Construction Industry - Audit Technique Guide - Uncle Fed's Tax ...

Internal Revenue ServiceConstruction IndustryAudit Technique Guide (ATG)NOTE: This guide is current through the publication date. Since changesmay have occurred after the publication date that would affect the accuracyof this document, no guarantees are made concerning the technicalaccuracy after the publication date.This material was designedspecifically for trainingpurposes only. Under nocircumstances should thecontents be used or cited assustaining a technicalposition.The taxpayer names andaddresses shown in thispublication arehypothetical. They werechosen at random from alist of names ofAmerican colleges anduniversities as shown inWebster’s Dictionary orfrom a list of names ofcounties in the UnitedStates as listed in theU.S. GovernmentPrinting Office StyleManual.www.irs.govTraining 3147-123 (10-2004)Catalog Number 84851H

CONSTRUCTION INDUSTRY GUIDE(Formerly Audit Technique Guide)TABLE OF CONTENTSChapter 1: Introduction to the Construction IndustryIntended Audience ............................................................................. 1-1The Construction Industry as a Market Segment............................... 1-1Participants in the Construction Industry........................................... 1-2The Contracting Process .................................................................... 1-5Contract Income................................................................................. 1-6Types of Contracts ............................................................................. 1-7Bonding.............................................................................................. 1-8Building Permits ................................................................................ 1-8Notice of Completion......................................................................... 1-9Chapter 2: Long Term ContractsBackground........................................................................................ 2-1Definition of Long-Term Contract..................................................... 2-1Contracts Subject to IRC Section 460 ............................................... 2-1Contracts Exempt from IRS Section 460........................................... 2-2Construction Contracts versus Manufacturing Contracts .................. 2-2Real Property and its Integral Components(Treas. Reg. Section 1.460-3(a) ...................................................... 2-3Classifications of Contracts ............................................................... 2-4Hybrid Contracts................................................................................ 2-5

De minimis Construction Activities................................................... 2-5Non-Long-Term Contract Activities(e.g., Architect, Engineer Services)................................................. 2-6Contracts of Related Parties............................................................... 2-7Severing and Aggregating Contracts ................................................. 2-9Chapter 3: Small Construction ContractorsIntroduction........................................................................................ 3-1Exceptions to the Percentage of Completion Accounting Methodsand Look-Back Interest.................................................................. 3-1Production Period Interest.................................................................. 3-2$10 Million Gross Receipts Test........................................................ 3-2Determining the Proper Method of Accounting for SmallContractors...................................................................................... 3-4General Rules of Accounting Methods.............................................. 3-4Methods of Accounting...................................................................... 3-5Selecting an Accounting Method....................................................... 3-6Computation of the Cash Method of Accounting.............................. 3-11Accrual Method of Accounting ......................................................... 3-11Completed Contract Method (CCM) ................................................. 3-14Completion of a Long-Term Contract ............................................... 3-14Subcontracts and Completion ............................................................ 3-17Exempt-contract Percentage-of-Completion Method (EPCM) ......... 3-18Alternative Minimum Tax (AMT)..................................................... 3-19Small Contractors Becoming Large Contractors ............................... 3-22Pros and Cons of Long-Term Accounting Methods.......................... 3-22

Chapter 4: Large Construction ContractorsIntroduction........................................................................................ 4-1Methods of Accounting, Contracts subject to IRC Section 460 ........ 4-1Cost-to-Cost Method.......................................................................... 4-1Allocable Contract Costs ................................................................... 4-2Impact of Cost Allocation on the Percentage of CompletionComputation .......................................................................................4-4Cost-Plus Contracts and Federal Long-Term Contracts .................... 4-6Simplified Cost-to-Cost Method........................................................ 4-6Percentage-of-Completion (10 Percent Method)............................... 4-7Percentage-of-Completion/Capitalized-Cost Method (PCCM)......... 4-7Total Estimated Contract Price and Claim Income............................ 4-8Additional Considerations for PCM .................................................. 4-9Terminated Contract: Reversal of Income......................................... 4-10Chapter 5: Look-Back Interest - New ChapterIntroduction........................................................................................ 5-1Look-Back is Hypothetical ................................................................ 5-1Scope of Look-Back Method............................................................. 5-2Exceptions from the Application of Look-Back................................ 5-3Election Not to Apply Look-Back ..................................................... 5-4Computation of Look-Back ............................................................... 5-5Step 1, Hypothetically Reapply the PCM to all Long-Term Contracts..... 5-5Step 2, Hypothetical Overpayment or Underpayment of Tax ................. 5-7Step 3, Interest on Underpayment or Overpayment of Tax..................... 5-9

Tax Issues........................................................................................... 8-12Chapter 9: Income Probes - New ChapterIntroduction........................................................................................ 9-1Understanding the Accounting System.............................................. 9-1Minimum Income Probes................................................................... 9-2Internal Controls ................................................................................ 9-4Use of Indirect Method ...................................................................... 9-6Miscellaneous Income Sources.......................................................... 9-8Chapter 10: Construction Joint VenturesOverview............................................................................................ 10-1Types of Joint Ventures ..................................................................... 10-1Joint Venture Examinations............................................................... 10-3Potential Joint Venture Issues............................................................ 10-3Chapter 11: Employee or Independent Contractor - New ChapterClassification of Workers .................................................................. 11-1Chapter 12: Alternative Resolution - New ChapterOverview............................................................................................ 12-1Industry Issue Resolution Program.................................................... 12-1Pre-Filing Agreements....................................................................... 12-2Fast Track Mediation and Settlement ................................................ 12-3

Chapter 13: Electronic Filing and Paying of Business Taxes (“E-submissions”) -New ChapterE-File for Business............................................................................. 13-1Electronic Federal Tax Payment System (EFTPS)............................ 13-3AppendixAppendix 1- Applicable Federal Tax Law & Guidance .................... A-1Appendix 2- Tax Methods of Accounting ......................................... A-2Appendix 3- Construction Industry Associations and Resources...... A-3Appendix 4- Cost Allocation ............................................................. A-4Appendix 5- Definitions and Terminology........................................ A-5

Table of Contents / Chapter 2Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 1: Introduction to the Construction IndustryIntended AudienceThis Industry Guide is intended to be used by examiners conducting audits in theconstruction industry and as information for taxpayers and practitioners associated withthe construction industry. Review of this guide is recommended prior to initiating anaudit. Users of this guide may need to augment these guidelines by researching specifictax issues and new tax law.The Construction Industry as a Market SegmentThe construction industry represents a large segment of the total economy. Over 2.5million companies ranging in size and specialty make the construction industry one ofthe largest of all industries. Businesses in the construction industry interact withbusinesses in related industries that supply materials, equipment, financing, andbonding to the construction contractor. Each business is dependent on one another fortheir survival.In 2000, approximately 2.5 million returns with construction income were filed in theUnited States reporting gross receipts of $1,160,379,989,413 (see the chart below).• Individual Forms 1040 Schedule C, represented 1,820,522 or 73.5% of totalconstruction industry filings and $134,146,800,842 (11.5%) of the total reportedgross construction receipts.• Corporate filings were 540,697 or 21.8% of the total construction filings and wereresponsible for over $901,204,198,936 (77.8%) of the reported gross receipts.• The remaining 115,803 filings, by Partnerships, represented 4.7% of the totalconstruction filings and $125,028,989,635 (10.8%) of the total gross receipts.2.5 Million Returns filed reporting gross receipts of $1,160,379,989,413For the Construction Industry in 2000Type of Return Filings % Gross Receipts %Individual Form 1040Schedule C 1,820,522 73.5 % $134,146,800,842 11.5 %Corporate Forms1120,1120S & Misc. 1120 540,697 21.8 % $901,204,198,936 77.7 %Partnership Form 1065 115,803 4.7 % 125,028,989,635 10.8 %1-1

This information was extracted from codes placed on each return by the taxpayer. Thesix digit codes are based on the North American Industry Classification System (NAICS)and are used to facilitate the administration of the Internal Revenue Code. NAICS wasdeveloped jointly by the U.S., Canada, and Mexico to provide new comparability instatistics about business activity across North America. The North American IndustryClassification System (NAICS pronounced Nakes) is a unique, all-new system forclassifying business establishments. It was adopted in 1997 to replace the old StandardIndustrial Classification (SIC) system, and is the industry classification system used bythe statistical agencies of the United States.U.S. Construction IndustryReturn Filing (2000) per thousands(2.5 million total filings. Includes 1040, 1120, 1120S, 1065, etc.)800,000700,000600,000500,000400,000300,000200,000100,0000Building,Developing,andContractingPlumbing,Heating, &Air-ConditioningElectricalHeavyConstructionParticipants in the Construction IndustryNumerous participants that part in the construction industry. Each participant plays adistinct role in the process. The key participants will be discussed briefly in thisintroduction.ContractorsContractors perform the construction work in accordance with the plans andspecifications provided by the owner. In general, contractors are required to be licensedby state law under separate classifications (plumbing, electrical, general building, etc.).General/Prime ContractorsA general building contractor's principal business is the performance of the constructionwork in accordance with the plans and specifications of the owner. A general contractortakes full responsibility for the completion of the project. The general contractor willnormally subcontract out a substantial part of the work, while maintaining overall control1-2

through project managers and onsite supervision. The general contractor can be anysize and any form of entity, i.e., sole proprietorship, partnership, or corporation. Thegeneral contractor may utilize specialty subcontractors, but can perform any portion ofthe work. Generally contractors must be licensed. If the contractor is a corporation orpartnership, an officer or partner must be licensed.Construction ManagersGenerally, the construction manager does not perform construction work on projects,but is an agent for the owner. The construction manager may be engaged in lieu of or inaddition to a general contractor. As an agent, the construction manager coordinates theconstruction project, but has no contractual relationship with the subcontractors.Generally, construction managers provide only services, neither doing the actualconstruction work, nor being liable for defects in the construction. However, theconstruction manager may be liable for design defects.Commercial ContractorsCommercial contractors specialize in commercial construction projects. These projectsmay include the construction of a single building or any number of buildings.Commercial Projects include:• Retail Projects: Shopping centers, restaurants, grocery stores, etc.• Rental Facilities: Office buildings, industrial parks, apartments, etc.• Business Locations: Company headquarters, manufacturing plants, insurancecompanies, etc.• Municipal Buildings: City halls, prisons, schools, hospitals, etc.• Special Projects: Amusement parks, race tracks, coliseums, churches, etc.A distinction is made between the residential and commercial contractor. A residentialcontractor specializes in single family homes, duplexes, etc., usually building for resaleto one or more individual homeowners. A commercial contractor constructsnonresidential buildings, such as office buildings, warehouses, and shopping centers.Commercial Project OwnersThe owner of a construction project may be an individual, corporation, partnership, orgovernment body. The owner evaluates whether a project is feasible and will providethe future benefits desired. The owner then engages an architect or engineer to designthe plans and specifications of the project. Normally, the owner secures the necessaryfinancing for the project for both the construction period and permanent financing uponcompletion. The owner will retain title to the project throughout the construction phase,subject to liens from construction loans and mechanics liens. The general contractormay or may not have an ownership interest in the project. The contractor may own apercentage interest in one of the following ways:1. Owning stock in the corporation that owns the project2. Being a partner in a development partnership1-3

3. Owning the property or an interest in a joint venture as an individualResidential Construction DeveloperThe examination of residential developers is different than the examination of acontractor who builds in accordance with a contract between himself or herself and anowner. The developer is generally the owner of the residential development as well asthe builder. The developer acquires land, obtains approval, secures constructionfinancing, and begins construction of the residential development in stages or phases ofconstruction. The initial phase is sold, and the construction process begins on the nextphase. This process requires that the builder allocate a per-unit cost to each unit sold.The cost of each unit (on-site costs, such as direct materials and labor, and an allocatedportion of off-site costs such as streets and amenities) must be matched with the salesprice of each unit sold. The sales price is often based on what the market will bearunder the current economic environment. During periods of low interest ratesresidential construction usually booms, while high interest rates cause the market torecede.SubcontractorsThe largest number of taxpayers in the Construction Industry are specialtysubcontractors. They can range from one-man operations to nationwide, publicly tradedcorporations, or divisions of larger corporations. Over 70 percent of the constructionreturns filed are Schedule C returns by individuals. Subcontractors are distinguishedfrom the general contractor by the limited scope of their work, which usually involves aspecial skill, knowledge, or ability. Subcontractors include specialists, such as plumbers,electricians, framers, and concrete workers. They generally enter into contracts with thegeneral contractors, and may provide the raw materials used in their specialty areas.The general contractor, not the owner of the property, will usually pay thesubcontractors. Materials purchased by the subcontractors are generally delivereddirectly to the job site. The subcontractors' work may be completed in stages, or it maybe continuous.Highway ContractorsHighway and street contractors require specialized equipment and techniques. Theequipment includes bulldozers, graders, dump trucks, and rollers. Examples of highwayconstruction include city streets, freeways, country roads, highway bridges, and tunnels.Heavy Construction ContractorsHeavy construction contractors require large and complex mechanized equipment, suchas cranes, bulldozers, pile drivers, dredges, and pipe-laying devices. Some examples ofprojects in this category include dams, large bridges, refineries, petrochemical plants,nuclear and fossil fuel power plants, pipelines, and offshore platforms. Most industrial1-4

plants are classified in this category because of the complexity of the work. The largestengineering and construction firms are included in the heavy construction classification.Architect/EngineersThe architect or engineer designs the plans to be used by the construction contractors.The plans provide the necessary detail (dimensions, materials to be used, location offixtures, etc.) to the contractors. When the project is started, the architect/engineer maymonitor the contractor's progress and often approves progress payments to thecontractors. The architect/engineer will make modifications (change orders) in the plansas needed. Change orders are written revisions to the contract, which increase ordecrease the total contract price paid to the construction contractors. The change orderdocument contains the change order number, change order date, a description of thechange, and the amount of the change order. Change orders can also be issued by thecontractors under the terms of the contract.Material SuppliersMaterial suppliers provide the raw materials used in the construction project. Materialsupplies are purchased by the subcontractors and installed by them in accordance withtheir contract. General contractors often write joint checks to subcontractors andmaterial suppliers to ensure that all parties have been properly paid. Materials aregenerally delivered directly to the job site and are direct job costs, which are notnormally inventoried by the contractor. In some situations the contractor will maintaininventories of miscellaneous yard stock frequently used.Construction LendersThe construction lender provides the necessary funds to pay contractors on a progressbasis. In return for making the loan, the lender receives interest on the outstanding loanbalance. Construction period interest (referred to as "soft costs") paid to lenders mustbe capitalized by the owner during the construction period. Interest and other loan costsare often taken directly from the loan principal as a result of the institutions interestprovisions. As construction work progresses, the construction lender (bank, savings andloan, insurance company, etc.) will advance the funds based on the work performed orbased on a payment schedule. The construction loan is generally secured by the landand construction in progress. When construction is completed, the owner will securepermanent long-term financing.Surety CompaniesSureties are generally insurance companies who provide bonding to contractors. Bondsprovide a form of insurance to the owner. Performance bonds protect the owner if thecontractor fails to complete the construction work. Performance bonds are typically apercentage of the contract amount. Bid bonds guarantee that the contractor will signthe contract after it is awarded and furnish the necessary performance and payment1-5

onds within a specified time. Contractors must submit detailed financial data to thesurety company to secure a bond. Financial statements prepared in accordance withgenerally accepted accounting principles (GAAP) are often furnished to the surety on aquarterly basis or more often. Supporting schedules included in these financialstatements provide extensive job information, required by the surety in order that theymay analyze and limit their risk. Personal financial statements are often required to besupplied from officer shareholders.Multiple RolesEach of the above participants can and often do have multiple roles in the constructionprocess. For example, the owner could also be the general contractor(builder/developer). The general contractor in addition to providing supervision may alsodo specialty work that would typically be subcontracted (for example, concrete work).Design-build companies are growing. Construction lenders frequently hold an equityposition in a development partnership in order to participate in the managementdecisions and to share in the profits. Anchor tenants, such as major department storechains participate in the development partnership in exchange for signing long-termleases. Contractors and material suppliers can obtain rights in the project by filingmechanics liens against the property. The auditor should thoroughly understand eachparticipant's role in order to determine whether the transactions have received theproper tax treatment.THE CONTRACTING PROCESSWhen the owner determines that the project is feasible and that construction financing isavailable,he will solicit bids from general contractors and/or specialty contractors. Owners will usetrade publications and newspapers to invite contractors to bid for the constructioncontract. The notice will provide the contractors with the procedures to be followed insubmitting a bid. The bidding contractor obtains a copy of the plans and specificationsfrom the owner to prepare the formal bid. The bidding contractor solicits bids fromsubcontractors, estimates direct material and labor costs, and evaluates the ultimateprofit potential of the contract. The amount of the bid covers the estimated costs andprofit for the construction project. The owner evaluates the submitted bids and willaward the contract to the successful bidder. The contract document contains thecontract amount, project start/completion dates, progress billing procedures, insurancerequirements, and other pertinent information. There are standard cost manuals that ageneral contractor can use as a guideline in computing the bid. These guides contain acompilation of cost data for each phase of construction.It is important to realize that the cost of bidding a job can be considerable. The costsinclude reviewing and reproducing the job specifications and blueprints, calling insubcontractors to get bids on the work involved, developing the total cost figure for theproject, and preparing a formal bid. The preparation of the bid is the first step in the costcontrol system. The bid becomes the budget by which the actual expenditures are1-6

measured. The object of the cost control system is to provide the general contractorwith information regarding actual project costs versus anticipated or budgeted costs.These cost comparisons are essential for internal control as well as for auditingpurposes. You may see situations where a contractor might pursue a "break-even" bidto generate enough cash flow to meet payroll, etc., particularly in recession periods.The general contractor solicits bids from subcontractors in the various trades, thesubcontractors bid for the jobs in much the same way general contractors do.Scheduling SubcontractorsThe general contractor is expected to schedule the subcontractors so that theconstruction runs smoothly and is completed on time. The various specialty areasinclude, but are not limited to, the following:1. Clearing the land, which may include demolition of existing structures2. Excavating the land, which may include digging holes and leveling3. Pouring the foundation4. Steel and/or wood framing5. Rough framing6. Rough electrical7. Wood or concrete flooring8. Roofing9. Heating and air conditioning10. Ductwork for the heating and air conditioning11. Installing elevators and/or escalators12. Installing sprinklers and other safety equipment13. Installing electrical fixtures14. Insulating and weather-stripping15. Framing window and door sashes16. Installing tile and marble17. Installation of suspended acoustic ceilings18. Installing toilets, sinks and other plumbing fixtures19. Painting walls, inside and out20. Laying carpet and other floor coverings21. Clean upThis list conveys some of the complexity inherent in the construction process. It reflectsthe necessity of scheduling the work of subcontractors and using a budget, bid costs,and actual cost variances for cost control purposes. Budgeting and scheduling arecritical factors in determining the success of the contractor.CONTRACT INCOMEMost companies use a standard construction contract. The most important informationcontained in the contract is the amount the general contractor will be paid and how oftenhe or she will be paid. The contract will state whether the contractor will bill monthly, at1-7

the completion of the contract, or at certain stages of the project. The billing invoicesmay include copies of the subcontractor bills and lien releases. The owner may have asupervisor at the site that confirms the contractor has completed the work for which hehas billed. The contract may also include provisions for retainages, which are usuallywithheld from the general contractor until the project is complete. Retainages areusually withheld at a rate of 10 percent of the billed amounts, but the percentage maydecrease over the life of the project. The general contractor, in turn, will retain a portionfrom the amounts owed to the subcontractors.TYPES OF CONTRACTSLong-Term ContractsLong-term contracts are defined in IRC section 460(f)(1) as any contract for themanufacture, building, installation, or construction of property, if such contract is notcompleted within the taxable year in which such contract is entered.Short-Term ContractsShort-term contracts are contracts started and completed within the taxpayer's taxableyear. For short-term contracts, construction costs are treated as current period costsunder all methods of accounting except the cash method. Under the cash method,construction costs are treated as current period costs for a short-term contract only ifthe expense is also paid during the year.Fixed Price or Lump Sum ContractsA fixed price or lump sum contract states that the contractor will complete the project foran agreed price, despite unforeseen costs that might exist during the constructionphase. Some fixed price contracts, in reality, provide for some variations for economicprice adjustments, incentives, etc. If any modifications to the original contract occur,change orders are executed. These often increase or decrease the contract amount.Cost-Plus ContractsCost-plus contracts stipulate that the contract amount will be the cost of the constructionproject plus a fee. The fee may be earned in various ways. A fixed fee is generallyearned evenly throughout the term of the contract. A percentage fee is frequentlybased on the amount of cost incurred. Most cost-plus contracts have a guaranteedmaximum to protect the owner from cost overruns. Many cost-plus contracts allow thecontractor to share in cost savings if the project is completed under budgeted cost. Thecontract will specify which costs are included in the contract amount. Generally, thecontract will include a clause that allows the owner to review or audit those costs.Time and Material Contracts1-8

Time and material contracts are contracts that provide payments to the contractorbased on direct labor hours at a fixed rate plus the cost of materials and other specifiedcosts.Unit Price ContractsThe unit price contract method is a variation of the lump-sum (or fixed price) contractmethod where the contractor bids a set price per unit item. The unit-price method isgenerally used in cases in which the number of units required has not been determinedwhen the contract is bid.Change OrdersChange orders can be initiated by the contractor or the owner. A change order modifiesthe original contract, and either increases or deceases the contract costs and/orcontract price.BONDINGOwners often require the general contractor to be bonded. In these cases, the generalcontractor is required to purchase a guarantee or surety bond. The purpose of the bondis to guarantee to the owner and lender that, should the general contractor fail to finishthe project, the funds will be available to hire a replacement. A general contractor'sbonding capacity is based upon their financial statements and past performance. Abond request will be denied if it exceeds the bonding capacity. A contractor may leavewhat appears to be an unusually large amount of cash in the company for the purposeof increasing his or her bonding capacity. This should be considered when determiningwhether or not accumulated earnings tax is applicable. The following types of bondsare available:• BID BONDS provide for payment to the owner of the difference between the bidthat is accepted and the next lowest bid if the general contractor with theaccepted bid fails to enter into a contract.• CONTRACT BONDS indemnify the owner against the failure of a generalcontractor to comply with the requirements of a contract.• PERFORMANCE or COMPLETION BONDS guarantee completion of the projectby the general contractor.• LABOR and MATERIAL PAYMENT BONDS guarantee the owner that all costs oflabor, material, and supplies incurred by the general contractor in connection withthe project will be paid, thus voiding mechanics' liens.• MAINTENANCE BONDS guarantee the owner against defects in workmanshipand are usually one year in duration.1-9

• SUBCONTRACTOR BONDS are performance and payment bonds issued by thesubcontractor to the general contractor to guarantee the subcontractor'sperformance and payment of obligations required under the contract.State and federal contracts usually require surety bonds. In other cases, collateralbonds in which the contractor pledges real or personal property as collateral with valueequivalent to the contract price may be used. When a performance bond is defaulted, itis not unusual for the insurer or bonding company to hire the defaulted contractor tocomplete the job, because they are familiar with the project. Most bond defaults resultfrom financial difficulties with the project at hand, rather than from the lack of technicalability on the part of the contractor. Thus, the bonding company can act as anotherthird-party control on the business and accounting practices of the contractor.BUILDING PERMITSBefore construction can begin on a project the necessary building permits must bereceived from the appropriate municipality. The specifications and blueprints of theproject are turned into the Building Department, along with an application for a permit.The issuance of a permit may take time, because the approval process is likely quiteinvolved, especially in the case of new construction. The general contractor or ownermay have to submit results of soil testing, environmental impact studies, or otherinformation. Sometimes a public hearing is mandated, if opposition to the project isknown. However, in most cases, the permit is issued within a few months. The cost ofthe permit may be the responsibility of the general contractor. The owner may pay forit, however, along with the costs of any related studies. Construction projects follow thestandards of the Uniform Building Code. A Building inspector examines the project atvarious stages to verify that the project is being constructed according to this Code.NOTICE OF COMPLETIONOnce the building is completed, a Notice of Completion is requested. The project mustpass a final inspection. Once the project passes that inspection, a Notice of Completionis issued by the municipality, along with a Certification of Occupancy. Thesedocuments are recorded at the office of the local recorder. At this point the property isappraised for property tax purposes. Note: Several appraisals are made throughout theconstruction process that address timing or allocation issues.Table of Contents / Chapter 2Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search1-10

Chapter 1 / Table of Contents / Chapter 3Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 2: Long Term ContractsBackgroundBefore the enactment of the Tax Reform Act of 1986, construction contractors couldchoose an accounting method from various alternatives with few restrictions.Contractors would recognize income and expense from construction contracts under thecash method, accrual method, completed contract method, or percentage of completionmethod. Many contractors adopted the completed contract method for tax purposesbecause they could defer taxes until the completion of the contract.Internal Revenue Code (IRC) § 460 (effective for contracts entered into after February28, 1986) generally requires the use of the percentage of completion method.Additionally, IRC section 460 introduced the "Look-back Method." Look-back isdiscussed in detail in Chapter 5.A long-term contract method of accounting (completed contract or percentage ofcompletion) is only available to taxpayers that have long-term contracts. Therefore,whether or not a long-term contract exists and the classification of the contract must bedetermined prior to electing a proper method of accounting. This chapter is designed tobring out the various factors involved in making this determination.Definition of Long-Term ContractThe term "long-term" tends to indicate a contract that lasts a long period of time, but theduration of the contract is irrelevant in order for it to be classified as a long-termconstruction contract. IRC § 460(f)(1) generally defines a long-term contract as one thatis not complete at the end of the tax year.The long-term contract must also be for the manufacture, building, installation, orconstruction of property.IRC § 460(f)(1) In general. The term "long-term contract" means any contract forthe manufacture, building, installation, or construction of property if such contractis not completed within the taxable year in which such contract is entered into.Example:A calendar-year taxpayer begins a construction job on December 31 and completes thejob on January 1 of the subsequent year. The contract is considered a long-termcontract even though the job was only two days in duration.2-1

Contracts Subject to IRC § 460Under IRC § 460(b)(1), taxpayers must use the percentage of completion method toreport taxable income from long-term contracts. The degree of completion is generallydetermined by comparing the total allocated contract costs incurred to date with the totalestimated contract costs, otherwise known as the “cost-to-cost method.” Engineeringestimates or other approaches to determine the degree of completion may not be usedif the contractor is subject to the PCM under IRC § 460. If a contractor is able to meetthe exemptions of IRC § 460(e), the use of the engineering estimates (or any otherrecognized output methods) or any appropriate method, meeting the definition ofsection 460, is allowed. See Chapter 4 (Large Contractors) for additional informationregarding contracts subject to IRC § 460.Contracts Exempt from IRC Section 460IRC § 460(e) provides two exceptions for long-term construction contracts to therequired use of the percentage of completion rules and the application of look-back:1. Any home construction contract (defined in IRC § 460(e)(6)(A)) entered into afterJune 20, 1988. Home construction contractors not meeting the small contractorexception (discussed below) are required, under IRC § 460(e)1)(B), to capitalizecosts using IRC § 263A. See Chapter 7 (Home Builders and Land Developers)for additional information regarding these home construction contracts.2. Small construction contracts, as defined in IRC § 460(e)1)(B), require that at thetime the contract was entered into, it was estimated that such contract would becompleted within a 2-year period beginning on the commencement date of suchcontract; and the contractor's average annual taxable gross receipts for the 3taxable years preceding the year in which such contract was entered into did notexceed $10 million. See Chapter 3 (Small Contractors) for additional informationregarding these types of contracts.Example:A contractor enters into two long-term contracts during the taxable year, neitherwhich are home construction contracts. The average annual taxable grossreceipts for the prior 3 taxable years are $9,000,000. Job 1 is expected to becompleted within 18 months and Job 2 is expected to be completed within 30months. Job 1 is exempt from the percentage of completion and look-backrequirements of IRC § 460 and may be accounted for under the taxpayer’selected method of accounting for long-term contracts (e.g. completed contract,accrual). However, Job 2 must be accounted for using the percentage ofcompletion method and look-back may be required upon the completion of the2-2

job. Even though the average annual taxable gross receipts for the prior 3 yearsis less than $10,000,000, the contract is not estimated to be completed with the2-year period. In this example, two methods of accounting for long-termcontracts are proper.The two exceptions provided under IRC § 460(e) do not apply to long-termmanufacturing contracts.Construction Contracts versus Manufacturing ContractsIRC § 460 makes a distinction between the two categories of long-term contracts:construction contracts and certain manufacturing contracts. A construction contractpertains to real property versus a manufacturing contract, which pertains to personalproperty.• Construction Contract Defined: IRC § 460(e)(4) Construction contract. Forpurposes of this subsection, the term "construction contract" means any contract for thebuilding, construction, reconstruction, or rehabilitation of, or the installation of anyintegral component to, or improvements of, real property.• Manufacturing Contract Defined: IRC § 460(f)(2) Special rule formmanufacturing contracts. A contract for the manufacture of property shall not betreated as a long-term contract unless such contract involves the manufacture of- -(A) any unique item of a type which is not normally included in the finished goodsinventory of the taxpayer, or(B) any item which normally requires more than 12 calendar months to complete(without regard to the period of the contract).Treas. Reg. § 1.460-1(b)(1) further distinguishes a long-term constructioncontract from a long-term manufacturing contract:Treas. Reg. § 1.460-1(b)(1) Long-term contract. A long-term contract generally isany contract for the manufacture, building, installation, or construction of propertyif the contract is not completed within the contracting year, as defined in[Regulation § 1.460-1(b)(5)]. However, a contract for the manufacture of propertyis a long-term contract only if it also satisfies either the unique-item or 12-monthrequirements described in § 1.460-2. A contract for the manufacture of personalproperty is a manufacturing contract. In contrast, a contract for the building,installation, or construction of real property is a construction contract.This guide is written primarily for the discussion of construction contracts.2-3

Real Property and its Integral Components under Treas. Reg. § 1.460-3(a)A contract not completed in the contracting year is a long-term construction contract if itinvolves the building, construction, reconstruction, or rehabilitation of real property; theinstallation of an integral component to real property; or the improvement of realproperty (collectively referred to as construction).Real property means land, buildings, and inherently permanent structures, as defined insection 1.263A-8(c)(3), such as roadways, dams, and bridges. Real property does notinclude vessels, offshore drilling platforms, or unsevered natural products of land.An integral component to real property includes property not produced at the site of thereal property but is intended to be permanently affixed to the real property, such aselevators and central heating and cooling systems.Example:A contract to install an elevator in a building is a construction contract because abuilding is real property, but a contract to install an elevator in a ship is not aconstruction contract because a ship is not real property.Example:A taxpayer enters into a contract to manufacture an elevator; however, an unrelatedparty will install it. The contract for the manufacture of the elevator is not a constructioncontract. Even though the elevator is considered an integral component to realproperty, the regulations define a construction contract as one that involves theinstallation of the integral component.Classification of ContractsA taxpayer must determine the classification of a contract on a contract-by-contractbasis as one of the following:• Long-term construction contract,• Long-term manufacturing contract, or• Non-long-term contractTreas. Reg. § 1.460-1(b)(2)(i) clarifies that a contract's classification should be based onthe performance required of the taxpayer under the contract, regardless of whether the2-4

contract would be classified as a sales contract or a construction contract. It is irrelevantwhether title in the property constructed under the contract is delivered to the customer.Treas. Reg. § 1.460-1(b)(2) Contract for the manufacture, building, installation, orconstruction of property. (i) In general. A contract is a contract for themanufacture, building, installation, or construction of property if the manufacture,building, installation, or construction of property is necessary for the taxpayer'scontractual obligations to be fulfilled and if the manufacture, building, installation,or construction of that property has not been completed when the parties enterinto the contract. If a taxpayer has to manufacture or construct an item to fulfillhis obligations under the contract, the fact that the taxpayer is not required todeliver that item to the customer is not relevant. Whether the customer has titleto, control over, or bears the risk of loss from, the property manufactured orconstructed by the taxpayer also is not relevant. Furthermore, how the partiescharacterize their agreement (e.g., as a contract for the sale of property) is notrelevant.Example:A developer, whose taxable year ends December 31, owns 5,000 acres of undevelopedland. To obtain permission from the local county government to improve this land, aservice road must be constructed on this land to benefit all 5,000 acres. In 2000, thedeveloper enters into a contract to sell a 1,000-acre parcel of undeveloped land to aresidential developer, for its fair market value. In this “sales” contract, the developeragrees to construct a service road running through the land that it is selling to theresidential developer. The construction of the service road is estimated to be completedin 2002. The “sales” contract is a construction contract because the construction of anitem (the service road) is necessary for the developer to fulfill its contractual obligations.Note: for contracts entered into after January 10, 2001, de minimus constructionactivities, which are discussed later in this chapter, must also be considered inclassification of the contract.Hybrid ContractsA hybrid contract is a single long-term contract that requires a taxpayer to perform bothmanufacturing and construction activities. Generally, the regulations classify a hybridcontract as two contracts--a manufacturing contract and a construction contract. Treas.Reg. § 1.460-1(f)(2) permits a taxpayer to elect, on a contract-by-contract basis to doeither of the following:• Treat the entire contract as a long-term construction contract if at least 95% ofthe estimated total allocable contract costs are reasonably allocable toconstruction activities.2-5

• Treat the entire contract as a long-term manufacturing contract subject to thepercentage of completion method of accounting. (Note: there is not a 95% rule aswith the election to treat a hybrid contract as a construction contract.)Treas. Reg. § 1.460-1(f)(2) Hybrid contracts - -(i) In general. A long-term contract thatrequires a taxpayer to perform both manufacturing and construction activities (hybridcontract) generally must be classified as two contracts--a manufacturing contract and aconstruction contract. A taxpayer may elect, on a contract-by-contract basis, to classifya hybrid contract as a long-term construction contract if at least 95% of the estimatedtotal allocable contract costs are reasonably allocable to construction activities. Inaddition, a taxpayer may elect, on a contract-by-contract basis, to classify a hybridcontract as a long-term manufacturing contract subject to the [percentage of completionmethod (PCM)].De minimis Construction ActivitiesA contract with de minimis construction activities is not a construction contract underIRC § 460 if the contract includes the provision of land by the taxpayer and theestimated total contract costs attributable to the construction activities are less than10% of the contract's total contract price. For purposes of the 10% test, the cost of theland provided to the customer is not included in the allocable contract costs. Treas.Reg. § 1.460-1(b)(2)(ii).This 10% threshold provides a "bright-line" test. Prior to enactment of the regulation,Notice 89-15 provided that a contract was a construction contract if the constructionactivity required by the contract was necessary for the taxpayer to fulfill its contractualobligations.Example:A developer owns 5,000 acres of undeveloped land with a cost basis of $5,000,000. Toobtain permission from a local county government to improve this land, a service roadmust be constructed on this land to benefit all 5,000 acres. In 2001, the developerenters into a contract to sell a 1,000-acre parcel of undeveloped land to a residentialdeveloper for $10,000,000. In the sales contract, there is a provision that commits thetaxpayer to construct the portion of the service road that benefits the acreage sold, asrequired by the local county government. The portion of the cost of the service roadattributable to the 1,000-acre parcel is estimated to be $10,000. The service road is notcompleted until 2002. Because the estimated total allocable contract costs attributableto the construction activities ($10,000) are less than 10% of the total contract price($10,000,000), the contract is not a construction contract, and is not to be accounted forunder a long-term contract method.2-6

Non-Long-Term Contract Activities (e.g., Architect, Engineer Services)Long-term contract methods of accounting apply only to the gross receipts and costsattributable to long-term contract activities. Non-long-term contract activities are definedin Treas. Reg. § 1.460-1(d)(2).Treas. Reg. § 1.460-1(d)(2) Non-long-term contract activity. Non-long-termcontract activity means the performance of an activity other than manufacturing,building, installation, or construction, such as the provision of architectural,design, engineering, and construction management services, and thedevelopment or implementation of computer software. In addition, performanceunder a guaranty, warranty, or maintenance agreement is a non-long-termcontract activity that is never incident to or necessary for the manufacture orconstruction of property under a long-term contract.Several revenue rulings have held that contracts for services cannot use a long-termmethod of accounting:• An architect is not entitled to report income from contracts extending over morethan one year on the completed contract method because the work is in thenature of personal service. (Rev. Rul. 70-67, 1970-1 C.B. 117)• Engineering services and construction management, unrelated to theconstruction contractor, are not entitled to use either the completed contractmethod or percentage of completion method because the contract does notrequire the taxpayer to construct or build anything, even though the services arefunctionally related. (Rev. Rul. 82-134, 1982-2 C.B. 88; Rev. Rul. 80-18, 1980-1C.B. 103)• A painting contractor cannot use the completed contract method because heprovides only painting services. (Rev. Rul. 84-32, 1984-1 C.B. 129)However, if the performance of a non-long-term contract activity is incident to ornecessary for the manufacture, building, installation, or construction of the subjectmatter of one or more of the taxpayer's long-term contracts, the gross receipts andcosts attributable to that activity must be allocated to the long-term contract. Treas.Reg. § 1.460-1(d) requires allocation of the contract’s gross receipts and costs amongthe activities.Treas. Reg. § 1.460-1(d) Allocation among activities - - (1) In general. Long-termcontract methods of accounting apply only to the gross receipts and costsattributable to long-term contract activities. Gross receipts and costs attributableto long-term contract activities means amounts included in the total contract priceor gross contract price, whichever is applicable, as determined under § 1.460-4,and costs allocable to the contract, as determined under § 1.460-5. Gross2-7

easonably expected to be used in the production of the subject matter of therelated party's contract.Treas. Reg. § 1.460-1(b)(4) defines a related party as a person whose relationship to ataxpayer is described in IRC § 707(b) or § 267(b) which includes:• A partnership and a person owning, directly or indirectly, more than 50 percent ofthe capital interest, or the profits interest, in such partnership.• Two partnerships in which the same persons own, directly or indirectly, morethan 50 percent of the capital interests or profits interests.• Members of a family, including only brothers and sisters (whether by the whole orhalf blood), spouse, ancestors, and lineal descendants.• An individual and a corporation, more than 50 percent in value of the outstandingstock of which is owned, directly or indirectly, by or for such individual.• Two corporations which are members of the same controlled group.• A grantor and a fiduciary of any trust.• A fiduciary of a trust and a fiduciary of another trust, if the same person is agrantor of both trusts.• A fiduciary of a trust and a beneficiary of such trust.• A fiduciary of a trust and a beneficiary of another trust, if the same person is agrantor of both trusts.• A fiduciary of a trust and a corporation more than 50 percent in value of theoutstanding stock of which is owned, directly or indirectly, by or for the trust or byor for a person who is a grantor of the trust.• A person and an organization to which section 501 (relating to certaineducational and charitable organizations which are exempt from tax) applies andwhich is controlled directly or indirectly by such person or (if such person is anindividual) by members of the family of such individual.• A corporation and a partnership if the same persons own--more than 50 percentin value of the outstanding stock of the corporation, and more than 50 percent ofthe capital interest, or the profits interest, in the partnership.• An S corporation and another S corporation if the same persons own more than50 percent in value of the outstanding stock of each corporation.2-9

• An S corporation and a C corporation, if the same persons own more than 50percent in value of the outstanding stock of each corporation• Except in the case of a sale or exchange in satisfaction of a pecuniary bequest,an executor of an estate and a beneficiary of such estate.Example:An architectural firm enters into a contract with a customer to design an office building.The contract is for the performance of services, and therefore would not be classified asa long-term construction contract. If, however, the architect's related constructioncompany enters into a contract with the same customer to build this "designed" building,and the construction company is required to account for the long-term constructioncontract under the PCM, the architect must account for the design services under PCMsince the services are incidental to the related construction company's contract.Severing and Aggregating ContractsUnder IRC § 460(f)(3), contractors are permitted and may be required to sever oraggregate contracts. Severance treats one agreement as two or more contracts.Aggregation treats two or more agreements as one contract. Whether an agreementshould be severed, or two or more agreements should be aggregated, depends, withcertain exceptions, on the following factors as provided in Treas. Reg. § 1.460-1(e):• Pricing. Independent pricing of items in an agreement is necessary for theagreement to be severed into two or more contracts.• Separate delivery or acceptance. An agreement may not be severed into two ormore contracts unless it provides for separate delivery or separate acceptance ofitems that are the subject matter of the agreement. The separate delivery orseparate acceptance of items by itself does not, however, necessarily require anagreement to be severed.• Reasonable business person. Two or more agreements to performmanufacturing or construction activities may not be aggregated into one contractunless a reasonable business person would not have entered into one of theagreements for the terms agreed upon without also entering into the otheragreement(s).A taxpayer may not sever a long-term contract that would be subject to the percentageof completion method without obtaining the Commissioner's prior written consent.2-10

Treas. Reg. § 1.460-1(e)(3). Exceptions- - (i) Severance for PCM. A taxpayer may notsever under this paragraph (e) a long-term contract that would be subject to the PCMwithout obtaining the Commissioner's prior written consent.In the case of options and change orders, subject to the above Treasury Regulation,a taxpayer must sever an agreement that increases the number of units to be suppliedto the customer, such as through the exercise of an option or the acceptance of achange order, if the agreement provides for separate delivery or separate acceptance ofthe additional units.Example of Severance:On January 1, 2001, a construction contractor enters into an agreement to build twooffice buildings in different areas of a large city. The agreement provides that the twooffice buildings will be completed and accepted by the customer in 2002 and 2003,respectively, and that the contractor will be paid $1 million and $1.5 million for the twooffice buildings, respectively. The agreement will provide a reasonable profit from theconstruction of each building. Unless the contractor is required to use the PCM toaccount for the contract, the contractor is required to sever this contract because thebuildings are independently priced, the agreement provides for separate delivery andacceptance of the buildings, and, as each building will generate a reasonable profit, areasonable business person would have entered into separate agreements for theterms agreed upon for each building.Example of Aggregation:In 2001, a contractor enters into two separate contracts, as the result of a singlenegotiation, to construct two identical special use buildings (i.e. nuclear plant). Becausethe contractor has never constructed this type of building before, the contractoranticipates that it will incur substantially higher costs to construct the first building. If theagreements are treated as separate contracts, the first contract probably will produce asubstantial loss, while the second contract probably will produce substantial profit.Based upon these facts, aggregation is required because the buildings areinterdependently priced and a reasonable business person would not have entered thefirst agreement without also entering into the second.Example of Contract Options:A contractor enters into a contract with a developer to construct 10 homes on landowned by the developer to be built in year 1. The contract provides an option in whichthe contractor is to build an additional 10 homes. In year 2, the option is exercised andthe additional homes are built. The option would be severed from the original contract.2-11

ConclusionThe construction industry is both unique and complex with respect to the number ofavailable tax methods of accounting. The proper method of accounting for a long-termconstruction contract is determined contract-by-contract based on the type and terms ofthe contract, along with related party considerations.Chapter 1 / Table of Contents / Chapter 3Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search2-12

Chapter 2 / Table of Contents / Chapter 4Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 3: Small Construction ContractorsIntroductionIRC § 460 was enacted as part of the Tax Reform Act of 1986, which requires theuse of percentage of completion method for long-term construction contracts.However, as with many Code sections, there are exceptions to the required use ofthe percentage of completion accounting method and to the application of “look-back”interest rules. The exceptions are the home construction contract and the smallconstruction contract. This chapter will provide an overview of the methods ofaccounting that are available to small construction contractors ─ cash, accrual,completed contract, and exempt percentage of completion. Specific accountingmethods for home construction contracts and large construction contracts (i.e.,contracts that do not meet one of the two exceptions of IRC § 460) will be discussedin later chapters.Exceptions to the Required Use of the Percentage of CompletionAccounting Method and Look-back InterestIRC § 460(e) provides two exceptions to the required use of the percentage ofcompletion accounting method and application of the look-back interest rules applicableto certain construction contracts. (These exceptions do not apply to long-termmanufacturing contracts.)1. The home construction contract.2. The small contractor exception. In order to meet the small construction contractexception contained in IRC §460(e)(1)(B), two requirements must be met:− At the time the contract was entered, it was estimated that the contractwould be completed within a 2-year period beginning on thecommencement date of the contract; and− The contractor’s average annual gross receipts for the 3 taxable yearspreceding the year in which the contract was entered did not exceed $10million.IRC § 460(e) EXCEPTION FOR CERTAIN CONSTRUCTION CONTRACTS.--460(e)(1) IN GENERAL.--Subsections (a), (b), and (c)(1) and (2)shall not apply to--460(e)(1)(A) any home construction contract, or3-1

460(e)(1)(B) any other construction contract entered into by ataxpayer--460(e)(1)(B)(i) who estimates (at the time such contract is enteredinto) that such contract will be completed within the 2-year periodbeginning on the contract commencement date of such contract,and460(e)(1)(B)(ii) whose average annual gross receipts for the 3taxable years preceding the taxable year in which such contract isentered into do not exceed $10,000,000.In the case of a home construction contract with respect to whichthe requirements of clauses (i) and (ii) of subparagraph (B) are notmet, section 263A shall apply notwithstanding subsection (c)(4)thereof.Example of 2-year requirement not being met:The taxpayer’s average annual gross receipts are less than $10,000,000 for the prior 3taxable years. The taxpayer enters into two different jobs, which are not homeconstruction contracts. Job 1 is expected to last 18 months. Job 2 is expected to last 3years. The taxpayer would account for Job 1 under its normal method of accounting forlong-term contracts (accrual, completed contract, or percentage of completion).However the taxpayer must account for Job 2 using the percentage of completionmethod as required by IRC § 460.Production Period InterestEven though small contractors are otherwise exempt from the requirements of IRC §460 (i.e. reporting using PCM and applying the look-back interest rules) the interestcapitalization rules of IRC § 460(c)(3) are applicable to all contractors. IRC § 460(e)(1)only exempts the small contractor from subsections (a), (b), and (c)(1).$10 Million Gross Receipts TestIncome from all trades or businesses (whether or not incorporated) that are under thecommon control with the taxpayer are considered in determining the gross receipts test.This is an area that is often overlooked with small construction contractors. Eachreturn of a related group of tax returns may appear to qualify for the small contractorsexception, but, once the gross receipts of all related entities are aggregated, theexception is not met. Therefore, the IRC § 460 requirements of the use of thepercentage of completion method and application of “look-back” may apply to each“small contractor”.IRC §460(e)(2) DETERMINATION OF TAXPAYER’S GROSS RECEIPTS.--Forpurposes of paragraph (1), the gross receipts of--3-2

460(e)(2)(A) all trades or businesses (whether or not incorporated) whichare under common control with the taxpayer (within the meaning ofsection 52(b)),460(e)(2)(B) all members of any controlled group of corporations of whichthe taxpayer is a member, and460(e)(2)(C) any predecessor of the taxpayer or a person described insubparagraph (A) or (B), for the 3 taxable years of such personspreceding the taxable year in which the contract described in paragraph(1) is entered into shall be included in the gross receipts of the taxpayerfor the period described in paragraph (1)(B). The Secretary shallprescribe regulations which provide attribution rules that take intoaccount, in addition to the persons and entities described in thepreceding sentence, taxpayers who engage in construction contractsthrough partnerships, joint ventures, and corporations.The gross receipts test looks to the prior 3 taxable years rather than including the taxyear during which the contract was entered. This enables the contractor at thecommencement of the contract to know whether or not it must be reported using thepercentage of completion method, and can adjust the accounting system accordingly. Ifa taxpayer has been in existence for less than the three taxable years, the taxpayerdetermines its average annual gross receipts for the number of taxable years (includingshort taxable years) that the taxpayer (or its predecessor) has been in existence.Treas. Reg. § 1.460-3(b)(3) directs the taxpayer to §1.263A-3(b) to determine whatitems are included for this gross receipts test. Gross receipts are the totalamount, as determined under the taxpayer’s method of accounting, derived fromall trades or businesses. Gross receipts does not include (not all inclusive):• returns or allowances;• interest, dividends, rents, royalties, or annuities, not derived in theordinary course of a trade or business;• Receipts from the sale or exchange of capital assets.Explanation of a Controlled GroupTwo or more corporations whose stock is substantially held by five or fewer personscompose a “controlled group”. These groups include “brother-sister” controlled groups,parent-subsidiary groups, combined groups, and insurance companies. Members of acontrolled group are subject to related party transaction rules (i.e., income/deductionmatching and loss deferrals on sales between members).Example of aggregation of gross receipts for a controlled group:Mr. A is the sole shareholder of two corporations. Corporation A operates a roofinstallation business. Corporation B operates a grocery store. The gross receipts from3-3

oth businesses are considered when determining the $10,000,000 average grossreceipts test per IRC § 460(e)(1)(B)(ii).Example of a controlled group:Building Corporation has four unrelated shareholders, each owning 25% of the stock.The same four shareholders also own 25% each of Bridge Corporation. Building andBridge corporations are related parties.Attribution of gross receipts of less than controlling interestA contractor that has less than 50% ownership but more than 5% ownership mustaggregate a proportionate share of the construction-related receipts in determination ofthe $10,000,000 test.Treas. Reg. 1.460-3(b)(3) $10,000,000 gross receipts test--(i) In general.Except as otherwise provided in paragraphs (b)(3)(ii) and (iii) of thissection, the $10,000,000 gross receipts test is satisfied if a taxpayer’s (orpredecessor’s) average annual gross receipts for the 3 taxable yearspreceding the contracting year do not exceed $10,000,000, asdetermined using the principles of the gross receipts test for smallresellers under §1.263A-3(b).(ii) Single employer. To apply the gross receipts test, a taxpayer is notrequired to aggregate the gross receipts of persons treated as a singleemployer solely under section 414(m) and any regulations prescribedunder section 414.(iii) Attribution of gross receipts. A taxpayer must aggregate aproportionate share of the construction-related gross receipts of anyperson that has a five percent or greater interest in the taxpayer. Inaddition, a taxpayer must aggregate a proportionate share of theconstruction-related gross receipts of any person in which the taxpayerhas a five percent or greater interest. For this purpose, a taxpayer mustdetermine ownership interests as of the first day of the taxpayer’scontracting year and must include indirect interests in any corporation,partnership, estate, trust, or sole proprietorship according to principlessimilar to the constructive ownership rules under sections 1563(e), (f)(2),and (f)(3)(A). However, a taxpayer is not required to aggregate under thisparagraph (b)(3)(iii) any construction-related gross receipts required to beaggregated under paragraph (b)(3)(i) of this section.Example of $10,000,000 test for attribution of gross receipts:3-4

Bob owns 100% of Building Corporation, which has average annual gross receipts of$8,000,000. Bob also owns 10% of Construction Corporation, which has averageannual gross receipts of $25,000,000. The aggregate gross receipts, for IRC § 460purposes, of Building Corporation are $10,500,000 ($8,000,000 + (25,000,000 x 10%)).Therefore, Building Corporation would be required to account for its long-termconstruction contracts under the percentage of completion method.Determining The Proper Method Of Accounting For Small ContractorsIt is important to note that within the construction industry, a contractor will normallyhave, as a minimum, at least two methods of accounting: an overall method ofaccounting (cash, accrual, or hybrid) and one or more methods for its long-termcontracts (completed contract, percentage of completion, percentage of completioncapitalized cost method). The small contractor’s exception must be determined on acontract-by-contract basis.Example of Several Methods of Accounting Used by One Contractor:A small contractor uses the accrual method of accounting as its overall method toaccount for short-term contracts and the income and expenses not related to long-termcontracts. The contractor uses the completed contract method for its exempt contractsand must use the percentage of completion method for the contracts that are estimatedto exceed 2 years.Rev. Rul. 92-28 I.R.B. 1992-15,41, (Apr. 13, 1992) - IRC § 460(e)(1) permits a taxpayerto use different methods of accounting for exempt and nonexempt contracts within thesame trade or business.General Rule for Accounting MethodsIRC § 446 provides for the general rule for the methods of accounting that are availableto the taxpayer.IRC section 446 General Rule for Methods of Accounting446(a) GENERAL RULE.--Taxable income shall be computed under the method of accounting onthe basis of which the taxpayer regularly computes his income in keepinghis books.446(b) EXCEPTIONS.--If no method of accounting has been regularly used by the taxpayer, or ifthe method used does not clearly reflect income, the computation oftaxable income shall be made under such method as, in the opinion ofthe Secretary, does clearly reflect income.446(c) PERMISSIBLE METHODS.--3-5

Subject to the provisions of subsections (a) and (b), a taxpayer maycompute taxable income under any of the following methods ofaccounting--446(c)(1) the cash receipts and disbursements method;446(c)(2) an accrual method;446(c)(3) any other method permitted by this chapter; or446(c)(4) any combination of the foregoing methods permitted underregulations prescribed by the Secretary.IRC § 446 allows the cash method of accounting and the accrual method of accounting.The other methods that IRC § 446(c)(3) references for construction contracts would be,namely, the completed contract method and the percentage of completion method.Methods of AccountingBecause long-term methods of accounting are determined on a contract-by-contractbasis, a taxpayer potentially could be reporting long-term contracts under severalmethods of accounting. The choice of a proper method of accounting for long-termcontracts is complex. The methods available to a contractor to account for the incomeand expenses of a long-term contract are as follows:CashAccrualHybridAccrual with deferred retainagesCompleted contract method (CCM)Exempt-contract percentage of completion method (EPCM)Percentage of completion method (PCM) (cost-to-cost) as required byIRC § 460*Percentage of completion simplified cost method *Percentage of completion 10% method *Percentage of completion capitalized cost method (PCCM) **These methods are discussed in Chapter 4 Large Construction ContractorsSelecting an Accounting MethodIf a contractor is exempt from the percentage-of-completion method under IRC3-6

§ 460, the contractor may adopt a method of accounting for its long-term contracts onthe initial income tax return, or in the first year it has long-term contracts. Once amethod of accounting is adopted, this method must be used for all long-term contractsin the same trade or business. Generally, a change is not permitted without obtainingprior permission from the Commissioner.Cash Method of AccountingGenerally, the cash method of accounting is an acceptable method for smallcontractors. However, there are limitations on the use of the cash method.IRC § 448 prohibits the use of the cash method by "C" corporations and partnershipswith a "C" corporation partner, unless such entities have annual gross receipts that donot exceed $5 million. This section also prohibits use of the cash method by all taxshelters.IRC § 448 does not allow the use of the cash method. It merely limits the use of thecash method for certain entities.Example:An S Corporation that files a Form 1102-S is not subject to the $5 million gross receiptslimitation of I.R.C. § 448. An S corporation that has gross receipts of $50 million mayuse the cash method of accounting as long as there are no other sections prohibiting it(e.g., taxpayer required to use accrual method to account for inventory; IRC § 460requires the use of PCM for long-term contracts).Cash vs. Accrual IssueIn prior years, the IRS won many cases supporting the change from cash to accrualwhen merchandise was considered an income-producing factor. Treasury RegulationSection 1.446-1(c)(2)(i) requires the use an accrual method of accounting, if thetaxpayer is required to account for inventories per IRC § 471. Treasury Regulation§1.471-1 requires an accounting of inventory in every case in which the production,purchase, or sale of merchandise is an income-producing factor.After much litigation in this area, a safe harbor allowing the use of the cash method (viaRevenue Procedure 2001-10 and Revenue Procedure 2002-28) was provided totaxpayers that would otherwise have been required to use an accrual method ofaccounting.Revenue Procedure 2001-10Revenue Procedure 2001-10 permits eligible small businesses (with average grossreceipts equal to or less than $1 million) to use the cash method when an accrual3-7

method would normally be required by IRC § 471 due to inventory. Revenue Procedure2001-10 was issued on January 8, 2001. The Commissioner provided administrativerelief from the requirements of IRC § 471 and Treas. Reg. § 1.446-1(c)(2)(i) to certainsmall taxpayers. This revenue procedure allows qualifying taxpayers (including thosethat provide goods and services to their customers) with average annual gross receiptsof $1 million or less to use the cash method.However, contractors that qualify under this revenue procedure must treat certain property asnon-incidental materials and supplies, as defined under Treas. Reg. § 1.162-3. The taxpayercannot deduct these expenses until the later of the year in which payment for them was made orthe year in which the materials and supplies are actually used or consumed in the taxpayer'sbusiness. In other words, even though the cash method is an acceptable method, the contractorstill has some type of accounting for inventories. See the discussion later in this chapterpertaining to non-incidental materials and supplies.Revenue Procedure 2002-28On May 6, 2002, Revenue Procedure 2002-28 was issued. This guidance allows a“qualifying” small business taxpayer, with average annual gross receipts of $10 millionor less, to use the cash receipts and disbursements method of accounting with respectto an eligible trade or business.Gross Receipts Test for Revenue Procedure 2001-10 & Revenue Procedure 2002-28Similar to IRC § 460, the gross receipts test uses the average annual taxable grossreceipts for the prior three taxable years. However, the definition of gross receipts forthese two revenue procedures differs from IRC § 460. IRC § 460 gross receipts doesnot include returns and allowances, interest, dividends and rents. Both RevenueProcedures 2001-10 and 2002-28 define gross receipts to include total sales (net ofreturns and allowances), all amounts received from services, interest, dividends, andrents.What is a Qualifying Taxpayer Under Revenue Procedure 2002-28?The average annual gross receipts for the 3 prior years must be $10,000,000 or lessand the taxpayer’s principal business activity must be a North American IndustryClassification System (NAICS) code other than one of the ineligible NAICS codes listedin the Revenue Procedure:• Mining (NAICS 211 and 212)• Manufacturing (NAICS 31 – 33)• Wholesale Trade (NAICS 42)• Retail Trade (NAICS 44 and 45)• Information Industries (NAICS 5111 and 5122)3-8

Revenue Procedure 2002-28 does not override IRC § 448. C corporations orpartnerships with a C corporate partner with average annual gross receipts greater than$5 million cannot use the cash method of accounting. Neither does the RevenueProcedure override IRC § 460. Long-term construction contracts (contracts expectedto require more than 2 years) that are not home construction contracts must beaccounted for under the percentage of completion method.Another important qualification is that the taxpayer cannot have previously changedfrom the cash to the accrual method as a result of becoming ineligible to use the cashmethod under this revenue procedure.Rev. Proc. 2002-28 Section 4.01 (1) A qualifying small business taxpayermay use the cash method as described in this revenue procedure for all of itstrades or businesses if the taxpayer satisfies any one of the following threetests and did not previously change (and was not previously required to havechanged) from the cash method to an accrual method for any trade orbusiness as a result of becoming ineligible to use the cash method under thisrevenue procedure.Revenue Procedure 2002-28 and InventoryA taxpayer that is required to account for inventories under IRC § 471 have threeoptions:1. Can use overall cash method and account for inventories under IRC§ 471.2. Can use overall accrual method and account for inventories as materials andsupplies that are not incidental under Treasury Regulation Section 1.162-3 (notdeductible until used or consumed in business).3. Can use overall cash method and account for inventoriable items the same asmaterials and supplies that are not incidental under Treasury Regulation Section1.162-3.If the taxpayer chooses to treat materials under Treasury Regulation Section 1.162-3,they are not subject to IRC Section 263A.Non-Incidental Material and SuppliesAn inventoriable item is any item that is either purchased for resale to customers orused as a raw material in producing finished goods. Inventoriable items that are treatedas non-incidental material and supplies, per Rev. Proc. 2002-28, are deductible in thelater of the tax year in which payment is made for them or in the tax year in which theyare actually used and consumed.3-9

Rev. Proc. 2002-28 Section 6 Example 15--Timing of Deduction forInventoriable Items Treated as Non-Incidental Materials and SuppliesUnder §1.162-3 --Construction. Taxpayer is a roofing contractor that iseligible to use the cash method under this revenue procedure. Taxpayerchooses to use the cash method and to account for inventoriable items asnon-incidental materials and supplies under §1.162-3. Taxpayer entersinto a contract with a homeowner in December 2001 to replace thehomeowner’s roof. Taxpayer purchases roofing shingles from a localsupplier and has them delivered to the homeowner’s residence. Taxpayerpays the supplier $5,000 for the shingles upon their delivery later thatmonth. Taxpayer replaces the homeowner’s roof in December 2001, andgives the homeowner a bill for $15,000 at that time. Taxpayer receives acheck from the homeowner in January 2002. The shingles are nonincidentalmaterials and supplies. The cost of the shingles is deductible inthe year Taxpayer uses and consumes the shingles or actually pays forthe shingles, whichever is later. In this case, Taxpayer both pays for theshingles and uses the shingles (by providing the shingles to the customerin connection with the performance of roofing services) in 2001. Thus,Taxpayer deducts the $5,000 cost of the shingles on its 2001 federalincome tax return. Taxpayer includes the $15,000 in income in 2002 whenit receives the check from the homeowner.Rev. Proc. 2002-28 Section 6 Example 16--Timing of Deduction forInventoriable Items Treated as Non-Incidental Materials and SuppliesUnder §1.162-3 --Construction. Same as in Example 15, except thatTaxpayer does not replace the roof until January 2002 and is not paid untilMarch 2002. Because the shingles are not used until 2002, their cost canonly be deducted on Taxpayer’s 2002 federal income tax returnnotwithstanding that Taxpayer paid for the shingles in 2001. Thus, on its2002 return, Taxpayer must report $15,000 of income and $5,000 ofdeductions.Revenue Procedure 2002-28 and Contractors Building Property to Sell on LandThey OwnA contractor that meets the requirements of Revenue Procedure 2001-10 or 2002-28 ispermitted to use the cash method of accounting. However, these revenue proceduresdo not apply to a contractor to the extent it enhances the value of land it owns bybuilding structures it intends to sell. Such contractors are not permitted to immediatelydeduct the costs of this construction. These costs must be capitalized, and willeventually be offset against the sales price of the land and its improvements (the latterbecoming real property as they are completed).IRC § 263(a)(1) and Treas. Reg. § 1.263(a)-1 generally prohibit deductions for anyamount that a taxpayer pays for new buildings or for permanent improvements or3-10

etterments that increase the property’s value. Treas. Reg. § 1.263(a)-2 sets forthexamples of capital expenditures, including the cost of acquisition, construction, orerection of buildings. Consequently, the taxpayer-contractor must capitalize expensesin connection with real property construction on its own land, including construction ofproperty that it intends to sell.The purpose of Revenue Procedures 2001-10 and 2002-28 is to provide qualifyingsmall taxpayers an exception to the required accrual method (under IRC § 446) whenthe taxpayer is required to account for inventories per IRC § 471. However, a taxpayercontractorbuilding on its own land for the purpose of selling the property constructed isproducing or constructing a real property asset that it cannot inventory. See W.C. &A.N. Miller Development Company v. Commissioner 81 T.C. 619 (1983); Pierce v.Commissioner, T.C. Memo.1997-411 (1997); Rev. Rul. 86-149, 1986-2 C.B. 67.Revenue Procedure 2002-28, section 4.02, and Revenue Procedure 2001-10, section 4,provide inventory options that do not apply to expenses related to construction oftaxpayer-owned real property. If the taxpayer has expenses related to inventoriableitems that are not required to be capitalized (and are not related to construction oftaxpayer-owned real property), it can choose from the applicable revenue procedure’sinventory options. The taxpayer can still use the overall cash method so long as it meetsthe definitions of a qualifying small taxpayer. Under the cash method, the taxpayer candeduct business expenses that are not required to be capitalized, the later of when itpays them, sells the expense items, or uses the items for the customer, rather thanwhen accrued. Similarly, the taxpayer would recognize income upon receipt (subject toapplicable special rules, such as IRC § 1001), rather than when accrued.Example 17 of Revenue Procedure 2002-28 illustrates that a taxpayer-contractor mustcapitalize building costs that occur on its own land and are attributable to property that itholds for sale, rather than deduct or inventory them.Rev. Proc. 2002-28 Section 6 Example 17--Timing of Deduction forNon-Inventoriable Items--Speculative Home Sales. Taxpayer is eligibleto use the cash method as described in this revenue procedure. Taxpayeris a speculative builder of houses that are built on land it owns. In 2001,Taxpayer builds a house using various items such as lumber, piping, andmetal fixtures that it had paid for in 2000. In 2002, Taxpayer sells thehouse to a buyer. Because the house is real property held for sale byTaxpayer, the house and the material used to build the house are notinventoriable items under this revenue procedure. Thus, Taxpayer may notaccount for the items used to build the house as non-incidental materialsand supplies under § 1.162-3. Rather, Taxpayer must capitalize the costsof the lumber, piping, metal fixtures and other goods used by Taxpayer tobuild the house under § 263. Upon the sale of the house in 2002, the costscapitalized by Taxpayer will be offset against the house sales price todetermine Taxpayer’s gain or loss from the sale.3-11

Example 18 of Revenue Procedure 2002-28 emphasizes the importance of determiningthe ownership of the property that the taxpayer builds.Rev. Proc. 2002-28 Section 6 Example 18--Timing of Deduction forInventoriable Items Treated as Non-Incidental Materials and SuppliesUnder § 1.162-3 --Construction. Same as in Example 17, except that (1)Taxpayer builds houses on land its customers own, and (2) the houses arebuilt in three months with payment due at completion. Because Taxpayerdoes not own the house, the lumber, piping, metal fixtures and other goodsused by Taxpayer in the provision of construction services areinventoriable items, not real property held for sale. Taxpayer elects to treatthe goods used to build the house as non-incidental materials and suppliesunder § 1.162-3. Taxpayer must deduct the cost of the lumber, piping,metal fixtures and other non-incidental materials and supplies that are usedby it to build the house in 2001 (the year those items were used byTaxpayer to build the house) notwithstanding that Taxpayer had paid forthe items in 2000. Taxpayer will report income it receives from its customeras the income is actually or constructively received.Summary of Accounting MethodsConstruction TaxpayersAverage Annual Gross ReceiptsGross Receipts < $1 MillionAll entities except C corporations &Partnerships w/ C corporationpartners -Gross Receipts > $1 Million and $5 MillionEntities with gross receipts 2 years.Use of Cash Method?***Rev. Proc. 2001-10 and Rev.Proc. 2002-28 allows CashMethod but must account forinventories per IRC § 471 or asnon-incidental materials andsupplies per Treas. Reg. 1.162-3.Rev. Proc. 2002-28 allows CashMethod but must account forinventories per IRC § 471 or asnon-incidental materials andsupplies per Treas. Reg. 1.162-3.IRC § 448 prohibits use of CashMethodIRC § 460 requires the use ofPCM for long-term contracts thatare not exempt per IRC § 460(e).3-12

All Entities with long-term contracts -Gross Receipts > $10 MillionIRC § 460 requires use of PCMfor long-term contracts (withexception of home constructioncontracts)*** Rev. Proc. 2002-28 can apply to taxpayers with average annual gross receipts of 10million dollars or less, but excludes certain types of businesses; whereas, Rev. Proc.2001-10 can only apply to taxpayers with average annual gross receipts of one milliondollars or less, but INCLUDES many types of businesses that Rev. Proc. 2002-28excludes.Computation of the Cash Method of AccountingThe general rule (as shown in Treas. Reg. §1.446-1(c)(1)(i)) requires the taxpayer toreport income when received and to deduct expenses when paid. Income may beactually or constructively received. Constructive receipt occurs when the taxpayer hasunrestricted access to income that has been earned. Treas. Reg.1.461-1(a)(1) provides,as a general rule, that a cash basis taxpayer shall deduct expenses in the year ofpayment. It further provides, however, that where an expenditure results in the creationof an asset having a useful life extending “substantially” beyond the close of the taxableyear, such an expenditure may not be deductible, or may be deductible only in part, forthe taxable year in which made. In Zaninovich, 616 F.2d 429, the appellate courtadopted the “one-year rule”, on a cash basis taxpayer, distinguishing between currentlydeductible expenses and capital expenditures having a useful life extending“substantially beyond” the taxable year. The court allowed a full deduction for prepaidrent in the year of payment and did not require it to be deducted on a prorated basis.Example of constructive receipt:A general contractor contacted a subcontractor and offered payment for a job recentlycompleted in December of Year 1. The subcontractor did not pick up the check untilJanuary of Year 2. The subcontractor would be required to report the income in Year 1,because it had been constructively received.Accrual Method of AccountingFor book purposes, the contractor generally includes revenue in gross income when it isbillable under the contract. For tax purposes, however, the general principle is thatincome is included upon the first event fixing the taxpayer's right to receive incomeunder IRC § 451, and must be determined under the terms of each particular contract.The relevant test is commonly called the "all-events test." All events that fix the right toreceive income occur at the earliest of the following:• When the required performance occurs3-13

• When payment is due• When payment is madeSee Rev. Rul. 2003-10, Rev. Rul. 84-31; Rev. Rul. 83-106; Rev. Rul. 81-176; Rev. Rul.80-308; Rev. Rul. 79-292; Rev. Rul. 79-195.In Boise-Cascade Corp, 530 F.2d 1367, cert denied, 429 US 867, the Court of Claimspermitted the accrual of income based on the work performed and not upon billingentitlement.Front-loading BillingsFront-loading billings is common in the construction industry. The taxpayer may requirepayment of 30 percent “up front” before the contract begins to cover the cost of thematerials needed at the job site. Under the accrual method, the 30 percent is incomewhen it is received under the contract, even though no performance of the job has beenincurred.Exception to Reporting Advance Payments in Year of ReceiptAs previously mention, accrual method taxpayers generally include advance paymentsfor services in the year of receipt. An accrual-method taxpayer may, however, elect theprovisions of Revenue Procedure 71-21, which defers the advance payments forservices until the next tax year. This election is available only for advance paymentsfor services to be performed within the next 12 months.Rev. Proc. 71-21--Section 3.02 An accrual-method taxpayer who, pursuantto an agreement (written or otherwise), receives a payment in one taxableyear for services, where all of the services under such agreement arerequired by the agreement as it exists at the end of the taxable year of receiptto be performed by him before the end of the next succeeding taxable year,may include such payment in gross income as earned through theperformance of the services, subject to the limitations provided in RevenueProcedure 71-21 §§3.07, 3.08, and 3.11. If the inclusion in gross income ofpayments received is properly deferred under the preceding sentence, and forany reason a portion of such services is not performed by the end of the nextsucceeding taxable year, however, the amount allocable to the services notso performed must be included in gross income in such next succeeding year,regardless of when (if ever) such services are performed.Example of Advance Payments pursuant to Rev. Proc. 71-21:On June 1, 2000, B, a calendar-year accrual-method taxpayer, who is alandscape architect, receives full payment for services, which, under the terms ofthe agreement, must be completed by December 31, 2001. On December 31,2000, B estimates that three-fourths of the work under the agreement has been3-14

completed. Under the method prescribed in Section 3.02 of Rev. Proc. 71-21, Bmust include three-fourths of the payment in 2000, but may choose to include theother one-fourth in income in either 2000 or 2001.Deducting Expenses under the Accrual Method of AccountingUnder the accrual method of accounting, expenses are deductible when all events haveoccurred that establish the fact of the liability, the amount can be determined withreasonable accuracy, and economic performance has occurred.Reg. §1.446-1(c)(1)(ii) Accrual method. (A) Generally, under an accrual method,income is to be included for the taxable year when all the events have occurred thatfix the right to receive the income and the amount of the income can be determinedwith reasonable accuracy. Under such a method, a liability is incurred, andgenerally is taken into account for Federal income tax purposes, in the taxable yearin which all the events have occurred that establish the fact of the liability, theamount of the liability can be determined with reasonable accuracy, and economicperformance has occurred with respect to the liability.The regulations define when economic performance has been met.Treas. Reg. §1.461-4(d)(2)Services or property provided to the taxpayer.(i) In general. Except as otherwise provided in Regulation §1.461-4(d)(5), ifthe liability of a taxpayer arises out of the providing of services or property tothe taxpayer by another person, economic performance occurs as theservices or property is provided.Accrual Method and RetainagesRetainages that are withheld from a contractor are generally included in income as thework, related to the retained amounts, is provided. The amounts have been earned.However Revenue Ruling 69-314 allows an accrual-basis taxpayer to elect to defer theretainages withheld until they are billable under the terms of the contract, which isnormally when the contractor has the right to receive the retention. The contractor mustalso defer retainages payable.If the taxpayer is not currently deferring the retainages and wants to elect this provisionunder Revenue Ruling 69-314, it is a change in method of accounting that requires theCommissioner’s permission.Retainages that the contractor withholds on subcontractors is not deductible until the“all-events” test is met. Therefore, even though economic performance has occurred(i.e. the subcontractor has completed a portion of the work) the all events test withrespect to the retainage may not be established if the contract requires full acceptanceand completion.3-15

Example of Retainage Payable:A contractor hires a subcontractor and the contract requires a $1,500,000.00 totalpayment and a 10% retainage. The retainage is not payable until full acceptance andcompletion of the job. The subcontractor completes 1/3 of the job and bills thecontractor for $500,000. The contractor withholds10% and pays the subcontractor $ 450,000. The contractor can only deduct $450,000,because all events that establish the fact of the liability in regards to the $50,000 havenot occurred. If the subcontractor fails to complete the job or completes the jobunsatisfactorily, the $50,000 does not have to be paid per the terms of the contract.Completed Contract Method (CCM)Taxpayers may elect the CCM to account for their exempt contracts. The general rule isthat all contract income and contract related expenses (both direct and indirect) aredeferred until the taxable year that the contract is completed. Because of this taxdeferral, this is the method preferred by most taxpayers.Treas. Regulation § 1.460-4(d) Completed-contract method. (1) In general.Except as otherwise provided in paragraph (d)(4) of this section, a taxpayerusing the CCM to account for a long-term contract must take into account inthe contract's completion year, as defined in § 1.460-1(b)(6), the grosscontract price, and all allocable contract costs incurred by the completionyear. A taxpayer may not treat the cost of any materials and supplies that areallocated to a contract, but actually remain on hand when the contract iscompleted, as an allocable contract cost.Completion of a Long-Term ContractPrior to the issuance of the final regulations, facts and circumstances determinedwhether there was final completion and acceptance. See Ball, Ball & Brosamer, Inc. v.Commissioner, 964 F.2d 890 (9th Cir. 1992) (aff'g T.C. Memo. 1990-454). For contractsentered into after January 10, 2001, the new regulations further define completion byproviding a "bright-line" test that explicitly differs from Ball, Ball, & Brosamer, Inc. Acontract is deemed complete when the customer uses the primary subject matter of thatcontract and the taxpayer has incurred at least 95% of the total allocable costs.Treas. Reg. §1.460-1(c)(3) Date contract completed. (i) In general. Ataxpayer's contract is completed upon the earlier of:(A) use of the subject matter of the contract by the customer for itsintended purpose (other than for testing) and at least 95% of the totalallocable contract costs attributable to the subject matter have beenincurred by the taxpayer, or(B) final completion and acceptance of the subject matter of the contract.3-16

Example of completion Customer-use rule:In 2002, a calendar year-end construction contractor enters into a contract to constructa building for a customer. In November 2003, the building is completed in every respectnecessary for its intended use, and the customer occupies the building. In earlyDecember of 2003, the customer notifies the contractor of some minor deficiencies thatneed to be corrected and the contractor agrees to correct them in January 2004.Reasonable estimates of the costs to correct these deficiencies will be less than 5% ofthe total allocable contract costs. The contract is complete in 2003 because in that yearthe customer used the building and at least 95% of the total allocable contract costsattributable to the building had been incurred. The contractor would then use apermissible method of accounting for any deficiency-related costs incurred after 2003.Example of completion: Customer-use rule:In 2001, a calendar year-end construction contractor agrees to construct a shoppingcenter, which includes an adjoining parking lot. By October 2002, the contractor hasfinished constructing the retail portion of the shopping center. By December 2002, thecontractor has graded the entire parking lot, but has paved only one-fourth of it becauseinclement weather conditions prevented the contractor from laying asphalt on theremaining three-fourths. In December 2002, the customer opens the retail portion of theshopping center and the paved portion of the parking lot to the general public. Thecontractor reasonably estimates that the cost of paving the remaining three-fourths ofthe parking lot when weather permits will exceed 5% of the total allocable contractcosts. Even though the customer is using the subject matter of the contract, the contractis not completed in December 2002 because the contractor has not incurred at least95% of the total allocable contract costs attributable to the subject matter.Post Completion ExpensesWhen the contract is considered complete under the 95% completion rule per Treas.Reg. § 1.460-1(c)(3), the remaining contract costs incurred after the completion year aredeductible under the taxpayer’s permissible method of accounting (i.e. accrual method).The completed contract method (CCM) requires that the taxpayer include all income(gross contract price) in the completion year AND account for all costs incurred after thecompletion year in the normal manner for such expenses.Treas. Reg. § 1.460-4(d)(2): . . .If a taxpayer incurs an allocable contract cost afterthe completion year, the taxpayer must account for that cost using a permissiblemethod of accounting.Example of Post Completion Expense on CCM:As of Dec 31, 2001 a contract, entered into after January 10, 2001, was determined tobe 97% complete. The total contract price is reported as income in 2001 as well as therelated contract costs that have been incurred to date. The remaining contract costs3-17

(approx. the remaining 3% of total contract costs) incurred during 2002 are deductible in2002.Allocation of Indirect CostsBecause all contract costs are deferred until the contract is deemed complete, the nonallocationof all indirect costs, that are required to be allocated, can lead to a substantialmismatching of income and expenses. The non-allocated costs are deducted as periodexpenses rather than being capitalized to the long-term contract that they benefit.Taxpayers electing the CCM have the option of allocating all direct and indirect costs asdefined in §1.263A-1(e) or as provided in Treas. Reg. §1.460-5(d). Treas. Reg. §1.460-5(d) lists the various indirect costs that are allocable to the contract:Treas. Reg. §1.460-5(d)(2) Indirect costs--(i) Indirect costs allocable to exemptconstruction contracts. A taxpayer allocating costs under this paragraph (d)(2) mustallocate the following costs to an exempt construction contract, other than a contractdescribed in paragraph (d)(3) of this section, to the extent incurred in theperformance of that contract--(A) Repair of equipment or facilities;(B) Maintenance of equipment or facilities;(C) Utilities, such as heat, light, and power, allocable to equipment or facilities;(D) Rent of equipment or facilities;(E) Indirect labor and contract supervisory wages, including basic compensation,overtime pay, vacation and holiday pay, sick leave pay (other than paymentspursuant to a wage continuation plan under section 105(d) as it existed priorto its repeal in 1983), shift differential, payroll taxes, and contributions to asupplemental unemployment benefits plan;(F) Indirect materials and supplies;(G) Non-capitalized tools and equipment;(H) Quality control and inspection;(I) Taxes otherwise allowable as a deduction under section 164, other than state,local, and foreign income taxes, to the extent attributable to labor, materials,supplies, equipment, or facilities;(J) Depreciation, amortization, and cost-recovery allowances reported for thetaxable year for financial purposes on equipment and facilities to the extentallowable as deductions under chapter 1 of the Internal Revenue Code;(K) Cost depletion;3-18

(L) Administrative costs other than the cost of selling or any return on capital;(M) Compensation paid to officers other than for incidental or occasionalservices;(N) Insurance, such as liability insurance on machinery and equipment; and(O) Interest, as required under paragraph (b)(2)(v) of this section.(ii) Indirect costs not allocable to exempt construction contracts. A taxpayerallocating costs under this paragraph (d)(2) is not required to allocate thefollowing costs to an exempt construction contract reported using the CCM--(A) Marketing and selling expenses, including bidding expenses;(B) Advertising expenses;(C) Other distribution expenses;(D) General and administrative expenses attributable to the performanceof services that benefit the taxpayer’s activities as a whole (e.g., payrollexpenses, legal and accounting expenses);(E) Research and experimental expenses (described in section 174 andthe regulations thereunder);(F) Losses under section 165 and the regulations thereunder;(G) Percentage of depletion in excess of cost depletion;(H) Depreciation, amortization, and cost recovery allowances onequipment and facilities that have been placed in service but are temporarilyidle (for this purpose, an asset is not considered to be temporarily idle on nonworkingdays, and an asset used in construction is considered to be idle when itis neither en route to nor located at a job-site), and depreciation, amortizationand cost recovery allowances under chapter 1 of the Internal Revenue Code inexcess of depreciation, amortization, and cost recovery allowances reported bythe taxpayer in the taxpayer’s financial reports;(I) Income taxes attributable to income received from long-term contracts;(J) Contributions paid to or under a stock bonus, pension, profit-sharing,or annuity plan or other plan deferring the receipt of compensation whether ornot the plan qualifies under section 401(a), and other employee benefitexpenses paid or accrued on behalf of labor, to the extent the contributions orexpenses are otherwise allowable as deductions under chapter 1 of the Internal3-19

Revenue Code. Other employee benefit expenses include (but are not limitedto): worker’s compensation; amounts deductible or for whose paymentreduction in earnings and profits is allowed under section 404A and theregulations thereunder; payments pursuant to a wage continuation plan undersection 105(d) as it existed prior to its repeal in 1983; amounts includible in thegross income of employees under a method or arrangement of employercontributions or compensation which has the effect of a stock bonus, pension,profit-sharing, or annuity plan, or other plan deferring the receipt ofcompensation or providing deferred benefits; premiums on life and healthinsurance; and miscellaneous benefits provided for employees such as safety,medical treatment, recreational and eating facilities, membership dues, etc.;(K) Cost attributable to strikes, rework labor, scrap and spoilage; and(L) Compensation paid to officers attributable to the performance ofservices that benefit the taxpayer’s activities as a whole.Primary Issues To Consider For Completed Contract Method Taxpayers• Determining an in-process contract to be complete (over 95% complete)• Allocation of Indirect Costs (not all costs allocated to the contract)• Alternative Minimum Tax (if a non-home construction contract may be subject toAlternative Minimum Tax which is discussed later in this chapter).Subcontracts and completionTreas. Regulation §1.460-1(c)(3)(iii) clarifies that a subcontractor's customer is thegeneral contractor. Thus, the subject matter of the subcontract is the relevant subjectmatter in determining a contract's completion.Treas. Reg. §1.460-1(c)(3)(iii) Subcontracts. In the case of a subcontract, asubcontractor's customer is the general contractor. Thus, the subject matterof the subcontract is the relevant subject matter under paragraph (c)(3)(i) ofthis section.Example:In 2001, a customer hires a general contractor to construct an office building. Thebuilding will not be completed until 2003. The general contractor, in turn, hires asubcontractor to pour the concrete foundation. The subcontractor pours the concretefoundation and it is accepted by the general contractor in 2002. The subcontractor'scontract is considered complete in 2002, not 2003 upon the customer's use of and/oracceptance of the building.Exempt-contract percentage-of-completion method (EPCM)A taxpayer who is exempt from the requirement to use the percentage of completionunder IRC § 460 (using the cost-to-cost method) still may elect a PCM. The percentage3-20

of completion may be determined by using any method of cost comparisons, such asthe following:• Direct labor costs to estimated total labor costs• Work performed (e.g., units of production)--the criteria used to compare the workperformed on a contract must clearly reflect the earning of income with respect tothe contract• Treas. Reg. §1.460-4(c)(2) Exempt-contract percentage-of-completionmethod.(i) In general. Similar to the PCM described in paragraph (b) of thissection, a taxpayer using the EPCM generally must include in income theportion of the total contract price, as described in paragraph (b)(4) of thissection, that corresponds to the percentage of the entire contract that thetaxpayer has completed during the taxable year. Under the EPCM, thepercentage of completion may be determined at of the end of the taxableyear by using any method of cost comparison (such as comparing directlabor costs incurred to date to estimated total direct labor costs) or bycomparing the work performed on the contract with the estimated totalwork to be performed, rather than by using the cost-to-cost comparisonrequired by paragraphs (b)(2)(i) and (5) of this section, provided suchmethod is used consistently and clearly reflects income. In addition,paragraph (b)(3) of this section (regarding post-completion-year income),paragraph (b)(6) of this section (regarding the 10% method) and §1.460-6(regarding the look-back method) do not apply to the EPCM.(ii) Determination of work performed. For purposes of the EPCM, thecriteria used to compare the work performed on a contract as of the end ofthe taxable year with the estimated total work to be performed must clearlyreflect the earning of income with respect to the contract. For example, inthe case of a road builder, a standard of completion solely based on milesof roadway completed, in a case where the terrain is substantiallydifferent, may not clearly reflect the earning of income with respect to thecontract.Example of Exempt PCM:An exempt contract requires the taxpayer to install 50 miles of utility lines. The entire 50miles is on comparable terrain, meaning no particular area will require additional coststo install the utility lines. The contract elects the percentage of completion based onunits (e.g., miles). At the end of the tax year, 10 miles have been installed; thus, 20% ofthe contract is determined to be complete.Alternative Minimum Tax (AMT)3-21

Generally contractors meeting the “small contractor exemption” under IRC section460(e)(1) are not required to use PCM for regular tax purposes. However, I.R.C. § 56requires that long-term contracts shall be determined under the percentage ofcompletion method of accounting for alternative minimum tax. Alternative minimum taxis a separate tax system designed to ensure that taxpayers pay a minimum amount oftax on the true economic income when the income may not yet be taxable for regularincome tax purposes. Therefore, small contractors that elect a method other than PCMmay be required to compute alternative minimum taxable income.IRC §56 ADJUSTMENTS APPLICABLE TO ALL TAXPAYERS.--56(a)(3) TREATMENT OF CERTAIN LONG-TERM CONTRACTS.--In the case of anylong-term contract entered into by the taxpayer on or after March 1, 1986, thetaxable income from such contract shall be determined under the percentage ofcompletion method of accounting (as modified by section 460(b) ). For purposesof the preceding sentence, in the case of a contract described in section460(e)(1), the percentage of the contract completed shall be determined undersection 460(b)(1) by using the simplified procedures for allocation of costsprescribed under section 460(b)(3). The first sentence of this paragraph shall notapply to any home construction contract (as defined in section 460(e)(6)).There are two exceptions to the percentage of completion method for alternativeminimum tax:1. The last sentence in IRC § 56(a)(3), above, states that the alternative minimumtax adjustment for PCM does not apply to home construction contracts.A home construction contract is defined by I.R.C. §460(e)(6)(A)HOME CONSTRUCTION CONTRACT.--The term “home construction contract”means any construction contract if 80 percent of the estimated total contractcosts (as of the close of the taxable year in which the contract was enteredinto) are reasonably expected to be attributable to activities referred to inparagraph (4) with respect to—460(e)(6)(A)(i) dwelling units (as defined in section 168(e)(2)(A)(ii) )contained in buildings containing 4 or fewer dwelling units (as so defined),and460(e)(6)(A)(ii) improvements to real property directly related to suchdwelling units and located on the site of such dwelling units.For purposes of clause (i), each townhouse or row house shall be treated asa separate building.2. “Small corporations” are exempt from alternative minimum tax for years beginningafter 1997 per IRC § 55(e). The definition of a “small corporation” for purposes ofthe exemption, the corporation must:3-22

a. Be a C corporation (S Corporations, partnerships, and individual entities(Schedule C) are not exempt per IRC 55(e)).b. For the first tax year beginning after 1996, the average gross receipts forthe prior 3 years must be $5,000,000 or less.c. A C corporation that meets the initial $5,000,000 will continue to beexempt from AMT as long as the average gross receipts do not exceed$7,500,000.IRC §55 ALTERNATIVE MINIMUM TAX IMPOSED.(e) EXEMPTION FOR SMALL CORPORATIONS.--(1) IN GENERAL.--(A) $7,500,000 GROSS RECEIPTS TEST.--The tentative minimum tax of acorporation shall be zero for any taxable year if the corporation’s average annualgross receipts for all 3-taxable-year periods ending before such taxable year doesnot exceed $7,500,000. For purposes of the preceding sentence, only taxableyears beginning after December 31, 1993 shall be taken into account.(B) $5,000,000 GROSS RECEIPTS TEST FOR FIRST 3-YEAR PERIOD.--Subparagraph (A) shall be applied by substituting “$5,000,000” for “$7,500,000” forthe first 3-taxable-year period (or portion thereof) of the corporation which is takeninto account under subparagraph (A).(C) FIRST TAXABLE YEAR CORPORATION IN EXISTENCE.--If such taxableyear is the first taxable year that such corporation is in existence, the tentativeminimum tax of such corporation for such year shall be zero.D) SPECIAL RULES.--For purposes of this paragraph, the rules of paragraphs(2) and (3) of section 448(c) shall apply.If a small corporation later exceeds the $7.5 million average, the corporation becomessubject to AMT, but only for those contracts entered into after the average wasexceeded. C Corporation contractors (other than home construction contracts) withaverage gross receipts falling between $7.5 million and $10 million would be subject tothe long-term AMT adjustment. Contractors exceeding the $10 million average wouldbe required to use PCM for regular tax purposes, and no AMT adjustment would benecessary.Example:Assume a calendar-year corporation was in existence on January 1, 1994. In order toqualify as a small corporation for 1998 (the first year the exemption is available), (1) thecorporation’s average gross receipts for the three-taxable year period 1994 through1996 must be $5 million or less and (2) the corporation’s average gross receipts for the1995 through 1997 period must be $7.5 million or less. If the corporation qualifies for1998, the corporation will qualify for 1999 if its average gross receipts for the threetaxableyear period 1996 through 1998 is $7.5 million or less. If the corporation doesnot qualify for 1998, the corporation cannot qualify for 1999 or any subsequent year.Example:3-23

Assume a calendar-year corporation is first incorporated in 1999 and is neitheraggregated with a related, existing corporation under IRC § 448(c)(2) nor treated ashaving a predecessor corporation under IRC § 448(c)(3)(D). The corporation will qualifyas a small corporation for 1999 regardless of its gross receipts for such year. In orderto qualify as a small corporation for 2000, the corporation’s gross receipts for 1999 mustbe $5 million or less. If the corporation qualifies for 2000, the corporation also willqualify for 2001 if its average gross receipts for the two-taxable year period 1999through 2000 is $7.5 million or less. If the corporation does not qualify for 2000, thecorporation cannot qualify for 2001 or any subsequent year. If the corporation qualifiesfor 2001, the corporation will qualify for 2002, if its average gross receipts for the threetaxableyear period 1999 through 2001 is $7.5 million or less.Sole proprietorships (Schedule C), S corporations (1120-S), and partnerships (1065) donot have a gross receipts exception. Therefore, percentage of completion foralternative minimum tax purposes is required for non-home construction contracts.Long-Term Contract Adjustment for Alternative Minimum TaxThe AMT adjustment is computed by taking the difference in the two gross profits, i.e.,the gross profit using the taxpayer’s accounting method for regular tax purposes vs. thegross profit computed under PCM (using the simplified method or the alternativemethod to determine percent complete). PCM is required to be used for financialstatements per SOP 81-1(Statement of Position) and many companies are required tohave financial statements for bonding or lending purposes. Thus, this information isusually available.Example of AMT Adjustment:A Schedule C contractor reports income and expenses from long-term contracts on thecompleted contract method. The contracts are not home construction contracts. TheAMT adjustment for the job below would be as follows (only one job-in-process used forsimplification purposes):Tax Year - Job 1PCM GrossProfitCCM Gross ProfitAMT Adjustment2000 50,000 0 50,0002001 75,000 0 75,0002002 25,000 150,000 (125,000)For the tax years 2000 and 2001, the contractor would pay alternative minimum taxsince no regular income tax is paid. However, in 2002, the negative AMT adjustmentwould most likely result in no alternative minimum tax and the contractor would receivean AMT credit on the prior AMT paid.3-24

This AMT adjustment is shown on the line labeled Long-Term Contracts which is line21 of the 2002 Form 6251 Alternative Minimum Tax – Individuals and line 2f of the 2002Form 4626 Alternative Minimum Tax – Corporations.S Corporations, partnerships, and Alternative Minimum TaxThe alternative minimum tax adjustment for long-term contracts is determined at theentity level. Each shareholder then reports the AMT adjustment on his or her pro-rataownership. This amount should be reported on the Schedule K-1 provided to thepartner or shareholder which would then be reported on the appropriate line on theForm 6251 if the shareholder/partner is an individual or Form 4626 if theshareholder/partner is a corporation.Look-Back and Alternative Minimum TaxEven though small contractors are exempt from the requirement to report long-termcontracts on PCM and apply look-back to completed contracts, the look-back applies tothose small contractors that must compute PCM for alternative minimum tax purposes.See the look-back module for more detailed information on the computation of lookback.Small Contractors Becoming Large ContractorsSmall contractors that were exempt from the IRC §460 PCM reporting requirements(due to the average annual gross receipts being less than $10,000,000) become largecontractors when the average annual gross receipts exceeds $10,000,000. During thisconverting year, any contracts previously in progress are still accounted for under themethod they have been using (e.g., completed contract method). Any new contractsstarted are computed on the percentage of completion method. This is known as the“cut-off” method. Because this is a statutory change, the change in accounting methodprocedures (i.e., filing Form 3115) do not apply. Conversely, if, in a subsequent year,the average annual taxable gross receipts go back below $10,000,000, the taxpayer willcompute any new contracts under its “exempt” contract method (e.g., completedcontract), and continue to report previous contracts using to PCM.Example:The contractor has been in business since 1990 and properly elected the completedcontract method for reporting its long-term construction contracts. 2000 is the firsttaxable year that the average annual gross receipts for the prior three taxable yearsexceeded $10,000,000. In 2002, the average annual gross receipts dropped below$10,000,000:3-25

2000 2001 2002Job 1 – in process in1999CCM CCM – jobcompletedJob 2 – started 2000 PCM PCM PCM – job completedJob3 – started in 2001 PCM PCMJob 4 – started in 2002CCMPros and Cons of Long-Term Accounting MethodsCompleted Contract• Defer gross profits and income tax on contracts until the job is completed.• Several contracts completed within one year may require substantial incomerecognition in a single year.• Contractors may spend cash received from early billings and not have sufficientfunds to pay income tax in year of completion.• Alternative minimum tax must be calculated using the percentage of completionmethod, unless taxpayer meets one of the exceptions.Percentage of Completion• Allows recognition of income as work is performed, rather than recognizingsubstantial amounts when several contracts are completed in one year. Thisenables taxpayers to take advantage of the graduated tax rates.• Allows for the deferral of income from front-loading, which, under the accrualmethod, is recognized when received or billed.• There may not be any difference in reporting for financial statement purposesand the tax return. This reduces burden of record keeping.• An alternative minimum tax calculation will not be necessary.ConclusionSmall construction contractors have more flexibility in electing methods of accountingfor their long-term contracts. However, the small contractor may be subject toalternative minimum tax for those contracts that are not computed on the percentage ofcompletion method. The choice of a proper accounting method, the proper computationof each accounting method, and the alternative minimum tax consequences arecomplex concepts that must be considered by each contractor.Chapter 2 / Table of Contents / Chapter 4Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search3-26

Chapter 3 / Table of Contents / Chapter 5Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 4: Large Construction ContractorsIntroductionThis chapter introduces the taxation of large construction contractors. For purposes ofthis chapter, large construction contractors are defined as contractors not meeting theexceptions under IRC section 460(e). Contractors meeting the exceptions of IRCsection 460(e) are discussed in separate chapters, Small Construction Contractors(Chapter 3) and Home Construction Contracts (Chapter 7).Methods of Accounting for Contracts Subject to IRC § 460 Percentageof Completion Method (PCM)Large construction contractors are required to account for long-term contracts on thepercentage of completion method. The amount of revenue reported each year underthe contract, using the percentage of completion method, is determined by multiplyingthe total estimated contract price times the percentage of completion at the end of thetaxable year (completion factor) less any gross receipts reported in the prior tax years ofthe contract. See Treas. Reg. § 1.460-4(b)(2). IRC § 460 provides two methods ofdetermining the degree of contract completion. They are the “cost-to-cost method” andthe “simplified cost-to-cost method.”Cost-to-Cost MethodIRC § 460(b)(1)(A) generally requires that the percentage of completion method (PCM)be computed utilizing the cost-to-cost method. Treas. Reg. § 1.460-4(b) describes the“cost-to-cost” computation as follows:Total allocable contractcosts incurred to date x Total estimated - Prior years’ reported gross receiptsTotal estimated allocablecontract pricecontract costs= Gross receipts to be reported for the taxable yearTreas. Reg. § 1.460-4(b) Percentage-of-completion method - -(1) In general. Under the PCM, a taxpayer generally must include in incomethe portion of the total contract price, as defined in [Regulation § 1.460-4(b)(4)(i)]that corresponds to the percentage of the entire contract that the taxpayer has4-1

completed during the taxable year. The percentage of completion must bedetermined by comparing allocable contract costs incurred with estimated totalallocable contract costs. Thus, the taxpayer includes a portion of the totalcontract price in gross income as the taxpayer incurs allocable contract costs.(2) Computations. To determine the income from a long-term contract, ataxpayer - -(i) Computes the completion factor for the contract, which is the ratio ofthe cumulative allocable contract costs that the taxpayer has incurred throughthe end of the taxable year, to the estimated total allocable contract costs thatthe taxpayer reasonably expects to incur under the contract;(ii) Computes the amount of cumulative gross receipts from the contractby multiplying the completion factor by the total contract price;(iii) Computes the amount of current-year gross receipts, which is thedifference between the amount of cumulative gross receipts for the currenttaxable year and the amount of cumulative gross receipts for the immediatelypreceding taxable year (the difference can be a positive or negative number);and(iv) Takes both the current-year gross receipts and the allocable contractcosts incurred during the current year into account in computing taxableincome.Example of Cost-to-Cost PCM:B enters into a construction contract in 2001 for which B is to receive $10 million. Bestimates that its total costs under the contract will be $8 million. At the end of 2002, Bhas incurred $4 million of its estimated costs on this project. If using this formula, Bincluded $3 million of the contract price as gross receipts in 2001, B must include $2million as gross receipts for 2002:($4,000,000 ÷ $8,000,000) x ($10,000,000) – ($3,000,000) = $2,000,000Allocable Contract CostsThe allocable contract costs that are used in determining the cost-to-cost method areprovided in Treas. Reg. § 1.460-5(b) which has a direct link to IRC § 263A costs.Treas. Reg. § 1.460-5(b) Cost allocation method for contracts subject to PCM--(1) Ingeneral. Except as otherwise provided in paragraph (b)(2) of this section, a taxpayermust allocate costs to each long-term contract subject to the PCM in the same mannerthat direct and indirect costs are capitalized to property produced by a taxpayer under §1.263A-1(e) through (h). Thus, a taxpayer must allocate to each long-term contractsubject to the PCM all direct costs and certain indirect costs properly allocable to thelong-term contract (i.e., all costs that directly benefit or are incurred by reason of the4-2

performance of the long-term contract). However, see paragraph (c) of this sectionconcerning an election to allocate contract costs using the simplified cost-to-costmethod. As in section 263A, the use of the practical capacity concept is not permitted.See § 1.263A-2(a)(4).Direct costs listed in Treas. Reg. § 1.263A-1(e)(2) include:• Direct material costs• Direct labor costsIndirect costs under Treas. Reg. § 1.263A-1(e)(3) include:• Indirect labor costs• Officers’ compensation• Pension and other related costs• Employee benefit expenses• Indirect material costs• Purchasing costs• Handling costs• Storage costs• Cost recovery• Depletion• Rent• Taxes• Insurance• Utilities• Repairs and maintenance• Engineering and design costs• Spoilage• Tools and equipment• Quality control• Bidding costs• Licensing and franchise costs• Interest• Capitalizable service costsSubject to PCM, direct material and labor costs, are properly allocable to the long-termcontract are all costs that directly benefit or are incurred through the contract’sperformance. Treas. Reg. § 1.460-5(b)(1). Similarly, indirect costs are properly allocableto property produced or property acquired for resale when the costs directly benefit orare incurred by reason of the performance of production or resale activities. Treas.Reg. § 1.263A-1(e)(3)(i). Some indirect costs, on the other hand, may benefit both thelong-term contract and other business activities of the taxpayer and are not alwaysspecifically identified to a particular long-term contract. This allocation may be a4-3

specific “facts-and-circumstances” method, including the specific identification (ortracing) method, burden rate method (i.e., ratios based on direct costs, direct labor,etc.), standard cost method, a “simplified method” provided in Treas. Reg. §§ 1.263A-2(b) and 1.263A-3(d), or any other reasonable method (as defined under Treas. Reg. §1.263A-1(f)(4)). See Treas. Reg. § 1.263A-1(f) and (g)(3).Direct Material CostsDirect material costs include the costs of those materials that become an integral part ofspecific property produced and those materials that are consumed in the ordinarycourse of production that can be identified or associated with particular units or groupsof units of property produced. Treas. Reg. § 1.263A-1(e)(2)(i)(A). Direct material costsmust be allocated to a long-term contract when “dedicated” to the contract. Thus, ataxpayer dedicates direct materials by associating them with a specific contract,including by purchase order, entry on books and records, or shipping instructions.Treas. Reg. § 1.460-5(b)(2)(i). Therefore, uninstalled materials that are dedicated to acontract become an allocable job cost.Direct Labor CostsDirect labor costs include the costs of labor that can be identified or associated with thelong-term contract. For this purpose, labor encompasses full-time and part-timeemployees, as well as contract employees and independent contractors. Direct laborcosts include all elements of compensation other than employee benefit costs describedin Treas. Reg. § 1.263A-1(e)(3)(ii)(D). Elements of direct labor costs include basiccompensation, overtime pay, vacation pay, holiday pay, sick leave pay (other thanpayments pursuant to a wage continuation plan under section 105(d) as it existed priorto its repeal in 1983), shift differential, payroll taxes, and payments to a supplementalunemployment benefit plan. See Treas. Reg. § 1.263A-1(e)(2)(i)(B).Bidding CostsBidding expenses are those costs incurred by a contractor in the solicitation of a longtermcontract. The taxpayer must defer all bidding costs paid or incurred in thesolicitation of a particular contract until the contract is awarded. If the contract isawarded to the taxpayer, the bidding costs become part of the indirect costs allocated tothe subject matter of the contract. If the contract is not awarded to the taxpayer, biddingcosts are deductible in the taxable year that the contract is awarded to another party, orin the taxable year that the taxpayer is notified in writing that no contract will be awardedand that the contract (or a similar or related contract) will not be rebid, or in the taxableyear that the taxpayer abandons its bid or proposal, whichever occurs first. See Treas.Reg. § 1.263A-1(e)(3)(ii)(T).Indirect Costs Not Generally Allocable4-4

Subject to the exception in IRC § 460(c)(2)(costs identified under cost-plus and certainfederal contracts) , costs not allocable to the contract are independent research anddevelopment expenses, expenses for unsuccessful bids and proposals, and marketing,selling, and advertising expenses. See IRC § 460(c)(4). Treas. Reg. § 1.263A-1(e)(3)(iii) provides a list of additional indirect costs not allocable to the long-termcontract under Treas. Reg. § 1.460-5(b). These indirect costs include “deductibleservice costs,” which generally include costs incurred by reason of the taxpayer’soverall management or policy guidance functions, such costs from the board ofdirectors, chief executive, financial, accounting, and legal officers. See Treas. Reg. §1.263A-1(e)(3)(iii)(K) and (e)(4)(ii)(B) and (e)(4)(iv)(A). Even though a service cost isclassified as “general and administrative,” however, it is allocable to the long-termcontract if it directly benefits or is incurred by reason of the taxpayer’s performance ofthe production or resale activities. Examples are costs from data processing, personneloperations, security services, and legal services. See Treas. Reg. § 1.263A-1(e)(4)(i)(A) and (B) and (e)(4)(ii) -(iii).Nondeductible CostsCosts that would normally be allocable to a contract but are nondeductible by theInternal Revenue Code are not an allocable contract cost. A common example wouldbe the nondeductible portion of meals per IRC § 274. The amount incurred as well asthe total estimated amount of the nondeductible cost must be removed from thepercentage of completion computation.Treas. Reg. § 1.460-5(f) Special rules applicable to costs allocated under this section--(1) Nondeductible costs. A taxpayer may not allocate any otherwise allocable contractcost to a long-term contract if any section of the Internal Revenue Code disallows adeduction for that type of payment or expenditure (e.g., an illegal bribe described insection 162(c)).Impact of Cost Allocation on the Percentage of CompletionComputationUnlike the percentage of completion method, a taxpayer using the completed contractmethod must defer the deduction of all allocable contract costs until the contract iscompleted. See Treas. Reg. § 1.460-4(d)(1). Under the percentage of completionmethod, however, the taxpayer deducts the allocable contract costs in the year incurred,but the allocable contract cost’s exclusion from the percentage of completioncomputation (also known as “completion factor”) may affect the gross receipts amountreported in each taxable year of the contract. The key is to know what costs thepercentage of completion taxpayer included in the completion computation.The following scenarios point out the effect that allocation of indirect costs could haveupon the gross receipts reported by a percentage of completion taxpayer:4-5

Year 1: At year end, the taxpayer’s estimated completion is 20%, determined asfollows:$100,000 Total allocable contract costs incurred to date$500,000 Total estimated costs allocable contract costsScenario 1: An indirect allocable contract cost was included in the total estimatedallocable contract costs in the denominator, but the cost, which was incurred during thetaxable year, was erroneously not included in the numerator. This incurred cost wasdeducted on the tax return. The amount is still deductible as an expense; however, itshould also be added to the numerator and, as such, impacts the amount of grossreceipts to be reported on this contract.100,000 + 10,000500,000 = 22% completeScenario 2: An indirect allocable contract cost, which is not incurred pro-rata over thelife of the contract (e.g., architect fee and building permits which are incurred early inthe contract), was improperly excluded from both the numerator and denominator of thePCM computation. The amount incurred during the tax year is the same as the totalestimated cost of this expense – no additional amount of this indirect cost is to beincurred on this contract. Again, as mentioned in scenario 1, the deductibility of thisexpense is proper, 1 only the gross receipts amount to be reported under this contract isimpacted.100,000 + 10,000500,000 + 10,000 = 21.57% completeScenario 3: An indirect allocable contract cost, which is incurred pro-rata over the life ofthe contract (e.g., indirect labor and officer’s salary, which are incurred throughout theduration of the contract), was improperly excluded from both the numerator anddenominator of the PCM computation. The cost incurred during the taxable year isincluded in the numerator and the total estimated cost, which must be determined, isincluded in the denominator.100,000 + 10,000500,000 + 50,000 = 20% completeAs Scenario 3 indicates, theoretically, if a pro-rata cost is not included in the numeratoror denominator of the percentage of completion computation it may not have a materialimpact on the gross receipts to be reported.1 Under PCM, the reference to the regulations under section 263A applies only to what costs to allocate, and how.Allocable contract costs under PCM, however, are still deductible in the year incurred when computing taxableincome. See Treas. Reg. §§ 1.460-4(b)(2)(iv) and (h)Ex. 2; 1.460-5(b)(1).4-6

Cost-Plus Contracts and Federal Long-Term ContractsCost-plus fee contracts are common in the construction industry. With this type ofcontract, the owner agrees to pay the contractor a fee in addition to the costs thecontractor incurs to complete the project. This fee may be fixed or based on apercentage of the costs. This type of contract shifts much of the risk to the owner;however, the owner can reduce the risk by establishing a Guaranteed Maximum Price(GMP). The GMP establishes a maximum cost that the owner will pay and may containa clause for the owner and contractor to share in any savings if the project is completedat less than the maximum price. In cost-plus contracts, the contract will detail whichcosts are to be reimbursed by the owner. For percentage of completion purposes, ifany of these “contract costs” would not normally be allocated to the long-term contract,IRC § 460(c)(2) requires those costs be allocated. See also Treas. Reg. § 1.460-5(b)(2)(iv):Treas. Reg. § 1.460-5(b)(2)(iv) Costs identified under cost-plus long-term contracts andfederal long-term contracts. To the extent not otherwise allocated to the contract underthis paragraph (b), a taxpayer must allocate any identified costs to a cost-plus long-termcontract or federal long-term contract (as defined in section 460(d)). Identified costmeans any cost, including a charge representing the time-value of money, identified bythe taxpayer or related person as being attributable to the taxpayer’s cost-plus longtermcontract or federal long-term contract under the terms of the contract itself or underfederal, state, or local law or regulation.Example of Cost-Plus Cost Allocation:A cost-plus contract lists some marketing expenses, which are not normally consideredan allocable contract cost per IRC § 460(c)(4). However, per IRC § 460(c)(2) thesecosts are allocated to the long-term contract.Simplified Cost-to-Cost MethodIRC § 460(b)(1)(A) generally requires the cost-to-cost method to determine completion.However, IRC § 460(b)(3)(A) provides an elective simplified cost-to-cost method fordetermining the degree of contract completion for taxpayers using the PCM. Under thesimplified cost-to-cost method, only the following costs are used in determining thepercentage-of-completion:• Direct material costs• Direct labor costs• Depreciation, amortization, and cost recovery allowances on equipmentand facilities directly used to construct or produce the subject matter of thelong-term contract4-7

Subcontracted costs represent either direct material or direct labor costs, which must beallocated to a contract. Treas. Reg. §1.460-5(c)(1).Treas. Reg. § 1.460-5(c) Simplified cost-to-cost method for contracts subject tothe PCM.--. (1) In general. Instead of using the cost-allocation method prescribedin [Treas. Reg. § 1.460-5(b)], a taxpayer may elect to use the simplified cost-tocostmethod, which is authorized under section 460(b)(3)(A), to allocate costs toa long-term contract subject to the PCM. Under the simplified cost-to-costmethod, a taxpayer determines a contract's completion factor based upon onlydirect material costs; direct labor costs; and depreciation, amortization, and costrecovery allowances on equipment and facilities directly used to manufacture orconstruct the subject matter of the contract. For this purpose, the costsassociated with any manufacturing or construction activities performed by asubcontractor are considered either direct material or direct labor costs, asappropriate, and therefore must be allocated to the contract under the simplifiedcost-to-cost method. An electing taxpayer must use the simplified cost-to-costmethod to apply the look-back method under § 1.460-6 and to determinealternative minimum taxable income under § 1.460-4(f).A taxpayer using the simplified cost-to-cost method must utilize the costs describedabove in determining both the costs allocated to the contract and incurred before theclose of the taxable year, and the estimated total contract cost.Percentage-of-Completion – 10 Percent MethodUnder IRC § 460(b)(5) and Treas. Reg. § 1.460-4(b)(6), the taxpayer may elect to deferrecognition of revenue under PCM until 10% of the total estimated allocable contractcosts are incurred. Accordingly, the costs incurred before the 10% year are consideredpre-contracting year costs and thus are not deductible until the 10% year.This method of accounting is an election and applies to all long-term contracts enteredinto during, and all taxable years after, the electing year. Once elected, the taxpayerwould be required to obtain the Commissioner's permission to change to anothermethod.This election is unavailable if the taxpayer elected to use the simplified method forallocation of costs under IRC § 460(b)(3)(A) or is exempt under IRC § 460(e).Example –PCM -10 Percent Method:A contractor, C, whose taxable year ends December 31, determines the income fromlong-term contracts using the 10 Percent Method. For each of the taxable years, C'sincome from the contract is computed as follows:4-8

2001 2002 2003Cumulative Incurred Costs 40,000 300,000 600,000Total Estimated Costs 600,000 600,000 600,000Percent Complete 6.67% 50.00% 100.00%Total Contract Price 11,000,000 11,000,000 11,000,000Gross Revenue Reported -0- 500,000 500,000Expenses Deducted -0- 300,000 300,000Percentage-of-Completion/Capitalized-Cost Method (PCCM)A taxpayer may determine the income from a long-term construction contract that is aresidential construction contract using either the PCM or the PCCM. The PCCM allowsthe residential construction contractor to report 70 percent of the contract under PCM(as required by IRC § 460) and the remaining 30 percent to be reported under anexempt method (e.g., completed contract method).A residential construction contract differs from a home construction contract in that ahome construction contract involves buildings with four or fewer dwelling units; whereas,a residential construction contract involves buildings with more than four dwelling units(e.g., apartment buildings or condominiums with five or more units in each building).See IRC § 460(e)(6).The final regulations explain the PCCM.Treas. Reg. § 1.460-4(e) Percentage-of-completion/capitalized-cost method.Under the PCCM, a taxpayer must determine the income from a long-termcontract using the PCM for the applicable percentage of the contract and itsexempt contract method, as defined in paragraph (c) of this section, for theremaining percentage of the contract. For residential construction contractsdescribed in § 1.460-3(c), the applicable percentage is 70 percent, and theremaining percentage is 30 percent. For qualified ship contracts described in §4-9

1.460-2(d), the applicable percentage is 40 percent, and the remainingpercentage is 60 percent.Even though the residential construction contracts are allowed the 70/30 hybridmethod for reporting income for regular tax, the entire contract must be reportedunder PCM for alternative minimum tax purposes. See Treas. Reg. § 1.460-4(f).Total Estimated Contract Price and Claim IncomeThe total estimated contract price is the amount the contractor reasonably expects toreceive from the owner under the long-term contract. Total estimated contract priceincludes: the original contract price, “retainages,” “holdbacks,” and approved contractchange orders. In addition, contractors must include, in the estimated contract price,contingent compensation such as awards, incentive payments, unapproved contractchange orders, and amounts relating to claims 2 when there is a reasonable expectationthe contractor will receive these amounts.Treas. Reg. § 1.460-4(b)(4) Total contract price-- (i) In general--. (A) Definition.Total contract price means the amount that a taxpayer reasonably expects toreceive under a long-term contract, including holdbacks, retainages, and costreimbursements. See § 1.460-6(c)(1)(ii) and (2)(vi) for application of the lookbackmethod as a result of changes in total contract price.Contingent compensation (i.e., bonus, award, incentive payment, and amount indispute) is included in total contract price as soon as the taxpayer can reasonablypredict that the amount will be earned, even if the all-events test has not yet been met.The portion of the contract price that is in dispute is includible in the total contract priceat the time and to the extent that the taxpayer can reasonably predict that the disputewill be resolved in the taxpayer's favor, regardless of when the taxpayer actuallyreceives payment or when the dispute is resolved. See Treas. Reg. § 1.460-4(b)(4)(i)(B); Tutor-Saliba Corp. v. Commissioner, 115 T.C. 1 (2000). This regulationalso provides that contingent income is includible in the total contract price not later thanwhen it is included in income for financial reporting purposes under generally acceptedaccounting principles (GAAP).Treas. Reg. § 1.460-4(b)(4)(i)(B) Contingent compensation. Any amount relatedto a contingent right under a contract, such as a bonus, award, incentivepayment, and amount in dispute, is included in total contract price as soon as thetaxpayer can reasonably predict that the amount will be earned, even if the allevents test has not yet been met. For example, if a bonus is payable to ataxpayer for meeting an early completion date, the bonus is includible in totalcontract price at the time and to the extent that the taxpayer can reasonablypredict the achievement of the corresponding objective. Similarly, a portion of thecontract price that is in dispute is includible in total contract price at the time andto the extent that the taxpayer can reasonably predict that the dispute will beresolved in the taxpayer's favor (regardless of when the taxpayer actually2 See Appendix 5 for definitions of “award,” “bonus,” “change order,” “claims,” “holdback,” and “retainage.”4-10

eceives payment or when the dispute is finally resolved). Total contract pricedoes not include compensation that might be earned under any other agreementthat the taxpayer expects to obtain from the same customer (e.g., exercisedoption or follow-on contract) if that other agreement is not aggregated under §1.460-1(e). For the purposes of paragraph (b)(4)(i)(B), a taxpayer can reasonablypredict that an amount of contingent income will be earned not later than whenthe taxpayer includes that amount in income for financial reporting purposesunder generally accepted accounting principles. If a taxpayer has not includedan amount of contingent compensation in total contract price under paragraph(b)(4)(i) by the taxable year following the completion year, the taxpayer mustaccount for that amount of contingent compensation using a permissible methodof accounting. If it is determined after the taxable year following the completionyear that an amount included in total contract price will not be earned, thetaxpayer should deduct that amount in the year of the determination.Example of Contingent Compensation:In 2002, a contractor reports $10 million of disputed income as income on the financialstatements, which are prepared in accordance with GAAP. Per Treas. Reg. §1.460-4(b)(4)(i)(B), this amount must also be included the total contract price in 2002.Example of Bonus:A contract specifies that the contractor will receive a bonus for meeting an earlycompletion date. At the end of the 2001 taxable year, the contractor is ahead ofschedule and anticipates meeting the early completion date; therefore, the bonus wouldbe included in the total contract price.Additional Considerations for PCMEach component of the PCM computation needs to be analyzed to ensure the propergross income amount is reported each year under the contract.Total allocable contract costs incurred to dateTotal estimated allocable contract costsx Total estimated contract priceTotal Allocable Contract Costs Incurred to Date (Numerator) &Total Estimated Allocable Contract Costs (Denominator) Considerations:• Verify that the direct and indirect allocable contract costs, per Treas. Reg. §1.460-5(b), are included in both the numerator and the denominator as the cost isincurred. See Treas. Reg. § 1.460-4(b). For example, the denominator includesthe total estimated allocable cost of equipment rental; however, as this cost isincurred it must also be included in the numerator of the PCM computation. Ifthis cost were not included in the numerator, the completion of the contract isunderstated which results in understated gross income for the taxable year.4-11

• Verify that warranty expenses are not included in the PCM computation. SeeTreas. Reg. §§ 1.460-1(d)(2) and 1.263A-1(e)(3)(iii)(H).• A taxpayer may not allocate any otherwise allocable contract cost to a long-termcontract if any section of the Internal Revenue Code disallows a deduction forthat cost or expenditure (e.g., an illegal bribe described in section 162(c),nondeductible portion or meals and entertainment per section 274). See Treas.Reg. § 1.460-5(f)(1).• Total Estimated Contract Price Considerations:• Retainages, holdbacks, and cost reimbursements are included in the totalestimated contract price because the taxpayer reasonably expects to receivethese amounts under the long-term contract. See Treas. Reg. § 1.460-4(b)(4)(i)(A).• Contingent compensation such as a bonus, award, incentive payment, andamount in dispute, is included in total contract price as soon as the taxpayer canreasonably predict that the amount will be earned, even if the all events test hasnot yet been met. Additionally, if the contingent amount is included in income forfinancial reporting per generally accepted accounting principles, the amount isalso included in the total contract price. See Treas. Reg. § 1.460-4(b)(4)(i)(B).Terminated Contract: Reversal of IncomeIf a long-term contract (under PCM) is terminated before completion and, as a result,the taxpayer retains ownership of the property, the taxpayer must reverse thetransaction in the taxable year of termination. The taxpayer reports a loss (or gain)equal to the cumulative allocable contract costs reported under the contract in all priortaxable years less the cumulative gross receipts reported under the contract in all priortaxable years.As a result of reversing the transaction, a taxpayer will have an adjusted basis in theretained property equal to the cumulative allocable contract costs reported under thecontract. If the taxpayer received and retains any consideration or compensation fromthe customer, however, the taxpayer must reduce the adjusted basis in the retainedproperty (but not below zero) by the fair market value of that consideration orcompensation. To the extent that the amount of the consideration or compensationdescribed in the preceding sentence exceeds the adjusted basis in the retainedproperty, the taxpayer must include the excess in gross income for the taxable year oftermination.The look-back method does not apply to a terminated contract.Treas. Reg. § 1.460-4(b)(7) Terminated contract—4-12

(i) Reversal of income. If a long-term contract is terminated before completionand, as a result, the taxpayer retains ownership of the property that is the subjectmatter of that contract, the taxpayer must reverse the transaction in the taxableyear of termination. To reverse the transaction, the taxpayer reports a loss (orgain) equal to the cumulative allocable contract costs reported under the contractin all prior taxable years less the cumulative gross receipts reported under thecontract in all prior taxable years.(ii) Adjusted basis. As a result of reversing the transaction under [Treas. Reg.§ 1.460-4(b)(7)(i)], a taxpayer will have an adjusted basis in the retained propertyequal to the cumulative allocable contract costs reported under the contract in allprior taxable years. However, if the taxpayer received and retains anyconsideration or compensation from the customer, the taxpayer must reduce theadjusted basis in the retained property (but not below zero) by the fair marketvalue of that consideration or compensation. To the extent that the amount of theconsideration or compensation described in the preceding sentence exceeds theadjusted basis in the retained property, the taxpayer must include the excess ingross income for the taxable year of termination.(iii) Look-back method. The look-back method does not apply to a terminatedcontract that is subject to this paragraph (b)(7).Example of Terminated Contract:A contractor-taxpayer buys a parcel of land. In 2002, the contractor enters into acontract to construct an office building on that parcel of land. In 2002, the contractorreports gross receipts and allocable contract costs on this contract under thepercentage of completion method as follows:2002Gross Receipts $2,000,000Allocable ContractCostsGross Profit onContract1,500,000500,000In 2003, the customer defaults on the contract due to bankruptcy. The unfinished officebuilding remains with the contractor. In 2003, the contractor will report a loss of$500,000 in relation to this terminated contract, computed by deducting the prior taxableyears' reported cumulative gross receipts of $2 million from the prior taxable years'reported cumulative allocable contract costs of $1.5 million. As of termination, providedthere were no additional expenses incurred on this office building in 2003 and thecontractor does not receive or retain consideration or compensation from the customer,the contractor will have an adjusted basis of $1.5 million, equivalent to the cumulativeallocable contract costs reported under the contract in all prior taxable years.4-13

If the contractor had billed and received $1.8 million from the customer in 2002 (ofwhich none of the proceeds are due back to the customer), the contractor will report$300,000 in gross income in 2002 because the $1.8 million compensation exceeds theadjusted basis of $1.5 million. The adjusted basis of the property would be zero.ConclusionLarge construction contractors must use the percentage of completion method to reportincome from long-term contracts. They do not have the flexibility of selecting amongseveral methods as the small construction contractors.Chapter 3 / Table of Contents / Chapter 5Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search4-14

Chapter 4 / Table of Contents / Chapter 6Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 5: Look-Back InterestIntroductionTaxpayers using the percentage of completion method must generally apply the lookbackmethod upon completion of each contract. IRC § 460(b)(2) provides that in thetaxable year in which a contract is complete, a determination is made whether the taxespaid with respect to the contract in each year of the contract were more or less than theamount that would have been paid if the actual cost and contract price, rather thanestimated contract price and cost, had been used to compute gross income. This lookbackcomputation does not result in an adjustment to tax, but instead results in interestdue to or from the taxpayer, depending on the results of the computation.IRC § 460(b)(1)(B) upon completion of the contract (or, with respect to anyamount properly taken into account after completion of the contract, when suchamount is so properly taken into account), the taxpayer shall pay (or be entitledto receive) interest computed under the look-back method of paragraph (2).A taxpayer must file Form 8697, Interest Computation Under the Look-Back Method forCompleted Long-Term Contracts, in the tax year in which a contract subject to the lookbackmethod is completed. Such a taxpayer must pay interest (but no tax) if the lookbackmethod reveals an underpayment with respect to a taxable year, and the taxpayerwill receive interest if the look-back computation reveals an overpayment.Look-Back Is HypotheticalThe computation of the amount of deferred or accelerated tax liability under the lookbackmethod is hypothetical. The application of look-back does not result in anadjustment to the tax liability (i.e., the prior years’ look-back computation does notamend the tax liability of those years). The computation is only to determine the interestdue to or owed by the taxpayer on the tax differential in each year due to the differencesin the estimated and actual figures.Treas. Reg. § 1.460-6(a)(1) …The computation on the amount of deferred oraccelerated tax liability under the look-back method is hypothetical; application ofthe look-back method does not result in an adjustment to the taxpayer’s taxliability as originally reported, as reported on an amended return, or as adjustedon examination. Thus, the look-back method does not correct for differences intax liability that result from over- or underestimation of contract price and costsand that are permanent because, for example, tax rates change during the termof the contract.5-1

Example of hypothetical computation:Job 1 commenced during Year 1 and was completed in Year 3. The taxpayer wasrequired to report the gross receipts and expenses on Job 1 using the percentage ofcompletion method pursuant to the formulas set forth below (IRC § 460(b)):Total allocable contractcosts incurred to date x Total estimated contract price - Prior years’ reported grossreceiptsTotal estimated allocablecontract costs= Gross receipts to be reported for taxable yearIn Year 3, the year of completion, the percentage of completion computation would berecomputed in Year 1 and Year 2 using the actual figures rather than the estimatedamounts as follows:Per Return Year 1 Year 2 Year 3Job 1 450,0004,500,000 x5,000,000=4,000,0004,800,000 x 5,200,000=4,333,333 – 500,000=3,833,333 Gross Income500,000 Gross IncomeLook back Year 1 Year 2 Year 3Job 1 450,0005,000,000 x5,500,000=495,000 Gross IncomeGross IncomeOverstated by 5,000(500,000 – 495,000)4,000,0005,000,000 x 5,500,000=4,400,000 – 495,000=3,905,000 Gross IncomeGross Income Understatedby 71,667 (4,333,333 –4,400,000)5-25,000,0005,000,000 x 5,500,000=5,500,000 – 4,333,333=1,166,667 Gross IncomeCompletion Year =Look-back interestcomputed on the prioryears of the contractIn the above example, Year 1 and Year 2 tax returns are not amended; the taxcomputation of look-back is hypothetical. The interest is computed on the taxdifferential of the changes to income in Year 1 and Year 2, which would be shown onForm 8697 filed in Year 3, the year of completion.Scope of Look-back MethodThe look-back method applies only to long-term contracts subject to the percentage ofcompletion method described in IRC § 460(b). Thus, look-back interest does not applyto construction contracts meeting the exceptions under IRC § 460(e), such as homeconstruction contracts and taxpayers meeting the small contractor exception. The lookbackmethod applies to the following:

• Percentage of Completion Method (PCM): any income from a long-termcontract that is required to be reported under the percentage of completionmethod for regular income tax purposes. Treas. Reg. § 1.460-6(b)(1).• Alternative Minimum Tax (AMT): any income from a long-term contract that isrequired to be reported under the percentage of completion method foralternative minimum tax purposes. These include non-home constructioncontracts, with average annual gross receipts for the prior 3 years that are lessthan $10,000,000. Although these non-home construction contracts are exemptfrom reporting income on the percentage of completion method for regularincome tax purposes, for alternative minimum tax purposes the taxpayer mustreport the income on the percentage of completion method. The look-backmethod is applied in recomputing AMT. Treas. Reg. § 1.460-6(b)(2)(ii).• Percentage of Completion-Capitalized Cost Method (PCCM): Residentialconstruction contracts may be reported under PCCM in which 70% of thecontract is reported under PCM and the other 30% is reported under an exemptcontract method. (See Treas. Reg. § 1.460-4(e)). Look-back would becomputed on the 70% PCM portion of the contract. Treas. Reg. § 1.460-(6)(b)(1).• Related Parties: To the extent that the percentage of completion method isrequired to be used under Treas. Reg. §1.460-1(g) with respect to income andexpenses that are attributable to activities that benefit a related party’s long-termcontract, the look-back method also applies to these amounts, even if thoseactivities are not performed under a contract entered into directly by the taxpayer.Treas. Reg. § 1.460-(6)(b)(1).Exceptions from the Application of Look-BackLook-back does not apply to the regular taxable income from any long-term constructioncontract in the following situations:• Home construction contract: exempt per IRC § 460(e)(1)(A) and defined byIRC § 460(e)(6)(A).• Small Contractor exception: any contract which is not a home constructioncontract but is estimated to be completed within a 2-year period is exempt perIRC § 460(e)(1)(B) if the taxpayer’s average annual gross receipts for the 3 taxyears preceding the tax year the contract is entered into do not exceed$10,000,000. However, the look-back may apply to the alternative minimumtaxable income from a contract of this type.• De Minimis Small Contract Exception: The look-back method does not applyto any long-term contract that is (1) completed within 2 years of the contract5-3

commencement date, and (2) has a gross contract price that does not exceedthe lesser of:− $1,0000,000 or− 1% of the average annual gross receipts of the taxpayer for the 3 taxyears preceding the tax year that the contract is completed.Exception from the look-back method is mandatory for de minimis small contracts andapplies for purposes of computing both regular taxable income and alternative minimumtaxable income. See IRC § 460(b)(3)(B).IRC § 460 (b)(3)(B) LOOK-BACK METHOD NOT TO APPLY TO CERTAIN CONTRACTS.—Paragraph (1)(B) shall not apply to any contract—(i) the gross price of which (as of the completion of the contract) does notexceed the lesser of—(I) $1,000,000, or(II) 1 percent of the average annual gross receipts of the taxpayer forthe 3 taxable years preceding the taxable year in which the contract wascompleted, and(ii) which is completed within 2 years of the contract commencement date.Example of De minimis Small Contract Exception:The average annual gross receipts for the 3 preceding tax years are $55,000,000. Thefollowing non-home construction contracts were completed during the taxable year andall jobs were completed within 2 years of the contract commencement date:Job 1 Gross Contract Price $5,000,000Job 2 Gross Contract Price 900,000Job 3 Gross Contract Price 15,000,000Job 4 Gross Contract Price 2,500,000Job 5 Gross Contract Price 400,000Only Job 5 would be exempt from the application of look-back. The de minimusexception applies to jobs which have a gross contract price less than $550,000 (1% of$55,000,000 – average annual gross receipts), which is the lesser of $1,000,000 or 1%.However, if Job 5 was not completed within 2 years of the contract commencementdate, the de minimis exception would not apply, and look-back would be required.Note: The $1,000,000 benchmark would only apply when the average annual grossreceipts of the three preceding years exceeds $100,000,000.Election Not to Apply Look-Back to Certain Contracts in De MinimisDiscrepancy Cases5-4

For contracts completed in tax years ending after August 5, 1997, contractors may electnot to apply the look-back method if the amount reported is within 10 percent of thecumulative taxable income or loss as determined using actual contract price and costsfor each prior contract year. The 10% test must be met in each year of the contract; it isnot 10% of the entire contract (i.e. a contract will not meet the de minimis exception ifthe entire contract is within 10% of the look-back computation but in Year 1 the contractwas 11% different). IRC § 460(b)(6)(B).IRC § 460(b)(6)(B) DE MINIMIS DISCREPANCIES.—Paragraph (1)(B) shall not apply in anycase to which it would otherwise apply if—(i) the cumulative taxable income (or loss) under the contract as of the closeof each prior contract year, is within(ii) 10 percent of the cumulative look-back income (or loss) under the contractas of the close of such prior contract year.This is an election and is not mandatory, compared to the mandatory de minimis smallcontract exception per IRC § 460(b)(3)(B) (lesser of $1,000,000 or 1% of averageannual gross receipts and within 2 year-completion). Once elected, the de minimisdiscrepancy exception applies to all long-term contracts completed during the taxableyear for which the election is made and any subsequent taxable year. Revoking thiselection is considered a change in method of accounting, which requires theCommissioner’s consent. See IRC § 460(b)(6)(D) and Treas. Reg. § 1.460-6(j).Computation of Look-BackThe computation of look-back interest involves a three-step process, which is describedin IRC § 460(b)(2):1. Hypothetically reapply the PCM for each year of all long-term contracts that arecompleted or adjusted in the current year, using the actual, rather thanestimated, total contract price and contract costs to determine income for eachyear of the contract.2. Compute the hypothetical overpayment or underpayment of tax for each year,which will be the difference between the amount of income reported each year,and the amount that would have been reported if actual, rather than estimated,contract price and costs had been used.3. Apply the rate of interest on overpayments to the hypothetical overpayment orunderpayment of tax.IRC § 460(b)(2) LOOK-BACK METHOD.—The interest computed under the lookbackmethod of this paragraph shall be determined by—5-5

(A) first allocating income under the contract among taxable years before theyear in which the contract is completed on the basis of the actual contract priceand costs instead of the estimated contract price and costs,(B) second, determining (solely for purposes of computing such interest) theoverpayment or underpayment of tax for each taxable year referred to insubparagraph (A) which would result solely from the application of subparagraph(A), and(C) then using the adjusted overpayment rate (as defined in paragraph (7)),compounded daily, on the overpayment or underpayment determined undersubparagraph (B).For purposes of the preceding sentence, any amount properly taken into account aftercompletion of the contract shall be taken into account by discounting (using the Federalmid-term rate determined under section 1274(d) as of the time such amount wasproperly taken into account) such amount to its value as of the completion of thecontract. The taxpayer may elect with respect to any contract to have the precedingsentence not apply to such contract.Each step of the three-step process will be discussed in-depth.Step 1: Hypothetically Reapply the PCM to all Long-Term ContractsUsing the Actual Contract Price and Contract Costs (Treas. Reg. §1.460-6(c)(2))For each filing year, a taxpayer must reallocate total contract income among prior years,using actual contract price and costs, to all contracts that are completed or adjusted(e.g., post-completion revenue and expenses, discussed later in this chapter) in thefiling year. Treas. Reg. § 1.460-6(c)(2)(i). Look-back cannot be applied to a contractbefore it is completed. Treas. Reg. § 1.460-6(c)(2)(iii).The following items may be included in the “actual” contract income and costs for thelook-back computation:• Treatment of Estimated Future Costs - If a taxpayer reasonably expects toincur additional allocable contract costs in a tax year subsequent to the year inwhich the contract is completed, the taxpayer includes these additional costs withthe actual costs in the denominator of the PCM ratio. The completion year is theonly filing year for which the taxpayer may include additional estimated costs inthe denominator of the PCM ratio in applying the look-back method. If look-backis reapplied in any year after the completion year, only the cumulative costsincurred are includible in the denominator of the PCM ratio for look-backpurposes. Treas. Reg. § 1.460-6(c)(2)(ii).• Amount Treated as Contract Price – All amounts that the taxpayer expects toreceive from the customer are treated as part of the contract price as soon as it is5-6

easonably estimated that they will be received even if the all-events test has notyet been met. Treas. Reg. § 1.460-6(c)(2)(vi)(A).Percentage of Completion – 10% Method and Application of Look-backContractors that are required by IRC § 460 to use the percentage of completion methodto report income on long-term construction contracts may elect to defer the recognitionof gross income and the deduction of costs incurred on contracts until the year in which10% of the estimated allocable contract costs have been incurred (This method ofaccounting is discussed in depth in Chapter 4, Large Contractors). Contractors thatelect this method must also use the 10% method to compute look-back interest. Treas.Reg. § 1.460-6(c)(2)(v). Use of actual contract price and costs under the look-backmethod will occasionally reveal that the year that 10% of the allocable contract costshave been incurred for look-back (the 10% year) was earlier or later than the yearoriginally reported.When the look-back year is earlier than the year originally reported, the contract costsmust be reallocated to the new 10% year and to subsequent years as incurred. Whenthe look-back year is later than the year originally reported, the contract costs incurredbefore the new 10% year must be reallocated to the new 10% year. Treas. Reg.§1.460-6(c)(2)(v).Example of PCM – 10% Method and Application of Look-back:Per Return Year 1 Year 2 Year 3-Completion YearCumulative Incurred Costs 58,000 300,000 500,000Estimated Total Costs 600,000 600,000 500,000Percent Complete 9.6% 50% 100%Total Contract Price 1,000,000 1,000,000 1,000,000Income to be Reported -0- 500,000 500,000Expenses to be Deducted -0- 300,000 200,000Per Look-Back Year 1 Year 2 Year 3Cumulative Incurred Costs 58,000 300,000 500,000Actual Total Costs 500,000 500,000 500,0005-7

Percent Complete 11.6 % 60.00% 100.00%Total Contract Price 1,000,000 1,000,000 1,000,000Gross income that should havebeen Reported for look-backpurposesExpenses that should havebeen deducted for look-backpurposes116,000 484,000(600,000 –116,000)58,000 242,000(300,000 –58,000)Year 1 is the new 10% year for look-back, and the income and expenses arereallocated to year 1 to determine the underpayment of tax in Year 1 under the lookbackmethod.Step 2: Computation of Hypothetical Overpayment or Underpaymentof Tax (Treas. Reg. § 1.460-6(c)(3))This step involves the computation of a hypothetical overpayment or underpayment oftax for each year (a “redetermination year”) in which the tax liability is affected byincome from contracts that are completed or adjusted in the filing year. Rather thanrecomputing the tax liability of each “redetermination year,” a taxpayer may be required,or elect, to use the simplified marginal impact method (SMIM), which uses an assumedmarginal tax rate. This simplified method is discussed later in this chapter. Theremaining discussion of Step 2 is applicable to those taxpayers not using SMIM.The redetermination year is any affected tax year for which a look-back computationmust hypothetically be computed. The filing year is the year that contracts arecompleted or adjusted (e.g., post-completion revenue and expenses, discussed later inthis chapter).The taxpayer must determine what its regular and alternative minimum tax liabilitywould have been for each redetermination year if the actual amounts of contract incomeallocated in Step 1 were substituted for the amounts reported on the taxpayer’s originalreturn (or as subsequently adjusted on an amended return or an examination). Treas.Reg. § 1.460-6(c)(3)(ii). The hypothetical underpayment or overpayment for eachaffected year is the difference between the tax liability as redetermined under the lookbackmethod and the amount of tax liability as originally reported, subsequentlyamended or adjusted, or the last previous application of look-back, whichever is latest.Treas. Reg. § 1.460-6(c)(3)(iii). The redetermination of tax liability resulting fromprevious applications of the look-back method is cumulative. Treas. Reg. § 1.460-6(c)(3)(iv).5-8

Example of Cumulative Application of Look-back:In Year 2, the year of completion, income for look-back is reallocated to Year 1, whichresults in an increase in the “hypothetical “ tax liability as follows:Year 1Tax Liability Per Original Tax Return 500,000Tax Liability Per Look-Back Application 600,000Underpayment of “hypothetical tax” 100,000In Year 3, the look-back method is once again applied, and income is reallocated toYear 1 and Year 2, the affected years. In determining the hypothetical overpayment orunderpayment of tax liability in Year 1, the $600,000 tax liability is used in determiningthe underpayment of the “hypothetical” tax, rather than the tax liability reported on theoriginal return:Year 1Tax Liability Per Year 2 reallocation 600,000Tax Liability Per Look-Back Application (Year 3 reallocation) 650,000Underpayment of “hypothetical tax” 50,000Years Affected by Look-backA redetermination of income tax liability under Step 2 is required for every tax year forwhich the tax liability would have been affected by a change in the amount of income orloss for any other year for which a redetermination is required. For example, if theallocation of contract income under Step 1 changed the amount of a net operating lossthat was carried back to a year preceding the year the taxpayer entered into thecontract, the tax liability for the earlier year must be redetermined. Treas. Reg. § 1.460-6(c)(3)(v).Example of Net Operating Loss (NOL) and Look-back:In Year 5, a contract is completed which was in process in Years 3 and 4. On theoriginal tax return for Year 3, the taxpayer incurred a NOL, which was carried back andfully absorbed in Year 1. When computing look-back for Year 5, the completion year,the reallocation of contract income to Year 3 “hypothetically” decreases the NOL thatwas carried back to Year 1. The tax liability for Year 1 would be recomputed todetermine the underpayment or overpayment of tax for look-back purposes.Definition of Tax Liability5-9

The income tax liability, computed in Step 2, must be redetermined by taking intoaccount all applicable additions to tax, credits, and net operating loss carrybacks andcarryovers. For example, if the taxpayer did not pay alternative minimum tax but wouldhave paid it with the application of look-back, the hypothetical overpayment orunderpayment of tax is determined by comparing the hypothetical tax liability (whichincludes alternative minimum tax) with the actual tax liability for that year. Treas. Reg. §1.460-6(c)(3)(vi).Summary of Step 2For each affected tax year (redetermination year) the hypothetical overpayment orunderpayment of tax is the difference between:• Hypothetical Tax Liability (includes all taxes, credits, NOLs), and• Actual Tax Liability per return adjusted by amendments, examination, andprevious applications of look-back.Step 3: Calculation of Interest on Underpayment or Overpayment ofTax (Treas. Reg. § 1.460-6(c)(4))Once the overpayment or underpayment of tax is calculated for each redeterminationyear, the interest is determined by applying the overpayment rate designated underIRC § 6621, compounded daily.Generally, the time period over which the interest is charged begins on the due date(not including extensions) of the return for the redetermination year and ends on theearlier of:• The due date (not including extensions) of the return for the filing year (i.e. yearof completion or adjustment) and• The date both the income tax return for the filing year is filed and the tax for thatyear has been paid in full. Treas. Reg. § 1.460-6(c)(4)(i).Example of Interest Computation PeriodIn Year 3, contracts were completed by a corporate calendar year-end taxpayer. Lookbackis required to be computed for Years 1 and Year 2. The interest computation forYear 1 look-back would be computed from the due date of the Year 1 tax return(3/15/X2) to the due date of the Year 3 tax return (3/15/X4), if not filed before the duedate of the Year 3 tax return. The interest computation for Year 2 look-back would becomputed from the due date of the Year 2 tax return (3/15/X3) until the due date of theYear 3 tax return (3/15/X4).Different Interest Period For Changes in Net Operating Losses (NOLs)5-10

(Treas. Reg. § 1.460-6(c)(4)(ii))As previously mentioned, if the allocation of contract income under Step 1 changed theamount of a net operating loss that was carried back to a year preceding the year thetaxpayer entered into the contract, the tax liability for the earlier year must beredetermined. The interest is computed from the due date of the tax return that givesrise to the net operating loss carryback and not from the due date of the return in whichthe net operating loss is absorbed. However, for net operating loss carryovers, theinterest is computed from the due date of tax return in which the net operating losscarryover is absorbed.Example of Interest Computation Period on Changes in NOLsIn Year 5, a contract is completed which was in process in Year 3 and 4. On theoriginal tax return for Year 3, the taxpayer incurred a NOL, which was carried back andfully absorbed in Year 1. When computing look-back for Year 5, the completion year,the reallocation of contract income to Year 3 “hypothetically” decreases the NOL thatwas carried back to Year 1. The tax liability for Year 1 would be recomputed todetermine the underpayment or overpayment of tax for look-back purposes. However,the interest computation period would be from the due date of the Year 3 tax return untilthe due date of the Year 5 tax return.In the above example, if the NOL in Year 3 was not carried back but carried over andfully absorbed in Year 4, the interest computation period for look-back would becomputed from the due date of the Year 4 tax return until the due date of the Year 5 taxreturn.Different Interest Period for Changes in Tax Liability That Generated aSubsequent Refund (Treas. Reg. § 1.460-6(c)(4)(iii))If the tax liability in a redetermination year is decreased by the application of look-backand any portion was absorbed by a loss or credit carryback in a year subsequent to theredetermination year, the interest computation period would be as follows:• To the extent the amount of tax absorbed because of the carryback exceeds thetotal hypothetical tax liability for the year, the interest period for look-back endson the due date (not including extensions) of the return for the year in which thecarryback arose and not the due date of the filing year (i.e. completion year).Example:In Year 5, upon the completion of a long-term contract, the taxpayer redetermines its taxliability for Year 3 under the look-back method. This redetermination results in ahypothetical reduction of tax liability of $300 determined as follows:Year 3Tax Per Return 1,500Hypothetical Tax Per Look-back 1,2005-11

Hypothetical Overpayment of Tax 300In Year 4, a NOL was incurred and carried back to Year 3. The interest computationperiod for look-back would depend on the amount of reported tax liability of Year 3 thatwas refunded:(A)(B)(C)If the amount refunded because of the NOL is $1,500: interest is credited to thetaxpayer on the entire hypothetical overpayment of $300 from the due date of theYear 3 return, when the hypothetical overpayment occurred, until the due date ofthe Year 4 return, when the taxpayer received a refund for the entire amount ofthe Year 3 tax, including the hypothetical overpayment. Treas. Reg. § 1.460-6(c)(4)(iii)(A).If the amount refunded because of the NOL is $1,000: interest is credited to thetaxpayer on the entire amount of the hypothetical overpayment of $300 from thedue date of the Year 3 return, when the hypothetical overpayment occurred, untilthe due date of the Year 5 return. In this situation interest is credited until the duedate of the return for the completion year of the contract, rather than the due dateof the return for the year in which the carryback arose, because the amountrefunded was less than the hypothetical tax liability. Therefore, no portion of thehypothetical overpayment is treated as having been refunded to the taxpayerbefore the filing year. Treas. Reg. § 1.460-6(c)(4)(iii)(B).If the amount refunded because of the NOL is $1,300: interest is credited to thetaxpayer on $100 ($1,300 - $1,200) from the due date of the Year 3 return untilthe due date of the Year 4 return because only this portion of the totalhypothetical overpayment is treated as having been refunded to the taxpayerbefore the filing year. However, the taxpayer did not receive a refund for theremaining $200 of the overpayment at that time and, is therefore is credited withinterest on $200 from the due date of the Year 3 return to the due date of the taxreturn for Year 5.Interest Rate Computation Period is Annual, not QuarterlyGenerally, IRS computes interest on a quarterly basis. Prior to the Taxpayer Relief Actof 1997, the look-back interest computation was also computed quarterly. However, theTaxpayer Relief Act of 1997 added IRC § 460(b)(7), which provided the annual rate fortax returns ending after August 5, 1997. Rather than using the rates in effect for eachquarter, the look-back rate will change only once for each twelve month period. Theinterest rate to be used for this period is the rate in effect for the calendar quarter inwhich the interest rate accrual begins.IRC § 460(b)(7) ADJUSTED OVERPAYMENT RATE.—(A)IN GENERAL.—The adjusted overpayment rate for any interest accrualperiod is the overpayment rate in effect under section 6621 for thecalendar quarter in which such interest accrual period begins.5-12

(B)INTEREST ACCRUAL PERIOD.—For purposes of subparagraph (A), the term“interest accrual period” means the period—(i) beginning on the day after the return due date for any taxable year ofthe taxpayer, and(ii) ending on the return due date for the following taxable year.For purposes of the preceding sentence, the term “return due date” means the dateprescribed for filing the return of the tax imposed by this chapter (determined withoutregard to extensions).Corporate Interest RatesFor tax periods ending after 1994, corporate interest rates are different for increases ordecreases of tax exceeding $10,000. Therefore, the first $10,000 of the look-backinterest is computed at one interest rate with any amount over $10,000 being computedat a lower rate (i.e. 1.5% lower). IRC § 6621(a)(1).5-13

Simplified Marginal Impact Method (SMIM)(Treas. Reg. § 1.460-6(d))The SMIM eliminates the need to refigure the tax liability based on actual contract priceand actual contract costs each time the look-back method is applied. Under thesimplified method, prior year hypothetical underpayments or overpayments in tax arefigured using an assumed marginal tax rate, which is generally the highest statutory ratein effect for the prior year under IRC § 1 (for an individual) or IRC § 11 (for acorporation).Required Use of SMIM by Certain Pass-Through Entities (Treas. Reg. § 1.460-6(d)(4))The simplified marginal impact method is required to be used with respect to incomereported from domestic contracts by a pass-through entity that is either a partnership,an S-Corporation, or a trust, and that is not closely held. With respect to contractsdescribed in the preceding sentence, the simplified marginal impact method is appliedby the pass-through entity at the entity level. Treas. Reg. § 1.460-6(d)(4)(i).The assumed marginal rate to be used at the entity level is determined by theownership of the entity. For determining the amount of any hypothetical underpaymentor overpayment, the applicable regular and alternative minimum tax rates, respectively,are generally the highest rates of tax in effect for corporations under section 11 andsection 55(b)(1). However, the applicable regular and alternative minimum tax rates arethe highest rates of tax imposed on individuals under section 1 and section 55(b)(1) if,at all times during the redetermination year involved (i.e., the year in which thehypothetical increase or decrease in income arises), more than 50 percent of theinterests in the entity were held by individuals directly or through 1 or more pass throughentities. Treas. Reg. § 1.460-6(d)(4)(i)(A).A pass-through entity is closely held if, at any time during any redetermination year, 50percent or more (by value) of the beneficial interests in that entity are held (directly orindirectly) by or for 5 or fewer persons. For this purpose, the term “person” has thesame meaning as in IRC § 7701(a)(1), except that a pass-through entity is not treatedas a person. In addition, the constructive ownership rules of IRC § 1563(e) apply bysubstituting the term “beneficial interest” for the term “stock” and by substituting the term“pass-through entity” for the term “corporation” used in that section, as appropriate, forpurposes of determining whether a beneficial interest in a pass-through entity isindirectly owned by any person. Treas. Reg. § 1.460-6(d)(4)(i)(B).A domestic contract is any contract in which substantially all of the income is fromsources in the United States. For this purpose, “substantially all” of the income from along-term contract is considered to be from United States sources if 95 percent or moreof the gross income from the contract is from sources within the United States asdetermined under the rules in IRC §§ 861 through 865. Treas. Reg. § 1.460-6(d)(4)(i)(D).5-14

If a widely held pass-through entity has some foreign contracts and some domesticcontracts, the owners of the pass-through entity each apply the look-back method(using, if they elect, the simplified marginal impact method) to their respective share ofthe income and expense from foreign contracts. Moreover, in applying the look-backmethod to foreign contracts at the owner level, the owners do not take into account theirshare of increases or decreases in contract income resulting from the application of thesimplified marginal impact method with respect to domestic contracts at the entity level.Treas. Reg. § 1.460-6(d)(4)(i)(E).Elective Use of SMIMC corporations, individuals, and owners of closely held pass-through entities that are notrequired to use the SMIM may elect to use this simplified marginal impact method. Inthe case of an electing owner in a pass-through entity, the simplified marginal impactmethod is applied at the owner level, instead of at the entity level, with respect to theowner’s share of the long-term contract income and expenses reported by the passthroughentity. Treas. Reg. § 1.460-6(d)(4)(ii)(A).A taxpayer elects the simplified marginal impact method by stating that the election isbeing made on a timely filed income tax return (determined with regard to extensions)for the first tax year the election is to apply. An election to use the simplified marginalimpact method applies to all applications of the look-back method to all eligible longtermcontracts for the tax year for which the election is made and for any subsequenttax year. The election may not be revoked without the consent of the Commissioner.Treas. Reg. § 1.460-6(d)(4)(ii)(B).In the case of a consolidated group of corporations, as defined in Treas. Reg. §1.1502-1(h), an election to use the simplified marginal impact method is made by the commonparent of the group. The election is binding on all other affected members of the group(including members that join the group after the election is made with respect to allapplications of the look-back method after joining). If a member subsequently leaves thegroup, the election remains binding as to that member unless the Commissionerconsents to a revocation of the election. If a corporation using the simplified marginalimpact method joins a group that does not use the method, the election is automaticallyrevoked with respect to all applications of the look-back method after it joins the group.Treas. Reg. § 1.460-6(d)(4)(ii)(C).Operation of SMIMFirst, under the simplified marginal impact method, income from those contracts that arecompleted or adjusted in the filing year is first reallocated in accordance with theprocedures of Step 1, discussed earlier in this chapter.Second, the increase or decrease in taxable income in the redetermination year due tothe reallocation of contract income (Step 1) is multiplied by the applicable tax rate(highest rate of tax in effect for the redetermination year). This rate is determinedwithout regard to the taxpayer’s actual rate bracket. The amount of any overpayment5-15

determined in this step may be limited to the taxpayer’s actual tax liability (see below).Treas. Reg. § 1.460-6(d)(2)(i).Overpayment Ceiling on RefundsThe net hypothetical overpayment of tax for any redetermination year is limited to thetaxpayer’s total federal income tax liability for the redetermination year reduced by thecumulative amount of net hypothetical overpayments of tax for that redetermination yearresulting from earlier applications of the look-back method. If the reallocation of contractincome results in a net overpayment of tax and this amount exceeds the actual taxliability (as of the filing year) for the redetermination year, as adjusted for pastapplications of the look-back method and taking into account net operating loss, capitalloss, or credit carry over and carry back to that year, the actual tax so adjusted istreated as the overpayment for the redetermination year. This overpayment ceilingdoes not apply when the simplified marginal impact method is applied at the entity levelby a widely held pass-through entity. Treas. Reg. § 1.460-6(d)(2)(iii).Anti-Abuse rule.If the simplified marginal impact method is used with respect to any long-term contract(including a contract of a widely held pass-through entity), the IRS may recomputeinterest for the contract (including domestic contracts of widely held pass-throughentities) under the look-back method using the actual method. See Treas. Reg. §1.460-6(d)(3) for additional information on the anti-abuse rule.Post-Completion Revenue and Expenses (Treas. Reg. § 1.460-6(c)(1)(ii))When a contractor incurs post-completion year costs or receives post-completion yearrevenues, additional look-back computations are necessary. Any year in which thelook-back method must be applied is treated as a filing year. Treas. Reg. § 1.460-6(c)(1)(ii)(A). The amount of any post-completion adjustment to the total contract priceor contract costs is discounted, solely for purposes of applying the look-back method,from its value at the time the amount is taken into account in computing taxable incometo its value at the completion of the contract. Treas. Reg. § 1.460-6(c)(1)(ii)(C)(1).Items to consider with post-completion revenue and expenses are:• Taxpayers have the option not to discount post-completion year revenues andcosts. Treas. Reg. § 1.460-6(c)(1)(ii)(C)(2).• For purposes of reapplying the look-back method after the year of contractcompletion, a taxpayer may elect the “delayed reapplication method” to minimizethe number of required reapplications of the look-back method. Treas. Reg. §1.460-6(e).5-16

• A taxpayer may elect not to apply the look-back method in de minimis cases.IRC § 460(b)(6); Treas. Reg. § 1.460-6(j).Revenue Acceleration Rule (Treas. Reg. § 1.460-6(c)(1)(ii)(D))IRC § 460(b)(1) requires a taxpayer to include in gross income, for the tax yearimmediately following the year of completion, any unreported portion of the totalcontract price not previously required to be included in income (including amounts thatthe taxpayer expects to receive in the future) determined as of that year. This treatmentis required even if the percentage of completion ratio is less than 100 percent becausethe taxpayer expects to incur additional allocable contract costs in a later year. At thetime any remaining portion of the contract price is includible in income under this rule,no offset against this income is permitted for estimated future contract costs. To achievethe requirement to report all remaining contract revenue without regard to additionalestimated costs, a taxpayer must include only costs actually incurred through the end ofthe tax year in the denominator of the percentage of completion ratio in applying thepercentage of completion method for any tax years after the year of completion. Treas.Reg. § 1.460-6(c)(1)(ii)(D).Reporting Look-Back – Form 8697 (Treas. Reg. § 1.460-6(f))Form 8697 is used for the Look-Back Computation. Each contract year is computed ina separate column on Form 8697, with the totals being netted to determine whether anoverall refund or additional tax is due for the filing year (the completion year or a postcompletionyear). If a taxpayer owes interest under the look-back method, the Form8697 is attached to the tax return and is considered an additional tax. See Treas. Reg. §1.460-6(f)(2)(i), and the Instructions to Form 8697. If the taxpayer is due a refund, theForm 8697 is not attached to the taxpayer’s tax return, but instead is filed separately.See the Instructions to Form 8697.If the taxpayer was an owner of an interest in a partnership or an S-Corporation duringany year in which long-term contracts were being accounted, Form 8697 must be filedfor the tax year that ends with or includes the end of the entity’s tax year in which thecontract was completed. See Instructions to Form 8697.Interest required to be paid on Form 8697 will be added to the tax on the income taxreturn and the Form 8697 will be attached to the income tax return. For a corporationthe interest due would still be an interest deduction even though it is added to the totaltax on the return. Treas. Reg. § 1.460-6(f)(2)(i). For an individual, the interest isnondeductible personal interest. A taxpayer that fails to pay the amount of interest dueis subject to any applicable penalties and interest. Treas. Reg. § 1.460-6(f)(2)(i). If ataxpayer owes interest on Form 8697, the Form 8697 is a form within the tax return, andthe statute of limitations on the return under IRC §§ 6501 and 6502 is controlling.Treas. Reg. § 1.460-6(f)(3).In cases where the taxpayer is entitled to receive a refund of interest, the Form 8697must be filed separately; it is not attached to the tax return. The amount of interestreceived is treated as taxable interest income and is not treated as a reduction in tax5-17

liability or a tax refund. Treas. Reg. § 1.460-6(f)(2)(i). The amount is includible in grossincome as interest income in the tax year it is properly taken into account under thetaxpayer’s method of accounting for interest income. When the taxpayer is entitled to alook-back refund, the taxpayer has a 6-year period in which to file a claim. See Rev.Rul. 56-506, 1956-2 C.B. 959, and Rev. Rul. 57-242, 1957-1 C.B. 452.Treas. Reg. § 1.460-6(f)(2) Treatment of interest on return--(i) General rule. Theamount of interest required to be paid by a taxpayer is treated as an income taxunder subtitle A, but only for purposes of subtitle F of the Code (other thansections 6654 and 6655), which addresses tax procedures and administration.Thus, a taxpayer that fails to pay the amount of interest due is subject to anyapplicable penalties under subtitle F, including, for example, an underpaymentpenalty under section 6651, and the taxpayer also is liable for underpaymentinterest under section 6601. However, interest required to be paid under the lookbackmethod is treated as interest expense for purposes of computing taxableincome under subtitle A, even though it is treated as income tax liability forsubtitle F purposes. Interest received under the look-back method is treated astaxable interest income for all purposes, and is not treated as a reduction in taxliability or a tax refund. The determination of whether or not interest computedunder the look-back method is treated as tax is determined on a “net” basis foreach filing year. Thus, if a taxpayer computes for the current filing year bothhypothetical overpayments and hypothetical underpayments for prior years, thetaxpayer has an increase in tax only if the interest computed on theunderpayments for all those prior years exceeds the interest computed on theoverpayments for all those prior years, for all contracts completed or adjusted forthe year.In general, the look-back method is applied by the taxpayer that reports the income froma long-term contract. See Treas. Reg. § 1.460-6(g) for rules regarding who isresponsible for applying the look-back method when, prior to the completion of a longtermcontract, there is a transaction that changes the taxpayer that reports income fromthe contract (also known as mid-contract change in taxpayer).ConclusionLook-back is hypothetical and does not result in an adjustment to the taxpayer’s taxliability as originally reported or amended. It does result, however, in payment ofinterest from or to the taxpayer upon completion of the contract, depending on theaccuracy of the estimated numbers used by the taxpayer in its PCM computations. Dueto the hypothetical nature of look-back, a separate tax system is necessary to accountfor look-back, similar to that of alternative minimum tax. Look-back is a very complexarea of the tax law which causes many errors in compliance.Chapter 4 / Table of Contents / Chapter 6Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search5-18

Chapter 5 / Table of Contents / Chapter 7Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 6: Financial Accounting Versus Tax AccountingIntroductionThe accounting methods available within in the construction industry are unique to thisindustry. Understanding both the financial accounting and tax accounting requirementsis important, so the proper book-to-tax adjustments are made.Financial AccountingThe primary sources for generally accepted accounting principles (GAAP) foraccounting for construction contracts are Accounting Research Bulletin (ARB) No. 45,Long-Term, Construction-Type Contracts and Statement of Position (SOP) 81-1,Accounting for Performance of Construction-Type and Certain Production-TypeContracts. Under (GAAP) there are two methods of recognizing revenues onconstruction contracts:• percentage-of-completion method and• completed contract method.These two methods are not alternatives from which a contractor is free to choose.SOP 81-1 establishes a strong preference for the percentage-of-completion method.The only time the completed contract method should be used is when either of thefollowing conditions exists:(1) The results do not vary materially from those under the percentage-of-completionmethod, or(2) The contractor can overcome the basic presumption that it has the ability tomake reasonably dependable estimates.Therefore, the financial statements (whether certified, reviewed, or complied) that areprepared for bonding, banking, or other reporting purposes are almost exclusivelyprepared using the percentage of completion accounting method. However, asdiscussed in the Small Contractors and Large Contractors chapter, many moreaccounting method choices are available to the contractor for tax purposes, dependingon the length of the contract, the type of construction involved, and the gross receipts ofthe taxpayer.6-1

Balance Sheet AccountsWhen accounting for contracts using the percentage-of-completion method (PCM),costs, rather than the contract’s earned or billed income, determines the revenuerecognition. Determining completion by costs (Total Costs Incurred divided by TotalEstimated Costs) is a computation not made through the day-to-day book recordingprocedures. For instance, there is not a general ledger account for total estimatedcontract costs.To account for the difference between percentage of completion method and billings,two balance sheet accounts are created:• Costs and Estimated Earnings in Excess of Billings (Asset)• Billings in Excess of Costs and Estimated Earnings (Liability)Example Of Journal Entries for a Construction Contract Using Percentage OfCompletion Method:The contractor entered into a long-term construction contract during the 2001 taxableyear. The total estimated contract price is $3,000,000, the total estimated contractcosts are $2,000,000 and the contract is estimated to be completed in 2002. The totalcosts incurred on this contract during 2001 are $1,000,000. The contractor billed thecustomer $1,200,000 during 2001.During the tax year journal entries to record the transactions of this contractwould be recorded as follows:Costs IncurredAccounts Payable1,000,000 (debit)1,000,000 (credit)Accounts Receivable 1,200,000 (debit)Costs and Estimated Earnings in Excess of Billings 1,200,000 (credit)At year end, the contractor would determine the income to be included under thepercentage of completion method as follows:1,000,000 (Total Costs Incurred)2,000,000 (Total Estimated Costs) x $3,000,000 = 1,500,000The adjusting journal entry necessary to bring the books/financial statements inaccordance with the percentage of completion method would be as follows:Costs and Estimated Earnings in Excess of BillingsIncome1,500,000 (debit)1,500,000 (credit)6-2

At year end the Costs and Estimated Earnings in Excess of Billings account hasa debit balance of $300,000, thus is represented as an asset on the balancesheet.Basically, these two balance sheet accounts represent the difference between theaccrual method and the percentage-of-completion method for reporting income on along-term contract. Under either method, the costs related to the long-term contract arededucted as incurred. Therefore, generally no difference exists between the twomethods for costs.Income per billings (accrual) $1,200,000Income per percentage of completion $1,500,000Costs and Earnings in Excess of Billings 300,000.Balance Sheet ReportingA basic reporting principle prevents assets and liabilities from being netted or offsetagainst each other. Thus both accounts (Costs and Earnings in Excess of Billings andEarnings and Costs in Excess of billings) should be present on the balance sheet. Thefollowing procedures are performed at year-end:• For each contract in progress at year-end, the total cost incurred to date plus theestimated earnings (on percentage of completion method) is reduced by the totalamount of bills rendered to arrive at a net balance. The net balance, for eachcontract, will be a debit if the total costs and estimated earnings exceed thebillings and a credit if the billings exceed the costs and estimated earnings.• All contracts that have a debit balance are added together with the total shownas an asset on the balance sheet.• All contracts that have a credit balance are added together with the total shownas a liability on the balance sheet.See the Contracts In Process Schedule at the end of the chapter for an illustration of theabove procedures.Book/Tax DifferencesSchedule M-1 adjustments result from both timing differences and permanentdifferences between financial and tax accounting. The following items are intended topoint out some of the differences in financial and tax accounting that are unique to theconstruction industry. These differences should be reconciled through Schedule M-1adjustments.6-3

Revenue RecognitionAs discussed above, Statement of Position 81-1 (SOP 81-1) virtually requiresconstruction companies to report income on the percentage of completion method.Generally, the bonding company or a lending bank will require the taxpayer to submitcertified (possibly reviewed) financial statements, which will be reported on thepercentage of completion method. For tax accounting, the contractor may use adifferent method, such as completed contract method, percentage of completionmethod, or capitalized cost method.Contract Related ServicesSOP 81-1 paragraph 12 provides a listing of contracts which are covered by thisstatement. Included in that listing are engineers, architects, and constructionmanagement taxpayers. Therefore, for financial purposes these contracts would beaccounted for under the percentage of completion method. However, for tax purposes,they generally cannot use a long-term contract method (e.g., completed contract orpercentage of completion). Revenue Ruling 70-67, Revenue Ruling 80-18, RevenueRuling 82-134, Revenue Ruling 84-32.Determining Completion for Percentage of Completion Method.SOP 81-1 paragraph 44 provides a number of methods to measure the extent ofprogress towards completion. They include the cost-to-cost method, variations of thecost-to-cost method, efforts expended method, the units-of-delivery method, and theunits-of-work-performed method. For tax purposes, IRC § 460 generally requires thecost-to-cost method. However, the taxpayer may also elect the percentage ofcompletion, 10% method in which none of the contract revenue or costs are included intaxable income until the contract is 10% complete. The contractor may also elect thesimplified cost-to-cost method to determine contract completion.Loss RecognitionSOP 81-1 paragraph 85 requires the contractor to report the total loss on a contract assoon as it is evident that a loss will occur. “When the current estimates of total contractrevenue and contract cost indicate a loss, a provision for the entire loss on the contractshould be made. Provisions for losses should be made in the period in which theybecome evident under either the percentage-of-completion method or the completedcontractmethod.” However, for tax purposes, the loss is not recognized until the job iscompleted, if on the completed contract method, and as incurred, if on the percentageof completion method.6-4

See the following pages for an illustration of sample financial statementsreporting construction contracts on the percentage of completion method anditems to consider when reviewing these statements.XYZ CorporationBalance SheetDecember 31, 2002AssetsCurrent AssetsCash 9,000Contract Receivables 335,000Costs & Estimated Earnings in Excess of Billings *** 28,711372,711Property & EquipmentFurniture, Fixtures, & Equipment 6,000Accumulated Depreciation -1,5004,500Other AssetsDeposits 750Total Assets 377,961Liabilities and Stockholder's EquityAccounts Payable 121,000Accrued Liabilities 17,000Deferred Income Taxes 36,000Billings in Excess of Costs and Estimated Earnings *** 5,666179,666Common Stock 1,000Retained Earnings 197,295377,961***These accounts should reconcile to the Schedule 3 Contracts in Progress6-5

XYZ CorporationStatement of Income and Retained EarningsDecember 31, 2002Contract Revenue Earned ** 1,439,159Costs of Revenue Earned ** 1,174,000Gross Profit 265,159General & Administrative Expenses 199,000Income Before Income Taxes 66,159Income TaxesCurrent 12,000Deferred 4,000Net Income *** 50,159Beginning Retained Earnings 147,136Ending Retained Earnings 197,295**From Schedule 1 Earnings From Contracts***Should reconcile to Schedule M-1 Line 1 Book Income6-6

XYZ CorporationSchedule 1 - Earnings From ContractsYear Ended December 31, 2002Revenues Cost of Gross ProfitEarned Revenues (Loss)Contracts Completed During the year** 502,000 361,000 141,000Contracts in progress at year end*** 937,159 813,000 124,1591,439,159 1,174,000 265,159** From Schedule 2 Contracts Completed– represents the amounts of revenueearned and costs incurred during the 2002 tax year.***From Schedule 3 Contracts in Progress – represents the amounts of revenueearned and costs incurred during the 2002 tax year.Chapter 5 / Table of Contents / Chapter 7Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search6-7

XYZ CorporationSchedule 2 - Contracts CompletedYear Ended December 31, 2002Contract Totals Before Jan. 1, 2002 Year Ended December 31, 2002Gross Gross GrossProject Construction Revenues Cost of Profit Revenues Cost of Profit Revenues Cost of ProfitNumber Project Earned Revenues (Loss) Earned Revenues (Loss) Earned Revenues (Loss)121 John's Store 312,000 248,000 64,000 193,000 172,000 21,000 119,000 76,000 43,000122Ron's Club 267,000 197,000 70,000 178,000 144,000 34,000 89,000 53,000 36,000127 Parking Lot 403,000 312,000 91,000 250,000 199,000 51,000 153,000 113,000 40,000128 Hospital 35,000 38,000 -3,000 -- -- -- 35,000 38,000 -3,000130 Office Bldg 106,000 81,000 25,000 -- -- -- 106,000 81,000 25,0001,123,000 876,000 247,000 621,000 515,000 106,000 502,000 361,000 141,000These amounts would be usedfor the tax return if on completedcontract method6-8

XYZ CorporationSchedule 3 - Contracts In ProgressYear Ended December 31, 2002Total Contract From Inception to December 31, 2002 Before January 1, 2002 At Dec. 31, 2002 For the Year ended December 31, 2002ProjectNumberRevenuesEstimatedGross Profit(Loss)RevenuesEarnedCost ofRevenuesGrossProfit(Loss)Billed toDateEstimatedCost toCompleteRevenuesEarnedCost ofRevenuesGrossProfit(Loss)Costs &Est.Earningsin Excessof BillingsBillings inExcess ofCosts &Est.EarningsRevenuesEarnedCost ofRevenuesGrossProfit(Loss)PercentComplete119 1,275,000 210,000 1,228,310 1,026,000 202,310 1,225,000 39,000 1,049,000 880,000 169,000 3,310 --- 179,310 146,000 33,310 96.34%120 211,000 -10,000 107,887 113,000 -5,113 106,000 108,000 --- --- --- 1,887 --- 211,000 221,000 -10,000 51.13%123 53,000 15,000 43,237 31,000 12,237 46,000 7,000 --- --- --- --- 2,763 43,237 31,000 12,237 81.58%124 258,000 50,000 129,000 104,000 25,000 117,000 104,000 --- --- --- 12,000 --- 129,000 104,000 25,000 50.00%125 218,000 40,000 79,607 65,000 14,607 74,000 113,000 --- --- --- 5,607 --- 79,607 65,000 14,607 36.52%126 85,000 13,000 47,222 40,000 7,222 43,000 32,000 --- --- --- 4,222 --- 47,222 40,000 7,222 55.56%129 220,000 42,000 181,685 147,000 34,685 180,000 31,000 --- --- --- 1,685 181,685 147,000 34,685 82.58%131 160,000 38,000 28,852 22,000 6,852 30,000 100,000 --- --- --- --- 1,148 28,852 22,000 6,852 18.03%133 152,000 1,000 37,245 37,000 245 39,000 114,000 --- --- --- --- 1,755 37,245 37,000 245 24.50%2,632,000 399,000 1,883,045 1,585,000 298,045 1,860,000 648,000 1,049,000 880,000 169,000 28,711 5,666 937,159 813,000 124,159Audit Considerations:(1) Job #120 has a total estimated loss of (10,000) – the full loss is being reported for financialpurposes. However, the job is only 51.13% complete. Thus, there should be an Schedule M-1adjustment from book to tax.(2) Where is Job #132? – Not located on this schedule or the completed contract schedule.(3) Job #133 has an unusually low gross profit compared to other jobs. Why?Balance SheetAccounts6-9

Chapter 6 / Table of Contents / Chapter 8Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 7: Homebuilders and DevelopersIntroductionHome construction contracts are one of the two exceptions from some of therequirements of IRC § 460. The small contractors exception is the other one that isdiscussed in detail in Chapter 3. Contracts that meet the home construction contractsdefinition are exempt from:• The requirement to use percentage of completion method• The application of the look-back provisions• The requirement to use percentage of completion method for alternativeminimum tax purposes.Even though exempt from the above requirements, construction period interest is stillrequired to be capitalized per IRC § 460(c)(3).IRC § 460(e)(1)(A) excepts any home construction contract and thus is not based onthe length of the contract nor the gross receipts of the contractor as with the smallcontractors exception. However, the last sentence of IRC § 460(e)(1) provides thathome construction contracts that do not meet the 2-year or gross receipts test($10,000,000) are subject to the application of IRC 263A. These contractors arecommonly termed Large Home Builders and will be discussed separately in thischapter.IRC § 460(e) EXCEPTION FOR CERTAIN CONSTRUCTION CONTRACTS.—(1) IN GENERAL.—Subsections (a), (b), and (c)(1) and (2) shall not apply to—(A) any home construction contract, or(B) any other construction contract entered into by a taxpayer—(i) who estimates (at the time such contract is entered into) that such contractwill be completed within the 2-year period beginning on the contractcommencement date of such contract, and(ii) whose average annual gross receipts for the 3 taxable years precedingthe taxable year in which such contract is entered into do not exceed$10,000,000.7-1

In the case of a home construction contract with respect to which therequirements of clauses (i) and (ii) of subparagraph (B) are not met, section 263Ashall apply notwithstanding subsection (c)(4) thereof.HOME CONSTRUCTION CONTRACT DEFINEDA home construction contract is any contract where 80% or more of the estimated totalcontract costs, as of the close of the tax year that the contract was entered into, isreasonably expected to be attributable to the building, construction, reconstruction, orrehabilitation of dwelling units contained in buildings containing four or fewer dwellingunits and improvement to real property that are directly related to such dwelling unit.The distinction between a home construction contract and a residential constructioncontract is important because residential construction contracts do not meet theexception to the use of percentage of completion and look-back provided by IRC §460(e). Residential construction contracts contain more than 4 dwelling units (e.g.apartments, condominiums). Residential construction contracts are discussed in moredetail in Chapter 4.IRC § 460(e)(6)(A) HOME CONSTRUCTION CONTRACT.—The term “home constructioncontract” means any construction contract if 80 percent of the estimated total contractcosts (as of the close of the taxable year in which the contract was entered into) arereasonably expected to be attributable to activities referred to in paragraph (4) withrespect to—(i) dwelling units (as defined in section 168(e)(2)(A)(ii)) contained in buildingscontaining 4 or fewer dwelling units (as so defined), and(ii) improvements to real property directly related to such dwelling units andlocated on the site of such dwelling units.For purposes of clause (i), each townhouse or rowhouse shall be treated as a separatebuilding.Treas. Reg. § 1.460-3(b)(2) clarifies that a contract of a subcontractor working for ageneral contractor is included in the definition of home construction contracts if itotherwise qualifies, and that common improvements that benefit the dwelling units beingconstructed or located at the site of the dwelling units are included as part of the 80%test.Treas. Reg. § 1.460-3(b)(2) Home construction contract--(i) In general. A long-termconstruction contract is a home construction contract if a taxpayer (including asubcontractor working for a general contractor) reasonably expects to attribute 80percent or more of the estimated total allocable contract costs (including the cost ofland, materials, and services), determined as of the close of the contracting year, tothe construction of—7-2

(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), contained in buildingscontaining 4 or fewer dwelling units (including buildings with 4 or fewerdwelling units that also have commercial units); and(B) Improvements to real property directly related to, and located at the site of,the dwelling units.(ii) Townhouses and rowhouses. Each townhouse or rowhouse is aseparate building.(iii) Common improvements. A taxpayer includes in the cost of thedwelling units their allocable share of the cost that the taxpayer reasonablyexpects to incur for any common improvements (e.g., sewers, roads,clubhouses) that benefit the dwelling units and that the taxpayer is contractuallyobligated, or required by law, to construct within the tract or tracts of land thatcontain the dwelling units.(iv) Mixed use costs. If a contract involves the construction of bothcommercial units and dwelling units within the same building, a taxpayer mustallocate the costs among the commercial units and dwelling units using areasonable method or combination of reasonable methods, such as specificidentification, square footage, or fair market value.What is a Dwelling Unit?Dwelling units are defined in IRC § 168(e)(2)(A)(ii)(I). The term “dwelling unit” means ahouse or apartment used to provide living accommodations in a building or structure,but does not include a unit in a hotel, motel, or other establishment more than one-halfof the units in which are used on a transient basis.Mixed Use BuildingsIf a contract requires construction of a mixed-use building (e.g. a building that willinclude both dwelling units and offices) the costs are allocated among the commercialunits and the dwelling units using a reasonable method, pursuant to Treas. Reg. §1.460-3(b)(2)(iv).Taxation of HomebuildersTo avoid confusion in the tax accounting rules, for both income and expenses, thefollowing types of construction or development will be discussed separately:• Homes Built for Speculation (No Contract)• Contractors Building Homes Under Contract7-3

• Land DevelopersHomes Built for Speculation (No Contract)Homebuilders will purchase a number of lots from a developer of a subdivision to buildhouses. The homebuilder may build some of the homes as speculative (spec) homes.Speculative homes are not built under a contract. In the industry, homes built forspeculation that are on hand at year end are referred to as inventory of unsold housesor work in process. These speculation houses do not meet the definition of inventory inthe Code. The Internal Revenue Code defines inventory as tangible personal property.Speculation houses are capital assets as defined in IRC § 263. The builder owns thereal property (land) and the house inherently attached to the land. Courts haveconsistently held that developed real property must be accounted for under acapitalization method. See W.C. & A.N. Miller Development Co. v. Commissioner,81 T.C. 619 (1983); Homes by Ayres v. Commissioner, T.C. Memo. 1984-475, aff’d,795 F.2d 832 (9th Cir. 1986). See also Rev. Rul. 86-149, 1986-2 C.B. 67; Rev. Rul. 66-247, 1966-2 C.B. 198.Income RecognitionSince speculation homes are not built under a contract, long-term contract accountingmethods (completed contract and percentage of completion) do not apply. Speculativehomebuilders report their income from the sale of a speculative house at the time ofsettlement/closing per IRC § 1001.Sometimes speculative homes are started but “sold” during the construction phase,which could become a long-term construction contract (if not completed within the sametax year) subject to the taxpayer’s long-term contract method of accounting. However,in most cases, the completed contract method is the one elected, and the “sale” wouldnot constitute a taxable event until completion.Cost RecognitionThe direct and indirect costs incurred by a taxpayer in the construction of a house forspeculative sale (including the cost of the land, direct materials and direct labor) shouldbe capitalized according to the principles in IRC § 263(a) and IRC § 263A, regardlessof the taxpayer’s overall method of accounting.Under IRC § 263(a)(1) and Treas. Reg. § 1.263(a)-1, costs incurred in the constructionof homes and other permanent improvements to real property are not currentlydeductible. Instead the cost of unsold homes and construction in progress is a capitalexpenditure that becomes part of the basis of the real estate, which in turn, is recoveredeither through a depreciation allowance if the property is used in a trade or business(rented), or as an offset against the price received in the sale or disposition of suchproperty.7-4

Treas. Reg. § 1.263(a)-2 sets forth examples of capital expenditures, including the costof acquisition, construction, or erection of buildings having a useful life substantiallybeyond the tax year.The uniform capitalization rule of IRC § 263A(a)(1) applies to speculation homes, whichmandates certain costs to be allocated to property produced by the taxpayer, and thatsuch costs be capitalized if the property is not inventory in the hands of the taxpayer.IRC § 263A(a)(1) In general. --In the case of any property to which this sectionapplies, any costs described in paragraph (2) shall be capitalized.The homebuilder must determine the accumulated production expenditures,described in Treas. Reg. § 1.263A-11, with respect to each home. This requires thehomebuilder to allocate the cumulative amount of direct and indirect costs described in§ 263A(a) that are required to be capitalized with respect to the unit of property. A unitof property is defined by Treas. Reg. § 1.263A-10(b) as any components of realproperty that are functionally interdependent, along with an allocable share of anycommon feature owned by the taxpayer. For example, the components of a singlefamily home (land, foundation and walls) are functionally interdependent; in contrast,condo units separately placed in service in a multi-unit building are each treated as afunctionally interdependent unit, even though they are all located in the same building.In the case of property produced for sale, components of real property are functionallyinterdependent if they are customarily sold as a single unit. All costs that have beenaccumulated for a particular home are charged to cost of sales at the time of settlementwith the purchaser of the home.Rev. Rul. 66-247- the costs incurred in the construction of a house for speculative saleare capitalized regardless of the taxpayer's overall method of accounting. Such costsshall be applied against the amount realized upon the sale of the house for purposes ofdetermining gain or loss in computing taxable income.Carpenter v. Commissioner, T.C. Memo 1994-289 - A building contractor could notuse the cash method of accounting for expenses related to construction of houses thatwere unsold at the end of the tax year because he was a producer of the property. Thecontractor was required to capitalize (per IRC section 263A) the costs of constructionrelated to the unsold houses.Inventory vs. Real EstateIn the construction industry, it is common for a contractor to use “inventory” terminologyfor unsold homes or work-in-progress. However, unsold homes or work-in-progress isreal estate which is never considered inventory. Both real estate and inventory areassets but this distinction is important because under several accepted inventorymethods, a departure from the actual cost could take place (that is, lower of cost ormarket).7-5

Atlantic Coast Realty Co. v. Commissioner, 11 B.T.A. 416 (1928), and Rev. Rul. 69-536, 1969-2 C.B. 109 - Home builders are not allowed to treat real estate held for saleas “inventory” and write their work in process down to market value using a lower ofcost or market valuation.Homes by Ayres v. Commissioner, T.C. Memo 1984-475, aff’d., 795 F.2d 832 (9thCir. 1986) - Taxpayers engaged in the construction and sale of large-scale tract housingdevelopments could not use the LIFO method to account for the property. The courtheld that real estate is not inventory, and thus an inventory method to account for theproperty is not allowed.W.C. & A.N. Miller Development Co. v. Commissioner, 81 T.C. 619 (1983) - Thetaxpayer was engaged in the business of developing real estate, which it acquired, andconstructed single-family, detached homes. The taxpayer applied a LIFO method toaccount for its completed homes. All costs related to each home were charged to thecost of sales only at the time of settlement with the purchaser of the home. The courtheld that the individual homes or lots which the taxpayer sells are real estate and do notconstitute “merchandise” within the meaning of Treas. Reg. § 1.471-1. Thus, LIFO isnot permitted.“...there is a fundamental difference between capitalization and an inventorymethod. Under capitalization, gain will be determined pursuant to section1001 on each individual home when it is sold, and such gain is to bedetermined based generally on the taxpayer’s actual cost for that particularhome.”Rev. Rul. 86-149, 1986-2 C.B. 67 - A real estate developer filed a Form 970 to applyfor the LIFO method of accounting for its “inventory” of completed homes and homes inprogress. The construction costs of completed homes and costs of construction inprogress are capital expenditures under IRC § 263. A taxpayer engaged in thebusiness of developing real estate capitalizes its costs in accordance with IRC § 263.“Under section 263(a)(1), costs incurred in the construction of homes andother permanent improvements to real property are not currently deductible.Instead the costs of unsold homes and construction in progress is capitalexpenditure that becomes part of the cost of the real estate, which, in turn, isrecovered either through a depreciation allowance if the property is used in atrade of business, or as an offset against the price received in the subsequentsale or disposition of such property.”Speculation Homes Becoming Long-Term ContractsA contractor may begin building a speculative home and enter into a “sales” agreementwith a customer prior to completion. If the remaining construction on the home, after thecontract is entered into, extends beyond the taxable year, the contractor has entered7-6

into a long-term contract and would then be able to account for the contract under along-term method of accounting available for exempt contracts. See Treas. Reg. §1.460-4(c)(1).Contractors Building Homes Under ContractAs previously mentioned, any home construction contract is exempt from therequirement to use the percentage of completion method per IRC § 460(e)(1)(A).Therefore, the contractor may elect a permissible exempt contract method whichincludes percentage of completion, exempt percentage of completion, completedcontract, or any other permissible method per section 446. (See Treas. Reg. § 1.460-4(c)(1)). The contractor must use the elected method to account for all its long-termcontracts that are exempt from the requirements of section 460(a). Even thoughexempt construction contracts are not subject to the percentage of completion method,production period interest is subject to the cost allocation rules per IRC § 460(c)(3).See Treas. Reg. § 1.460-1(a)(2)(i).Long-Term Methods of AccountingIf a contractor elects a long-term method of accounting for an exempt constructioncontract (e.g., completed contract method, percentage of completion method, or exemptcontract percentage of completion method) it is not relevant who has title to the land onwhich the home is being built. Within the definition of a contract for the construction ofproperty, Treas. Reg. § 1.460-1(b)(2) states, “Whether the customer has title to, controlover, or bears the risk of loss from, the property manufactured or constructed by thetaxpayer also is not relevant.”Treas. Reg. § 1.460-4 describes the tax recognition of the contract income andexpenses attributable to long-term methods of accounting. (See Chapter 3 for adetailed discussion of each accounting method):• Completed Contract Method - Gross contract price and all allocable contractcosts incurred are included in taxable income in the year of completion under thecompleted contract method per Treas. Reg. § 1.460-4(d).• Percentage of Completion Method (PCM)– A taxpayer generally must includein income the portion of the total contract price that corresponds to thepercentage of the entire contract that the taxpayer has completed during thetaxable year. The percentage of completion must be determined by comparingallocable contract costs incurred with estimated total allocable contract costs.Thus, the taxpayer includes in gross income a portion of the contract price as thetaxpayer incurs allocable contract costs. See Treas. Reg. § 1.460-4(b).• Exempt Contract Percentage of Completion Method – Similar to PCM, above,except the percentage of completion may be determined using any method of7-7

cost comparison(such as direct labor costs incurred to estimated total direct laborcosts) or by comparing the work performed on the contract with the estimatedtotal work to be performed. See Treas. Reg. § 1.460-4(c)(2).Other Permissible Accounting MethodsTitle to the property is relevant if the taxpayer elects any permissible method, per IRC §446, other than a long-term method of accounting, because the appropriate rules forincome and expenses are contained in other sections of the Internal Revenue Code andregulations.Treas. Reg. § 1.460-1(a)(2)Exceptions to required use of PCM--(i) Exemptconstruction contract. The requirement to use the PCM does not apply to anyexempt construction contract described in §1.460-3(b). Thus, a taxpayer maydetermine the income from an exempt construction contract using anyaccounting method permitted by §1.460-4(c) and, for contracts accounted forusing the completed-contract method (CCM), any cost allocation methodpermitted by §1.460-5(d). Exempt construction contracts that are not subjectto the PCM or CCM are not subject to the cost allocation rules of §1.460-5except for the production-period interest rules of §1.460-5(b)(2)(v). Exemptconstruction contractors that are large homebuilders described in §1.460-5(d)(3) must capitalize costs under section 263A. All other exemptconstruction contractors must account for the cost of constructionusing the appropriate rules contained in other sections of the InternalRevenue Code or regulations. [emphasis added]If the contractor does not elect a long-term accounting method and owns the property,the land and the home being built upon it, the contractor must capitalize all costsincurred in the construction of the home per IRC § 263. See Rev. Rul. 86-149, 1986-2C.B. 67. These costs are capital expenditures that become a part of the real estate costwhich, in turn, is recovered as an offset against the price received upon the dispositionof the property. See IRC §1001. Therefore, the cash or accrual methods are notallowable methods for contractors building on property it owns.Conversely, a contractor that builds a home on the customer’s property may be eligiblefor the cash or accrual method of accounting. See Chapter 3 for additional informationon these methods of accounting.Large HomebuildersA large homebuilder is one failing to meet the requirements of IRC § 460(e)(1)(B),which are:A. Any homebuilder whose average annual gross receipts, for three preceding years,exceed $10,000,000 or7-8

B. Contracts which are expected to exceed a 2-year period beginning on the contractcommencement date.The only distinction between a large homebuilder and a small homebuilder, is that alarge homebuilder is required to capitalize the allocable contract costs according to IRC§ 263A.Treas. Reg. § 1.460-1(a)(2)”…Exempt construction contractors that are largehomebuilders described in § 1.460-5(d)(3) must capitalize costs under section263A.”Treas. Reg. § 1.460-5(d)(3) Large homebuilders. A taxpayer must capitalizethe costs of home construction contracts under section 263A and theregulations thereunder, unless the contract will be completed within two yearsof the contract commencement date and the taxpayer satisfies the$10,000,000 gross receipts test described in § 1.460-3(b)(3).Model HomesHomebuilders may buy several lots in a subdivision and build one or more styles ofhomes to use as a model home. These model homes may contain a portion of thehome as a sales office. The model home will eventually be sold at the end of thedevelopment. Rev. Rul. 89-25, 1989-1 C.B. 79, states that model homes and salesoffices are not subject to an allowance for depreciation.Land DeveloperIn the industry, the developer is generally the owner of the development. The developeracquires the raw land, obtains approval for development, secures the financing, andbegins to clear the land, install roads, utilities, etc. The land developer may also buildthe homes in the development, sell the lots to a builder that will build the homes, or acombination of both.Income Recognition ─ Applicable MethodSince land developers are involved in the production of property without contracts, theygenerally report their income from the sale of a parcel of property at the time ofsettlement/closing.Cost RecognitionThe direct costs incurred by a land developer in the development of real estate(including the original cost of the land, direct materials and direct labor) should becapitalized according to IRC §§ 263(a) and 263A.7-9

The uniform capitalization rules of IRC § 263A(a)(1) apply to land developers, andmandates certain costs to be allocated to property produced by the taxpayer as realproperty. These costs include pre-production costs (real estate taxes, zoning costs,design fees, etc.), production costs, and post-production costs.IRC § 263A(a)(1) In general.--In the case of any property to which this sectionapplies, any costs described in paragraph (2) shall be capitalized.Von-Lusk v Commissioner, 104 T.C. 207 (1995) - Predevelopment costs werecapitalized per IRC section 263A because taxpayer was involved in the "production" ofproperty.The land developer must determine the accumulated production expenditures withrespect to each unit of property per Treas. Reg. § 1.263A-11. Each unit of property, asdefined in Treas. Reg. § 1.263A-10, is treated as a separate costing unit to which alldirect and indirect costs described in § 263A(a) are required to be capitalized.How Are Costs Allocated to Each Parcel of Property?Generally Accepted Accounting Principles (GAAP) establishes a hierarchy of costallocation methods via SFAS 67 Paragraph 11. These methods (in order) are:1. Specific identification method.2. Relative value methods (appraised value, relative assessed value for real estatetaxes)3. Other allocation methods (square footage)If the lots have the same general characteristics and size, cost can be allocated evenlyto each lot. If the lots have similar characteristics but different sizes, cost can beallocated on square footage. If lots have different characteristics, costs can normally beallocated based on relative sales value.In Homes by Ayres, 795 F.2d 832 (9 th Cir. 1986), the court addressed job-costingmethods:“Taxpayers accounted for their construction costs by accumulating costs for eachphase of a subdivision…taxpayers would accumulate all direct and indirect costs forthe year and then allocate them according to one of three methods to determine thecost of the houses sold in each phase (relative sales value method, average costmethod, and “square footage method”).…All three of these methods comport withgenerally accepted accounting principles and the IRS admits that they accuratelyreflect income.”7-10

Normally each house is a separate cost center. But when job costs are accumulated fora subdivision in phases, a cost pool may be used. Costs may be allocated according tostandard cost accounting principals. Examples of methods used to determine the costbasis of the houses sold in each phase follow:1. One technique for allocating the pool of capitalized costs is the "relative salesvalue method." This method determines cost of houses sold by multiplying totalcapitalized costs (already incurred plus estimated costs of completion) by theratio of the selling prices of the houses sold to the estimated selling prices of allthe houses in the phase.2. Another technique for cost allocation, called "average cost method," calls formultiplying total capitalized costs by the ratio of the total number of houses soldto the aggregate number of houses to be sold in a phase.3. Finally, the "square footage method" allocates costs by multiplying totalcapitalized costs by the ratio of the aggregate square footage of houses sold tothe aggregate square footage of all houses to be sold in the phase.Rev. Proc. 92-29: Alternative Cost Method of Accounting forReal Estate DevelopersUnder the “alternative cost method” of Revenue Procedure 92-29, 1992-1 C.B. 748, adeveloper may allocate estimated costs of common improvements to the basis oflots sold despite the limitations imposed by IRC § 461(h). Developers must obtainpermission from the Service to use the alternative cost method.Common improvements must have the following qualities:(1) Be real property or real property improvement that benefits two or moreproperties separately held for sale;(2) The developer must be contractually obligated or required by law to providethe improvement; and(3) The improvement must not be depreciable by the developerThe common improvement has to be contractually obligated or required by thegoverning body of law. For example, an agreement to provide improvements inexchange for a building permit is a common improvement (see Herzog Building Corp. v.Commissioner, 44 T.C. 694 (1965). A statement in a buyer’s HUD report that thedeveloper will provide improvements does not qualify as a contractual obligation (seeRev. Rul. 76-247, 1976-1 C.B. 217), nor does an oral promise to a buyer to provide7-11

improvements (see Bryce’s Mountain Resort, Inc. v. Commissioner, T.C. Memo. 1985-293 (1985).Common improvements vary depending on the type of development. Some normalexamples of common improvements include:• Streets• Sidewalks• Sewer lines• Playgrounds• Clubhouses• Tennis Courts• Swimming PoolsFor any taxable year, the estimated cost of common improvements is equal to theamount of common improvement costs incurred under IRC § 461(h) plus the amount ofcommon improvement costs the developer reasonably anticipates it will incur during the10 succeeding taxable years. See Rev. Proc. 92-29, Section 2.02(1).A developer may include in the basis of properties sold their allocable share of theestimated cost of common improvements without regard to whether the costs areincurred IRC § 461(h). There is an important limitation, however. As of the end of anytaxable year, the total amount of common improvement costs included in the basis ofthe properties sold may not exceed the amount of common improvement costs thathave been incurred under IRC § 461(h). If the alternative cost statutory limitationprevents a developer from including the entire allocable share of the estimated cost ofcommon improvements in the basis of the properties sold, the costs not included canbe deducted in the subsequent taxable year(s) to the extent that additional commonimprovement costs have been incurred under IRC § 461(h). See Rev. Proc. 92-29,Section 4.01.Which business division of the IRS that a taxpayer requests the use the alternative costmethod provided by Rev. Proc. 92-29 depends on the taxpayer’s business and size.The Large and Mid-Size Business Division (LMSB) generally serves corporations, Scorporations, and partnerships with assets in excess of $10 million. The SmallBusiness/Self-Employed Division (SB/SE) generally serves corporations, Scorporations, and partnerships with assets less than or equal to $10 million, andindividuals filing an individual federal income tax return with accompanying Schedule C.Taxpayers must comply with certain requirements in order to use the Alternative CostMethod.(1) File a request with the Area Director (for SB/SE) or Director, Field Operations(LMSB) and attach a copy to return, in accordance with section 6.01 of Rev.Proc. 92-29 on or before the due date of the return for the taxable year in whichthe first lot is sold. The request to use the Alternative Cost Method must include:7-12

• Developer’s identifying information• Description of the project• Schedule showing the lots covered by the request and the costs to acquiresuch lots• Schedule showing the common improvements required to be provided andinformation concerning the estimated cost of such improvements, the costallocable to each lot, and the estimated date of completion of theimprovements(2) Sign a restricted consent extending the statute of limitations on assessmentwith respect to the use of the alternative cost method. The restricted consentprocedures require:• Developer must extend the statute of limitations for each year thealternative cost method is used• Limitations period must be extended to one year beyond the expectedcompletion date of the project• Developer uses Form 921 (or 921A if a partnership) for this purpose(3) File an annual statement with the Area Director or Director, FieldOperations(and attach copy to return) in accordance with section 8.02 of Rev.Proc. 92-29. The annual statement must include:• Developer’s identifying information• Date of expiration of the extended statute of limitations• Description of the project• Schedule showing an updated estimated cost of common improvements,the manner of allocating the costs among lots, the lots sold as of the endof the previous taxable year, the costs incurred under 461(h), and thecosts included in the basis of lots soldA developer that fails to substantially comply with the provisions of Rev. Proc. 92-29 willnot be permitted to use the alternative cost method and therefore may not includecommon improvement costs that have not been incurred under IRC § 461(h) in thebasis of properties for purposes of determining gain or loss from such properties.7-13

Example – Statute of Limitations:A developer (partnership) applied for Rev. Proc. 92-29 approval for calendar tax year1998 and agreed to the statute extension as required. A six-year common improvementperiod was requested. The Form 921 consent was secured at the time that theapproval was issued and covered tax years ending 1998, 1999, 2000, 2001, 2002, and2003. Tax returns for all project years were filed timely. During 2004 the developercame under audit for the 2003 return. The audit was completed by late 2004. The agentfound that major aspects of the development disqualified it for Rev. Proc. 92-29treatment and proposed audit adjustments for all six project years (1998 through 2003).The 1998, 1999, 2000, and 2001 statutes for Rev. Proc. 92-29 adjustments expire April15, 2005.The statute of limitations for all project years is computed as follows:• Projected completion year for the common improvements: 2003• Return (1065) due date for project completion year: April 15, 2004Add one year to project completion year return filing date: April 15, 2005Normal 921 Rev. Proc. 92-29Date Return Statute Statute StatuteFiled Expiration Expiration Expiration************* ************* ************ ************1998 April 15, 1999 April 15, 2002 April 15, 2005 April 15, 20051999 April 15, 2000 April 15, 2003 April 15, 2005 April 15, 20052000 April 15, 2001 April 15, 2004 April 15, 2005 April 15, 20052001 April 15, 2002 April 15, 2005 April 15, 2005 April 15, 20052002 April 15, 2003 April 15, 2006 April 15, 2005 April 15, 20062003 April 15, 2004 April 15, 2007 April 15, 2005 April 15, 2007Example – Statute of Limitations:Assume the same facts as above except that the developer has not yet filed thecompletion year (2003) tax return. The statute of limitations for all project years is asfollows.Normal 921 Rev. Proc. 92-29Date Return Statute Statute StatuteFiled Expiration Expiration Expiration************* ************* ********* *********1998 April 15, 1999 April 15, 2002 open open1999 April 15, 2000 April 15, 2003 open open2000 April 15, 2001 April 15, 2004 open open2001 April 15, 2002 April 15, 2005 open open2002 April 15, 2003 April 15, 2006 open open2003 not filed open open openRev. Proc. 92-29 Section 10 provides that “If the first year in which the alternative costmethod is improperly used is no longer open for assessment of a deficiency of tax, the7-14

Commissioner may use her statutory discretion to change the taxpayer’s method ofaccounting in a later year and impose an adjustment under section 481(a) of the Code.”This allows the IRS to make a cumulative adjustment/correction for all barred years inthe earliest open year.Example – Allocation of Common Improvements:A developer will build 20 units of three cost classes (5 condo units, 6 town home units,and 9 single family homes) on a tract of land. The developer is contractually obligated toprovide the common improvements and estimates that the common improvements willcost $1,400,000 (including the cost of land associated with the common improvements).The common improvements are allocated as follows: $200,000 for the 5 condominiumunits, $300,000 for the 6 town homes, and $900,000 for the 9 single-family lots. Thecost of the common improvements is not properly recoverable through depreciation bythe developer. Common improvement costs are allocated as follows: 5 condo units @$40,000 each, 6 town home units @ $50,000 each, and 9 single family lots @$100,000 each.Example – Allocation of Common Costs Compared – Rev. Proc. 92-29 vs. IRC §461(h):A developer building 10 properties of equal value on a tract of land is contractuallyobligated to provide common improvements. The common improvements will benefit allthe lots in the development equally. The developer estimates that these commonimprovements will cost $1,000,000 (including the cost of the land associated with thecommon improvements). The cost of the common improvements is not properlyrecoverable through depreciation by the developer. Each lot’s allocable share of theestimated cost of the common improvements is $100,000 ($1,000,000/10 lots). In year1, the developer incurs $250,000 in common improvement expenses and sell 2 lots.Under IRC § 461(h), the deduction would be $50,000( $250,000/10 lots = $25,000 X2 sales = $50,000 ).However, per Rev. Proc. 92-29 the deduction in year 1 is $200,000. ($100,000allocation to each lot sold does not exceed the total IRC 461(h) limitation of$250,000).Example – IRC § 461(h) Limitation:Year 1: The development has 20 single-family lots and estimated common improvementcosts are $1,500,000. The application states that costs are allocated equally to eachlot, therefore $75,000 would be allocated to each lot ($1,500,000/20). During Year 1,$300,000 in common improvement costs were incurred and five lots were sold.7-15

Without the IRC § 461(h) limitation, the Rev. Proc. 92-29 deduction for commonimprovements for Year 1 would be $375,000 ($1,500,000/20 x 5 lots sold). However,the total costs incurred for the common improvements is $300,000, thus the deductionis limited to $300,000. The $75,000 barred in Year 1 is carried forward to Year 2provided the additional costs are incurred.Year 2: $600,000 in obligated common improvement costs were incurred and 6 lotswere sold. The year 2 deduction consists of both the deduction for currentyear’s sales and the unused Year 1 deduction carryforward.450,000 6 lots sold x $75,00075,000 Barred amount from Year 1 sales525,000 Total Deduction for Year 2Supplemental Request to Use the Alternative Cost Method of AccountingThere are many circumstances outside the developer’s control (changes mandated bythe EPA, the local municipality, etc. and/or damage to the construction site resultingfrom tornadoes, floods, etc.) that can result in project completion delays. Asupplemental request pursuant to section 9.01 of Rev. Proc. 92-29 is required to extendthe common improvement construction period past the original estimated completiondate.The IRS will respond to the taxpayer within 45 days of receipt of the supplementalrequest and notify the taxpayer of either approval or disapproval. An updated Form 921(statute consent) must be secured. The IRS response of approval/ disapproval ofthe supplemental request must be in writing. Supplemental Requests are notappropriate for avoiding the required periodic adjustments for overstated estimatedexpenses versus what were actually incurred to date thus deferring the final yearreconciliation, and adding new developments and/or expanding current projects.Annual Reports/StatementsAnnual reports are required for every year that construction is occurring and estimatedcosts of common improvements are being claimed against sales income, pursuant tosection 8 of Rev. Proc. 92-29. Annual statements are no longer required when any onethe following occur:(a) The approval period expires. If all obligated costs are not incurred by the end ofthe expiration period, the developer has a change in method of accounting toaccount for common costs per IRC § 461(h). A new unit cost allocation iscalculated based upon total actual costs incurred during the approved Rev. Proc.92-29 period. A prior period correction is recognized for the difference in alldeductions claimed under Rev. Proc. 92-29 vs. IRC § 461(h).7-16

) All obligated common improvement costs are incurred. As the developer is nolonger including estimated future costs in Cost of Goods Sold (COGS) therestricted Rev. Proc. 92-29 consent, secured when the application wasprocessed, is no longer applicable. The Rev. Proc. 92-29 project file can beclosed.(c) If all inventory is sold before all obligated expenses are incurred, the developerhas a change in method of accounting to IRC § 461(h) in the year that the finalunit is sold. A new unit cost allocation is calculated based upon total actualcommon improvement costs incurred. A prior period correction is recognized forthe difference in all deductions claimed under Rev. Proc. 92-29 vs. IRC § 461(h).On each annual statement, the developer reports revisions to the original estimate andre-computes the per unit allocations, reports prior and current obligated costs incurred,prior and current sales of units, prior and current Rev. Proc. 92-29 deductions claimed,and reports any corrections or revisions to prior information reported. The developer isrequired to adjust the production budget, replace estimated costs with actual costs, andpresent an accurate picture of the project. The developer is required to be able tosubstantiate the reasonableness/accuracy of the estimated cost figures that weresubmitted on the Rev. Proc. 92-29 application. In the initial years, estimated costscomprise a large part of the per unit cost allocations. As work on the developmentprogresses and actual costs are incurred, the developer must recognize the variancesand report the latest budget on the annual statement. As the project nears completion,the per-unit cost allocations used and prior period adjustments reported result in anongoing reconciliation/correction of the timing differences.ConclusionA construction contract that meets the requirement of a home construction contract isexempt from the percentage of completion method of accounting for both regularincome tax and alternative minimum tax. Speculation homes, land developers, andsome large homebuilders build homes that are not under a long-term contract, and longtermcontract methods of accounting do not apply to such contracts. RevenueProcedure 92-29 allows a developer an alternative cost allocation of commonimprovements in an attempt to even out the gross profit of each lot produced over thelife of the project.Chapter 6 / Table of Contents / Chapter 8Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search7-17

Chapter 7 / Table of Contents / Chapter 9Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 8: Other Tax Issues In ConstructionThe construction industry is so broad and extensive that many issues found in otherindustries will also appear in construction cases. There are, however, some issues thatare more closely identified with the construction industry. This chapter is intended toproduce an awareness of those issues. The construction issues discussed do notcompose an all-inclusive list.Accounting Method IssuesImproper Computation of the $10 Million Average Annual Gross Receipts per IRC§ 460Taxpayers are not aggregating the gross receipts of all the related companies for thiscomputation and, therefore, are improperly electing an exempt, long-term method ofaccounting, when the percentage of completion method (PCM) is required. The InternalRevenue 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 amember, and• Any predecessor of the taxpayer or of the entities in the prior two groups. I.R.C.• § 460(e)(2).Because a three-year average is involved, consideration of the gross receipts producedby the entities from each of these three groups for each of the three years is required.Aggregations of all gross receipts of all trades or businesses under common controlinclude:• Parent-Subsidiary group - When more than 50% ownership by one entity• Brother - Sister group - When 5 or fewer owners own more than 50%Aggregations of construction gross receipts for entities not under common control:• 5% to 50% ownership of taxpayer requires inclusion of that owner’s proportionateshare of gross receipts according to percentage of ownership. (Attribution rulesapply - indirect or direct ownership)Example of Aggregation of Gross Receipts:A small contractor teams up with a large contractor on a joint venture. The joint venturewas set up as a partnership to construct property for a large government job. The small8-1

contractor owned 51% of the joint venture, and the large contractor owned 49%. Forthe gross receipts test, determined at the joint venture level, 100% of the smallcontractor’s gross receipts, 100% of the joint venture, and 49% of the large contractor’sconstruction gross receipts exceeded the $10 million. The joint venture was reportingincome using the completed contract method, but is required to use the percentage ofcompletion method per IRC § 460.See IRC § 460(e)(2), IRC 460(e)(3) and Treas. Reg. § 1.460-3(b)(3).Improper Computation of the $5 Million Average Annual Gross Receipts per IRC §448Taxpayers may improperly be using the cash method of accounting. As with IRC § 460above, the aggregation rules apply to all entities under common control. IRC § 448 (a)prohibits the use of the cash method by a tax shelter. According to I.R.C. § 448(b)(3)and (c) , C corporations and partnerships with a corporate partner are allowed to usethe cash method of accounting, if the average annual gross receipts of the entity do notexceed $5,000,000.00Gross Receipts are netted for the $5 million (IRC 448) and $10 million (IRC 460)ThreshholdThe taxpayer may be using an improper method of accounting, if gross receipts havealready been offset with expenses (other than returns and allowances), so that only thenet amount is reported as gross receipts on the tax return. This netting may improperlyreflect average annual gross receipts below the $5 million and $10 million thresholdsper IRC § 448 and IRC § 460, respectively.RetainagesA specified amount is usually withheld from progress billings pending satisfactorycompletion and final acceptance of the project. The customer will withhold theretainage from the contractor (aka Retainages Receivable). The contractor will alsowithhold a retainage on the subcontractors (aka Retainages Payable).When are retainages recognized in taxable income? This depends on the method ofaccounting used by the taxpayer:• Cash: Income when received or upon constructive receipt• Accrual: Income when received, due, or earned, whichever comes first. Theretainages are earned as the work is performed. However, the taxpayer mayelect to exclude the retainages until billable per Revenue Ruling 69-314.• Completed Contract: Income when the contract is considered complete.8-2

• Percentage of Completion: Included in the contract price as the job progresses.When are Retainages reported as an expense? This depends on the method ofaccounting used by the taxpayer:Cash: Expense when retainage is paid.Accrual: Deductible when all events test has been met per IRC 461. However, if thetaxpayer has elected to defer the retainages receivable per Rev. Rul. 69-314, it mustalso 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 PCMcomputation when the all-events test has been met per IRC 461Delayed Billings Under Accrual MethodUnder the accrual method, the taxpayer may delay billings or structure the billingentitlement in the contract in an attempt to defer reporting of gross receipts. In Boise-Cascade Corp. 530 F.2d 1367 (Ct. Claims 1976), cert. denied , 429 US 867 (1976), theCourt determined that the accrual of income is based upon the work performed ratherthan upon billing entitlement.Determining Completion under Completed Contract Method (CCM)Taxpayers using this method may defer completing the contract in an attempt to deferthe reporting of the gross profit. The Regulations at § 1.460-1(c) provide a “bright-line”test in determining completion. The earlier of:1. 95% of contract costs have been incurred and the customer has the intended useof the subject matter of the contract or2. Final completion and acceptance.Reviewing the year-end work-in-progress schedule would reveal the percent completeon each job. Any job that is 95% or more complete would require further investigationto determine if the contract meets the completing requirements above.See Treas. Reg. § 1.460-1(c)(3).Improper Use of the PCM or Completed Contract MethodIn the construction industry, many taxpayers provide construction management,engineering, and architectural professional services that are an essential part of theconstruction process. However, their contracts do not meet the definition of a long-termconstruction contract which involves the building, construction, reconstruction orrehabilitation of real property. In contrast, the general contractor and subcontractors areresponsible for the actual construction, and are usually working under the direction or8-3

advice of the construction manager, engineer, or architect. Because constructionmanagement, engineering, and architects provide services that do not meet thedefinition of a construction long-term contract, they can not report their income underany long-term contract method (i.e., completed contract or percentage of completionmethod). They can only report income under the cash or accrual method.See IRC § 460(e)(4), Treas. Reg. § 1.460-1(d)(2), Rev. Rul. 70-67, Rev. Rul. 80-18,Rev. Rul. 84-32, and General Counsel Memo (GCM) 39803 for further guidance in thisarea.Deferring Costs under Percentage of Completion MethodCosts incurred (per IRC § 461) under the cost-to-cost percentage of completion methodrequired by IRC § 460, determine the completion rate of the job. Costs incurred nearyear-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 thepercentage of completion method. For generally accepted accounting principles(GAAP), this is appropriate. However, for tax purposes, direct materials are allocated toa long-term contract when dedicated to the contract. A taxpayer dedicates directmaterials by associating them with a contract. This is accomplished by purchase order,entry on books and records, or shipping instructions.See Treas. Reg. § 1.460-1(b)(8) and Treas. Reg. § 1.460-5(b)(2)(i).Allocation of Indirect CostsTaxpayers sometimes fail to allocate the appropriate indirect costs to jobs. There arefour separate Code sections or regulations under which costs should be allocated:• IRC § 460 (c)(1) through (c)(5) applies to long-term contracts which do not meetthe home construction contract or small contract exception per IRC § 460(e)(1).Treas. Reg. § 1.460-5(b) provides a direct link to IRC § 263A for the appropriateindirect costs to include in the percentage of completion method.• IRC § 460(b)(3) allows taxpayers that fall under IRC § 460 (above) to elect thesimplified production method. See also Treas. Reg. § 1.460-5(c).• IRC § 263A applies to large home construction contracts that do not meet theexceptions at IRC § 460(e) (less than $10 million gross receipts or job isexpected to last less than 2 years). Speculation home builders and landdevelopers must also allocate costs per IRC § 263A as “producers of property”.• Regulation § 1.460-5(d) applies to small contractors (both residential andcommercial) using the completed contract method.8-4

For all of the above, construction period interest is capitalized per IRC § 460(c)(3) for alllong-term contracts and IRC § 263A(f) for producers of property (land developers andspeculative homebuilders).Failure to allocate all appropriate indirect costs may increase or decrease the income tobe reported using the percentage of completion method. This will produce the largestadjustment for completed contract method users, speculation home builders and landdevelopers, because none of the costs are deductible for them until a later year (e.g.,upon completion of the long-term contract or sale of the house or lot).Production Period InterestMany contractors that meet one of the two exceptions of IRC § 460(e)(1) - homeconstruction contracts or small contractor (less than $10 million gross receipts and lessthan 2-year contract) do not capitalize construction period interest as required by IRC §460(c)(3). The exceptions found in IRC § 460(e) only exempt the taxpayer from IRC §460(a), (b), (c)(1), and (c)(2) - all other subsections of IRC § 460 apply. Thus,production period interest applies to all long-term contracts. Land developers andspeculation homebuilders also must capitalize production period interest since they arerequired to allocate costs per IRC § 263A.Improper Inclusion of Costs in PCM ComputationsThe cost-to-cost method, required by IRC § 460, is used to determine the completionpercentage of a contract which determines the amount of income to be reported in ataxable year.The completion is determined by:Costs Incurred To dateTotal Estimated Costs = % CompleteThe taxpayer might improperly include overstated estimates, include nondeductiblecosts, or allowances for contingencies in the total estimated costs figure that, in turn,reduces the percentage of completion. This understates the corresponding income tobe reported on the contract.Also, costs that are included in the total estimated costs figure may not be included inthe numerator, i.e., the costs incurred. This also reduces the amount of income to bereported for a taxable year.Improper Expense Recognition under the Completed Contract MethodThe taxpayer might improperly allocate costs from contracts that are still in progress tocompleted contracts, which accelerates the expense recognition. An unusually lowgross profit on a job may be an indication of improper job allocation.8-5

Homebuilder Building for SpeculationThis type of taxpayer might improperly deduct costs that are incurred as the house isbuilt. All of these costs, direct and indirect, must be capitalized per IRC § 263 and IRC§ 263A. The taxpayer is building an asset. Thus, the costs become the basis in theproperty, and are not recognized until the asset is sold.George D. Carpenter, T.C. Memo. 1994-289- - A taxpayer building a house onspeculation is required to capitalize the costs of building the house under IRC § 263A.Common Improvements“Common improvements” are any real property or improvements to real property thatbenefit two or more properties that are separately held for sale by a developer (i.e.,roads, sidewalks, sewer lines, playground, pool, etc.)In general, under Section § 461, common improvement costs may not be added to thebasis of benefited properties until the common improvement costs are incurred withinthe meaning of Section § 461(h).Taxpayers may be improperly deducting common improvements costs as incurred,rather than allocating them to the basis in the lots.Also, if a taxpayer elects the “alternative cost method” of Revenue Procedure 92-29, itmay be deducting estimated costs of common improvements without being incompliance with Revenue Procedure 92-29. (See the Homebuilder and Land DeveloperChapter for more information regarding Revenue Procedure 92-29.)Income IssuesAdvance PaymentsFront-load billing is common in the construction industry. Many contractors want apercentage of their fee paid in advance before any work is performed in order to buy thematerials necessary to perform the job. Under both the cash and accrual methods(using the “all events” test), these advance payments are reported in income whenreceived.Improper Computation of the Contract Amount under Percentage of CompletionMethod (PCM)Once the percentage of completion of a long-term contract has been calculated, it isapplied to the total contract price to determine the amount of income to be reported.The contract price includes change orders, retainages, expected bonuses, and claimrevenue. The taxpayer may not be including any one of these items as part of the8-6

contract price, thereby understating the amount of income to be reported. Theregulations also specify that, if any contingent amount is included in income for financialstatement purposes, it is to be included for tax purposes.See Treas. Reg. 1.460-4(b)(4)(B).Claim Income under PCMClaim income is an amount in excess of the original contract price that the contractorseeks to collect from the owner (e.g., disputed change orders, costs associated withowner delays, errors in specification, contract termination), Under the percentage ofcompletion method, the amount that the taxpayer reasonably expects to receive isincluded in the contract price, and is reported in income as the job progresses.Examiners should inspect final progress billing requests, legal files (correspondences,complaints filed with the court, etc.) and Schedule M-1 for 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 Treas. Reg. § 1.460-4(d)(4)(ii).• Taxpayer unable to determine a profit or loss – See Treas. Reg. § 1.460-4(d)(4)(iii).Unreported IncomeSmaller contractors, not faced with bonding or similar requirements for financialstatements and performance verification, might report income for only a portion of theirwork. For example, the contractor could erroneously report only the income reflected onthe Forms 1099. Some contractors may be willing to work for 20% to 25% less on thecondition that no Form 1099 is issued or that the payment is made in cash. This has anadverse effect on the industry, as well as compliance in general.With the proliferation of check-cashing schemes, payment with a check is an insufficientcontrol to validate income using bank deposit records. The auditor should look to somecentral element of the specialty contractor's business and measure that factor to confirmthe reporting of gross income by an indirect method. With a smaller contractor, theauditor can also look at the owner's return, life-style, assets or county recordsinformation to gain a reasonable assurance as to the economic reality of reportedincome.Other Compensation IncomeA contractor may receive an interest in a project for his or her services, rather thanmaking an initial investment of capital. Inspecting the contractor's partnership returns8-7

will frequently reveal an interest in a construction project. Review should be made ofelectronic databases (i.e., LEXIS, ChoicePoint) for public records. The contractbetween the owner and the general contractor will often specify what the generalcontractor is to receive in lieu of cash payment.See IRC § 83.Delayed BillingsDepending on the method of accounting, the contractor might delay billings or therecording of receivables in an effort to defer the reporting of gross receipts. The auditormight consider selecting a sample of jobs and inspect the job folders to review thecontract billing terms, progress-billing applications sent to the owner, and ownerpayment documents retained by the contractor in order to test income.Other Income Omission 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 courtdecisions or arbitrationSubcontractor Improperly Deferring IncomeSubcontractors hired early in a project (e.g., land clearing, installation of cables orwiring, laying concrete slabs) may improperly defer the recognition of income under thecompleted contract method, because “final completion and acceptance” does not occuruntil the total job is complete. However, Regulation § 1.460-1(c)(3)(iii) states that finalcompletion and acceptance of a contract with respect to a subcontractor occurs whenthe subcontractor’s work has been completed and accepted by the party with whom thesubcontractor has contracted (usually the general contractor).Scrap SalesThe nature of the materials used, as in plumbing, heating, and air-conditioning, maylead to the issue of scrap sales. For example, copper piping and tubing that are cut forjobs may leave small pieces that cannot be used. The scrap is then sold to metaldealers. Also, as in other industries, excess job materials may be inventoried for afuture job, returned to the vendor for credit, or applied to another job.Built-In Gains TaxWhen a C corporation is converted to an S corporation, taxpayers using the completedcontract method may be subject to a built-in gains tax. The value of the contracts inprogress as of the day of conversion is computed under the percentage of completion8-8

method and which would be subject to the built-in gains tax. The income that wasearned while a C corporation, but not reported until the following year, is unrealizedincome at the time of conversion.See Reliable Steel Fabricators, Inc., T.C. Memo. 1995-293.Installment SalesIRC § 453 provides that dealer dispositions do not qualify for the installment salecalculation of income. Homebuilders and land developers, therefore, cannot use theinstallment method of accounting. IRC § 1237 does provide a limited exception in whicha disposition of real property subdivided for sale will not be deemed to be held primarilyfor sale in the ordinary course of trade or business. However, no substantialimprovements can be made to the property, and the property must have been held bythe taxpayer for a period of 5 years.See Raymond v. Commissioner, T.C. Memo. 2001-96.Model Homes: Character of Gain in Sale And Leaseback ArrangementsHomebuilders sometimes sell a model home and then lease it back for use in their salesactivities. The homebuilder sells the model home(s) to an unrelated party for the lowerof 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 thepurchase price. The homebuilder retains the right to determine both the time of sale ofthe model home and the terms (price and buyer). The proceeds of the sale first repaythe loan of the unrelated party, a contractual bonus, with any remainder to be paid tothe homebuilder. Title has passed, but the homebuilder retains many significantownership rights.The essence of the transaction is that of a loan. The title to the unrelated party merelyacts as security. Thus, the loss on the “sale” and the lease expenses would not bedeductible.See Frank Lyon Co., 435 U.S. 561 (1978); Commissioner vs. F.& R. Lazarus & Co., 308U.S. 252 (1939).Expense IssuesPer Diem - 50% Meals Disallowance on Out-Of-Town TravelMeals paid for out-of-town travel are subject to the 50% travel and entertainmentlimitation per IRC § 274(n). Employers may be paying their out-of-town employees aper diem rate with nothing being applied to meals, and deducting the total as lodging8-9

expense. Revenue Procedure 2003-80, however, sets forth the rules for per diemallowances. Generally, a portion of the allowance must be treated as paid for meals.Depreciation of Automobiles and SUV’sFor passenger automobiles, the total depreciation deduction (including the Section 179deduction) that can be claimed is limited.Passenger automobile defined: A passenger automobile is any four-wheeled vehiclemade primarily for use on public streets, roads, and highways and rated at 6,000pounds or less of unloaded gross vehicle weight. However, in the case of a truck or vangross vehicle weight is substituted for unloaded gross vehicle weight. It includes anypart, component, or other item physically attached to the automobile or usually includedin the purchase price of an automobile. I.R.C. § 280F(d)(5)(A)SUVs (Sport Utility Vehicles) are commonly used within the construction industry.Revenue Procedure 2003-75 defines the term “trucks and vans” as passengerautomobiles that are built on a truck chassis, including minivans and sport utilityvehicles (SUVs) that are built on a truck chassis. If the taxpayer is depreciating SUVs,research (via internet or the manufacturer/dealership) may be necessary to determinethe gross vehicle weight to determine if the passenger automobile depreciationlimitation is applicable.Personal Use of Business AssetsContractors in closely held businesses sometimes deduct expenses for improvementsto a personal residence. These expenses are frequently deducted through cost of sales,along with other contract costs. If the taxpayer is a corporation and the expenses areincurred to improve a shareholder's residence, a potential dividend issue exists, and theexpenses are not deductible. If improvements are made to an employee's residence,then a possible employment tax issue exists. Being able to understand the contractor’sbilling and job cost records is crucial to the examination of a contractor. Samplinginvoices for deliveries to the contractor’s residence or for excess building suppliescharged to a job is an example of audit techniques for this issue.Unreasonable CompensationOfficer/owner compensation often fluctuates significantly. An argument may be madethat the present-year compensation is due to artificially low compensation in earlieryears. This argument may be valid, and will be sustained where the early years of theoperation were used to build capital. However, if the operation is well established, andthe profits of a high-volume year are being reduced through high compensation, theexaminer should seriously consider raising the issue. Industry averages are alsoavailable through Web sites such as Bizstats.com. This issue is dependent upon thefacts and circumstances of each case.8-10

Double DeductionsDouble deductions can occur when the contractor uses a single-entry bookkeepingsystem. 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 auditorshould consider usingin-depth investigative techniques.Interest Expense – Cash MethodFor a contractor on the cash method of accounting, interest expense on a constructionloan is not deductible until it is paid. A construction loan differs from a conventional loanin that a construction loan usually does not require interim payments. Even the loanorigination fees may be financed. These expenses are not deductible until the paymentsare made. The loan documents should be examined to determine the terms for makingprincipal and interest payments, as well as verifying the actual payments made duringthe year.See Heyman v. Commissioner, 70 T.C. 482 (1978), aff'd, 652 F.2d 598 (6th Cir. 1980).Capitalization of Pre-development CostsA developer may purchase a parcel of property for future development. Predevelopmentcosts must be capitalized and are not currently deductible. Several judicialdecisions support this position:John J. Reichel, 112 TC 14 - A real estate developer who purchased properties fordevelopment was required to capitalize related real estate taxes as indirect productionexpenses.Lee D. Hustead, T.C. Memo 1994-374 - A developer was required to capitalize costsincurred to challenge the zoning of property.Von-Lusk, 104 TC 207 - Property taxes and preliminary costs associated with thecontemplated construction were required to be capitalized per IRC § 263A.Contributions of Land and FacilitiesLand developers and building contractors often donate land, buildings, or other assetsto state or local governments, charitable organizations, or civic organizations. Theseassets usually have appreciated in value, due to the passage of time and/or thedevelopment activity by the builder. Be alert to deductions of the fair market value ofthe donated property as a charitable contribution.8-11

Examiners should consider the “donative intent” of the builder. A common practice isfor state and local government agencies having control of zoning and building permits torequire the developer/builder to set aside and donate land and facilities for some of thefollowing uses: schools, parks, police and fire stations, government offices, medicalfacilities, community centers, water and sewer plants, roads, and maintenancebuildings. If the developer/builder donated the asset due to a requirement of agovernment agency or the facility was used as a promised improvement in sellingefforts to customers, then the requisite “donative intent” for a contribution deduction ismissing. Without this intent, the non-deductible donation is a part of the cost ofdeveloping lots. In addressing this issue, examiners should inspect the builder’scorrespondence and legal files, zoning and permit documents, minutes of governmentagency meetings, corporate minutes of the builder, newspaper articles, and the builder’ssales literature.Examiners should be aware that developers/builders often allocate development costsonly to the properties that will generate sales revenue. Thus, the donated property mayonly have the cost of raw land charged to it. The allocation of costs usually takes placein the early stages of development, while donations of property are made in the latterstages. You should be alert to ensure that a double recovery of cost is not allowed.LossesThere may be an improper inclusion of the total loss on a contract that is still inprogress. Financial reporting (GAAP) requires the contractor to recognize the fullamount of any anticipated loss in the current period, regardless of the degree ofcompletion. However, for tax purposes, the loss is not deductible until the job isdetermined to be complete for taxpayers using the completed contract method. Theloss incurred to date (not the total loss) is deductible for taxpayers using the PCM.Abandonment LossesIf a taxpayer abandons an asset, the loss is generally deductible to the extent of thetaxpayer's adjusted basis in the abandoned property. To support an abandonment loss,the taxpayer must establish an intent to abandon the asset and must make someaffirmative act of abandonment. The loss is deductible in the year the abandonment issustained with regard to non-depreciable property.In general, abandonment losses occur with "spec" homebuilders, real estatedevelopers, and related-party entities more frequently than with other types ofcontractors. Some reasons for abandonment losses are due to lack of financing, lack ofbonding, disapproval of zoning changes, cost overruns or, in the case of related parties,possible tax avoidance.Related Party Transactions8-12

A contractor or subcontractor may incur expenses for improvements to his personalresidence (or that of a friend or relative) or build a home for his personal use (or that ofa friend or relative). These expenses might be applied to another job to disguise thecosts, or the taxpayer might report the job separately, but “sell” the residence for cost.Potential issues are disallowance of personal expenses and/or dividend issues, if acorporation. The difference between the FMV and the actual “sales” price to theshareholder would be subject to constructive dividend rules.Also, allocation of indirect costs not “charged” to the taxpayer/relative would result in anondeductible loss per IRC § 267.Severed ContractsFor tax purposes, losses are not deductible until incurred. Under the completedcontract 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 jobprogresses. By improperly severing a contract, the taxpayer is recognizing the lossprematurely.See Treas. Reg. § 1.460-1(e).Bad Debts and Cancellation of Debt IncomeThe typical bad debt issue must be reviewed when there are related party transactionsinvolved. If one party has a legitimate bad debt, the other related party should havecancellation, or forgiveness, of debt income. Bad debts are deductible under IRC § 166,and cancellation of debt is income pursuant to IRC § 108. Be aware that the facts ofbankruptcy or insolvency may impact the recognition of forgiveness of debt income.Also, net operating losses may have to be reduced if bankruptcy limits the recognition offorgiveness of debt income.Bad debts require an inquiry into the following:1. Debt or equity investment?2. Whose debt is it? (Related party?)3. Business or non-business?4. Have the funds actually been transferred, or have only adjusting journal entriesbeen made?5. Has interest been charged and reported?6. Do documents exist that support the transactions?Warranty Reserves or Contingent LiabilitiesAn accrual basis taxpayer may be deducting estimated warranty costs from a reserveaccount established to reflect a liability for future services:8-13

• Reg. §1.446-1(c)(1)(ii) - Under the accrual method a liability is incurred in thetaxable year in which all the events have occurred that establish the fact of theliability, the amount can be determined with reasonable accuracy, and economicperformance has occurred with respect to the liability.• IRC § 461(h)(1) - In determining whether an amount has been incurred, the allevents test shall not be met any earlier than when economic performance occurs.Economic performance occurs when service or property is provided by thetaxpayer.Economic performance has not occurred with respect to estimated warranty costs, andcontingent liabilities are nondeductible. The examiner should be aware that for GAAPthese items are reportable, so there should be an M-1 adjustment for these items.Model HomesThe taxpayer is in the business of building and selling residential houses. To assist inits sales activity, the taxpayer may use certain houses as models and/or sales officestemporarily. Such use generates no rental income to the taxpayer. Revenue Ruling 75-538 provides guidance. It holds that a vehicle is not property used in the business (thussubject to depreciation) if it is used merely for demonstration purposes or is temporarilywithdrawn from stock-in-trade. Model homes/sales offices are used for a small fractionof their expected useful lives, and the taxpayer ultimately expects to sell these houses.Although the taxpayer may be reluctant or unwilling to sell the houses while they arebeing used as a model home or sales office, they remain property held primarily for saleto customers and may not be depreciated.See Rev. Rul. 89-25.Tax IssuesAccumulated Earnings TaxClosely-held entities are more likely to accumulate earnings and profits beyond thereasonable needs of the business in order to avoid income taxes on its shareholdersthan are large corporations. Each accumulated earnings case is unique. No pro formaguide for calculating a taxpayer’s reasonable needs can be prepared. Reasonableneeds that would usually be considered in any accumulated earnings case are the needfor sufficient net liquid assets to pay reasonably anticipated, normal operating coststhrough one business cycle and sufficient net liquid assets to pay reasonablyanticipated, extraordinary expenses and capital improvement financing. In addition,the following represents a non-exclusive list of specific items that should be consideredfor construction contractors:Working Capital necessary for Bonding Purposes - The general rule of thumb is thatworking capital needs to be at least 10% of "backlog" for bonding purposes. A specifictaxpayer’s situation may result in a different percentage based on the bonding8-14

company’s requirements. Thus, this percentage should be determined on a case-bycasebasis. "Backlog" (work program) is the sum of contracts in process, less thebillings from those contracts, plus contracts not started.Equipment Needs - Contractors who have high equipment needs will generally have aneed to replace the equipment on a periodic basis.The following information is included to assist an examiner in determining whether,during an examination of a construction company, an accumulated earnings tax issuemay exist. Generally, when considering whether an IRC § 531 issue exists, examinersare advised to employ the Bardahl, Mead, or similar method used in determining thereasonable business needs. However an examiner must consider that, unlike mostentities, a construction company normally needs to retain earnings and profits to assureadequate bonding capacity. Relevant court cases involving the accumulated earningtax and construction contractors are:Ready Paving and Construction Co. v. Commissioner, 61 T.C. 826 (1974) – a pavingcontractor had permitted its earning to accumulate beyond the reasonable needs of itsbusiness. A ‘modified” Bardahl formula was used with the case hinging on what itemswere and were not to be included in determining working capital.Thompson Engineering Co. v. Commissioner, 80 T.C. 672 – A constructionsubcontractor was liable for the accumulated earnings tax. The IRS determined thetaxpayers reasonable business needs by applying the “Bardahl” formula. The courtagreed with the taxpayer that the Bardahl formula has “little or no value when applied toa mechanical contracting business that lacks a routine operating cycle.” The bondingcapacity, and not the Bardahl formula, is the major consideration in determining thetaxpayer’s business needs. This case was appealed and reversed – See 751 F.2d191.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 bondon a job when required is of primary importance and is clearly a reasonable need of thebusiness. The fact that the petitioner was rarely required to provide a performancebond on its jobs is immaterial since it had to be prepared to provide a bond if required..Alternative Minimum TaxTaxpayers who are not required to use PCM (per IRC § 460) or elect to use PCM for taxpurposes may owe alternative minimum tax. IRC § 56 states that the PCM must beused for long-term contracts for alternative minimum tax purposes. Therefore,taxpayers on the cash, accrual, or completed contract methods must computealternative minimum taxable income on the percentage of completion method.Exceptions to the required use of PCM for AMT:8-15

• Homebuilders - IRC § 56(a) applies to long-term contracts except for homeconstruction contracts• Small Corporations are exempt from AMT for tax years beginning after 1998.Small corporations are C corporations with average annual gross receipts of$5,000,000 or less. They remain exempt in subsequent years until their averageannual gross receipts exceeds $7,500,000.Many construction companies are required to prepare certified financial statements forbonding and lending purposes. Financial statements must be prepared on percentageof completion method. (Statement of Position 81-1) Thus, the difference between thepercentage of completion method and the tax return method can easily be determinedfor alternative minimum tax purposes.Employment TaxThe use of subcontractors is common within the construction industry. Many taxpayerstreat employees as subcontractors to avoid paying employment taxes. The agent mayneed to seek guidance from an employment tax specialist when confronted withpotential employment tax issues. Back-up withholding can apply to subcontractors. Thebargain sale of a house to an employee involving a discounted sales price couldproduce employment tax liability.ConclusionMany issues are common to all industries. However, some issues are specific to theconstruction industry, due to the nature of the business and the special accountingmethods available. Further facts and tax research will be necessary to develop theissues mentioned in this chapter.Chapter 7 / Table of Contents / Chapter 9Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search8-16

Chapter 8 / Table of Contents / Chapter 10Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 9: Income ProbesIntroductionThe methods of accounting, discussed in Chapters 3 and 4, govern contractor incomerecognition. Although contractors earn most of their income from building projects,including new construction and remodeling, there are other potential sources of incomerelated to construction, including:• Sales of construction equipment• Consulting fees• Forgiveness of debt income• Constructive dividends• Scrap sales• Interest income earned on retainages or deposits• Income from court settlementsSales may be generated in a variety of ways, including word-of-mouth, Web sites,newspapers, magazines, trade shows, showrooms, or model homes. Typically, acontractor will execute a contract detailing the total job costs and project specifications,as well as the method of payment. The contract may include provisions for retainages,which are usually kept by the general contractor until the project is complete. While theconstruction contract is an invaluable source of information as to the income from thejob, it is also useful in determining the materials consumed, completion dates, job costs,gross profit, and change orders that could result in additional income from the job.One of the most difficult tasks that an examiner faces is setting the scope of the incomeprobes. This determination must be based upon the risk assessment that is completedduring the pre-planning and initial phases of the examination. The initial interview iscritical in establishing what type of construction is involved and how the contractoraccounts for income, expenses, work in process, and the duties and responsibilities ofkey personnel. Without an understanding of the business operations, method ofaccounting, internal controls, and the involvement of the key personnel, the examinerwill not be able to properly set the scope of the examination. Internal Revenue Manual(IRM) Section 4.10.3.2 offers guidance in the preparation and documentation ofeffective interviews. The evaluation of internal controls is discussed in IRM 4.10.3.4.Understanding the Accounting SystemGeneral Techniques9-1

The initial interview is the best time to determine how the accounting system works andwhat types of internal controls are in place. Gaining an understanding of the business iscritical because a contractor could have multiple businesses operating within the sameentity. An example of this would be an electrical contractor who also operates a retailsales outlet. In this case, sales could be recorded on the cash basis for the servicebusiness, accrual for the retail business, and percentage of completion for thecontractor business. Establishing the type of construction involved, the method ofaccounting for income and expenses, work in process, and the duties andresponsibilities of key personnel are all areas to be covered in the interview.The Construction ContractThe construction contract is the keystone for understanding how income is determined.The contract will specify how much the contractor will be paid and when. Thisinformation will have an impact on income recognition issues as well as the profit to berecognized from the job. The contract may also provide information about retainageprovisions, incentives, awards, penalties, and change orders. Contracts will alsospecify whether the terms are “cost plus” or based on a bid.Part of the income probe will be determining if reported income is reasonable withrespect to cost of goods sold. Industry standards from Websites such as Bizstats.comcan also be used as a benchmark to determine if the reported gross profit is reasonable.The contract could also be a starting point for comparing materials as specified per thecontract to materials actually charged to the job. This might indicate materials beingdiverted for other use by the contractor or to small jobs that have no contract and werenot recorded in sales. Comparing the “budgeted cost” to the “actual cost” in situationswhere losses or nominal net profits are reported is a good audit technique whenreviewing contracts. Some municipalities have computerized building permit recordsthat could be compared with the actual contracts or job costs.Some specific examples that an examiner could use to test income from the contracts:• Compare the board feet of lumber delivered to the square footage of the building.Guides are available that provide this information. Large variances should beinvestigated.• Compare the cubic feet of concrete purchases to the size of the slab included inthe contract.• Compare the square footage of the roof area to the bundles of shinglespurchased and delivered to the job site.• Compare the number of major appliances, HVAC units, etc., to the size of thebuilding.• Compare the contractor’s gross profit to the industry standards.• Courthouse research could show properties transferred but not accounted for inthe contracts.9-2

Minimum Income ProbesThe IRM at 4.10.4.3 discusses the requirement for examiners to consider gross incomeduring the examination of all income tax returns. Certain minimum income probes areto be made regardless of the type of return filed by the taxpayer.Minimum Income Probes for Non-business Returns:The minimum probes for income outlined in IRM 4.10.4.3.2 include questioning thetaxpayer or representative regarding possible sources of income, other than thosereported:• Taxable sources• Non-taxable sources• Bartering activitiesThe responses to these questions concerning possible sources of unreported incomeshould be summarized and referenced to the workpapers that document the interviewquestions. Internal information, such as the Currency and Banking Retrieval System(CBRS) which is used to track cash transactions over $10,000 and Information ReturnsProcessing (IRP), should also be analyzed to ensure that all business or investmentactivities are listed on the return. Consideration of possible bartering income is alsopart of the minimum income probes. Based upon the analysis of income, externalsources (third parties) may be used to corroborate the information received or establishan understatement of income. Under Section 7602(c) of the Code, third party contractsmay not be initiated before giving advance notice to the taxpayer that such contractsmay be made as part of the examination. See IRM 4.10.4.5.3.6 for a discussion of theprocedures to initiate third party contracts.Minimum Income Probes for Individual Business Returns:IRM section 4.10.4.3.3 expands the minimum income probes to include an analysis todetermine if reported income is sufficient to support the taxpayer’s financial activities.There could be unreported income, overstated expenses, a simple math error, or acombination of these items that could indicate the taxpayers did not have sufficientfunds to support their financial activities. Several audit procedures should be utilized:• Prepare a preliminary cash transaction account (Cash-T) based upon the taxreturn data and updated with new information obtained during the examination.For contractors, the preliminary Cash-T will be modified by the job recordsshowing work in process that may not be reported on the return, but may have asubstantial economic impact. If the Cash-T is materially out of balance, furtherinformation from the taxpayer will be necessary.9-3

• Tour the business sites and record any observations or comments about thebusiness operations in the workpapers.• Evaluate the internal controls to gain an understanding of the taxpayer’sbusiness operations. Conclusions reached by the analysis of internal controlsshould be documented in the workpapers. See the discussion following thissection about the evaluation of internal controls.• Reconcile the taxpayer’s books and records to the tax return. If the taxpayeruses double entry accounting, a book-to-tax reconciliation should be availablefrom the taxpayer.• Analyze the personal bank statements and the business bank records. Normallythe minimum analysis would be to compare the total deposits with the reportedgross income. Bank statements can also provide information about otheraccounts, automatic transfers, etc.• Based upon the information gathered, the scope of the examination of incomewill be expanded or contracted.Minimum Income Probes for Corporations, Partnerships, S Corporations andOther Business Returns:According to IRM 4.10.4.3.4, the examination of gross income on a business return forcorporations or other business entities should include the following steps at a minimum:• Prior to contract, prepare a comparative analysis of the balance sheet andincome statement using the assigned year and prior and subsequent years ifavailable. This will assist in the identification of issues to be examined.• Evaluate copies of the tax returns of significant shareholders or partners (greaterthan 50% direct or indirect ownership) for examination potential, relatedtransactions, or possible diverted funds.• Prepare a comparative analysis of the balance sheet and income statementsincluding prior and subsequent years, if possible.• Reconcile Schedules M-1 and M2 and the trial balance to the return.• Analyze the adjusting journal entries and reconcile the trial balance to thegeneral ledger.• Analyze a significant balance sheet accounts which show substantial increasesor decreases, especially those that relate to income, e.g., deferred revenue,reserves, shareholder loans.The depth of the bank record inspection will depend on the internal controls, theanalysis of the primary shareholder/partner’s returns, and the judgment of the examiner.At this point, the examiner should have a solid basis for determining if there is potentialfor unreported income and if the books and records are reliable. When dealing withconstruction returns, the method of accounting is always important, because of theimpact on income recognition. This could result in a technical adjustment to income.9-4

Internal ControlsThe evaluation of internal controls is discussed in the IRM at 4.10.3.4. Examiners arerequired to evaluate the existence and effectiveness of internal controls for all types ofbusiness returns. Even in the small business environment, where the owner-managerscontrol the entire operation, it is essential to evaluate internal control to determine theappropriate audit techniques to be used. The type of business, the records, and theowner’s financial status should be considered as part of the evaluation of internalcontrols.What exactly are internal controls in a small business environment? When would theybe considered inadequate to the degree of requiring an indirect method? Does the lackof good internal controls mandate the use of an indirect method? Conversely, do goodinternal controls automatically negate the use of an indirect method?The answer to these questions is for the most part a judgment call by the examiner. Itwould be rare that a sole proprietor would be denied unlimited access to the cashresources of the business. While there could be a record keeping system thatincorporates a certain level of checks and balances, the credibility reverts back to theowner’s willingness to adhere to the established procedures.In the absence of legal requirements for contractors, such as bonding or governmentcontracts, for the most part a sole proprietorship with no employees is considered tohave very weak or nonexistent internal controls. This conclusion would normally requirestrong consideration of an indirect method during the course of the examination. Theexception would be a result of extenuating circumstances justifying a decision not topursue an indirect method.The next level would be “weak” internal controls. This might occur where the owner hasoccasional or limited access to the cash resources of the business. An example mightbe a larger Schedule C with an in-house accountant. The staff prepares the majority ofthe banking transactions. The owner, however, has the opportunity on occasion toskim cash sales and circumvent the control procedures that are in place.In situations similar to this example, deciding whether or not to pursue an indirectmethod would require several considerations.• Type of business involved (some are more prone to cash transactions);• The ease of skimming cash, e.g., a large number of unidentifiable customersversus a small number of traceable customers;• Established gross profit ratios, e.g., the fact that the business is operating wellbelow the normal gross profit ratios may indicate skimming practices are present;• The taxpayer’s standard of living, e.g., a higher standard of living than theamount of income reported may indicate potential skimming;• Cash expenditures not reflected in the taxpayer’s records that are identified by acourthouse records check; or9-5

• A high percentage of cash expenditures for business or personal expenses andsome (or all) are not reflected in the taxpayer’s records.The other end of the scale is a business with strong internal controls. This might beevidenced by an elaborate double entry record keeping system; periodic in-houseaudits; annual certified financial audits; an outside accountant who provides monthlywrite-up services; non-related owners with equal involvement in the businessoperations; or limited cash transactions with easily traceable customers. Under thesecircumstances, the general rule would be not to pursue an indirect method, and theexception would be where extenuating circumstances dictate otherwise.The key steps to evaluating internal controls are:• Understanding the control environment,• Understanding the accounting system, and• Understanding the control procedures.First, the control environment is made up of the many factors that affect the policies andprocedures of the business. The examiner must understand how the businessoperates. Interviewing the taxpayer (and/or the representative) and touring thebusiness are integral steps. Second, gaining knowledge of the accounting systemprovides information about many of the day-to-day business operations. Finally, thecontrol procedures are the methods established to assure that the business operates asintended. The separation of duties is the primary control procedure because it willreduce the opportunity for any one person to both perpetrate and conceal errors orirregularities. The greater the number of employees, and the more complex thebusiness, the more likely some formal control procedures will exist.In conclusion, the internal controls of a business must be evaluated and discussed inthe workpapers as a mandatory item on every business return examination. Theworkpapers should include a statement regarding the accessibility to cash by theowner/manager, the quality of internal controls overall, and the effect the internal controlenvironment had on the verification of income.Audit Techniques for Evaluating Internal ControlsThe internal control system should be tested for compliance with the procedures asdescribed in IRM 4.10.3.4.5.3. Observe a transaction through the entire accountingprocess. Look for consistency in recording similar transactions. At this point, the scopeand depth of the examination can be determined. If the books and records are reliable,the examination can include direct testing of transactions, such as tracing specific itemsto receipts. However, if it is determined that the books and records are not reliable, theexamination should include indirect analyses. Because the examination of the booksand records will reveal the likelihood of material errors, or that transactions were valid,determining reliability through internal control analysis is a key step.9-6

Use of Indirect MethodsIntroductionSmaller contractors, not faced with bonding or similar requirements for financialstatements and performance verification, may improperly report income for only aportion of their work. For example, they might limit income to the amount reported onForms 1099. Some contractors have been willing to work for 20% to 25% less on thecondition that no Form 1099 is issued. This has an adverse affect on the industry aswell as on the government.With the proliferation of check cashing schemes, payment with a check is an insufficientcontrol to validate income via bank deposit records. The auditor should look to somecentral element of the specialty contractor's business and measure that factor to confirmthe reporting of gross income by an indirect method. With a small contractor, the auditorcan also look at the owner's return, county record information, and life-style/assets togain a reasonable assurance as to the economic reality of reported income. As always,the examiner’s judgement will be required to determine if the examination should beexpanded to include the use of indirect methods of verifying income.Indirect Methods - OverviewAt some stage of all business return examinations consideration must be given to theuse of an indirect method. Equally important is the proper workpaper documentation ofthe decision to pursue (or not to pursue) an indirect method of income reconstruction.With the passage of the Revenue Recognition Act of 1998, the examiner mustdocument the likelihood of unreported income before proceeding with an indirectmethod:IRC § 7602(e) LIMITATION ON EXAMINATION ON UNREPORTED INCOMEThe Secretary shall not use financial status or economic reality examinationtechniques to determine the existence of unreported income of any taxpayerunless the Secretary has a reasonable indication that there is a likelihood ofsuch unreported income.When the records are incomplete, or there are other indications that the books andrecords are not reliable, income may be estimated by using other methods such asanalyzing building permits, commissions paid to the sales staff, or applying gross profitpercentages to jobs. The decision to use other estimates of income or to expand thescope of the income probes should be made after evaluating the results of the initialincome probes. The decision making process must be documented in the workpapers,and updated as information is received. The use of an indirect method of reconstructingincome should be considered when:9-7

• A review of the taxpayer’s prior and subsequent year returns show a significantincrease in net worth. In the case of a corporation or partnership, thisdetermination is made on the shareholder's return or the partner's return.• Gross profit percentages change significantly from year to year or are unusuallyhigh/low for that business.• The taxpayer’s business and personal expenses exceed the reported income perthe return and attempts to reconcile material imbalances have failed.• The taxpayer’s bank accounts have unexplained items of deposit.• The taxpayer does not make regular deposits of income, but uses cash instead.Types of Indirect MethodsNeither the Code nor the Regulations define or specifically authorize the use of indirectmethods. The authority to challenge a taxpayer’s income determination is seated inIRC § 446(b):If no method of accounting has been regularly used by the taxpayer, or if the methodused does not clearly reflect income, the computation of taxable income shall bemade under such method as, in the opinion of the Secretary, does clearly reflectincome.The application of the various indirect methods is outlined in detail in the IRM at4.10.4.6.3 through 8 and includes:• Bank Deposit Method• Cash Transaction and Source and Application of Funds Method• Net Worth Method• Percentage of Markup Method• Unit and Volume Method• Potential Defenses to Indirect Method ComputationsIn addition to a discussion of the relevant case law and the indirect methodcomputation, the IRM discusses each method in detail. In theory, each method appliedproperly should yield the same result. However, there are situations that indicate theuse of a specific method may be more appropriate.The bank deposit method is recommended when:• The taxpayer’s books and records are unavailable, withheld, or incomplete.• The taxpayer deposits most income as verified during the examination.• The taxpayer pays most business expenses by check.• The taxpayer used the bank deposit method to report income.• The taxpayer’s records indicate numerous cash expenses.• The assets and liabilities are stable from year to year.9-8

• A large volume of unsorted bills, invoices and receipts are submitted in support ofitems appearing on a return.• The taxpayer’s books and records appear complete and accurate, but a methodto probe for unreported income or confirm the accuracy of the books and recordsis needed.The Cash Transactions and Source and Applications of Funds methods arerecommended in the following situations:• If the review of a taxpayer’s return indicates that the taxpayer’s deductions andother expenditures appear out of proportion to the income reported.• The taxpayer’s cash does not all flow from a bank account which can beanalyzed for its source and subsequent disposition.• There is little or no increase in the net worth of the taxpayer, yet, based uponexpenditures of the taxpayer, it becomes apparent that the taxpayer has othersources of income.• The taxpayer makes it a common business practice to convert receipts into cashfor the purposed of paying claimed business expenditures.• If only one or two years are under examination.• The small amount of time needed to be expended, as compared with using thenet worth method.• The taxpayer has many transactions involving assets and liabilities.The net worth method is generally recommended in the following situations:• Two or more years are under examination.• Numerous changes to assets and liabilities are made during the period.• No books and records are maintained.• The books and records are inadequate or not available.• The books and records are withheld by the taxpayer.The percentage of markup method is recommended when:• When the inventories are a factor and the taxpayer has nonexistent orinadequate records.• Where a taxpayer’s cost of goods sold or merchandise purchased is from one ortwo sources and these sources can be ascertained with reasonable certainty. Inaddition, a reasonable degree of consistency as to sales prices exists.The unit and volume method is recommended when:• The examiner can determine the number of units handled by the taxpayer, andalso knows the price or profit charged per unit.9-9

Clearly, the examiner’s judgment is a crucial factor in determining the best method topursue when the examination indicates the use of an indirect method. With theexception of the unit and volume method, any of these methods would apply toconstruction returns. Construction activity results in the production of tangible personalproperty, so the cost of the materials can usually be determined. Most materials used inconstruction are not exotic, so pricing is generally not a barrier to determining job costs.For example, if the home builder constructed an average 2,000 square foot home, therewould be 13,127 board-feet of framing lumber, 3,100 square feet of roofing material,3,061 square feet of insulation, 15 windows, 12 interior doors, 2,085 square feet offlooring material, etc. The average material usage would give the examiner abenchmark to use for determining income based on costs. (Source: NationalAssociation of Home Builders, http://www.nahb.org) The Audit Technique Guides forCarpentry/Framing, Drywallers, and Masonry/Concrete also have standard usageformulas to help determine whether costs are reasonable.As policy, when an indirect method results in an understatement over $10,000, it ismandatory for the examiner to discuss the case with the group manager. The purposeof the discussion is to consider expanding the scope of the examination and to evaluateany elements of fraud. Fraud potential should always be considered in an examinationwhen unreported income is an issue. The taxpayer’s explanations or lack thereof mayhelp distinguish between civil and criminal fraud. It is important to document the casefile for the responses to interview questions, reliability of books and records, or anyother indications of fraud.Miscellaneous Income SourcesIncome may also arise from other sources. Some of the more common ones are:• A contractor may have interest income from escrow accounts, retainageaccounts, or deposits. Reconciling the IRP transcripts may reveal unreportedinterest income.• Income from a remote construction project could be omitted. Generally,expenses will be accounted for, so a careful understanding of the books andrecords is crucial.• It is not unusual for a contract to be involved in some litigation over complicatedconstruction contracts. The income from claims that are subsequently settled bycourt decisions or arbitration may not be reported.ConclusionThere are several resources available to the examiner when the taxpayer’s business isconstruction related.9-10

A potential resource is the IRS Website, www.irs.gov, which discusses variousconstruction issues. This information is updated with court cases and other documentsoutlining the Government’s position on various construction accounting issues.Because many construction businesses are sole proprietors, issues are found onindividual and business returns. An understanding of the industry is vital for examinersto complete a quality examination.Certain auditing techniques should always be applied when auditing a contractor.Special attention needs to be given to the possibility of unreported income. Thecontractor should be interviewed and asked to explain the operation of his or herbusiness. The construction contract should be reviewed to see how income is to bereceived. Income probes should be performed. Other sources of income common tocontractors should be investigated. And internal controls should be reviewed. If theresults of these reviews indicate the probability of unreported income, indirect methodsof determining income should be considered.No magic formula exists to use in examining contractors’ income tax returns. Theexaminer must use good judgment as well as innovative techniques when faced witheither inadequate or non-existent books and records. Using other resources to estimateincome can be sustained when the evidence is supported by increases in net worth orliving expenses.Chapter 8 / Table of Contents / Chapter 10Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search9-11

Chapter 9 / Table of Contents / Chapter 11Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 10: Construction Joint VenturesOverviewA joint venture is composed of two or more businesses combining their resources tobuild one or more projects. Construction companies that lack sufficient capital,resources, bonding capacity, or technical expertise to be awarded certain contractsoften find it necessary to form joint ventures. Other construction companies haverestricted access to international or domestic markets. By forming joint ventures,construction companies can often overcome these market limitations or restrictions.Although these forms of business have both advantages and disadvantages, they areoften necessary for the construction company's survival and growth in a highlycompetitive industry. .Types of Joint VenturesConstruction projects can be structured as joint ventures, that then are generallyconsidered partnerships under IRC sections 761(a) and 7701(a)(2). Joint ventures aregenerally formed for one specific purpose(a job, a contract, or a project) with the intent of operating for a limited duration.IRC §7701(a)(2) PARTNERSHIP AND PARTNER.—The term “partnership” includesa syndicate, group, pool, joint venture, or other unincorporated organization,through or by means of which any business, financial operation, or venture iscarried on, and which is not, within the meaning of this title, a trust or estateor a corporation; and the term “partner” includes a member in such asyndicate, group, pool, joint venture, or organization.Such construction projects may also be formed as corporations or, under state law, assome other type of entity. Regardless of the form of the entity under state law, federaltax law applies to classify the entity for federal tax purposes.The IRS and Treasury have published regulations for classifying businessarrangements for federal tax purposes. These regulations became effective January 1,1997. When classifying a business arrangement, first determine if there is a separateentity for federal tax purposes. A joint venture may create a separate entity for federaltax purposes if the participants (1) carry on a trade, business, financial operation, orventure and (2) divide the profits from the activity. Nonetheless, a joint undertakingmerely to share expenses does not create a separate entity for federal tax purposes.Whether a joint venture is a separate entity for federal tax purposes is a question offederal law. See Treas. Reg. § 301.7701-1.10-1

Treas. Reg. §301.7701-1. (a) Organizations for federal tax purposes—(1) In general. The Internal Revenue Code prescribes the classification ofvarious organizations for federal tax purposes. Whether an organization is anentity separate from its owners for federal tax purposes is a matter of federaltax law and does not depend on whether the organization is recognized as anentity under local law.(2) Certain joint undertakings give rise to entities for federal tax purposes. Ajoint venture or other contractual arrangement may create a separate entityfor federal tax purposes if the participants carry on a trade, business, financialoperation, or venture and divide the profits therefrom. For example, aseparate entity exists for federal tax purposes if co-owners of an apartmentbuilding lease space and in addition provide services to the occupants eitherdirectly or through an agent. Nevertheless, a joint undertaking merely to shareexpenses does not create a separate entity for federal tax purposes. Forexample, if two or more persons jointly construct a ditch merely to drainsurface water from their properties, they have not created a separate entityfor federal tax purposes. Similarly, mere co-ownership of property that ismaintained, kept in repair, and rented or leased does not constitute aseparate entity for federal tax purposes. For example, if an individual owner,or tenants in common, of farm property lease it to a farmer for a cash rental ora share of the crops, they do not necessarily create a separate entity forfederal tax purposes.A separate entity conducting construction operations will generally be treated as abusiness entity under the new regulations. A business entity with two or more membersis classified either (1) as an association taxable as a corporation or (2) as a partnership.Except for certain business entities that are defined as corporations, a business entitymay elect to be treated as either an association or a partnership (an eligible entity). SeeTreas. Reg. section 301.7701-2.Treas. Reg. §301.7701-2(a) Business entities. For purposes of this section and§301.7701-3, a business entity is any entity recognized for federal tax purposes(including an entity with a single owner that may be disregarded as an entityseparate from its owner under §301.7701-3) that is not properly classified as a trustunder §301.7701-4 or otherwise subject to special treatment under the InternalRevenue Code. A business entity with two or more members is classified for federaltax purposes as either a corporation or a partnership. A business entity with only oneowner is classified as a corporation or is disregarded; if the entity is disregarded, itsactivities are treated in the same manner as a sole proprietorship, branch, or divisionof the owner.The regulations provide default rules that classify eligible entities without requiring themto file elections. Unless it elects otherwise, a domestic eligible entity that is formed afterJanuary 1, 1997, is classified as a partnership, if it has at least two members. Unless itelects otherwise, a foreign eligible entity that is formed after January 1, 1997, is10-2

classified as either (1) a partnership, if it has at least two members and at least onemember does not have limited liability, or (2) an association, if all members have limitedliability. Generally, an eligible entity in existence prior to January 1, 1997, maintains theclassification it claimed under the classification regulations in effect prior to January 1,1997. An eligible entity may elect to be classified other than as provided in the defaultrules or to change its classification by filing a Form 8832, Entity Classification Election,with the appropriate service center. See Treas. Reg. section 301.7701-3.For financial statement purposes, investments in joint ventures are accounted for byeach member of the joint venture under the cost method, the equity method, as a prorata share, or the entity is consolidated with the investor's financial statements. Forfinancial accounting purposes, the accounting method used to account for theconstruction company's investment in a joint venture, is based on the ownershippercentage and the degree of control the construction company has over the venture.Inspection of the taxpayer's consolidated financial statements can provide the auditorwith an extended view of the construction company's investment in joint ventures,because both incorporated projects and joint ventures are often consolidated. Inaddition, financial information of unconsolidated joint ventures is frequently disclosed inthe notes to the financial statements.Joint ventures classified as partnerships are generally required to file separate incometax returns (Form 1065). Individual partners or investors recognize a distributive shareof partnership items (reported on Schedule K-1) from the construction joint venture ontheir income tax returns. Partnerships are formed as general partnerships or limitedpartnerships. A general partnership is an association where all partners have unlimitedliability. A limited partnership is an association in which one or more general partnershave unlimited liability, while one or more limited partners have limited liability.Joint Venture ExaminationsAuditors examining construction companies that are involved in joint ventures should beaware of the unique issues regarding the formation, operation, and liquidation of jointventures. The gross receipts of each joint venture needs to be considered in the rulesof attribution in determining the member’s eligibility to meet the small contractor’sexception under IRC 460(e)(1). See Chapter 3 for additional information regarding therules of attribution. Each member of a joint venture brings individual resources to ajoint venture, and can be compensated in various ways.Each party should be viewed independently. Such a review often raises questions andpotential issues:• What resources (assets, capital, services, etc.) were contributed by each party?• What was the value and basis of the property contributed?• Did a partner contribute appreciated property to the venture?• Was the contributed property encumbered?• What are the profit, loss and capital sharing ratios?10-3

• Do the partnership allocations have substantial economic effect within themeaning of IRC section 704(b)?• Have there been changes in the ownership structure?• Have there been distributions or partial liquidations from the joint venture?• What type of property was distributed and to whom?• How has the construction company been compensated (cash, increase in capitalinterest, etc.) for its construction work?• How does the construction company allocate its overhead or indirect expenses tojoint venture projects?• Are there related transactions (compensation payments, leases, loans, etc.)between the joint venture and the members of the joint venture?• What method of accounting does the joint venture use?• What effect do long-term contracts have on the allocation of income toincoming/outgoing partners?• Has construction period interest been properly capitalized?POTENTIAL JOINT VENTURE ISSUESAuditors that examine joint ventures deal with the common issues found in theexamination of any form of construction entity. However, joint ventures (classifiedprimarily as partnerships) can and do have unique tax issues. These issues often canbe divided into three broad categories: formation, operation, and liquidation/distributionissues.Formation Issues• Failure to file partnership returns (IRC sections 761, 6698).• Capitalization/amortization of organization and syndication fees (IRC section709).• Contribution of construction services (by the construction company) in exchangefor a capital interest in the partnership (Treas. Reg. section 1.721-1(b)(1)).• Contribution of construction services (by the construction company) in exchangefor a profits interest in the partnership when a predictable income stream exists.(Rev. Proc. 93-27).• Deemed (money) distributions on the assumption of a partner's liability onproperty contributed (IRC section 752(b)).Operation Issues• Allocation of income, gains, deductions, losses, etc., not having substantialeconomic effect. (IRC section 704(b)).• Cancellation of indebtedness income (COD income) upon bankruptcy orinsolvency (IRC section 61(a)(12), IRC section 108).• Withholding tax on distributive share of partnership taxable income to a foreignpartner (IRC 1446).10-4

Liquidation/Distribution Issues• Distributions of cash in excess of basis in the partnership interest (IRC section731, 752 and 741, 751).• Interest expense deductions in connection with debt financed distributions (IRCsection 163(h)).• Disguised sales (IRC section 707(a)(2)(B)).ConclusionIn addition to the other construction industry tax issues, joint ventures, by the nature ofthe entity produce separate issues that need consideration.Chapter 9 / Table of Contents / Chapter 11Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search10-5

Chapter 10 / Table of Contents / Chapter 12Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 11: Employee or Independent ContractorClassification of WorkersAn employer is required to withhold income taxes, withhold and pay social security andMedicare taxes, and pay unemployment taxes on wages paid to an employee. Anemployer does not generally have to withhold or pay any taxes on payments toindependent contractors. Determining whether a worker is an employee or independentcontractor is referred to as worker classification. This issue has become a majorconcern for businesses. Improperly classifying workers who are employees asindependent contractors can cause tremendous liabilities. The federal payroll tax laws,the federal wage and hour laws, state unemployment insurance coverage laws, andstate workers’ compensation laws use different definitions of the term “employee.” Beaware that a worker may be classified differently for purposes other than discussed herefor federal payroll tax purposes.Workers who perform services may be independent contractors, common-lawemployees, statutory employees (including corporate officers), or statutorynonemployees. For the construction industry workers generally will be either corporateofficers, common-law employees, or independent contractors. Businesses generallyprovide benefits to their employees and must observe certain employee rights duringemployment. However, workers who are independent contractors are considered to beself-employed. Independent contractors also must determine whether workers whowork for them are employees.You determine whether an individual is an employee or an independent contractorunder the common law by looking at the relationship of the worker and the business.The degree of control and the independence of that individual must be considered.Relevant facts generally fall into three categories that are used to make thedetermination. These categories are: behavioral control, financial control, andrelationship of the parties. It is very important to consider all the facts andcircumstances when making a determination, as no single factor can determine properclassification. Revenue Ruling 87-41, which identifies 20 common law factors toconsider in determining whether a worker is an employee or an independent contractor,is merely an analytical tool and is not the legal test for making the determination. Thelegal test is whether the business has the right to direct and control the worker.Behavioral control These facts show whether the business has a right to direct andcontrol how the worker does the work for which he or she is hired. It includes the typeand degree of instructions the business gives the worker and the training the businessgives the worker. A worker is an employee when the business has the right to direct andcontrol the worker. This control refers not only to the result to be accomplished by the11-1

work, but also the means and details by which that result is accomplished. It is notnecessary that the business actually direct or control the manner in which the servicesare performed; it is sufficient if the business has the right to do so.Instructions. An employee is generally subject to the employer’s instructions aboutwhen, where, and how to work. All of the following are examples of types of instructions:• When and where to do the work• What tools or equipment to use• What workers to hire or to assist with the work• Where to purchase supplies and services• What work must be performed by a specified individual• What order or sequence to followThe amount of instruction needed varies among different jobs. Even if no instructionsare given, sufficient behavioral control may exist if the employer has the right to controlhow the work results are achieved. A business may lack the knowledge to instruct somehighly specialized professionals. In other cases, the task may require little or noinstruction. In addition, instructions about the time and place are less important thandirections on how the work is performed. The key consideration is whether the businesshas retained the right to control the details of worker’s performance.Training. An employee may be trained to perform services in a particular manner.Independent contractors ordinarily use their own methods. If the business providestraining about required procedures and methods, this indicates that the business wantsthe work done in a certain way, and suggests that the worker may be an employee.Examples of factors related to this category.• Instructions• Oral or written reports• Hiring, supervising, and paying assistants• Training• Order or sequence setFinancial Control Facts that show whether the business has a right to control thebusiness aspects of the worker’s job include:• The extent to which the worker has unreimbursed business expenses.• The extent of the worker’s investment.• The extent to which the worker makes services available to the relevant market.• How the business pays the worker.• The extent to which the worker has the opportunity to realize a profit or loss.Independent contractors are more likely to have unreimbursed expenses than areemployees. They generally have fixed ongoing costs that are incurred regardless of11-2

whether they are working or not. Independent contractors are more likely to have asignificant investment in the facilities he or she uses in performing services for someoneelse. However, a significant investment is not necessary for independent contractorstatus. They are generally free to seek out business opportunities, advertise, maintain avisible business location, and are available to work in the relevant market. Independentcontractors can make a profit or loss.If a worker is guaranteed a regular wage amount for an hourly, weekly, or other periodof time, it usually indicates that a worker is an employee, even when a commissionsupplements the wage or salary. An independent contractor is often paid by a flat feefor the job. However, it is common in some professions, such as law, to pay hourly fees.In this case, other factors must be considered to determine whether the personreceiving the fees is an employee of the business or an independent contractor.Examples of factors related to this category:• Significant investment• Payment of business or traveling expenses• Making services available to general public• Payment by the hour, week, month• Realization of profit or loss• Furnishing of tools and materialsRelationship of the parties: Certain facts show the type of relationship, such as:• Written contracts describing the relationship the parties intended to create.• Whether the business provides the worker with employee-type benefits, such asinsurance, a pension plan, vacation pay, or sick pay.• The permanency of the relationship.• The extent to which services performed by the worker is a key aspect of theregular business of the company.If a worker is engaged with the expectation that the relationship will continue indefinitely,rather than for a specific project or period, this is generally considered evidence of anemployer-employee relationship. In addition, if a worker provides services that are a keyaspect of the regular business activity, it is more likely that the owner has the right todirect and control his or her activities.The worker or business can ask the IRS to determine whether a worker is an employeeby filing Form SS-8, Determination of Worker Status for Purposes of FederalEmployment Taxes and Income Tax Withholding.Additional information on this topic can be found:11-3

• In Publication 1779, Independent Contractor or Employee, which provides aconsolidated explanation of the three categories Behavioral Control, FinancialControl, and Relationship of the Parties.• In Publication 15-A, Employer’s Supplemental Tax Guide, concerning workerclassification.• At www.irs.gov, clicking on Businesses from the home page, then EmploymentTaxes under contents.Examples of factors related to this category:• Right to discharge• Right to terminate• Integration• Continuing relationship• Services rendered personallyExamples of factors of lesser importance that fall within the three categories that willtypically provide less useful evidence of whether a worker is an independent contractoror an employee.• Full time required• Doing work on employer’s premises• Set hours of work• Working for more than one firm at a timeExamples of Employee or Independent Contractor Determination:Example 1: Jerry Jones has an agreement with Wilma White to supervise theremodeling of her house. She did not advance funds to help him carry on the work. Shemakes direct payments to the suppliers for all necessary materials. She carries liabilityand worker’ compensation insurance covering Jerry and others he engaged to assisthim. She pays them an hourly rate and exercises almost constant supervision over thework. Jerry is not free to transfer his assistants to other jobs. He may not work on otherjobs while working for Wilma. He assumes no responsibility to complete the work andwill incur no contractual liability if he fails to do so. He and his assistants performpersonal services for hourly wages. They are employees of Wilma White.Example 2: Milton Manning, an experienced tile setter, orally agreed with a corporationto perform full-time services at construction sites. He uses his own tools and performsservices in the order designated by the corporation and according to its specifications.The corporation supplies all materials, makes frequent inspections of his work, pays himon a piecework basis, and carries workers’ compensation insurance on him. He doesnot have a place of business or hold himself out to perform similar services for others.11-4

Either party can end the services at any time. Milton Manning is an employee of thecorporation.Example 3: Wallace Black agreed with the Sawdust Co. to supply the construction laborfor a group of houses. The company agreed to pay all construction costs. However, hesupplies all the tools and equipment. He performs personal services as a carpenter andmechanic for an hourly wage. He also acts as superintendent and foreman andengages other individuals to assist him. The company has the right to select, approve,or discharge any helper. A company representative makes frequent inspections of theconstruction site. When a house is finished, Wallace is paid a certain percentage of itscosts. He is not responsible for faults, defects of construction, or wasteful operation. Atthe end of each week, he presents the company with a statement of the amount he hasspent, including the payroll. The company gives him a check for that amount from whichhe pays the assistants, although he is not personally liable for their wages. WallaceBlack and his assistants are employees of the Sawdust Co.Example 4: Bill Plum contracted with Elm Corporation to complete the roofing onhousing complex. A signed contract established a flat amount for the services renderedby Bill Plum. Bill is a licensed roofer and carries workers’ compensation and liabilityinsurance under the business name, Plum Roofing. He hires his own roofers who aretreated as employees for Federal employment tax purposed. If there is a problem withthe roofing work, Plum Roofing is responsible for paying for any repairs. Bill Plum, doingbusiness as Plum Roofing, is an independent contractor.Example 5: Vera Elm, an electrician, submitted a job estimate to a housing complex forelectrician work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeksfor the next 10 weeks. This is not considered payment by the hour. Even if she worksmore or less than 400 hours to complete the work, Vera Elm will receive $6,400. Shealso performs additional electrical installations under contracts with other companies,which she obtained through advertisements. Vera is an independent contractor.Additional information to consider if taxpayer hires employees:If it is determined that the taxpayer has employees, the employer is required to obtaineach employee's name and SSN and to enter them on Form W-2. This requirementalso applies to resident and nonresident alien employees. The employer should requesta copy of each employee's social security card and record the name and number ofeach employee exactly as it is shown on the employee's card. NOTE – There is nolegal requirement that an employer physically review a social security card. Theemployee provides his SSN, address and withholding data on form W-4.Remember, employees must have a social security number to be eligible for work in theUnited States. An Individual Taxpayer Identification Number (ITIN) cannot substitute fora SSN for an employee identification or for work. An ITIN is only available to residentand nonresident aliens who are not eligible for US employment and need identification11-5

for other tax purposes. For further information, please refer to Publication 15, CircularE, Employer's Tax Guide.Additional information to consider if taxpayer hires independent contractors:The taxpayer is required to file Form 1099-MISC, Miscellaneous Income, for eachperson to whom the taxpayer paid at least $600 in rents, services (including parts andmaterials), prizes, and awards or other income payments. The reporting on Form 1099-MISC is only required when the payments are made in the course of a trade orbusiness. The taxpayer is considered to be engaged in a trade or business if he (or thecompany) operates for gain or profit. For more information (including the rule for nonprofitentities), please refer to the instructions for Form 1099-MISC.ConclusionWhether to have employees or utilize independent contractors can be a valid andappropriate business choice. However, the classification of a worker as an employee orindependent contractor is determined by the facts in each situation. No single factordetermines the status of the worker, and some factors may be given more or lessweight than others when making this determination.When worker classification becomes an examination issue, “Section 530” relief mustfirst be considered, because, without proper notification, reclassification cannot beenforced. Section 530 of the Revenue Act of 1978 (and as later modified by the SmallBusiness Job Protection Act of 1996) provides businesses with relief from federalemployment tax obligations if certain requirements are met. Before or at the beginningof any audit inquiry relating to employment status, an examiner must provide thetaxpayer with a written notice of the provisions of Section 530. If the requirements ofSection 530 are met, a business may be entitled to relief from federal employment taxobligations. Section 530 terminates the employment tax liability (and any interest andpenalties attributable to the liability) of the business, not the worker, and reclassificationcannot be completed.Section 530 establishes a moratorium on the reclassification of workers as employeesfor purposes of the employer’s employment tax obligations. Under section 530 there aretwo tests that must be met:• Consistency test• Reasonable basis testFor the consistency test to be met, the business must have filed all required Forms1099 with respect to the worker for the period, on a basis consistent with the business's11-6

treatment of the worker as not being an employee. Also, the business or a predecessormust not have treated the worker, or any worker holding a substantially similar position,as an employee at any time after December 31, 1977.In order to meet the reasonable basis test, the business must have reasonably relied onthe following factors in making the determination that the worker is not to be treated asan employee:• judicial precedent; published rulings; technical advice memorandum, privateletter ruling, or determination letter issued with respect to the business;• past IRS audit of the business for employment tax purposes, if the audit beganafter December 31, 1996, and there was no assessment attributable to thebusiness’s employment tax treatment of workers holding positions substantiallysimilar to the position held by the worker;• longstanding recognized practice of a significant segment of the industry inwhich the business was engaged, or• some other basis that is demonstrated as reasonable.For an in-depth discussion of worker classification, see the training materials ondetermining employment status, “Independent Contractor or Employee?” Training 3320-102 (Rev. 10-96), TPDS No. 842361. For additional information concerning Section 530relief, IRM 4.23.5 is available at http:www.irs.gov, key word Internal Revenue Manual.Also, refer to section 4.23.6 (the Classification Settlement Program) for workerclassification cases and section 4.23.10 (Report Writing Guide for employment taxcases.Chapter 10 / Table of Contents / Chapter 12Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search11-7

Chapter 11 / Table of Contents / Chapter 13Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 12: Alternative ResolutionOverviewThe Revenue Reconciliation Act of 1998 sought to provide solutions to taxpayerproblems in a more simplified and expedient manner. This focus has produced variousprograms in both LMSB (Large and Mid-Sized Sized Business) and SB/SE (SmallBusiness/Self-Employed) to facilitate resolution of taxpayers’ issues at the earliestpossible point.Industry Issue Resolution ProgramThis program was created to provide a mechanism outside the normal post-filingexamination process to address frequently disputed tax issues that are common to asignificant number of business taxpayers. Both LMSB and SB/SE divisions shareoperational responsibility, with assistance from Appeals, Chief Counsel, and Treasury.Prior to formal implementation, a pilot program resulted in the successful resolution ofseveral issues by the issuance of published guidance, including issues directly affectingthe construction industry:• Impact fees – Revenue Ruling 2002-9 provides that impact fees paid by realproperty developers are added to the basis of the building.• Certain costs of golf course construction – Revenue Ruling 2001-60 allowscertain golf course land improvement costs to be depreciated.• Heavy Equipment – Revenue Ruling 2002-35 discusses the reporting ofpayments to employees who own heavy equipment used by their employer.As a result of the successful pilot program, Notice 2002-20 was issued to formalize theIndustry Issue Resolution (IIR) as a permanent program, and Revenue Procedure 2003-36 provides procedures for business taxpayers, industry associations, and otherinterested parties to request guidance on business tax issues. Issues most appropriateto the program will generally have two or more of the following characteristics:• Uncertainly about the appropriate tax treatment of a given factual situation• Frequent, often repetitive, examinations of the same issue• Significant taxpayer burden• Impacts a significant number of taxpayers, either within an industry or acrossindustry lines• Factual determination is a major component and an understanding of industrypractices and views would assist the Service12-1

Issues that are not deemed suitable for the program include:• Issues unique to one or a small number of taxpayers.• Issues under the jurisdiction of Operating Divisions other than LMSB or SB/SE• Issues regarding transactions that lack a bona fide business purpose or arecompleted with a significant purpose of reducing or avoiding federal taxes• Issues involving transfer pricing or international tax treatiesThe issue submission process does not involve a required format, but should include adescription of the issue, why guidance is needed, the estimated number of affectedtaxpayers, and possible resolution options. The request will be available for publicinspection and copying. A contact name and telephone number should be included.Issues can be e-mailed to IIR@IRS.gov.LMSB, SB/SE, Counsel, and Treasury will screen and select the issues. After an issueis selected, a team will be formed to gather and analyze information, provide legalanalysis, and propose a resolution. Examination of the selected issues will not besuspended while the issues are being considered in the program.The resulting guidance will most likely take the form of a Revenue Ruling or RevenueProcedure that will permit taxpayers to adopt a recommended treatment of the issue onfuture returns. The expected IIR program benefits are:• Establishment of a consistent position or safe harbor• Reduction of burden and administrative costs for taxpayers and the IRS• Promotion of customer and employee satisfactionFor more information on the IIR program, contact the LMSB Office of Pre-Filing &Technical Services. Information may be found on the LMSB Web site at:http://lmsb.irs.gov/hg/pftg or on the Digital Daily at: http://www.irs.gov under“Businesses” and “Industry Issue Resolution”.Pre-Filing AgreementsIn January 2001, the IRS announced that the Pre-Filing Agreement (PFA) Programwould be offered on a permanent basis to all LMSB taxpayers. Pre-filing agreementsprovide specific guidance on issues relating to a tax return before it is filed as a strategyto resolve disputes earlier in the examination process. Pre-filing agreements areapplicable to all open cases and would apply to rollover, recurring issues, and currentyear transactions. The IRS published Revenue Procedure 2001-22 to provide the basicinformation for taxpayers interested in participating in the program. The revenueprocedure is not intended to resolve issues that are more appropriately addressedthrough the private letter ruling process.Pre-filing agreement eligibility depends on the following criteria:12-2

• Availability of IRS and taxpayer resources• Taxpayers subject to the jurisdiction of LMSB• Return not yet filed• Issues involve factual questions and well-settled principles of law and someinternational issues.• Twelve excludible issues are detailed in Revenue Procedure 2001-22The taxpayer is subject to the user fees only if the PFA is accepted. The fee structure isas follows:• $10,000 if the taxpayer has $250 million or more in assets• $5,000 if the taxpayer has between $50 and $250 million in assets• $1,000 if the taxpayer has between $5 and $50 million in assetsThe user fees are charged on a per issue basis, and must be paid within 30 days afterbeing notified of selection. Generally, this is a nonrefundable fee. There is noprescribed form for a PFA request, but it is anticipated the request will be in the form ofa letter addressing the requirements outlined in Section 4 of the Revenue Procedure.Either party may withdraw from the process at any time prior to the execution of theagreement, and further examination is neither impeded nor precluded. If an agreementis not reached, the parties can consider alternative industry resolution proceduresfollowing the filing of the return, or consider an early referral to Appeals. The LMSBIndustry Director has jurisdiction over the final selection decision, and, if rejected, thedecision cannot be appealed. Pre-filing agreements are in the nature of a closingagreement, and will be developed in consultation with the Chief Counsel’s Office.The intention of this program is to provide the taxpayer with a greater level of certaintyregarding the examined issue at an earlier point in time than a post-filing examination.Internal resources can be better directed as a result of this program.The Pre-Filing Agreement Program Web site is: pfa.info@irs.gov.Fast Track Mediation and SettlementThe Appeals Division, with the assistance of LMSB and SB/SE, has developedprocedures for taxpayers to resolve disputes through the Fast Track Mediation andSettlement process. This process is available for examination as well as collectionissues, including Offer in Compromise, Collection Due Process, and Trust FundRecovery cases. The purpose of the fast track program is to enable taxpayers and theIRS to work together in an expedited fashion to resolve outstanding issues while thecase is still in Compliance’s jurisdiction. The ultimate goal of the program is to decreasethe overall time from the return filing date to the ultimate conclusion of the case.Mediation takes an average of 60 to 120 days. This can shorten the entire process by12-3

months or years, depending on the particular case. This procedure is optional, and thetaxpayer can choose either fast track mediation or the normal appeals process.This collaborative process involves Compliance, the taxpayer and Appeals, and will beclosed by a signed agreement on a Form 906. Any of the parties may withdraw at anytime, and the taxpayer retains the traditional Appeal rights. The mediator cannotimpose a resolution, and will not have settlement authority. The case is only resolved ifthe taxpayer and Compliance reach agreement on the issues. If the mediation isunsuccessful, a new Appeals Officer will be assigned to the case.The taxpayer should be offered the opportunity to participate in Fast Track Mediation(FTM) at the point when all the issues have been raised and the case cannot beresolved. A brief summary of the issues along with the “Agreement to Mediate” form isneeded to begin the process. Publication 3605 outlines the details of the mediationprocess. A formal unagreed report and a taxpayer protest is not required.The joint LMSB/Appeals Fast Track Settlement program uses the mediation skills anddelegated settlement authority of Appeals to resolve issues while the case remainsunder the jurisdiction of LMSB. The Appeals officer acts as a facilitator to develop andexecute a settlement that is mutually agreeable by both the taxpayer and the LMSBteam manager. Like the mediation process, the settlement process is designed tofacilitate the resolution of cases in the most expeditious manner that is satisfactory toboth the taxpayer and the IRS. Unlike mediation, Fast Track Settlement allows theparties to consider litigation hazards in resolving disputes.In all cases, specially trained Appeals mediators will be assigned to the case, generallyfrom the same geographic area, but not the same group where the case is assigned.The taxpayer may elect to use a non-Internal Revenue Service co-mediator. In thisscenario, the taxpayer and the Appeals Team Manager will make the selection form anylocal or national organization that provides a roster of neutral parties. The selectioncriteria may include completion of mediation training, previous mediation experience, asubstantive knowledge of tax law, or knowledge of industry practices. Each party willprepare and deliver a discussion summary of the issues for consideration by themediator two weeks before the mediation session begins.Ex parte contacts with the mediator outside the mediation session is prohibited. This isto ensure that one party is not in a position to exert undue influence on the mediator.This prohibition is intended to apply only to unsolicited contacts from one of the partiesoutside the mediation session, and is intended to ensure the mediator does not receiveinformation undisclosed to the other party. All information concerning any disputeresolution communication is confidential and may not be disclosed by any party involvedin the proceeding. If agreement is not reached, it is possible to request arbitration on anissue being mediated.12-4

Fast Track Mediation works best for cases where the issues are fully developed, thetaxpayer has stated its position in writing, and there are a limited number of unagreedissues. The following cases are excluded from the mediation process:Excluded Fast Track Mediation CasesDocketed Cases • Taxpayer already exercised option to takecase to court vs. FTM and / or otheravailable alternativesAbsence of Legal Precedence and/orConflicts between Jurisdictions• Issues do not lend themselves to quickresolution, as they are "precedent' settingand require the standard Appeals / TaxCourt process• Hazard SettlementsIndustry SpecializationAppeals Coordinated Issues (ACI)• Industry Specialization Program Coordinatorand the ACI Coordinator must be involved inthe decision-making process and will not beavailable for the Mediation SessionCompetent Authority Cases • Involves issues arising between the US anda foreign country that are under thejurisdiction of the Asst. Commissioner,InternationalService Center Penalty Appeals • System already in place to expeditiouslymove these cases to Appeals• Majority of the cases would not have hadmanagerial involvementNote: Penalty Appeals Cases worked byfield employees would not be excludedService Center (streamlined) OIC cases • Logistical restrictions (travel and budget)• Majority of the cases would not have hadmanagerial involvement• No Compliance personnel available tomediate Service Center OIC casesCAP case • "Five day" Collection Appeals Program(CAP)ACS cases • No compliance person available to mediateACS casesCases involving solely the failure orrefusal to comply with the tax lawsbecause of moral, religious, political,constitutional, conscientious, or similargrounds• Majority of the cases would not have hadmanagerial involvement• Issues do not lend themselves to quickresolution• See Reg. Sec 601.106(b) “Statement ofProcedural Rules”12-5

At the conclusion of the mediation session, the Mediator will provide the “IRS AppealsFast Track Mediation Customer Satisfaction Survey to the taxpayer and request theirparticipation. This survey will be used to evaluate the process and capture feedback.More information on the Fast Track procedures is available from Publication 3605 andthe Appeals Web site. If the business has assets under $10 million, go to SB/SE FastTrack Mediation. If over $10 million in assets, refer to Notice 2001-67 and the FastTrack Agreement Form for more information.In summary, all of the alternative resolution methods discussed here were designed toprovide improved customer service, business results, and employee satisfaction. Thevision was to provide premier dispute resolution services utilizing innovative approachesto meet the needs of both the IRS and its customers. Feedback indicates the goal ofproviding an efficient and independent appeal process for all taxpayers has been greatlyenhanced by these innovative programs.Chapter 11 / Table of Contents / Chapter 13Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search12-6

Chapter 12 / Table of ContentsInternal Revenue Code Search / Revenue Ruling Search / Treasury Regulations SearchChapter 13: Electronic Filing and Paying of Business Taxes(“E-submissions”)Lesson 5In the 21st Century an entire business can run electronically. So why not file and paybusiness taxes the same way? Now business taxpayers and tax preparers can file andpay by telephone, by Internet or by PC software. It’s more economical, with lesspaperwork. It’s more efficient, with increased accuracy. And it’s more effective, sinceless time is spent filing tax returns and making payments, and more time focused on thebusiness.Most small business filing requirements can be submitted electronically. For example:• Self-employed income tax returns (Form 1040, Schedules C, E and F)• Partnership income tax returns (Form 1065 and most related forms)• Employment tax returns (Forms 940/941)• Certain information returns (e.g., Forms 1098, 1099, W2-G), using the• Filing Information Returns Electronically (FIRE) system• Income tax returns for Estates and Trusts (Form 1041)Some Advantages of Going Totally Electronic• Increased Accuracy: IRS computers quickly and automatically check for errorsor other missing information, making e-file returns more accurate and reducingthe chance of getting an error letter from the IRS.• Quick Electronic Confirmation: Computer e-filers receive an acknowledgmentthat the IRS has received their returns. Callers using TeleFile receive aconfirmation number while they are still on the phone, letting them know that theTeleFile system has accepted their return.• Deletion of the Paperwork Through Electronic Signatures: Taxpayers cancreate their own Personal Identification Number (PIN) and file a completelypaperless return using their tax preparation software or tax professional. Thetaxpayer has nothing to mail to the IRS.• Easy Payment Options: With Electronic Federal Tax Payment System (EFTPS)payments can be made from the convenience of the office or home, 24 hours a13-1

day, 7 days a week, using the Internet, EFTPS PC software, or telephone. Onemust enroll in EFTPS to use the system.e-file for BusinessE-file for Business will meet the needs of big or small businesses, or a self-employedindividual. IRS e-file is available for:• employment taxes• information returns• partnerships• estates• trusts• corporations• exempt organizationsEmployment TaxesThe IRS electronic Employment Tax filing program offers business taxpayers a varietyof paperless options for filing Form 940, Employer's Annual Federal Unemployment(FUTA) Tax Return, and Form 941, Employer's Quarterly Federal Tax Return. Usingthis program, business taxpayers, reporting agents, software developers andtransmitters can file Form 940 and Form 941 electronically. The program conductssecurity checks, builds records to be processed by IRS computer systems and sendselectronic acknowledgments. Returns are transmitted nationwide via dial-up phone linesand menu driven software directly to the IRS where they are processed at theTennessee Computing Center (TCC)/Memphis Submission Processing Center (MSPC).Individuals using tax professionals to prepare their business returns should ask themabout e-file for Business and electronic payment options.IRS e-file for Business Partners are companies and providers the IRS has entered intocooperative marketing agreements to bring special offers and discounts for using e-filefor Business products and services. The listing of Approved IRS e-file for BusinessProviders contains addresses and phone numbers including links to their Web sites.The list is updated as new providers are added. Go to www.irs.gov then click onBusinesses under the Contents section. Now click on Approved IRSe-file for Business Providers.PartnershipsSection 1224, of the Taxpayer Relief Act of 1997, requires e-file partnerships with morethan 100 partners (Schedules K-1) to file their return on magnetic media (electronicallyas prescribed by the IRS Commissioner). This law became effective for partnership13-2

eturns with taxable years ending on or after December 31, 2000. Partnerships with100 or less partners (Schedules K-1) may voluntarily file their return electronically.The current 1065 e-file program does not accept and process all partnership returntypes. Refer to Publication 1524 for additional information.Filing Information Returns Electronically (FIRE)Electronic filing of information returns allows the following forms to be submitted:Form 1042S, Foreign Person’s U.S. Source Income Subject to WithholdingForm 1098, Mortgage Interest StatementForms 1099 (all)Form 5498, IRA Contribution InformationForm 8027, Employer’s Annual Information Return of Tip income and Allocated TipsForm W-2G, Certain Gambling WinningsQuestionable Form W-4 (QWF)The FIRE System allows high-speed transmissions and offers non-peak telephonehours. The system is operational 24 hours a day, 7 days a week.Any filer of information returns may file their returns electronically. Any corporation,partnership, employer, estate and/or trust, who files 250 or more information returns fora calendar year must file electronically or magnetically. The 250-or-more requirementapplies separately to each type of form.For example, if a filer has 500 Forms 1098 and 100 Forms 1099-A, Forms 1098 mustbe filed electronically or magnetically, but not Forms 1099-A. The electronic/magneticfiling requirement does not apply if you request and receive a hardship waiver.TIP: The IRS encourages filers who have less than 250 returns to file electronically ormagnetically.The format requirements for filing information returns electronically are the same as therequirements for filing on magnetic media. Publication 1582, Information ReturnsVendor List lists vendors of products and/or services that may enable individuals to fileinformation returns magnetically or electronically. Publication 1582 is for informationonly, and in no way implies IRS approval or endorsement of products or services.Check your telephone directory for service bureaus.For further information refer to Publication 1220, Specifications for Filing Forms 1098,1099, 5498 and W-2G Magnetically or Electronically or Publication 1187, Specificationsfor Filing Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding.Electronic Federal Tax Payment System13-3

Electronic Federal Tax Payment System (EFTPS) is a tax payment system offered freefrom the U.S. Department of Treasury. Pay federal taxes electronically on-line or byphone 24 hours a day, 7 days a week. Visit www.EFTPS.gov to enroll.More than 4 million taxpayers are currently using the system. EFTPS is:• Fast and economical• Easy to use• Convenient• Accurate• Flexible• Convenience at Your FingertipsEFTPS offers the convenience and flexibility of making tax payments through theInternet or by phone. Individuals can select how they want to make their payments.There are two primary payment methods, EFTPS-Direct and EFTPS-Through aFinancial Institution. Some financial institutions may also offer the Same Daypayment method.EFTPS-Direct is an electronic payment method that allows individuals to accessEFTPS directly to report your tax information. Individuals instruct EFTPS to move thefunds from their bank account to the Treasury's account on the date they indicate.Funds will not move from a bank account until the designated day. The two paymentmethods under EFTPS-Direct are EFTPS-OnLine (Internet) and EFTPS-Phone. WithEFTPS-Direct both methods are interchangeable.Individuals electing to use EFTPS-Through a Financial Institution, will instruct theirfinancial institution to electronically move funds from their bank account to theTreasury's account. Check with the financial institution for eligibility, services offered,and cost. Not all financial institutions offer this service.Individuals can also pay their quarterly 1040-ES estimated taxes electronically usingEFTPS, and they can make payments weekly, monthly, or quarterly as well as schedulepayments for the entire year in advance.Tax payments can be initiated 24 hours a day, seven days a week. As an addedconvenience, EFTPS-Direct allows payment scheduling to warehouse your taxpayments. Businesses can schedule payments up to 120 days in advance of their taxdue date, and individuals can schedule payments up to 365 days in advance of their taxdue date. EFTPS will automatically make payments on the due date indicated.In addition, EFTPS can make ALL federal tax payments, including income,employment, estimated, and excise taxes.13-4

EFTPS EnrollmentTo participate in EFTPS requires enrollment. There are two ways to enroll in theprogram: apply online at www.EFTPS.gov or call EFTPS Customer Service:1-800-555-4477 or 1-800-945-84001-800-945-8900 or 1-800-733-4829 (TDD Hearing-Impaired)1-800-945-8600 or 1-800-244-4829 (Español)It takes only minutes to make a tax payment using EFTPS-Direct. It's much lessburdensome than writing checks, getting signatures on checks and last minute trips tothe bank.Whether you use EFTPS-Direct or EFTPS-Through a Financial Institution is used,individuals are in control of initiating their payments. The tax due date remains the sameand no government agency has access to the account.An EFT Acknowledgement number is received to keep as a record of the tax payment.Enroll in EFTPS-OnLine to make a payment, cancel a payment, review payment history,and more. Easy to navigate, and it is secure with both a PIN and Internet Passwordcombination.Tax practitioners, accountants and payroll companies are discovering the addedbenefits of using EFTPS. EFTPS offers 4 easy ways to make payments for clients.• EFTPS-OnLine - The Internet is used to make payments for the business orclients. Registration is not required for practitioners; however, taxpayers must beenrolled. Visit EFTPS.gov.• EFTPS-Phone - Available to taxpayer or provider who wishes to make debitpayments using the telephone.• EFTPS-Batch Provider - Designed for payroll processors and others who wishto enroll their clients and submit batches of payments using Windows-basedsoftware.• EFTPS-Bulk Provider-Designed for payroll processors who initiate frequentpayments from and desire automated enrollment through an Electronic DataInterchange (EDI) compatible system.To find out more, visit www.irs.gov, and click on the e-file logo. You’ll also find a listingof Approved IRS e-file for Business Providers at http://www.irs.gov/efile/index.html. Toenroll or obtain more information about EFTPS, visit www.eftps.gov.13-5

File Smart…File Electronic“The fast and accurate way to file (www.irs.gov)and pay (www.eftps.gov) your federal taxes.”Chapter 12 / Table of ContentsInternal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search13-6

Appendix 1 – Applicable Federal Tax Law & GuidanceLawTopicI.R.C. § 263Capital expendituresI.R.C. § 263ACapitalization and inclusion in inventory costs of certain expensesIRC § 446General rule for methods of accountingTreas. Reg. § 1.451-3 Provided the rules for long-term contracts prior to March 1, 1986,the date of enactment of section 460. These regulations continueto apply to exempt long-term contracts entered into beforeJanuary 11, 2001. Exempt contracts are defined under I.R.C. §460(e).Treas. Reg. § 1.451-5 Advance payments for goods and long-term contractsI.R.C. § 460Special rules for long-term contractsTreas. Reg. § 1.460 Regulations for reporting income on long-term contracts enteredinto after January 10, 2001I.R.C. § 461General rule for taxable year of deduction.I.R.C. § 461(h)Certain liabilities not incurred before economic performanceI.R.C. § 1001I.R.C. § 1237Notice 89-15Determination of amount of and recognition of gain or lossReal property subdivided for saleProvides guidance through a series of questions and answersregarding the long-term contracts subject to section 460 – prior tothe issuance of the final regulations issued under section 460.

Appendix 1 – Applicable Federal Tax Law & GuidanceImportant Revenue Rulings and Revenue ProceduresIssueNumberDateSummary and Impact of Ruling or Procedure1/1/1966 Rev. Rul. 66-247 The costs incurred by a taxpayer in the construction of ahouse for speculative sale (including the cost of the land)must be capitalized regardless of the taxpayer’s overallmethod of accounting1/1/1969 Rev. Rul. 69-536 Real estate held for sale by a taxpayer cannot beinventoried in computing taxable income.1/1/1969 Rev. Rul. 69-314 Accrual basis taxpayer is not required to include inincome retainages receivable until the all-events test ismet under the contract.1/1/1970 Rev. Rul. 70-67 Construction vs. Services: An architect who draws theplans and supervises the work of construction cannotreport income from contracts extending over more thanone year on the completed contract basis.1/1/1974 Rev. Rul. 74-104 Evaluation expenditures incurred in connection with theacquisition of existing residential property for renovationand resale are capital expenditures that must be takeninto account as part of the cost of acquiring the property.However, if such expenditures do not result in theacquisitions of property they are deductible as losses inthe taxable year the corporation decides not to acquirethe property.1/1/1980 Rev. Rul. 80-18 Construction vs. Services: A contract to provideengineering services does not qualify as a long-termcontract because it does not require taxpayer to actuallyconstruct or build anything even though his services arefunctionally related to activities, which may be the subjectof long-term contracts. Thus, such taxpayer is notentitled to use either the completed contract orpercentage of completion method.1/1/1981 Rev. Rul. 81-277 The payment by a contractor of money to a buyer inexchange for a release of the buyer’s claim against thecontractor for failure to fulfill the contract for constructionof a plant constitutes a return of capital rather than grossincome to the buyer. The cost basis of the plant isadjusted downward to reflect the payment.1/1/1982 Rev. Rul. 82-134 Construction vs. Services: A taxpayer, who bycontract furnishes engineering services and constructionmanagement to clients, is not entitled to use thecompleted contract method of accounting. Taxpayerprimarily performs services and construction supervisionand is not required to actually construct anything.

Appendix 1 – Applicable Federal Tax Law & Guidance1/1/1984 Rev. Rul. 84-32 Construction vs. Services: A painting contractor whopaints industrial and commercial buildings, highways andrailroad bridges, and industrial plants is not entitled touse the completed contract method of accounting.Taxpayer’s contract is not a long-term contract becauseit does not require him to construct, build, or installanything.12/29/1986 Rev. Rul. 86-149 Construction costs of completed homes and costs ofconstruction in progress are capital expenditures underI.R.C. § 263. Taxpayers cannot inventory such costsunder the LIFO inventory method.2/27/1989 Rev. Rul. 89-25 Houses that a homebuilder used for models and/or salesoffices were not subject to an allowance for depreciation.4/13/1992 Rev. Rul. 92-28 I.R.C. § 460(e)(1) permits a taxpayer to use differentmethods of accounting for exempt and nonexemptcontracts within the same trade or business.10/25/1993 Rev. Rul. 93-70 An escrow agent that performs an oversight function withrespect to a construction project and makes payments onbehalf of the owner and general contractor is required tofile information returns (Form 1099) for payments ofreportable income.6/20/1994 Rev. Rul 94-38 Principles are set forth that define the capitalization ofconstruction costs in connection with groundwatertreatment facilities.12/17/2001 Rev. Rul. 2001-60 Where the cost of land preparation in the originalconstruction or reconstruction of a modern golf green isso closely associated with depreciable assets (such asunderground drainage pipes) that the land preparationwill be retired or replaced with those depreciable assets,the cost of land preparation may be depreciated over therecovery period of the associated depreciable assets.2/15/2002 Rev. Rul. 2002-9 “Impact Fees” incurred by a taxpayer in connection withthe construction of a new residential rental building arecapitalized costs allocable to the building under I.R.C. §§263(a) and 263A.7/1//1971 Rev. Proc. 71-21 Provides procedures under which accrual basistaxpayers may defer the inclusion in income of paymentsreceived (or amounts due and payable) in one taxableyear for services to be performed in the next succeedingtaxable year.10/19/1987 Rev. Proc. 87-56 This revenue procedure specifies class lives andrecovery periods for property subject to depreciationunder the general depreciation system provided in I.R.C.§ 168.

Appendix 1 – Applicable Federal Tax Law & Guidance4/27/1992 Rev. Proc.92-29 Provides procedure for a real estate developer to obtainthe Commissioner’s consent to use an alternativemethod (other than under I.R.C. § 461(h)) fordetermining when common improvement costs may beincluded in the basis of properties sold for purposes ofdetermining gain or loss resulting from the sales.6/5/1995 Rev. Proc. 95-27 Provides safe harbor for certain structural modificationsto a building that will not be treated as a demolition underI.R.C. § 280B1/8/2001 Rev. Proc. 2001-10 Qualifying taxpayers with average annual gross receiptsof $1,000,000 or less are excepted from an accrualmethod of accounting under I.R.C. § 446 and accountingfor inventories under I.R.C. § 471.5/6/2002 Rev. Proc. 2002-28 This procedure provides an exception from using anaccrual method of account and accounting for inventoriesto qualifying taxpayers in certain eligible businesses withaverage annual gross receipts of $10,000,000 or less.

Appendix 1 – Applicable Federal Tax Law & GuidanceDate OpinionIssuedImportant Court CasesName of Court Case andCitationSummary of Importance of Court CaseTaxpayer improperly changed to a LIFO methodof accounting for its home construction costs. Theindividual homes, which the taxpayer sold, werereal estate and did not constitute “merchandise”within the meaning of Treas. Reg. § 1.471-1.9/26/1983 W.C. & A.N. MillerDevelopment Company v.Commissioner, 81 T.C. 619(1983)7/28/1986 Homes by Ayres v.Commissioner, 795 F.2d 832(9 th Cir. 1986), aff’g, T.C.Memo. 1984-4752/24/1993 Tollis v. Commissioner, T.C.Memo. 1993-63, aff’d, 46F.3d 1132 (6 th Cir. 1995)6/23/1994 Carpenter v. Commissioner,T. C. Memo. 1994-2896/27/1994 Walsh v. Commissioner, T.C.Memo. 1994-293, aff’d, 1995U.S. App. LEXIS 16764 (8 thCir. 1995)8/8/1994 Hustead v. Commissioner,T.C. Memo. 1994-374, aff’dwithout opinion, 61 F.3d 895(3d Cir. 1995)The taxpayer was not allowed to use the LIFOmethod of accounting for its completed homesand homes under construction because realproperty is not considered “merchandise. Tracthome developers, as a matter of law, cannotmaintain inventories for tax purposes.Ordinary income vs. capital gain from the sale ofreal property. Taxpayers were in the trade orbusiness of selling real estate and, therefore, theyrealized ordinary income, not capital gain, fromtheir sales of parcels.Taxpayer is not entitled to use the cash method ofaccounting for expenses related to construction ofhouses that were unsold at the end of the taxableyear, but instead must capitalize the costs ofconstruction of such unsold houses.Ordinary income vs. capital gain from the sale ofreal property. Court held that the taxpayer was inthe trade or business of selling real estate andthat income from the sale of such property wasthus ordinary.Expenditures (legal expenses related to challengeof zoning variance) incurred in connection withland development must be capitalized per I.R.C. §263A.2/2/1995 Von-Lusk v. Commissioner,104 T.C. 207 (1995)Preliminary land development costs (obtainingbuilding permits and variances, negotiating permitfees, property taxes etc.) were nondeductiblecapital expenditures per I.R.C. § 263A.

Appendix 1 – Applicable Federal Tax Law & Guidance9/16/1997 Pierce v. Commissioner, T.C.Memo. 1997-4112/9/1998 Foothill Ranch CompanyPartnership v. Commissioner,110 T.C. 94 (1998)1/7/1999 Reichel v. Commissioner, 112T.C. 14 (1999)8/30/1999 Olstein v. Commissioner, T.C.Memo. 1999-29010/7/1999 Hancock v. Commissioner,T.C. Memo. 1999-3367/17/2000 Tutor-Saliba Corporation v.Commissioner, 115 T.C. 1(2000)3/14/2001 Hutchinson v. Commissioner,116 T.C. 172 (2001)A taxpayer engaged in buying and developingland for sale to residential builders is not entitledto use the lower of cost or market method, aninventory method, because real property may notbe inventoried.Sales Contract vs. Construction Contract:The construction of the buildings or improvementsto the real property did not have to be the primarysubject matter of the contract in order for ataxpayer to use the percentage of completionmethod. It only had to be necessary for thetaxpayer to fulfill its contractual obligations.Real estate taxes paid by a real estate developerwere required to be capitalized per I.R.C. § 263A,even though no positive steps to begin developingthe parcels had occurred, because the taxpayeracquired the parcels with the intent to developthem.Lots purchased from a predecessor were capitalassets because the property was not held for saleto customers in the ordinary course of thetaxpayer’s trade or business. Sale of these lotsthus resulted in capital gain.Ordinary income vs. capital gain from the sale ofreal property. The eight lots sold by the taxpayerin liquidation of her real estate developmentbusiness were in the ordinary course of her tradeor business and thus the tax losses from the saleswere ordinary losses.Disputed claims are part of contract price forpercentage of completion method of accountingas soon as it is reasonably estimated that theclaims would be received, not when the all-eventstest is met.Pursuant to Rev. Proc. 92-29 (alternative costmethod), the taxpayer could allocate estimatedclubhouse construction costs to bases in the lotssold. Under the general economic performancerule, however, taxpayer could not includeestimated future-period interest expense in thebases of the lots because neither law nor contractrequired taxpayer to obtain interest-bearing debtfor such common improvements.

Appendix 1 – Applicable Federal Tax Law & Guidance4/17/2001 Raymond v. Commissioner,T.C. Memo. 2001-96Taxpayer was denied the use of the installmentmethod of accounting on homes the taxpayer builtand sold in exchange for promissory notesbecause such sales were considered dealerdispositions.

Appendix 2 – Tax Methods of AccountingAvailable Accounting Methods for Long-Term Construction ContractorsRequired to Use the Percentage of Completion Method under I.R.C. § 460Percentage ofI.R.C. § 460(b)(1)(A) and Treas. Reg. § 1.460-4(b) generally requireCompletion Method that the PCM be computed utilizing the “cost-to-cost” method which(PCM)is: (Total cumulative allocable contract costs incurred to end oftaxable year / Total estimated allocable contract costs) x Contractprice = Cumulative gross receipts – Cumulative gross receipts fromimmediately preceding taxable year = Current-year gross receipts –Allocable contract costs incurred during current year = taxableincome to be reported during the taxable year. Upon contractcompletion, I.R.C. § 460(b)(1)(B) requires interest computed underthe “look-back” method.Simplified Cost-to-CostMethodI.R.C. § 460(b)(3)(A) and Treas. Reg. § 1.460-5(c) provide anelective for determining the contract completion factor for taxpayersusing PCM. Only three costs are used in determining thepercentage of completion:• Direct material costs• Direct labor costs• Depreciation, amortization, and cost recovery allowances onequipment and facilities directly used to construct or producethe subject matter of the long-term contractPercentage-of-Completion – 10%MethodPercentage-of-Completion/Capitalized-Cost Method (PCCM)I.R.C. § 460(b)(5) – The taxpayer may elect to defer recognition ofrevenue under PCM until 10% of the estimated total contract costsare incurred and allocated. This election is unavailable if thetaxpayer elected the simplified method mentioned above.A taxpayer may determine the income from a long-term constructioncontract that is a residential construction contract using either thePCM or the PCCM. Under the PCCM, this taxpayer must report70% of the contract under PCM (as required by I.R.C. § 460) andthe remaining 30% under a permissible exempt method (e.g.,Completed Contract, exempt PCM, etc). See Treas. Reg. § 1.460-4(e). A residential construction long-term contract differs from ahome construction contract in that a home construction contractinvolves buildings with four or fewer dwelling units, whereas aresidential construction long-term contract involves buildings withmore than four dwelling units. Definitions are found in I.R.C. §460(e).

Available Accounting Methods for Long-Term Construction ContractsExempt from the PCM Reporting Requirement of I.R.C. § 460Cash MethodThe general rule requires the taxpayer to report income whenreceived and deduct expenses when paid. This method is availablefor taxpayers that are not prohibited by I.R.C. § 448 and meet therequirements of Revenue Procedure 2001-10 or 2002-28.Revenue Procedure 2001-10 permits eligible small taxpayers (withaverage annual gross receipts equal to or less than $1 million) to usethe cash method when an accrual method would normally berequired by I.R.C. § 471 due to inventory.Accrual MethodAccrual with DeferredRetainages MethodCompleted ContractMethod (CCM)Exempt-ContractPercentage-of-Completion Method(EPCM)Revenue Procedure 2002-28 extends the use of the cash method tocertain qualifying taxpayers who are not prohibited by I.R.C. § 448from using the cash method and who have average annual grossreceipts of $10 million or less.The general rule is that income is reported when due, earned, orreceived, whichever comes first. Under the accrual method ofaccounting, expenses are deductible when all events have occurredthat establish the fact of the liability, the amount can be determinedwith reasonable accuracy, and not earlier than when economicperformance has occurred.An accrual-method taxpayer may, however, elect the provisions ofRevenue Procedure 71-21, which defer the inclusion in income ofpayments received in one taxable year for services to be performedin the next succeeding taxable year. This election is available onlyfor advance payments received for services.Revenue Ruling 69-314 allowed an accrual-basis taxpayer to elect todefer the inclusion in income of retainages withheld by the customeruntil final acceptance by the customer occurred as specified in thecontract.The general rule is that all income and expenses (both direct andindirect) related to a contract are deferred until the job is complete.Because of this deferral, this method is generally the one preferredby taxpayers who are exempt from using the PCM.A taxpayer who is exempt from the requirement to use the PCMunder I.R.C. § 460 (using the cost-to-cost method) still may elect asimilar PCM. The taxpayer must include in income the portion of thetotal contract price that corresponds to the percentage of the entirecontract completed during the taxable year. However, thecompletion may be determined by using any method of costcomparisons, such as direct labor costs incurred to date to estimatedtotal labor costs, or by comparing work performed with estimatedtotal work to be performed (e.g., units of production). See Treas.Reg. § 1.460-4(c)(2).

Nonautomatic Changes in Accounting MethodThe rules and procedures for obtaining IRS approval for taxpayer-initiated accountingmethod changes that do not receive automatic IRS consent are found in Rev. Proc. 97-27 (1997-1 CB 680). Generally, accounting method changes granted under Rev. Proc.97-27 result in “audit protection” for taxpayers (i.e., the taxpayer will not be required toretroactively change the method in question in an earlier year because of an audit).However, subject to certain exceptions, once a taxpayer is contacted by the Service toschedule an audit, a request for change in accounting method can no longer be filed.Both positive and negative Section 481(a) adjustments are included in taxable incomeratably over a four-year period beginning with the year of change. However, if the entireadjustment is less the $25,000, a de minimis rule permits taxpayers to take 100% of theamount, whether positive or negative, into account in the year of change. As a generalrule, for Section 481(a) adjustments of less than $25,000, taxpayers should use thefour-year spread period for positive adjustments (increases to taxable income ) and the100% deminimis rule for negative changes (decreases to taxable income).Automatic Changes in Accounting MethodIn Rev. Proc. 2002-9 (2002-3 IRB), the Service updated the rules for obtainingautomatic consent to change an accounting method. Rev. Proc. 2002-9 clarifies,modifies, amplifies, and supersedes Rev. Proc. 99-49, the previous Rev. Proc. dealingwith automatic change procedures. It also consolidates the automatic consentprocedures for changes in several methods of accounting published subsequent to thepublication of Rev. Proc. 99-49, and provides new automatic consent procedures forchanges in several other methods of accounting. Taxpayers complying with Rev. Proc.2002-9 are considered to have obtained the Service’s consent to change their methodof accounting in accordance with IRC Section 446(e) and the regulations thereunder.In general, Rev. Proc. 2002-9 is effective for tax years ending on or after Dec. 31, 2001.

Appendix 3 – Construction Industry Associations and ResourcesName Address Purpose, Goals, ObjectivesAssociated Builders andContractors(ABC)Associated GeneralContractors(AGC)http://www.abc.org/http://www.agc.org/A national trade associationrepresenting about 23,000contractors, subcontractors, andmaterial suppliers. This website alsoprovides license requirements byStateThe largest and oldest constructiontrade association.American Institute ofCertified PublicAccountants(AICPA)American Institute ofArchitects(AIA)American Institute ofConstructors(AIC)AmericanSubcontractorsAssociation(ASA)Blue Book of Buildingand Constructionhttp://www.aicpa.org/The AICPA is the national,professional organization for allCertified Public Accountants. Itsmission is to provide members withthe resources, information, andleadership that enable them toprovide valuable services in thehighest professional manner tobenefit the public as well asemployers and clients.http://www.aia.org/The AIA is the voice of thearchitecture profession dedicated toserving its members; advancing theirvalue; and improving the quality ofthe building environment. The AIAdocuments are standard forms in thebuilding industry.http://www.aicnet.org/AIC is an organization established tohelp individual constructionpractitioners achieve the professionalstatus they deserve.http://www.asaonline.com/ ASA is comprised of professionalconstructors, suppliers, and serviceproviders representing theconstruction industry throughadvocacy, leadership, education andnetworkinghttp://thebluebook.com/ Provides a listing of over 1,000,000general contractors, subcontractors,architects, engineers, etc by regionalarea.

Builder Online http://www.builderonline.com/ Comprehensive building informationwith numerous links.Building Online http://www.buildingonline.com/ Search over 100,000 building relatedsites. Links to top builders, topretailers, news, trade shows,contractor directories, homeimprovement tips, accounting andestimating software.Construction FinancialManagementAssociation(CFMA)Construction IndustryCPA Consultants(CICPAC)ConstructionManagementAssociation of America(CMAA)Design Build Institute ofAmerica(DBIA)Mechanical Contractorsof America Association(MCAA)National Association ofHomebuilders(NAHB)http://www.cfma.org/http://www.cicpac.com/http://cmaanet.org/http://www.dbia.org/http://www.mcaa.org/http://www.nahb.org/CFMA is a premier source ofeducation and information aboutthose aspects of financialmanagement unique to theconstruction industry. There are over7,000 members.CICPAC is a national, not-for-profitassociation for CPA firms providingfinancial and consulting services tothe construction industry.CMAA supports the professionalconstruction managers in enhancingtheir performance and improving theirbusiness results. CMAA alsoprovides information about theconstruction management practice.DBIA’s mission is to promote thewidespread and successful use ofdesign-build project delivery. DBIAsponsors educational programs,publishes a Manual of Practice andDesign-Build Contract Documents,and provides outreach to public andprivate facility owners.MCAA is an association of more than2,200 mechanical, plumbing, andservice contractors.The NAHB is a federation of morethan 800 state and local builderassociations throughout the US. Themission of this association is toenhance the climate for housing andthe building industry, and to promotepolicies that will keep housing anational priority.

Plumbing, Heating,Cooling ContractorsAssociation(PHCC)Secretary of StateSecurities ExchangeCommission(SEC)Taxpayer Websitehttp://www.phccweb.org/http://www.sec.gov/PHCC is a nationwide organizationwith approximately 3,700 members.This association is the advocate forthe plumbing, heating, and coolingcontractors.Search the Secretary of Statewebsites for any state to findinformation on companies, such as,the address, potential relatedcompanies, and the registeringagent.Provides extensive information onpublicly traded companies, includingthe 10-K, 10-Q filingsSearch for any constructioncompany’s website for annualreports, officers, headquarters,subsidiaries, etc.Trade MagazinesTitleFrequency ofPublishingSummary of Purpose/InformationIncluded/AvailabilityConstructor Monthly Magazine published by the Associated GeneralContractors of America (AGC). The magazine canbe downloaded, free of charge, from their website:http://www.agc.org/Builder Monthly Magazine published by the National Association ofHome Builders (NAHB).http://www.nahb.org/Building Design &ConstructionMonthlyFocuses on the design and construction ofnonresidential buildings – for architects, engineers,and construction managers. Articles can bedownloaded, free of charge, from their website:http://www.bdcmag.com/CFMA Building Profits Bi-monthly Magazine published by the Construction FinancialManagement Association (CFMA)http://www.cfma.org/

Journal of ConstructionAccounting & TaxationENR (Engineering NewsRecord)Trade PublicationsBi-monthlyWeeklyArticles on financial and tax accounting publishedby RIA (Research Institute of America). RIA is abusiness unit of The Thomson Corporation whichwas formed with the merger of RIA, ComputerLanguage Research (CLR), and Warren, Gorham,& Lamont (WG&L).http://riahome.com/Magazine published by McGraw Hill Construction.Ranking of contractors by type and gross income.Plus, articles on companies and projects.http://www.enr.com/Date of LatestEdition Title Summary of ContentsUpdated annually PPC (PractitionersPublishing Company) Guideto Construction ContractorsThree-volume guide that discusses theindustry in detail. The guide covers bothfinancial and tax aspects.Updated AnnuallyUpdated AnnuallyUpdated AnnuallyUpdated AnnuallyPPC (PractitionersPublishing Company) Guideto Real EstateWG&L (Warren, Gorham &Lamont) ConstructionController’ ManualRobert Morris Associates(RMA) Annual StatementStudiesCFMA Construction IndustryAnnual Financial SurveyThree-volume guide that discusses thedevelopment of real estate in detail. Theguide covers both financial and tax aspects.Provides insight to the complex accounting,tax, insurance, legal, and financial issues ofthe construction sector.Provides comparative financial data for alltypes of businesses organized bySIC/NAICS codes.The survey contains financial dataorganized by type of construction, dollarvolume, and geographic region.AICPA Auditing Standards and PublicationsDate of IssuanceRegularly Updated – notnecessarily annualUpdated AnnuallyTitleAICPAConstructionContractorsAICPA Audit RiskAlert on theConstructionIndustrySummary of Information IncludedAICPA Audit and Accounting Guide.Nonauthoritative practice aids designed to beused as engagement planning tools. The alertsare resources for checking vital auditconsiderations that might otherwise beoverlooked

June 1953October 1955July 15, 1981ARB (AccountingResearch Bulletin)No. 43 GovernmentContractsARB No. 45 Long-Term Construction-Type ContractsSOP (Statement ofPosition) 81-1Accounting forPerformance ofConstruction-Typeand CertainProduction-TypeContractsChapter 11 prescribes generally acceptedaccounting principles in three areas ofaccounting for government contracts. Section Adeals with accounting under cost-plus-fixed-feecontracts. Section B deals with aspects ofgovernment contracts and subcontracts that aresubject to renegotiation. Section C involvesaccounting for terminated war and defensecontractsDescribes the two generally accepted methodsof accounting for long-term construction-typecontracts: percentage-of-completion method andthe completed-contract method.Provides additional guidance on the applicationof the generally accepted accounting principlesset forth in ARB No. 43 & 45. SOP 81-1establishes a strong preference for thepercentage-of-completion method

Appendix 4 – Cost AllocationCOST ALLOCATION FLOWCHARTIs there a contract?NOI.R.C. §§ 263(a) and 263A(Land Developers & SpeculativeHomebuilders)YESExempt from I.R.C. §460?1. Home ContractorOR2. Small Contractor$10 millionYESI.R.C. § 263A (Large Homebuilders)NOSmall Contractors and Small Homebuilders:Treas. Reg. § 1.460-5(d) for Electing Completed Contract MethodTreas. Reg. § 1.460-5(b) for Electing Percentage of Completion Method

PRODUCTION PERIOD INTEREST IS ALLOCABLE UNDER ALL OF THEABOVE UNDER I.R.C. §§ 460(c)(3) AND 263A(f).COST ALLOCATION BY ITEM UNDER EACH METHODPercentage ofCompletionMethodrequired byI.R.C. § 460 &460(c) & Treas.Reg.§ 1.460-5(b)SimplifiedCost-to-CostMethodallowed byI.R.C. §460(b)(3)(A)& Treas.Reg. § 1.460-5(c)CompletedContractMethodallowed byTreas. Reg.1.460-5(d)UniformCapitalizationRules in CodeSection 263A(LargeHomebuildrs,Spec. Homes,Land Developers)Direct materials Yes Yes Yes YesDirect labor(Includingsubcontractors)Yes Yes Yes YesIndirect costs:• Repairs Yes No Yes Yes• Maintenance Yes No Yes Yes• Utilities Yes No Yes Yes• Rent Yes No Yes Yes• Certain indirectlaborYes No Yes Yes• Materials &SuppliesYes No Yes Yes• Small tools &equipmentYes No Yes Yes• QC & Inspection Yes No Yes Yes• Taxes other thanincome taxesYes No Yes Yes• Fin. StatementdepreciationNo No Yes NO• Tax returndepreciationYes Yes No Yes• Cost depletion Yes No Yes Yes• Percentagedepletion inexcess of costYes No No Yes

• Contract General& administrativeexpense• Non-Contract G&Aexpense• Adm. SupportdepartmentsPercentage ofCompletionMethodrequired byI.R.C. § 460 &460(c) & Treas.Reg.§ 1.460-5(b)YesYesSimplifiedCost-to-CostMethodallowed byI.R.C. §460(b)(3)(A)& Treas.Reg. § 1.460-5(c)NoNoCompletedContractMethodallowed byTreas. Reg.1.460-5(d)YesNoUniformCapitalizationRules in CodeSection 263A(LargeHomebuildrs,Spec. Homes,Land Developers)YesYesYes No No Yes• Contract relatedofficer salaries• Non-Contractrelated officerYesYesNoNoYesNoYesYessalaries• Insurance(including bonds)Yes No Yes Yes• Pension, profitsharing, etc.Yes No No Yesexcept for pastservice costs• Past servicecostsYes No No Yes• Direct R and D Yes No No Yes• Rework, scrap,and spoilageYes No No Yes• Successfulbidding expenseYes No No Yes• Engineering anddesignYes No No Yes• TransportationcostsYes No Yes Yes• Storage,handling,purchasing, andYes No No Yes

elated costs• Productionperiod interest• Any additionalcosts under costplus or certaingovernmentalcontracts• Marketing,selling,advertising, anddistributionPercentage ofCompletionMethodrequired byI.R.C. § 460 &460(c) & Treas.Reg.§ 1.460-5(b)SimplifiedCost-to-CostMethodallowed byI.R.C. §460(b)(3)(A)& Treas.Reg. § 1.460-5(c)CompletedContractMethodallowed byTreas. Reg.1.460-5(d)Yes No Yes YesYes No No YesNo No No NoUniformCapitalizationRules in CodeSection 263A(LargeHomebuildrs,Spec. Homes,Land Developers)• R & D not relatedto contracts• Losses underCode Section165, e.g.obsolescence ofmaterial, declinein value ofassets, casualtylosses, etc.• Income taxes• Costsattributable tostrikes• Repairs notassociated withproductionequipmentNo No No NoNo No No NoNo No No NoNo No No NoYES YES YES YES

Appendix 5 – Definitions and TerminologyTermDefinitionADVANCE PAYMENTS Payments generally made to a prime contractor priorto the performance of any work under a contract.These payments help the contractor coverdevelopmental and preliminary costs incurred prior tocommencement of work.ADVANCES ON A current liability on the books of contractors whereCONTRACTSbillings on contracts exceed accumulated costs.AGGREGATING (OR The process of treating two or more agreements asCOMBINING)one contract for the purpose of clearly reflectingincome.ASSEMBLAGE Acquisition of contiguous properties by one owner fora specific purpose, such as the development of ahousing tract.AWARDNotification given to a bidder informing him or her thathis or her bid was accepted.BACK CHARGES Billings between parties, such as from owners togeneralcontractors or general contractors to subcontractors,covering expenses, which, according to the contract,should have been incurred by the party to whombilled.BACKFILLBACKLOGBETTERMENTBIDBID BONDBID-RIGGINGSoil or other materials used to fill an excavation.The accumulation of unfinished jobs of a contractor,including those not started, measured by the amountof revenue expected to be received from them.Improvement to real property, such as the addition ofa sidewalk that increases the property’s value. It’s nota repair, restoration, or enlargement.A formal offer from a contractor, which specifies theprice to be charged for completing, work inaccordance with project specifications and contractrequirements.A bond issued on behalf of a contractor that providesfor the payment of the difference between thecontractor’s bid and the next lowest bid if thecontractor’s bid is accepted and the contractor fails toenter into a contract or furnish such bonds asrequired by the contract.Any collusive action by contractors that restricts thecompetitive bidding process by manipulating the bidssubmitted on a project or projects (such as, inflatingbid proposals or predetermining the lowest bidder).

TermBONDING CAPACITYBONUSBRIDGE LOANBROKERDefinitionThe total dollar amount of the construction bonds (ormaximum value of incomplete work) that a suretycompany will underwrite for a contractor.A premium paid to the contractor in excess of thebasic contract price as a reward for meeting variousgoals stated in the contract; for example, completingthe project prior to the contract completion date. Theprovisions for bonuses are stipulated in the bonusclause of the contract and are in contrast to thepenalty clause.Short-term loan to cover the period between thetermination of one loan and the beginning of anotherloan; for example, the period between theconstruction loan and the permanent loan.A party that acts as the general contractor for aproject but subcontracts all of the construction workrequired under the contract.2

BUILDING PERMITBUILD-TO-SUITBUY-DOWNCERTIFICATE OFOCCUPANCYCERTIFICATE FORPAYMENTCHANGE ORDERCLAIMSCLASS A OFFICEBUILDINGCLASS B OFFICEBUILDINGCLOSINGSTATEMENTCLUSTERDEVELOPMENTCOMMERCIAL REALESTATECOMMITMENTPermission granted by the local government toconstruct a building or to make propertyimprovements.Method of leasing whereby the lessor agrees to maketenant improvements to the lessee’s specifications inreturn for the lessee’s long-term commitment to leasethe space.Technique used to facilitate the sale of property. Thebuyer is offered a below-market interest rate on amortgage loan for an initial number of years. Thedeveloper or other seller pays the lender thedifference between the below-market rate and themarket rate during the buy-down period, after whichthe borrower pays the full interest cost.Written authorization issued by a local governmentstating that the structure is ready and fit foroccupancy.Statements prepared by an architect to inform theowner of the amount due a contractor as a result ofwork completed on a project.A modification of the provisions of a contract, such asa change in specifications or manner of performancethat may be initiated by either the owner or thecontractor.Amounts in excess of the original contract price thatthe contractor seeks to collect from the owner orothers due to unanticipated circumstances; forexample, owner-caused delays, errors inspecifications, contract terminations, and disputedchange orders.Relatively new office building in a prime location, witha high occupancy rate and highly competitive rentalrates.(1) Older office building that has been fully renovatedto modern standards that is in a prime location with ahigh occupancy rate and competitive rental rates. (2)Newer building that is not in a prime locationAlso called a settlement statement. Detailed cashaccounting of a real estate transaction. It is usuallyprepared by an escrow officer, broker, or attorney.Subdivision development in which detached housesare built close together. It results in allowing littleindividual yard space.Income-producing property, such as shoppingcenters, offices, hotels, or apartments.A promise to perform a certain act, such as making a3

COMMITMENT FEECOMPLETED-CONTRACT METHODCOMPLETION BONDCONSTRUCTIONCONTRACTCONSTRUCTIONCONTRACTORCONSTRUCTION INPROGRESSCONSTRUCTIONLOANCONSTRUCTIONMANAGEMENT\(CM)CONTRACT BONDCONTRACT COSTBREAKDOWNCOST-PLUSCONTRACTCOST-PLUS-AWARD-FEE CONTRACTloan.Fee paid for a written promise to make or insure aloan for a predetermined amount and on specifiedterms.One of the two generally accepted methods ofaccounting for long-term contracts under which allcontract income and all contract costs are deferreduntil the year in which the contract is finally completedand accepted.A bond, generally given to the owner and the lender,guaranteeing completion of a project and theprovision of funds to complete it.Any contract for the building, construction or erectionof or the installation of any integral component of, orimprovements, to real property. A constructioncontract generally specifies the work to be performedand the terms of payment.A person or entity that enters into an agreement tobuild, construct, or install improvements to realproperty according to the owner’s specifications.A current asset of contractors where accumulatedcosts exceed billings on a contract.Mortgage loan used to finance real estateconstruction. It may include funds for acquiring landfor the construction project and the permanentfinancing of the completed project.The function of managing and coordinating theconstruction of a project, including the negotiating ofcontracts with others to perform the constructionwork.A bond to indemnify the owner against the failure of acontractor to comply with the requirements of acontract.A schedule showing the various elements and phasesof work in a construction project and the cost of each.A contract, which provides for reimbursement to thecontractor of the costs incurred in completing thework plus some additional amount to compensate thecontractor for profit, overhead, and performance.Different types of cost-plus contracts include costplus-fixed-fee,cost-plus award-fee, and cost-plusincentivefee.A type of cost-plus contract in which the fee consistsof a fixed-fee plus an amount which varies according4

to the level of performance of the contractor in areassuch as cost savings and timeliness.COST-PLUS-FIXED-FEE CONTRACTCOST-PLUS-INCENTIVE-FEECONTRACTCRITICAL PATHMETHOD (C.P.M.)DELAYED BILLINGSDESIGN-CONSTRUCTCONTRACT (ORDESIGN-BUILDCONTRACT)DESIGN-MANAGECONTRACTDEVELOPERDEVELOPMENTAGREEMENTDEVELOPMENT LOANDIRECT COSTDRAWENGINEERINGA type of cost-plus contract in which the fee is usuallya stipulated sum or a percentage of cost.A type of cost-plus contract in which the fee is basedon either cost savings or performance. It variesaccording to the level the contractor achieves inmeeting such cost or performance criteria.A method of scheduling construction activitiesaccording to sequence and interdependence. Thesequence of activities that allows the project to becompleted in the shortest time is called the criticalpath.Billings from a contractor for which he or she wasentitled to payment in previous billing periods.A single contract in which the contractor agrees toprovide the design, procurement, and constructionservices necessary to complete a project.A contract in which construction is performed by anumber of independent contractors in a mannersimilar to the professional construction managementconcept.Person or entity that prepares raw land fordevelopment. The developer may develop the land,and then sell it to a builder, an investor, or anotherdeveloper.Agreement under California law by which localgovernments and developers can defend theirrespective interests during the development period.Such agreements can protect developers againstchanges in public policies that can cause delay orabandonment of a development project even thoughthe developer has spent substantial funds fordevelopment.Loan for off-site improvements, such as streets andutilities. (vs. Construction Loan)Any labor, material, job overhead, or other cost that isdirectly attributable to a specific construction job.The amount of progress payments that is currentlyavailable to a contractor under a contract with a fixedpayment schedule.A contract for engineering services only, as opposed5

CONTRACTto the actual construction of a project.ESCALATION CLAUSE A provision in contracts providing for upwardadjustments to be made in the contract price ofcertain items or elements of work when conditionsaffecting their cost change.ESTIMATESThese are estimated costs of a construction project. Aproject has three types of estimates during theevolution of the project. Conceptual estimates aregenerally made in the early phases of a project for theowner to consider whether the project is economicallyfeasible. Detailed estimates are made after the designhas been approved.These require a careful tabulation of all the quantitiesfor a project or portion of a project (quantity takeoff orquantity survey). A definitive estimate is made afterthe initial approximate estimates become moredefined and accurate as additional information isdeveloped. Definitive estimates forecast the finalproject cost with little margin for error.FACTORY-BUILT Houses whose shells are factory-built and assembledHOUSESat the building site to reduce construction costs.FAST-TRACKING (OR A system of scheduling the design and construction inPHASEDsuch a manner that both phases progressCONSTRUCTION) simultaneously, with an appreciable reduction in thetotal time to complete the project.FINAL ACCEPTANCE The owner’s acceptance of the project from thecontractor upon certification by an architect orengineer that it has been completed according tocontract requirements. Final acceptance usuallyprecedes the date when the owner makes the finalpayment. The procedures to determine finalacceptance will be specified in the contract.FINAL INSPECTIONFINANCIALENGINEERINGFIXED-PRICECONTRACT (ORThe final review or inspection of a project performedby an architect, engineer, or construction manager inorder to certify that work has been completedaccording to the contract requirements, after whichthe final certificate for payment may be issued.The providing of assistance by the contractor to theclient in arranging for the long-term financing of theproject. This is an emerging feature in some largecontracts, which requires the contractor to submit afinancial package with his or her bid.6

LUMP-SUMCONTRACT)Agreement in which the contractor agrees to performthe required work in return for a fixed price stipulatedin the contract.FRONT-END LOADING A common strategy used by contractors under whichhigher relative values are assigned to work to becompleted in the early stages of a contract than to thework to be completed in the later stages. The result isthat progress billings during the early stages exceedthe actual value of the work done, causing thecontractor’s revenue from the project to be higherduring the early stages than it otherwise would havebeen. See “Unbalanced Bid.”GENERALCONTRACTORGUARANTY BONDA contractor who contracts with an owner to beresponsible for all of the construction work necessaryto complete a project, even though subcontractorsmay be used to perform part of the work.A type of bond guaranteeing that the contractor willcomplete the work according to the contract and/orpay all obligations. Also known as a “surety bond.” Ifthe bond guarantees completion of the work, it isreferred to as a “performance bond” or “completionbond.” If it guarantees payment of obligations, it is a“payment bond.”7

HARD DOLLARCOSTSHISTORICSTRUCTUREHOLDBACKCash outlays for land, labor, and improvements.Pre-1936 building that qualifies for specialrehabilitation tax credits as a historic structure underthe Tax Reform Act of 1986. See IRC section47(c)(1)(B).A contract item that can be delayed in finalization.See “Retainage”.IMPROVEMENT BOND Bond issued by public agency to finance theconstruction of improvements such as highways andstreets.INDIRECT COSTSINVITED BIDJOB COSTSJOB OVERHEADCOSTSJOINT VENTUREKICKBACKSLABOR ANDMATERIAL PAYMENTBONDLABOR ANDMATERIAL RELEASEGenerally, overhead expenses of the contractor thatare not directly attributable to a particular constructionproject.A bid submitted by one of a selected group ofcontractors who have received an invitation to bid ona project, as opposed to bidding that is open to allqualified contractors.Costs that can be allocated to specific jobs of acontractor (such asmaterial, labor, and job overhead costs).See “Overhead Costs.”A cooperative undertaking, by two or more parties(contractors), operated as a separate business entityfor the purpose of combining resources and sharingrisks on a construction project.Payments made without any legal obligation, usuallyto individuals in return for their influence in obtaining acontract.A type of guaranty bond, which guarantees the ownerthat all costs of labor, material, and supplies incurredby the contractor in connection with a project, will bepaid.Document signed by laborers and material menwaiving their rights under any mechanic’s lien againstthe developer.LETTER OF CREDITLIENLIQUIDATEDA document issued by a financial institutionguaranteeing the payment of its client’s debts up to astated amount for a specific period.Legal claim against specific property of the owner tosecure payment of amounts due to material suppliersor contractors, who are engaged in the construction ofa project.Amounts stipulated in the contract, usually as a fixed8

DAMAGESLOAN COMMITMENTLOAN ORIGINATIONFEESLONG-TERMCONTRACTLOT BOOKLUMP-SUMCONTRACTMAINTENANCE BONDamount per day, that the contractor is obligated to paythe owner as compensation for damages suffered asa result of the contractor’s failure to complete thework within a specified time.See “Commitment.”Lender’s charge for services in originating amortgage. Such fees typically are 1 to 2 percent ofthe amount of the loan.A building, installation, construction, or manufacturingcontract, which is not completed within the taxableyear in which it is entered.Records maintained by a title company of recordedtransactions affecting a particular property.See “Fixed-Price Contract.”A bond guaranteeing the owner that, for a specifiedtime following the completion of a project (warrantyperiod), any defects in workmanship or materials willbe rectified. A one-year maintenance bond is normallyincluded in the performance bond.9

MECHANIC’S LIENNEGOTIATED BIDOFFSITE COSTSOFF BALANCE SHEETFINANCINGONSITE COSTSOVERHEAD COSTSOWNERPAYMENT BONDPENALTY CLAUSEPERCENTAGE-OF-COMPLETIONMETHOD--PERFORMANCEA lien on real property in favor of persons supplyinglabor or materials for a building or structure, generallyfor the value of the labor or materials provided. Amechanic’s lien also exists for professional services insome states. Clear title to the property cannot beobtained until the claim is settled.A bid proposal from a specific contractor (selected onthe basis of reputation, past performance, quality ofwork, expertise, or other reasons) in which the termsand conditions are negotiated between the owner andcontractor, as opposed to the competitive biddingprocess under which the lowest bid is sought fromvarious qualified contractors.Expenditures incurred for the improvement of rawland that are not related to the construction of thebuilding (such as, curbs, gutters, sidewalks, andstreets).Financing that does not appear on the balance sheet(such as, operating leases).Expenditures incurred for the actual construction of abuilding.May refer to either job overhead or operatingoverhead costs. “Job overhead costs” are direct costsof work, which can be allocated to a specific job, butthey cannot be allocated to specific items of workwithin that job. “Operating overhead costs” areindirect costs of operating a construction businessthat cannot be allocated tospecific jobs.The customer of a contractor, architect, or engineerwho generally owns the right to the land on which theproject is being built.A bond guaranteeing payment of the contractor’sobligations incurred in connection with a project. See“Labor and Material Payment Bond.”In contrast to the bonus clause, this provision of thecontract provides for a reduction of the amountpayable under a contract if the contractor fails to meetspecified targets or project specifications.One of the two generally accepted methods ofaccounting for long-term contracts in which theamount of gross income reportable in each year isthat portion of the gross contract price whichrepresents the percentage of the entire contractcompleted during the year.A guaranty bond executed by the contractor to protect10

BONDPHASEDCONSTRUCTIONPRE-QUALIFICATIONPRIME CONTRACTORPROFIT CENTERPROGRESS BILLINGSthe owner against the contractor’s failure to performaccording to the terms of the contract. It is usuallycombined with a labor and material payment bond.See “Fast-Tracking.”The approval given a contractor under circumstanceswhere an agency or owner requires bidders to meetcertain standards. This approval then authorizes thecontractor to submit a bid on the project.The general contractor or any major contractor whohas a contract directly with the owner.The unit, usually a single contract, used by acontractor to measure profit or loss for accountingpurposes.Amounts billed by a contractor during the progress ofwork on a project. The amounts of the billings aredetermined in accordance with the terms of thecontract, the amount of work completed, and thematerials suitably stored. Change orders will affectthe progress billings.11

PROGRESSPAYMENTSPROGRESSSCHEDULEPROJECT MANAGERPUNCH LISTQUANTITY TAKE-OFF(OR QUANTITYSURVEY)RETAINAGESEVERING (ORSEGMENTING)SPECIFICATIONS (ORSPECS)SUBCONTRACTSUBCONTRACTORSUBCONTRACTORBONDSUBSTANTIALCOMPLETIONSURETYSURETY BONDPayments made in response to progress billings.Usually a diagram or other pictorial prepared by thecontractor and updated monthly, showing theproposed and actual starting and completion times ofthe various elements or phases of work included in aproject.An employee of the general contractor or contractmanager who is responsible for all work performed ona project.A list prepared by the architect or owner near thecompletion of a project indicating items to becompleted or corrected by the contractor.A detailed compilation of the quantity of eachelementary work item that is called for on the project.These are used in making project cost estimates.Specified amount usually withheld from progressbillings pending satisfactory completion and finalacceptance of the project.The process of treating one agreement as two ormore contracts for the purpose of clearly reflectingincome.A technical description (along with working drawings)of the materials, workmanship, special constructionmethods, and standards required under a contract.A contract between a prime contractor and a separatecontractor or supplier to perform a portion of the workor supply materials for which the prime contractor isresponsible to the owner.A contractor who contracts with the general contractoror another prime contractor to perform a specific partof the work required on a project.Performance and payment bonds executed by asubcontractor and given to the prime contractor toguarantee the subcontractor’s performance andpayment of obligations required under thesubcontract.The point reached in a project at which all major workhas been completed. The remaining costs andpotential risks of the contractor are insignificant.A person or organization, such as a bondingcompany, who promises in writing to make good thedebt or default of another in return for consideration.A legal instrument under which a surety (bondingcompany) agrees to answer to another party (theowner) for the debt, default, or failure of performance12

TIME AND MATERIALSCONTRACTTURNKEY JOBUNBALANCED BIDUNIT-OF-DELIVERYMETHODUNIT-PRICECONTRACTof a third party (the contractor).A contract that generally provides for payments to thecontractor based on the number of direct labor hoursexpended at fixed hourly rates plus the cost ofmaterials. To cover indirect costs and profit, time (andsometimes material) is charged at marked-up rates.A project on which the contractor is responsible todeliver a completed and operational facility.A bid under which the contract price isdisproportionately allocated to elements or phases ofwork on a basis other than that of cost plus overheadand profit. For example, front-end loading is theassigning of higher relative values to the workcompleted during the early phases of a project, or theassigning of higher profits to high quantity itemsunder a unit-price contract.Under this method, revenue and cost of sales arerecorded as units of work are delivered. This is mostsuitable to production-type contracts where manyunits of a product are produced in a continuousprocess (for example, aircraft).A type of construction contract, which divides thework (or project) into various elements and fixes aprice per unit for each element. Thus, payments tothe contractor are based on the number of units ofwork performed for each element. This type ofcontract is particularly suited to projects where thequantities of work may vary substantially.Table of Contents13

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