Preface: Construction accounting – unbeknownst to many in the industry, contains special accounting rules for long-term contracts. Businesses with annual construction contracts in excess of $10m are required to apply long-term contract accounting. What is it, and what should you know?
Accounting for Long-Term Contracts
Long-term contracts for tax law recognition-of-income purposes are contracts for manufacturing, building, installing or constructing property that are not completed in tax year in which they are entered into. A contract is considered to be for building, installation or construction of property if it provides for the erection of a structure, such as a building, oil well or other improvement, bridge, railroad or highway, or large industrial machine.
Taxable income from long-term contracts generally must be determined using the percentage of completion method. Under the percentage-of-completion method, gross income is reported annually according to the percentage of the contract completed in that year. The completion percentage must be determined by comparing costs allocated and incurred before the end of the tax year with the estimated total contract costs (cost-to-cost method or simplified cost-to-cost method). A taxpayer who has entered into a small construction contract or home construction contract, however, may use an exempt contract method of accounting.
Direct-benefit services. Income and expenses attributable to engineering or architectural services are accounted for as part of the long-term contract if they enable the taxpayer to construct or manufacture the qualifying subject matter of the long-term contract. Other income and expense items, such as investment income, expenses not attributable to such contracts, and costs incurred with respect to any guarantee, warranty, maintenance or other service agreement relating to the subject matter of such contracts, including engineering activity performed after the delivery and acceptance of the subject matter of the contract, must be accounted under the taxpayer’s normal accounting method.
Construction management contracts. One type of construction contract that primarily involves the performance of services is a construction management contract. In a typical construction management contract, the construction manager coordinates the construction project for the owner. The construction management firm does not have a contractual relationship with the contractors or subcontractors and is not at risk for defects in the materials or for mistakes in the construction. The construction management firm will oversee and coordinate the construction activity, may provide engineering and design services, may negotiate with contractors, subcontractors or suppliers on the owner’s behalf, and may perform some construction services.
The IRS has inferred in a number of private rulings that a taxpayer may be able to carve out a portion of the income from a construction management contract and report such portion using the percentage of completion method in limited circumstances. The taxpayer would need to show that the separate construction activities qualify as long-term contract activities, that a reasonable amount of revenue has been allocated to the construction portion of the contract as opposed to the construction management portion, and that the proper costing techniques have been utilized in determining the annual percentage of completion for the construction portion of the contract.
Real property construction contracts. The requirement that income be computed using the percentage of completion method or the percentage of completion-capitalized cost method and the requirements concerning the allocation of costs to long-term contracts do not apply to construction contracts entered into by a taxpayer:
- who estimates, at the time the contract is entered into, that the contract will be completed within the two-year period beginning on the contract commencement date, and
- whose average annual gross receipts for the three tax years preceding the tax year the contract is entered into do not exceed $10 million.
However, the rules for allocation of production period interest to long-term contracts apply to the long-term construction contracts. A construction contract for this purpose is any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property.
Home construction contracts. Proposed IRS regulations provide that a contract for the construction of common improvements is considered a contract for the construction of improvements to real property directly related to and located on the site of the dwelling units, even if the contract is not for dwelling unit construction. For example, a land developer that sells individual lots (and its contractors and subcontractors) might have long-term construction contracts that qualify for the home construction contract exemption. These regulations also permit an individual condominium unit to be considered a “townhouse” or “rowhouse” under the exemption, so that each condominium unit can be treated as a separate building in determining whether the underlying contract qualifies.
If you have any questions about the tax rules related to long-term construction contracts or their application to your business, please contact this office.