Construction Company Tax Audit FAQs
What types of contracts are used in the construction industry?
A contract that begins and ends within the taxpayer’s taxable year is classified as a short-term contract. Under a short-term contract, construction costs are current period costs under all methods of accounting except the cash method. If the cash method is chosen, construction costs are current period costs only if the expense is also paid during the year.
A contract that cannot be completed within the taxable year it is entered into is classified as a long-term contract. However, a long-term contract’s term does not have to be for a year or more.
For example, consider a construction contract entered into by a calendar-year taxpayer on December 31, 2019 and concluded on January 1, 2020. Even though this was only a two-day contract, because it could not be completed in the taxpayer’s tax year it was entered into (2019), it is considered a long-term contract.
Fixed Price or Lump Sum Contracts
A construction contract for an agreed upon price, regardless of potentially unforeseen expenses, is classified as a fixed price or lump sum contract.
Cost-plus contracts arise when the contract amount is the cost of the job plus a fee. The fee may be based on a variety of factors.
Time and Material Contracts
Time and material contracts are contracts that provide payments to the contractor based on direct labor hours at a fixed rate plus the cost of materials and other specified costs.
Unit Price Contracts
A unit price contract is a type of Fixed Price or Lump Sum contract where the contractor bids a set price per unit. This type of contract is utilized when the number of units required has not been determined during contract bidding.
A change order modifies an original contract, and may increase or decrease the costs and/or price stated in an existing contract.
What method of accounting should be used for a construction contract?
Percentage of Completion Method
Prior to the Tax Reform Act of 1986, the construction industry could choose from various accounting methods with little restrictions. However, after IRC Section 460 was enacted, the construction industry was generally required to use the percentage of completion method.
However, the percentage of completion method is only available when using a long-term contract. Therefore, the type of contract chosen must be determined before electing which accounting method to use.
Construction and Manufacturing Contracts
IRC Section 460 differentiates between two types of long-term contracts; construction contracts and manufacturing contracts. A construction contract deals with real property and a manufacturing contract relates to personal property.
Under IRC Section 460(e)(4) defines a “construction contract” as any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property. Specifically excluded from construction contracts real property requirement are; vessels, offshore drilling platforms, or natural products of land that have not been severed. Moreover, a construction contract involves the installation of an integral part of real property.
Therefore, for example, a contract for the manufacture of an escalator is not a construction contract because it is not the actual installation of an integral part of the real property. However, if the contract was for the installation of that escalator into a mall (real property), it then would be considered a construction contract. But what happens when a single long-term construction contract contains both manufacturing and installation? Such a situation is classified as a hybrid contract.
A hybrid contract is broken into two contracts, a manufacturing contract and a construction contract. An election may be made, on a contract-by-contract basis, to choose one of the following:
- Treat the entire contract as a long-term construction contract if at least 95% of the estimated costs are allocable to construction activities; or
- Treat the entire contract as a long-term manufacturing contract subject to the percentage of completion method of accounting.
Minimal Construction Activities
A contract with minimal construction activities is not classified as a construction contract if the estimated costs attributable to construction activities are less than 10% of the total contract price.
Non-Long-Term Contract Activities
Since long-term contract methods of accounting apply only to the receipts and costs attributable to long-term contract activities, what methods of accounting are applied for non-long-term contract activities?
Non-long-term contract activities are defined as an activity other than manufacturing, building, installation, or construction. Examples of non-long-term activities include; architectural design, engineering, construction management services, and even the development of computer software. Additionally, performance under a guaranty, warranty, or maintenance agreement are also non-long-term contract activities.
Gross receipts and costs attributable to non-long-term contract activities must be separated from the contract and use methods of accounting other than a long-term contract method. However, if the execution 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. For example, under these requirements, a contract for designing and constructing an office building would contain both long-term (constructing) and non-long term (designing) activities. However, the design is incidental and necessary to the construction as it would be impossible to build the office building without design plans. Therefore, under this example, the entire contract would utilize long-term contract methods of accounting.
Related Party Contract
Sometimes an activity that normally would be classified as a non-long-term activity, such as architectural services, must use the percentage of completion method when the activity is incidental to or necessary to a related party’s long-term contract.
Severing and Aggregating Contracts
Contractors may elect to, and could 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 a contractor should sever, or aggregate depends on 3 factors; pricing, separate delivery or acceptance, and reasonable businessperson.
Pricing: Independent pricing of items in an agreement is necessary for the agreement to be severed into two or more contracts.
For example, a builder enters into a contract to construct two commercial buildings in different sections of a city. The contract provides that the two buildings will be completed in 2019 and 2020. The builder will be paid $500,000 for the first building and $1 million for the second. Unless the builder is required to use the percentage of completion method, the builder is required to sever this contract because the buildings are independently priced.
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.
For example, a builder enters into two separate agreements resulting from one negotiation to construct identical water treatment facilities. The builder, never having built a water treatment facility before, anticipates significantly higher costs for the first facility. If the agreements are treated as separate, the first likely will result in a significant loss while the second likely will result in a significant profit. Using this fact pattern, aggregation is required because the facilities are interdependently priced, and a reasonable contractor would not have taken on the first agreement without also taking on the second.
Reasonable businessperson: Two or more agreements to perform manufacturing or construction activities may not be aggregated into one contract unless a reasonable businessperson would not have entered into one of the agreements for the terms agreed upon without also entering into the other agreement. Exceptions provide that a taxpayer may not sever under this paragraph a long-term contract that would be subject to the percentage of completion method without obtaining the Commissioner’s prior written consent.
For example, a builder enters into a contract with a developer to construct 10 homes in 2020. The contract provides an option in which the builder is to build an additional 10 homes. In year 2022, the option is exercised, and an additional 10 homes are built. The option would be severed from the original contract.
Choosing the right accounting method varies significantly based on what type of construction contract is selected. For long-term contracts, the proper accounting method is further determined based on the specific terms of the contract.
What method of accounting should small construction contractors use?
Long-term contracts are generally required to use the percentage of completion method of accounting. However, there are exceptions to this general requirement for home construction contracts and small construction contracts.
Exceptions to the Percentage of Completion Accounting Method
IRC Section 460(e) provides two exceptions to the required percentage of completion accounting method. Of note, these exceptions do not apply to long-term manufacturing contracts. The exceptions are for home construction contracts; and small contractor contracts.
A small contractor must, (1) at the time the contract was entered, it was estimated that the contract would be completed within a two years of the contract’s inception and (2) whose average annual gross receipts for the prior three tax years did not exceed $25 million.
For example, a builder enters into two different contracts. Contract one is expected to be completed in 14 months. Contract two is expected to last over 4 years. Further the builder’s annual gross receipts are less than $25 million for the three prior tax years. For job one, the builder may use any of the normal methods of accounting. However, for job two, because it is not expected to be completed within two years, builder must use the percentage of completion method.
$25 Million Gross Receipts
Income from all trades or businesses that are under the common control of the taxpayer are considered in determining gross receipts.
The gross receipts test looks to the prior 3 taxable years but does not include the tax year during which the contract was entered. But what happens if the taxpayer has not been in existence for three prior tax years? When this occurs, the taxpayer takes the average annual gross receipts for the number of taxable years that the taxpayer has been in existence.
A contractor typically utilizes at least two forms of accounting methods, the normal overall method such as cash or accrual and one or more methods for long-term contracts such as percentage of completion. IRC Section 446(a) provides that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.