Improper Computation of the $10 Million Average Annual Gross Receipts per IRC § 460
Taxpayers are not aggregating the gross receipts of all the related companies for this computation and, therefore, are improperly electing an exempt, long-term method of accounting, when the percentage of completion method (PCM) is required. The Internal Revenue 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 a
member, 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 produced by 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 control include:
• 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 proportionate share of gross receipts according to percentage of ownership. (Attribution rules apply - 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 venture was set up as a partnership to construct property for a large government job. The small
contractor owned 51% of the joint venture, and the large contractor owned 49%. For the gross receipts test, determined at the joint venture level, 100% of the small
contractor’s gross receipts, 100% of the joint venture, and 49% of the large contractor’s construction gross receipts exceeded the $10 million. The joint venture was reporting income using the completed contract method, but is required to use the percentage of completion 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 § 448
Taxpayers may improperly be using the cash method of accounting. As with IRC § 460 above, 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 use the cash method of accounting, if the average annual gross receipts of the entity do not exceed $5,000,000.00
Gross Receipts are netted for the $5 million (IRC 448) and $10 million (IRC 460) Threshhold
The taxpayer may be using an improper method of accounting, if gross receipts have already been offset with expenses (other than returns and allowances), so that only the net amount is reported as gross receipts on the tax return. This netting may improperly reflect average annual gross receipts below the $5 million and $10 million thresholds per IRC § 448 and IRC § 460, respectively.
Retainages
A specified amount is usually withheld from progress billings pending satisfactory completion and final acceptance of the project. The customer will withhold the retainage from the contractor (aka Retainages Receivable). The contractor will also withhold a retainage on the subcontractors (aka Retainages Payable).
When are retainages recognized in taxable income? This depends on the method of accounting used by the taxpayer:
• Cash: Income when received or upon constructive receipt
• Accrual: Income when received, due, or earned, whichever comes first. The retainages are earned as the work is performed. However, the taxpayer may elect to exclude the retainages until billable per Revenue Ruling 69-314. • Completed Contract: Income when the contract is considered complete.
• Percentage of Completion: Included in the contract price as the job progresses.
When are Retainages reported as an expense? This depends on the method of accounting used by the taxpayer:
Cash: Expense when retainage is paid.
Accrual: Deductible when all events test has been met per IRC 461. However, if the taxpayer has elected to defer the retainages receivable per Rev. Rul. 69-314, it must also 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 PCM computation when the all-events test has been met per IRC 461
Delayed Billings Under Accrual Method
Under the accrual method, the taxpayer may delay billings or structure the billing entitlement 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), the
Court determined that the accrual of income is based upon the work performed rather than upon billing entitlement.
Determining Completion under Completed Contract Method (CCM)
Taxpayers using this method may defer completing the contract in an attempt to defer the 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 use of the subject matter of the contract or
2. Final completion and acceptance.
Reviewing the year-end work-in-progress schedule would reveal the percent complete on each job. Any job that is 95% or more complete would require further investigation to 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 Method
In the construction industry, many taxpayers provide construction management, engineering, and architectural professional services that are an essential part of the construction process. However, their contracts do not meet the definition of a long-term construction contract which involves the building, construction, reconstruction or
rehabilitation of real property. In contrast, the general contractor and subcontractors are responsible for the actual construction, and are usually working under the direction or
advice of the construction manager, engineer, or architect. Because construction management, engineering, and architects provide services that do not meet the definition of a construction long-term contract, they can not report their income under any long-term contract method (i.e., completed contract or percentage of completion method). 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 this area.
Deferring Costs under Percentage of Completion Method
Costs incurred (per IRC § 461) under the cost-to-cost percentage of completion method required by IRC § 460, determine the completion rate of the job. Costs incurred near year-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 the percentage of completion method. For generally accepted accounting principles
(GAAP), this is appropriate. However, for tax purposes, direct materials are allocated to a long-term contract when dedicated to the contract. A taxpayer dedicates direct
materials 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 Costs
Taxpayers sometimes fail to allocate the appropriate indirect costs to jobs. There are four 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 meet the 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 appropriate indirect costs to include in the percentage of completion method.
• IRC § 460(b)(3) allows taxpayers that fall under IRC § 460 (above) to elect the simplified production method. See also Treas. Reg. § 1.460-5(c).
• IRC § 263A applies to large home construction contracts that do not meet the exceptions at IRC § 460(e) (less than $10 million gross receipts or job is expected to last less than 2 years). Speculation home builders and land
developers must also allocate costs per IRC § 263A as “producers of property”. • Regulation § 1.460-5(d) applies to small contractors (both residential and
For all of the above, construction period interest is capitalized per IRC § 460(c)(3) for all long-term contracts and IRC § 263A(f) for producers of property (land developers and speculative homebuilders).
Failure to allocate all appropriate indirect costs may increase or decrease the income to be reported using the percentage of completion method. This will produce the largest adjustment for completed contract method users, speculation home builders and land developers, 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 Interest
Many contractors that meet one of the two exceptions of IRC § 460(e)(1) - home
construction contracts or small contractor (less than $10 million gross receipts and less than 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 and speculation homebuilders also must capitalize production period interest since they are required to allocate costs per IRC § 263A.
Improper Inclusion of Costs in PCM Computations
The cost-to-cost method, required by IRC § 460, is used to determine the completion percentage of a contract which determines the amount of income to be reported in a taxable year.
The completion is determined by: Costs Incurred To date
Total Estimated Costs = % Complete
The taxpayer might improperly include overstated estimates, include nondeductible costs, or allowances for contingencies in the total estimated costs figure that, in turn, reduces the percentage of completion. This understates the corresponding income to be reported on the contract.
Also, costs that are included in the total estimated costs figure may not be included in the numerator, i.e., the costs incurred. This also reduces the amount of income to be reported for a taxable year.
Improper Expense Recognition under the Completed Contract Method
The taxpayer might improperly allocate costs from contracts that are still in progress to completed contracts, which accelerates the expense recognition. An unusually low gross profit on a job may be an indication of improper job allocation.
Homebuilder Building for Speculation
This type of taxpayer might improperly deduct costs that are incurred as the house is built. 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 the property, and are not recognized until the asset is sold.
George D. Carpenter, T.C. Memo. 1994-289- - A taxpayer building a house on
speculation 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 that benefit 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 the basis of benefited properties until the common improvement costs are incurred within the 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, it may be deducting estimated costs of common improvements without being in
compliance with Revenue Procedure 92-29. (See the Homebuilder and Land Developer Chapter for more information regarding Revenue Procedure 92-29.)