Generally contractors meeting the “small contractor exemption” under IRC section 460(e)(1) are not required to use PCM for regular tax purposes. However, I.R.C. § 56 requires that long-term contracts shall be determined under the percentage of
completion method of accounting for alternative minimum tax. Alternative minimum tax is a separate tax system designed to ensure that taxpayers pay a minimum amount of tax on the true economic income when the income may not yet be taxable for regular income tax purposes. Therefore, small contractors that elect a method other than PCM may 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 any
long-term contract entered into by the taxpayer on or after March 1, 1986, the taxable income from such contract shall be determined under the percentage of completion method of accounting (as modified by section 460(b) ). For purposes of the preceding sentence, in the case of a contract described in section
460(e)(1), the percentage of the contract completed shall be determined under section 460(b)(1) by using the simplified procedures for allocation of costs
prescribed under section 460(b)(3). The first sentence of this paragraph shall not apply to any home construction contract (as defined in section 460(e)(6)).
There are two exceptions to the percentage of completion method for alternative minimum tax:
1. The last sentence in IRC § 56(a)(3), above, states that the alternative minimum tax 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 contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to activities referred to in paragraph (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), and
460(e)(6)(A)(ii) improvements to real property directly related to such dwelling units and located on the site of such dwelling units.
For purposes of clause (i), each townhouse or row house shall be treated as a separate building.
2. “Small corporations” are exempt from alternative minimum tax for years beginning after 1997 per IRC § 55(e). The definition of a “small corporation” for purposes of the exemption, the corporation must:
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 for the prior 3 years must be $5,000,000 or less.
c. A C corporation that meets the initial $5,000,000 will continue to be exempt 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 a corporation shall be zero for any taxable year if the corporation’s average annual gross receipts for all 3-taxable-year periods ending before such taxable year does not exceed $7,500,000. For purposes of the preceding sentence, only taxable years 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” for the first 3-taxable-year period (or portion thereof) of the corporation which is taken into account under subparagraph (A).
(C) FIRST TAXABLE YEAR CORPORATION IN EXISTENCE.--If such taxable year is the first taxable year that such corporation is in existence, the tentative minimum 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 becomes subject to AMT, but only for those contracts entered into after the average was
exceeded. C Corporation contractors (other than home construction contracts) with average gross receipts falling between $7.5 million and $10 million would be subject to the long-term AMT adjustment. Contractors exceeding the $10 million average would be required to use PCM for regular tax purposes, and no AMT adjustment would be necessary.
Example:
Assume a calendar-year corporation was in existence on January 1, 1994. In order to qualify as a small corporation for 1998 (the first year the exemption is available), (1) the corporation’s average gross receipts for the three-taxable year period 1994 through 1996 must be $5 million or less and (2) the corporation’s average gross receipts for the 1995 through 1997 period must be $7.5 million or less. If the corporation qualifies for 1998, the corporation will qualify for 1999 if its average gross receipts for the three- taxable year period 1996 through 1998 is $7.5 million or less. If the corporation does not qualify for 1998, the corporation cannot qualify for 1999 or any subsequent year. Example:
Assume a calendar-year corporation is first incorporated in 1999 and is neither aggregated with a related, existing corporation under IRC § 448(c)(2) nor treated as having a predecessor corporation under IRC § 448(c)(3)(D). The corporation will qualify as a small corporation for 1999 regardless of its gross receipts for such year. In order to qualify as a small corporation for 2000, the corporation’s gross receipts for 1999 must be $5 million or less. If the corporation qualifies for 2000, the corporation also will qualify for 2001 if its average gross receipts for the two-taxable year period 1999 through 2000 is $7.5 million or less. If the corporation does not qualify for 2000, the corporation cannot qualify for 2001 or any subsequent year. If the corporation qualifies for 2001, the corporation will qualify for 2002, if its average gross receipts for the three- taxable year period 1999 through 2001 is $7.5 million or less.
Sole proprietorships (Schedule C), S corporations (1120-S), and partnerships (1065) do not have a gross receipts exception. Therefore, percentage of completion for
alternative minimum tax purposes is required for non-home construction contracts. Long-Term Contract Adjustment for Alternative Minimum Tax
The 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. the gross profit computed under PCM (using the simplified method or the alternative
method to determine percent complete). PCM is required to be used for financial statements per SOP 81-1(Statement of Position) and many companies are required to have financial statements for bonding or lending purposes. Thus, this information is usually available.
Example of AMT Adjustment:
A Schedule C contractor reports income and expenses from long-term contracts on the completed contract method. The contracts are not home construction contracts. The AMT adjustment for the job below would be as follows (only one job-in-process used for simplification purposes):
Tax Year - Job 1 PCM Gross Profit
CCM Gross Profit AMT Adjustment
2000 50,000 0 50,000
2001 75,000 0 75,000
2002 25,000 150,000 (125,000)
For the tax years 2000 and 2001, the contractor would pay alternative minimum tax since no regular income tax is paid. However, in 2002, the negative AMT adjustment would most likely result in no alternative minimum tax and the contractor would receive an AMT credit on the prior AMT paid.
This AMT adjustment is shown on the line labeled Long-Term Contracts which is line 21 of the 2002 Form 6251 Alternative Minimum Tax – Individuals and line 2f of the 2002 Form 4626 Alternative Minimum Tax – Corporations.
S Corporations, partnerships, and Alternative Minimum Tax
The alternative minimum tax adjustment for long-term contracts is determined at the entity level. Each shareholder then reports the AMT adjustment on his or her pro-rata ownership. This amount should be reported on the Schedule K-1 provided to the partner or shareholder which would then be reported on the appropriate line on the Form 6251 if the shareholder/partner is an individual or Form 4626 if the
shareholder/partner is a corporation.
Look-Back and Alternative Minimum Tax
Even though small contractors are exempt from the requirement to report long-term contracts on PCM and apply look-back to completed contracts, the look-back applies to those small contractors that must compute PCM for alternative minimum tax purposes. See the look-back module for more detailed information on the computation of look- back.