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What method of accounting should be used for a construction contract?

Table of Contents

    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.


    Construction Contract

    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 requirements 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.


    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:

    1. Treat the entire contract as a long-term construction contract if at least 95% of the estimated costs are allocable to construction activities; or
    2. Treat the entire contract as a long-term manufacturing contract subject to the percentage of completion method of accounting.


    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.

    A related party is defined in IRC Section 707(b)(1) or IRC Section 267(b).


    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.

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