Accounting Methods for Long-Term Contracts: Completed Contract Method, Percentage of Completion Method
For short-term contracts, the taxpayer will use either the cash or accrual accounting method, but for certain long-term contracts, there are additional choices provided by IRC §460.
Long-term contracts that qualify under §460 are contracts for the building, installation, construction, or manufacturing in which the contract is completed in a later tax year than when it was started. However, a manufacturing contract only qualifies if it is for the manufacture of a unique item for a particular customer or is an item that ordinarily takes more than 1 year to manufacture. Long-term contracts for services do not qualify as a long-term contract under §460.
- §460 Long-Term Contract
- A contract that spans more than 1 tax year for building, installation, or construction. Manufacturing contracts may qualify either if the item ordinarily takes longer than 1 year to manufacture or if the item is unique and manufactured for a particular customer on demand. So if a contract is started December 20, 2015 and ends on January 10, 2016, then, even though the contract is for less than 1 month, this contract is a long-term contract for a calendar year taxpayer but a short term contract for a fiscal year taxpayer.
- Small Contractor
- A contractor with average annual revenue of $10 million or less for the preceding 3 years.
- Large Contractor
- A contractor whose average annual revenue is greater than $10 million for the preceding 3 years.
- Home Construction Contract
- A contract for the construction of residential buildings, where each building consists of 4 dwelling units or less.
Long-Term Methods of Accounting
There are 2 primary methods of accounting to determine when revenue is recognized for long-term contracts:
- completed contract method (CCM)
- percentage of completion method (PCM)
Because the CCM allows the deferral of taxes, a large contractor must usually choose the PCM, but a small contractor can choose CCM if the estimated life of the contract is 2 years or less.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, large contractors with revenue not exceeding a $25 million average within the 3 years prior to the current year may use the PCM, or any other allowable method. Moreover, construction companies are no longer required to use the PCM method, if the contract was entered into after 2017, is expected to be completed within 2 years, and is performed by a taxpayer satisfying the $25 million gross receipts test.
Completed Contract Method
Using the completed contract method, the taxpayer does not recognize revenue until the contract is completed and accepted by the customer. Except for home construction contracts, CCM can only be used by small contractors for contracts with an estimated life that does not exceed 2 years. There should be no terms in the contract with the only purpose of deferring tax.
The CCM is required for home construction contracts that are for the construction of residential buildings with 4 or fewer dwelling units, where at least 80% of the estimated cost is for the dwelling units and related land improvements, even if the contract is for longer than 2 years or the contractor is a large contractor. Other types of construction contracts qualify for the completed contract method if they satisfy the general CCM requirements.
Home construction contracts have obvious tax advantages, in that the recognition of income can be deferred for years, especially for large projects involving the construction of many housing units. The IRS sees many abuses in this area, where either construction contracts are improperly classified as home construction contracts or the date of completion is extended by contrivance. One common maneuver that contractors use to defer taxes is to construct numerous houses on a large residential plot, while delaying the completion of common improvements, such as roads and sewage, as long as possible. Therefore, the contractors argue, the construction of any one home is not complete until all the common improvements have been finished. However, the IRS is taking the position that a home construction contract is considered completed when it is sold. (See Super Completed Contract Method for more info.)
Disadvantages of the completed contract method are that income from multiple projects may have to be reported in the same tax year, and any losses on any of the contracts cannot be deducted until the contracts are completed and the income is recognized for tax purposes.
If the taxpayer or the contract does not qualify for the completed contract method, then the percentage of completion method must be used.
Percentage of Completion Method
Except for home construction contracts, large contractors must use the percentage of completion method for long-term contracts. PCM must also be used to determine liability under the alternative minimum tax (AMT) system. Under the PCM, the amount of progress on the project is determined by the total costs actually incurred as compared to the total estimated cost. Hence, revenue in any given year is determined by the actual contract costs incurred for that year divided by the total estimated cost multiplied by the total contract price:
|Reportable Income||=||Contract Price||×||Annual Contract Cost |
Estimated Total Cost
If there is a dispute in regards to the contract price, and the amount of the dispute is small in relation to the total amount of the contract, then reportable income is determined by subtracting the contract price by the amount in dispute. The disputed amount will be recognized when the dispute is resolved. Any additional costs incurred in completing the performance of the contract are deductible against the recognized disputed revenue.
The revenue reported for the last year is equal to the total revenue received minus the total reported revenue. Because the total cost of the contract is estimated, there may be an underpayment of taxes if costs were overestimated or an overpayment of taxes if costs were underestimated. The revenue that was actually reported may differ from the revenue that should have been reported based on actual costs. Therefore, upon completion of each contract, the revenue that should have been reported for each tax year must be calculated and compared to the revenue that was reported for those previous tax years. If there was an overpayment of tax, then the taxpayer is entitled to interest from the IRS based on the overpayment; on the other hand, an underpayment of tax requires that the taxpayer pay interest to the IRS. This look-back interest calculation is figured on Form 8697, Interest Computation Under the Lookback Method for Completed Long-Term Contracts, which can be avoided if estimated and actual costs are within 10%. A corporate taxpayer can deduct the payable interest but an individual taxpayer cannot, since it is considered nondeductible personal interest.
There is also a 10% rule, whereby, if the taxpayer so elects, the recognition of income and the deduction of expenses can be delayed until the tax year in which at least 10% of the cumulative, allocable contract costs have been incurred.
Example: Look-Back Method
You have a construction contract worth $4 million to be completed over 3 years. Originally, you estimated the cost to be $3,200,000. Your actual costs for the 1st year turned out to be $300,000, which is less than 10% of the total estimated costs, so you did not report income or deduct expenses for that 1st year. However, after you have completed the contract, your actual cost was $2,900,000, so the $300,000 of costs that were incurred in the 1st year exceeded 10% of the total actual costs. Therefore, you must use the lookback method to calculate the amount of interest that you will have to pay, based on what you should have reported minus what you actually reported.
|Per Return||Year 1||Year 2||Year 3|
|Cumulative Incurred Costs||$300,000||$1,500,000||$2,900,000|
|Estimated Total Costs||$3,200,000||$3,200,000||$2,900,000|
|Completion Percentage||9.38%||46.88%||100.00%||= Cumulative Costs / Estimated Total Cost|
|Total Contract Price||$4,000,000||$4,000,000||$4,000,000|
|Reported Income||0||$1,875,000||$2,125,000||= Total Contract Price × Completion Percentage, if Completion Percentage ≥ 10%, else income does not have to be reported.|
|Per lookback||Year 1||Year 2||Year 3|
|Cumulative Incurred Costs||$300,000||$1,500,000||$2,900,000|
|Actual Total Costs||$2,900,000||$2,900,000||$2,900,000|
|Actual Completion Percentage||10.34%||51.72%||100.00%||= Cumulative Costs / Actual Total Cost|
|Total Contract Price||$4,000,000||$4,000,000||$4,000,000|
|Lookback Gross Income||$413,793||$1,655,172|
|Lookback Expenses||$300,000||$1,200,000||Note that because income must be claimed for the 1st year, deductions of actual expenses must also be claimed. Therefore, in the 2nd year, the amount claimed in the 1st year must be subtracted from the amount originally claimed of $1,500,000.|
Under the regular tax system, the lookback method does not apply to home construction contracts or any other contract completed within 2 years of commencement and performed by a small contractor. There is also a mandatory de minimis small contract exception that applies to both the regular and AMT tax system, where the lookback method does not apply to any long-term contract completed within 2 years of commencement and where the contract price does not exceed the lesser of:
- 1% of the taxpayer's average annual gross revenue of the past 3 years or
- $1 million
Note that the $1 million exception would apply to contractors with revenues greater than $300 million over the previous 3 years.
Exempt Percentage of Completion Method
A hybrid variation of accounting for long-term projects is the exempt percentage of completion method (EPCM), where general and administrative costs and directs job costs are deducted with the accrual method, which are deducted when the liability for those costs are incurred. The main advantage of EPCM is that income is reported over the life of the contract and any losses will be recognized based on the percentage of the contract completed, which is referred to as the completion factor. The completion factor is the amount of work that has been completed compared to the estimated amount remaining. The completion factor must be certified by an engineer or an architect, or supported by appropriate documentation. The contract price must include cost reimbursements, all agreed changes to the contract, and any retainages receivable. Retainage is the amount earned by the contractor, but retained by the customer for payment at a later date until the quality of the work can be ascertained.
Percentage of Completion-Capitalized Cost Method
There is also a percentage of completion-capitalized cost method (PCCM) that can be used for residential apartment contracts, where at least 80% of the total contract cost is attributed to the construction of the buildings. Under PCCM, 70% of the contract is reported under PCM, while the remaining 30% is reported under EPCM. Treas. Reg. §460-4(e)
Since contractors often work on several contracts simultaneously and because contractors often incur costs that are not specific to a particular contract, these costs must be accumulated and allocated to specific contracts. The costs are not deductible until the income is recognized. Although the contractor has discretion in accumulating and allocating costs, the basis for cost allocation must be reasonable.
There are 2 types of costs:
- general and administrative costs
- job costs
General and administrative (G&A) expenses are those expenses incurred to run the business and are not allocable to a particular job. Job costs are the direct costs of a particular job, which are grouped into 2 categories: direct job costs are those that can be allocated to a particular job; indirect job costs are those incurred in performing the contract, but cannot be allocated to a particular job, such as utilities, repair maintenance for both equipment and facilities, and for tools and equipment. The distinction between indirect job costs and general and administrative costs is that indirect job costs directly benefit more than one job, whereas administrative costs would be incurred even if the contractor had no particular jobs.
Alternative Minimum Tax
Except for home construction contracts, the PCM method must be used for all current CCM contracts to determine any alternative minimum tax (AMT) liability, and the lookback method must be applied to determine any overpayment or underpayment of interest.