list of specific items that should be considered for construction contractors:
- Working Capital necessary for Bonding Purposes: The general rule of thumb is that working capital needs to be at least 10% of "backlog" for bonding purposes. A specific taxpayer’s situation may result in a different percentage based on the bonding company’s requirements. Thus, this percentage should be determined on a case-by-case basis. "Backlog" work program is the sum of contracts in process less the billings from those contracts plus contracts not started.
- Equipment Needs: Contractors who have high equipment needs will generally have a need to replace the equipment on a periodic basis.
The following information is included to assist an examiner during an examination of a construction company in determining whether an accumulated earnings tax issue exists. When considering whether an IRC Section 531 issues exist, examiners are advised to apply the Bardahl, Mead, or similar method used in determining the reasonable business needs. However an examiner must consider that, unlike most entities, a construction company normally needs to retain earnings and profits to have adequate bonding capacity. Relevant court cases involving the accumulated earning tax and construction contractors are:
- Ready Paving and Construction Co. v. Commissioner, 61 T.C. 826 (1974): A paving contractor had permitted its earnings to accumulate beyond the reasonable needs of its business. A “modified” Bardahl formula was used with the case hinging on what items were and were not to be included in determining working capital.
- Thompson Engineering Co. v. Commissioner, 80 T.C. 672 (1983) 751 F.2d 191 (6th Cir. 1985): A construction subcontractor was liable for the accumulated earnings tax. The IRS determined the taxpayer’s reasonable business needs by applying the “Bardahl” formula. The court agreed with the taxpayer that the Bardahl formula has “little or no value when applied to a mechanical contracting business that lacks a routine operating cycle.” The bonding capacity, and not the Bardahl formula, is the major consideration in determining the taxpayer’s business needs. This case was appealed and reversed.
- Peterson Bros. Steel Erection Co. v. Commissioner, T.C. Memo. 1988-381, 55 T.C.M. (CCH) 1605 (1988): The taxpayer, involved in the steel erection of high-rise buildings, was not liable for the accumulated earnings tax. The petitioner’s ability to obtain a bond on a job when required is of primary importance and is clearly a reasonable need of the business. The fact that the petitioner was rarely required to provide a performance bond on its jobs is immaterial since it had to be prepared to provide a bond if required.
Alternative Minimum Tax
Taxpayers who are not required to use PCM under IRC Section 460) may owe alternative minimum tax. IRC Section 56(a)(3) states that the PCM must be used for long-term contracts for alternative minimum tax purposes. Therefore, taxpayers on the cash, accrual or completed contract methods must compute alternative minimum taxable income on the percentage of completion method. Exceptions to the required use of PCM for AMT:
- Homebuilders: IRC Section 56(a) applies to long-term contracts except for home construction contracts
- Small Corporations: Exempt from AMT for tax years beginning after 1998. Small corporations are C corporations with average annual gross receipts of $5,000,000 remain exempt in subsequent years until their average annual gross receipts exceed $7,500,000.
Many construction companies are required to prepare certified financial statements for bonding and lending purposes. Financial statements must be prepared on percentage of completion method. (Statement of Position 81-1) Thus, the difference between the percentage of completion method and the tax return method can easily be determined for alternative minimum tax purposes.
The use of subcontractors is common within the construction industry. Many taxpayers treat employees as subcontractors to avoid paying employment taxes. The agent may need to seek guidance from an employment tax specialist when confronted with potential employment tax issues. Back-up withholding can apply to subcontractors. The bargain sale of a house to an employee involving a discounted sales price could produce employment tax liability.
Many issues are common to all industries. However, some issues are specific to the construction industry, due to the nature of the business and the special accounting methods available. Additional facts and tax research will be necessary to develop the issues in this chapter.