Contractors Can Benefit from IRS Exceptions On Long-Term Contracts

Guajardo explains exceptions to the PCM tax-code requirement for small contractors.

By Leslie Guajardo

A continuing source of confusion for many Texas contractors is the choice of accounting methods, particularly for long-term contracts. Smaller contractors in particular often find the issue daunting because they are less likely to have accountants on hand who can explain the latest IRS rules and regulations.

When it comes to long-term contracts, most contactors understand that they are required under General Accepted Accounting Principles (GAAP) to base their financial statements on the percentage-of-completion method (PCM) of accounting. What isn't understood as well is that Section 460 of the tax code allows exceptions to the PCM requirement for small contractors. Section 460(e)(1)(B) provides an exception to the PCM requirement if:

1) the taxpayer anticipates, when entering into the contract, that the contract will be completed within two years of the contract's commencement date, and; 2) the taxpayer's average annual gross receipts for the three taxable years preceding the taxable year of the contract do not exceed $10 million.

As an example, let's look at a contractor that has gross receipts of $5 million in Year One, $12 million in Year Two, $10 million in Year Three, $14 million in Year Four, and $4 million in Year Five. For contracts entered into during Year Four, the contractor would apply the "gross receipts test" for years one -three get average gross receipts of $9 million. In this case, the contractor meets the $10 million gross receipts test - and, for tax purposes, the PCM is not required for any contracts entered into during Year Four.

For contracts entered into during Year Five, the PCM must be used because the contractor fails the gross receipts test with $12 million in average gross receipts. However, in Year Six, the contractor meets the $10 million average gross receipts test again.

To determine eligibility under the $10 million gross receipts test, contractors must aggregate their gross receipts for commonly controlled entities. The tax code regulations also require contractors to include construction-related gross receipts of entities they own, even if the entities are not considered to be commonly controlled.

The small contractor exemption is determined annually. Because of the method choices available to contractors who are exempt from the PCM for tax purposes, contractors and their advisors must carefully consider the benefits and drawbacks of the tax methods they elect.

In the first year that a contract has not been completed by year-end, contractors must choose their tax treatment of accounting for long-term contracts. Once a method has been elected, it must be applied consistently on all subsequent returns.

Several long-term accounting methods are available, but the three most common are the cash method, accrual method and completed contract method.

Cash Method: A small contractor operating as a sole proprietorship, partnership or S corporation may use the cash method, provided it is not subject to the PCM requirements of Section 460. A C corporation or partnership with a C corporation as a partner may use the cash method only if its average annual gross receipts for the prior three-year period do not exceed $5 million as stipulated by Section 448 (b)(3) and (c). The general rule for the cash method requires taxpayers to report income when received and deduct expenses when paid. This allows contractors to control the bottom line by deferring income collection or accelerating cash payments. Regarding inventories, the tax code requires contractors to deduct the cost of materials and supplies in their inventory only in the amounts that are actually consumed and used in operations during the taxable year.

Accrual Method: Under Regulation 1.446-1(c)(1)(ii), taxpayers using the accrual method include revenues as income when all the events have occurred that fix the right to receive the income, and they can reasonably determine the amount of income. For contractors, revenue is generally earned when billed. Liability is incurred and typically taken into account: (1) in the taxable year in which all the events have occurred that establish the liability (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to liability. Unlike the cash method, tax planning for the accrual method contractor is not limited to the cash on hand at year-end. Similar to the cash method, contractors can affect taxable income by increasing or deferring billing at year-end, subject to contract terms. Typically contractors can choose between the regular method of accrual accounting, which is often called the "straight accrual method," or the "accrual excluding retention method" for long-term contracts. With the accrual excluding retention method, taxpayers can elect to not report or include retainages in gross income until it is billable under the contract. This effectively defers revenue until the end of the contract.

Completed Contract Method: The completed contract method allows small contractors to defer the recognition of income earned on a contract until the year the contract is completed. Billings and costs are deferred and not recognized until the contract is complete, even though payments may have been received in a taxable year before completion. According to the regulations, a contract is considered complete if (1) The product is used for its intended purpose (other than for testing) and the taxpayer incurs at least 95 percent of the total allocable contract costs, or (2) the contract is completed and accepted.

Although most contractors are required to use the PCM for financial reporting, they are not necessarily bound to use it to report income from long-term contracts on federal income tax returns.

Leslie V. Guajardo, CPA, CCIFP, is a partner at Padgett, Stratemann & Co. LLP. in San Antonio. (Leslie.Guajardo@padgett-cpa.com).