The IRS Large Business and International (LB&I) Division is currently pursuing a "compliance campaign" against large land developers of residential communities for improper use of the more taxpayer-friendly completed contract method (CCM) of accounting. The IRS believes that some developers are deferring profits under the CCM that should be recognized — and taxed — earlier.
For federal income tax purposes, long-term contracts are those that span a year end. For example, if you enter into a contract on December 29, but do not complete work until January 20, you have a long-term contract.
The CCM allows developers to defer the recognition of taxable income and expense until the year a long-term construction contract is completed and accepted by the customer. That way, the profit is not taxed until the year the project is completed.
The alternative way to account for construction contracts is the percentage of completion method (PCM). Under the PCM, taxable income is recognized over the life of the contract based on the percentage of total costs incurred to date. For example, if a contract is 30% complete at the end of the taxable year, you would have to include 30% of the projected profit in taxable income by the end of that year.
Developers generally prefer the CCM for income tax purposes, because it is simpler and allows income to be recognized later than under the PCM. By electing to use the CCM, developers potentially could defer recognizing millions of dollars of income for tax purposes.
The CCM is permitted for:
Home Construction Contracts. These are contracts for work on buildings that have four or fewer dwelling units. At least 80% of the estimated total contract costs must be for the construction, improvement or rehabilitation of these units. Contracts to build apartment buildings with more than four units would not be home construction contracts. If a contract is not a home construction contract, the IRS classifies it as a general construction contract.
Small Contractors. Small contractors may be eligible to use the CCM for general construction contracts if:
- The contract will be completed within two years; and
- The contractor's average annual gross receipts do not exceed $25 million for the three taxable years preceding the taxable year the contract is entered into.
The Tax Cuts and Jobs Act (TCJA) increased the gross receipts threshold for using the CCM for general construction contracts from $10 million to $25 million for taxable years beginning after 2017. Therefore, more developers and subcontractors may be eligible for the CCM, starting in 2018.
How does your firm account for construction contracts? Proactive measures can help reduce your odds of a costly audit. If you use the CCM, review contracts for compliance with the liberalized eligibility requirements under today's tax law.
If you discover you are impermissibly using the CCM, determine the appropriate corrective action, such as amending a tax return or changing accounting methods. Then determine the tax implications of making the change to the proper method, and adjust your tax planning accordingly.
Time for a Change?
The IRS considers the timing of income recognition on long-term contracts a "method of accounting." An examiner who determines that a developer is not permitted to use the CCM will initiate an "involuntary" change in accounting method.
But those affected need not wait for the IRS to take action. A developer that wants to change to or from the CCM also can apply for a change in accounting method. A voluntary change in accounting method must be made on a cutoff basis, meaning it will apply to contracts entered into on or after the first day of the year of the change.
A voluntary change will not necessarily prevent the IRS from investigating the issue in previous taxable years. However, the IRS has indicated that taxpayers that voluntarily correct their accounting methods generally will be protected from examination of the issue for years the taxpayer was not yet under audit.
The campaign shows that the IRS takes the CCM issue seriously. A "wait-and-see" approach could make your company vulnerable to an audit that could be costly. Set up a meeting with your tax advisor as soon as possible to discuss whether you are in compliance with the rules — and whether you might be one of the lucky contractors that are able to switch to the CCM method under the TCJA's liberalized eligibility requirements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.