Construction Industry October 2004

Transcription

1 Internal Revenue Service Audit Technique Guide Construction Industry October 2004 Provided by: Independent Accountants Association of Illinois Distributed by the Independent Accountants Association of Illinois, whose members are small businessmen serving the accounting and tax needs of small businesses and individuals. Members and their clients need to know what weaknesses and warning signs they have with their own accounting and tax systems AND to learn how to improve them. 1

2 Internal Revenue Service Construction Industry Audit Technique Guide (ATG) NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date. This material was designed specifically for training purposes only. Under no circumstances should the contents be used or cited as sustaining a technical position. The taxpayer names and addresses shown in this publication are hypothetical. They were chosen at random from a list of names of American colleges and universities as shown in Webster s Dictionary or from a list of names of counties in the United States as listed in the U.S. Government Printing Office Style Manual. Training ( ) Catalog Number 84851H 2

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

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

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

6 Simplified Marginal Impact Method (SMIM) Post-Completion Revenue and Expenses Revenue Acceleration Rules Reporting Look-Back, Form Chapter 6: Financial Accounting vs. Tax Accounting Introduction Financial Accounting Balance Sheet Reporting Chapter 7: Homebuilders and Developers Introduction Home Construction Contract Defined Taxation of Homebuilders Homes Built for Speculation (No Contract) Inventory vs. Real Estate Contractors Building Home Under Contract Land Developer Cost Allocated to Each Parcel of Property Alternative Cost Method of Accounting, Real Estate Developers Chapter 8: Other Tax Issues in Construction - New Chapter Accounting Method Issues Income Issues Expense Issues

7 Tax Issues Chapter 9: Income Probes - New Chapter Introduction Understanding the Accounting System Minimum Income Probes Internal Controls Use of Indirect Method Miscellaneous Income Sources Chapter 10: Construction Joint Ventures Overview Types of Joint Ventures Joint Venture Examinations Potential Joint Venture Issues Chapter 11: Employee or Independent Contractor - New Chapter Classification of Workers Chapter 12: Alternative Resolution - New Chapter Overview Industry Issue Resolution Program Pre-Filing Agreements Fast Track Mediation and Settlement

8 Chapter 13: Electronic Filing and Paying of Business Taxes ( E-submissions ) - New Chapter E-File for Business Electronic Federal Tax Payment System (EFTPS) Appendix Appendix 1- Applicable Federal Tax Law & Guidance... A-1 Appendix 2- Tax Methods of Accounting... A-2 Appendix 3- Construction Industry Associations and Resources... A-3 Appendix 4- Cost Allocation... A-4 Appendix 5- Definitions and Terminology... A-5 8

9 Table of Contents / Chapter 2 Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search Chapter 1: Introduction to the Construction Industry Intended Audience This Industry Guide is intended to be used by examiners conducting audits in the construction industry and as information for taxpayers and practitioners associated with the construction industry. Review of this guide is recommended prior to initiating an audit. Users of this guide may need to augment these guidelines by researching specific tax issues and new tax law. The Construction Industry as a Market Segment The construction industry represents a large segment of the total economy. Over 2.5 million companies ranging in size and specialty make the construction industry one of the largest of all industries. Businesses in the construction industry interact with businesses in related industries that supply materials, equipment, financing, and bonding to the construction contractor. Each business is dependent on one another for their survival. In 2000, approximately 2.5 million returns with construction income were filed in the United 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 total construction industry filings and $134,146,800,842 (11.5%) of the total reported gross construction receipts. Corporate filings were 540,697 or 21.8% of the total construction filings and were responsible 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 total construction filings and $125,028,989,635 (10.8%) of the total gross receipts. 2.5 Million Returns filed reporting gross receipts of $1,160,379,989,413 For the Construction Industry in 2000 Type of Return Filings % Gross Receipts % Individual Form 1040 Schedule C 1,820, % $134,146,800, % Corporate Forms 1120,1120S & Misc , % $901,204,198, % Partnership Form , % 125,028,989, % 1-1 9

10 This information was extracted from codes placed on each return by the taxpayer. The six 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 was developed jointly by the U.S., Canada, and Mexico to provide new comparability in statistics about business activity across North America. The North American Industry Classification System (NAICS pronounced Nakes) is a unique, all-new system for classifying business establishments. It was adopted in 1997 to replace the old Standard Industrial Classification (SIC) system, and is the industry classification system used by the statistical agencies of the United States. U.S. Construction Industry Return Filing (2000) per thousands (2.5 million total filings. Includes 1040, 1120, 1120S, 1065, etc.) 800, , , , , , , ,000 0 Building, Developing, and Contracting Plumbing, Heating, & Air- Conditioning Electrical Heavy Construction Participants in the Construction Industry Numerous participants that part in the construction industry. Each participant plays a distinct role in the process. The key participants will be discussed briefly in this introduction. Contractors Contractors perform the construction work in accordance with the plans and specifications provided by the owner. In general, contractors are required to be licensed by state law under separate classifications (plumbing, electrical, general building, etc.). General/Prime Contractors A general building contractor's principal business is the performance of the construction work in accordance with the plans and specifications of the owner. A general contractor takes full responsibility for the completion of the project. The general contractor will normally subcontract out a substantial part of the work, while maintaining overall control

11 through project managers and onsite supervision. The general contractor can be any size and any form of entity, i.e., sole proprietorship, partnership, or corporation. The general contractor may utilize specialty subcontractors, but can perform any portion of the work. Generally contractors must be licensed. If the contractor is a corporation or partnership, an officer or partner must be licensed. Construction Managers Generally, 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 in addition to a general contractor. As an agent, the construction manager coordinates the construction project, but has no contractual relationship with the subcontractors. Generally, construction managers provide only services, neither doing the actual construction work, nor being liable for defects in the construction. However, the construction manager may be liable for design defects. Commercial Contractors Commercial contractors specialize in commercial construction projects. These projects may 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, insurance companies, 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 residential contractor specializes in single family homes, duplexes, etc., usually building for resale to one or more individual homeowners. A commercial contractor constructs nonresidential buildings, such as office buildings, warehouses, and shopping centers. Commercial Project Owners The owner of a construction project may be an individual, corporation, partnership, or government body. The owner evaluates whether a project is feasible and will provide the future benefits desired. The owner then engages an architect or engineer to design the plans and specifications of the project. Normally, the owner secures the necessary financing for the project for both the construction period and permanent financing upon completion. The owner will retain title to the project throughout the construction phase, subject to liens from construction loans and mechanics liens. The general contractor may or may not have an ownership interest in the project. The contractor may own a percentage interest in one of the following ways: 1. Owning stock in the corporation that owns the project 2. Being a partner in a development partnership

12 3. Owning the property or an interest in a joint venture as an individual Residential Construction Developer The examination of residential developers is different than the examination of a contractor who builds in accordance with a contract between himself or herself and an owner. The developer is generally the owner of the residential development as well as the builder. The developer acquires land, obtains approval, secures construction financing, and begins construction of the residential development in stages or phases of construction. The initial phase is sold, and the construction process begins on the next phase. 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 allocated portion of off-site costs such as streets and amenities) must be matched with the sales price of each unit sold. The sales price is often based on what the market will bear under the current economic environment. During periods of low interest rates residential construction usually booms, while high interest rates cause the market to recede. Subcontractors The largest number of taxpayers in the Construction Industry are specialty subcontractors. They can range from one-man operations to nationwide, publicly traded corporations, or divisions of larger corporations. Over 70 percent of the construction returns filed are Schedule C returns by individuals. Subcontractors are distinguished from the general contractor by the limited scope of their work, which usually involves a special skill, knowledge, or ability. Subcontractors include specialists, such as plumbers, electricians, framers, and concrete workers. They generally enter into contracts with the general contractors, and may provide the raw materials used in their specialty areas. The general contractor, not the owner of the property, will usually pay the subcontractors. Materials purchased by the subcontractors are generally delivered directly to the job site. The subcontractors' work may be completed in stages, or it may be continuous. Highway Contractors Highway and street contractors require specialized equipment and techniques. The equipment includes bulldozers, graders, dump trucks, and rollers. Examples of highway construction include city streets, freeways, country roads, highway bridges, and tunnels. Heavy Construction Contractors Heavy construction contractors require large and complex mechanized equipment, such as cranes, bulldozers, pile drivers, dredges, and pipe-laying devices. Some examples of projects in this category include dams, large bridges, refineries, petrochemical plants, nuclear and fossil fuel power plants, pipelines, and offshore platforms. Most industrial

13 plants are classified in this category because of the complexity of the work. The largest engineering and construction firms are included in the heavy construction classification. Architect/Engineers The 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 of fixtures, etc.) to the contractors. When the project is started, the architect/engineer may monitor the contractor's progress and often approves progress payments to the contractors. The architect/engineer will make modifications (change orders) in the plans as needed. Change orders are written revisions to the contract, which increase or decrease the total contract price paid to the construction contractors. The change order document contains the change order number, change order date, a description of the change, and the amount of the change order. Change orders can also be issued by the contractors under the terms of the contract. Material Suppliers Material suppliers provide the raw materials used in the construction project. Material supplies are purchased by the subcontractors and installed by them in accordance with their contract. General contractors often write joint checks to subcontractors and material suppliers to ensure that all parties have been properly paid. Materials are generally delivered directly to the job site and are direct job costs, which are not normally inventoried by the contractor. In some situations the contractor will maintain inventories of miscellaneous yard stock frequently used. Construction Lenders The construction lender provides the necessary funds to pay contractors on a progress basis. In return for making the loan, the lender receives interest on the outstanding loan balance. Construction period interest (referred to as "soft costs") paid to lenders must be capitalized by the owner during the construction period. Interest and other loan costs are often taken directly from the loan principal as a result of the institutions interest provisions. As construction work progresses, the construction lender (bank, savings and loan, insurance company, etc.) will advance the funds based on the work performed or based on a payment schedule. The construction loan is generally secured by the land and construction in progress. When construction is completed, the owner will secure permanent long-term financing. Surety Companies Sureties are generally insurance companies who provide bonding to contractors. Bonds provide a form of insurance to the owner. Performance bonds protect the owner if the contractor fails to complete the construction work. Performance bonds are typically a percentage of the contract amount. Bid bonds guarantee that the contractor will sign the contract after it is awarded and furnish the necessary performance and payment

14 bonds within a specified time. Contractors must submit detailed financial data to the surety company to secure a bond. Financial statements prepared in accordance with generally accepted accounting principles (GAAP) are often furnished to the surety on a quarterly basis or more often. Supporting schedules included in these financial statements provide extensive job information, required by the surety in order that they may analyze and limit their risk. Personal financial statements are often required to be supplied from officer shareholders. Multiple Roles Each of the above participants can and often do have multiple roles in the construction process. For example, the owner could also be the general contractor (builder/developer). The general contractor in addition to providing supervision may also do specialty work that would typically be subcontracted (for example, concrete work). Design-build companies are growing. Construction lenders frequently hold an equity position in a development partnership in order to participate in the management decisions and to share in the profits. Anchor tenants, such as major department store chains participate in the development partnership in exchange for signing long-term leases. Contractors and material suppliers can obtain rights in the project by filing mechanics liens against the property. The auditor should thoroughly understand each participant's role in order to determine whether the transactions have received the proper tax treatment. THE CONTRACTING PROCESS When the owner determines that the project is feasible and that construction financing is available, he will solicit bids from general contractors and/or specialty contractors. Owners will use trade publications and newspapers to invite contractors to bid for the construction contract. The notice will provide the contractors with the procedures to be followed in submitting a bid. The bidding contractor obtains a copy of the plans and specifications from the owner to prepare the formal bid. The bidding contractor solicits bids from subcontractors, estimates direct material and labor costs, and evaluates the ultimate profit potential of the contract. The amount of the bid covers the estimated costs and profit for the construction project. The owner evaluates the submitted bids and will award the contract to the successful bidder. The contract document contains the contract amount, project start/completion dates, progress billing procedures, insurance requirements, and other pertinent information. There are standard cost manuals that a general contractor can use as a guideline in computing the bid. These guides contain a compilation of cost data for each phase of construction. It is important to realize that the cost of bidding a job can be considerable. The costs include reviewing and reproducing the job specifications and blueprints, calling in subcontractors to get bids on the work involved, developing the total cost figure for the project, and preparing a formal bid. The preparation of the bid is the first step in the cost control system. The bid becomes the budget by which the actual expenditures are

15 measured. The object of the cost control system is to provide the general contractor with information regarding actual project costs versus anticipated or budgeted costs. These cost comparisons are essential for internal control as well as for auditing purposes. You may see situations where a contractor might pursue a "break-even" bid to generate enough cash flow to meet payroll, etc., particularly in recession periods. The general contractor solicits bids from subcontractors in the various trades, the subcontractors bid for the jobs in much the same way general contractors do. Scheduling Subcontractors The general contractor is expected to schedule the subcontractors so that the construction runs smoothly and is completed on time. The various specialty areas include, but are not limited to, the following: 1. Clearing the land, which may include demolition of existing structures 2. Excavating the land, which may include digging holes and leveling 3. Pouring the foundation 4. Steel and/or wood framing 5. Rough framing 6. Rough electrical 7. Wood or concrete flooring 8. Roofing 9. Heating and air conditioning 10. Ductwork for the heating and air conditioning 11. Installing elevators and/or escalators 12. Installing sprinklers and other safety equipment 13. Installing electrical fixtures 14. Insulating and weather-stripping 15. Framing window and door sashes 16. Installing tile and marble 17. Installation of suspended acoustic ceilings 18. Installing toilets, sinks and other plumbing fixtures 19. Painting walls, inside and out 20. Laying carpet and other floor coverings 21. Clean up This list conveys some of the complexity inherent in the construction process. It reflects the necessity of scheduling the work of subcontractors and using a budget, bid costs, and actual cost variances for cost control purposes. Budgeting and scheduling are critical factors in determining the success of the contractor. CONTRACT INCOME Most companies use a standard construction contract. The most important information contained in the contract is the amount the general contractor will be paid and how often he or she will be paid. The contract will state whether the contractor will bill monthly, at

16 the completion of the contract, or at certain stages of the project. The billing invoices may include copies of the subcontractor bills and lien releases. The owner may have a supervisor at the site that confirms the contractor has completed the work for which he has billed. The contract may also include provisions for retainages, which are usually withheld from the general contractor until the project is complete. Retainages are usually withheld at a rate of 10 percent of the billed amounts, but the percentage may decrease over the life of the project. The general contractor, in turn, will retain a portion from the amounts owed to the subcontractors. TYPES OF CONTRACTS Long-Term Contracts Long-term contracts are defined in IRC section 460(f)(1) as any contract for the manufacture, building, installation, or construction of property, if such contract is not completed within the taxable year in which such contract is entered. Short-Term Contracts Short-term contracts are contracts started and completed within the taxpayer's taxable year. For short-term contracts, construction costs are treated as current period costs under 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 if the expense is also paid during the year. Fixed Price or Lump Sum Contracts A fixed price or lump sum contract states that the contractor will complete the project for an agreed price, despite unforeseen costs that might exist during the construction phase. Some fixed price contracts, in reality, provide for some variations for economic price 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 Contracts Cost-plus contracts stipulate that the contract amount will be the cost of the construction project plus a fee. The fee may be earned in various ways. A fixed fee is generally earned evenly throughout the term of the contract. A percentage fee is frequently based on the amount of cost incurred. Most cost-plus contracts have a guaranteed maximum to protect the owner from cost overruns. Many cost-plus contracts allow the contractor to share in cost savings if the project is completed under budgeted cost. The contract will specify which costs are included in the contract amount. Generally, the contract will include a clause that allows the owner to review or audit those costs. Time and Material Contracts

17 Time and material contracts are contracts that provide payments to the contractor based on direct labor hours at a fixed rate plus the cost of materials and other specified costs. Unit Price Contracts The unit price contract method is a variation of the lump-sum (or fixed price) contract method where the contractor bids a set price per unit item. The unit-price method is generally used in cases in which the number of units required has not been determined when the contract is bid. Change Orders Change orders can be initiated by the contractor or the owner. A change order modifies the original contract, and either increases or deceases the contract costs and/or contract price. BONDING Owners often require the general contractor to be bonded. In these cases, the general contractor is required to purchase a guarantee or surety bond. The purpose of the bond is to guarantee to the owner and lender that, should the general contractor fail to finish the project, the funds will be available to hire a replacement. A general contractor's bonding capacity is based upon their financial statements and past performance. A bond request will be denied if it exceeds the bonding capacity. A contractor may leave what appears to be an unusually large amount of cash in the company for the purpose of increasing his or her bonding capacity. This should be considered when determining whether or not accumulated earnings tax is applicable. The following types of bonds are available: BID BONDS provide for payment to the owner of the difference between the bid that is accepted and the next lowest bid if the general contractor with the accepted bid fails to enter into a contract. CONTRACT BONDS indemnify the owner against the failure of a general contractor to comply with the requirements of a contract. PERFORMANCE or COMPLETION BONDS guarantee completion of the project by the general contractor. LABOR and MATERIAL PAYMENT BONDS guarantee the owner that all costs of labor, material, and supplies incurred by the general contractor in connection with the project will be paid, thus voiding mechanics' liens. MAINTENANCE BONDS guarantee the owner against defects in workmanship and are usually one year in duration

18 SUBCONTRACTOR BONDS are performance and payment bonds issued by the subcontractor to the general contractor to guarantee the subcontractor's performance and payment of obligations required under the contract. State and federal contracts usually require surety bonds. In other cases, collateral bonds in which the contractor pledges real or personal property as collateral with value equivalent to the contract price may be used. When a performance bond is defaulted, it is not unusual for the insurer or bonding company to hire the defaulted contractor to complete the job, because they are familiar with the project. Most bond defaults result from financial difficulties with the project at hand, rather than from the lack of technical ability on the part of the contractor. Thus, the bonding company can act as another third-party control on the business and accounting practices of the contractor. BUILDING PERMITS Before construction can begin on a project the necessary building permits must be received from the appropriate municipality. The specifications and blueprints of the project 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 quite involved, especially in the case of new construction. The general contractor or owner may have to submit results of soil testing, environmental impact studies, or other information. Sometimes a public hearing is mandated, if opposition to the project is known. However, in most cases, the permit is issued within a few months. The cost of the permit may be the responsibility of the general contractor. The owner may pay for it, however, along with the costs of any related studies. Construction projects follow the standards of the Uniform Building Code. A Building inspector examines the project at various stages to verify that the project is being constructed according to this Code. NOTICE OF COMPLETION Once the building is completed, a Notice of Completion is requested. The project must pass a final inspection. Once the project passes that inspection, a Notice of Completion is issued by the municipality, along with a Certification of Occupancy. These documents are recorded at the office of the local recorder. At this point the property is appraised for property tax purposes. Note: Several appraisals are made throughout the construction process that address timing or allocation issues. Table of Contents / Chapter 2 Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search

19 Chapter 1 / Table of Contents / Chapter 3 Internal Revenue Code Search / Revenue Ruling Search / Treasury Regulations Search Chapter 2: Long Term Contracts Background Before the enactment of the Tax Reform Act of 1986, construction contractors could choose an accounting method from various alternatives with few restrictions. Contractors would recognize income and expense from construction contracts under the cash method, accrual method, completed contract method, or percentage of completion method. Many contractors adopted the completed contract method for tax purposes because they could defer taxes until the completion of the contract. Internal Revenue Code (IRC) 460 (effective for contracts entered into after February 28, 1986) generally requires the use of the percentage of completion method. Additionally, IRC section 460 introduced the "Look-back Method." Look-back is discussed in detail in Chapter 5. A long-term contract method of accounting (completed contract or percentage of completion) 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 be determined prior to electing a proper method of accounting. This chapter is designed to bring out the various factors involved in making this determination. Definition of Long-Term Contract The term "long-term" tends to indicate a contract that lasts a long period of time, but the duration of the contract is irrelevant in order for it to be classified as a long-term construction contract. IRC 460(f)(1) generally defines a long-term contract as one that is not complete at the end of the tax year. The long-term contract must also be for the manufacture, building, installation, or construction of property. IRC 460(f)(1) In general. The term "long-term contract" means any contract for the manufacture, building, installation, or construction of property if such contract is 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 the job on January 1 of the subsequent year. The contract is considered a long-term contract even though the job was only two days in duration

20 Contracts Subject to IRC 460 Under IRC 460(b)(1), taxpayers must use the percentage of completion method to report taxable income from long-term contracts. The degree of completion is generally determined by comparing the total allocated contract costs incurred to date with the total estimated contract costs, otherwise known as the cost-to-cost method. Engineering estimates or other approaches to determine the degree of completion may not be used if the contractor is subject to the PCM under IRC 460. If a contractor is able to meet the exemptions of IRC 460(e), the use of the engineering estimates (or any other recognized output methods) or any appropriate method, meeting the definition of section 460, is allowed. See Chapter 4 (Large Contractors) for additional information regarding contracts subject to IRC 460. Contracts Exempt from IRC Section 460 IRC 460(e) provides two exceptions for long-term construction contracts to the required 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 after June 20, Home construction contractors not meeting the small contractor exception (discussed below) are required, under IRC 460(e)1)(B), to capitalize costs 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 the time the contract was entered into, it was estimated that such contract would be completed within a 2-year period beginning on the commencement date of such contract; and the contractor's average annual taxable gross receipts for the 3 taxable years preceding the year in which such contract was entered into did not exceed $10 million. See Chapter 3 (Small Contractors) for additional information regarding these types of contracts. Example: A contractor enters into two long-term contracts during the taxable year, neither which are home construction contracts. The average annual taxable gross receipts for the prior 3 taxable years are $9,000,000. Job 1 is expected to be completed within 18 months and Job 2 is expected to be completed within 30 months. Job 1 is exempt from the percentage of completion and look-back requirements of IRC 460 and may be accounted for under the taxpayer s elected method of accounting for long-term contracts (e.g. completed contract, accrual). However, Job 2 must be accounted for using the percentage of completion method and look-back may be required upon the completion of the

21 job. Even though the average annual taxable gross receipts for the prior 3 years is less than $10,000,000, the contract is not estimated to be completed with the 2-year period. In this example, two methods of accounting for long-term contracts are proper. The two exceptions provided under IRC 460(e) do not apply to long-term manufacturing contracts. Construction Contracts versus Manufacturing Contracts IRC 460 makes a distinction between the two categories of long-term contracts: construction contracts and certain manufacturing contracts. A construction contract pertains to real property versus a manufacturing contract, which pertains to personal property. Construction Contract Defined: IRC 460(e)(4) Construction contract. For purposes of this subsection, the term "construction contract" means any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property. Manufacturing Contract Defined: IRC 460(f)(2) Special rule form manufacturing contracts. A contract for the manufacture of property shall not be treated 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 goods inventory 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 (b)(1) further distinguishes a long-term construction contract from a long-term manufacturing contract: Treas. Reg (b)(1) Long-term contract. A long-term contract generally is any contract for the manufacture, building, installation, or construction of property if the contract is not completed within the contracting year, as defined in [Regulation (b)(5)]. However, a contract for the manufacture of property is a long-term contract only if it also satisfies either the unique-item or 12-month requirements described in A contract for the manufacture of personal property 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

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

23 contract would be classified as a sales contract or a construction contract. It is irrelevant whether title in the property constructed under the contract is delivered to the customer. Treas. Reg (b)(2) Contract for the manufacture, building, installation, or construction of property. (i) In general. A contract is a contract for the manufacture, building, installation, or construction of property if the manufacture, building, installation, or construction of property is necessary for the taxpayer's contractual obligations to be fulfilled and if the manufacture, building, installation, or construction of that property has not been completed when the parties enter into the contract. If a taxpayer has to manufacture or construct an item to fulfill his obligations under the contract, the fact that the taxpayer is not required to deliver that item to the customer is not relevant. Whether the customer has title to, control over, or bears the risk of loss from, the property manufactured or constructed by the taxpayer also is not relevant. Furthermore, how the parties characterize their agreement (e.g., as a contract for the sale of property) is not relevant. Example: A developer, whose taxable year ends December 31, owns 5,000 acres of undeveloped land. To obtain permission from the local county government to improve this land, a service road must be constructed on this land to benefit all 5,000 acres. In 2000, the developer enters into a contract to sell a 1,000-acre parcel of undeveloped land to a residential developer, for its fair market value. In this sales contract, the developer agrees to construct a service road running through the land that it is selling to the residential developer. The construction of the service road is estimated to be completed in The sales contract is a construction contract because the construction of an item (the service road) is necessary for the developer to fulfill its contractual obligations. Note: for contracts entered into after January 10, 2001, de minimus construction activities, which are discussed later in this chapter, must also be considered in classification of the contract. Hybrid Contracts A hybrid contract is a single long-term contract that requires a taxpayer to perform both manufacturing and construction activities. Generally, the regulations classify a hybrid contract as two contracts--a manufacturing contract and a construction contract. Treas. Reg (f)(2) permits a taxpayer to elect, on a contract-by-contract basis to do either of the following: Treat the entire contract as a long-term construction contract if at least 95% of the estimated total allocable contract costs are reasonably allocable to construction activities

24 Treat the entire contract as a long-term manufacturing contract subject to the percentage of completion method of accounting. (Note: there is not a 95% rule as with the election to treat a hybrid contract as a construction contract.) Treas. Reg (f)(2) Hybrid contracts - -(i) In general. A long-term contract that requires a taxpayer to perform both manufacturing and construction activities (hybrid contract) generally must be classified as two contracts--a manufacturing contract and a construction contract. A taxpayer may elect, on a contract-by-contract basis, to classify a hybrid contract as a long-term construction contract if at least 95% of the estimated total allocable contract costs are reasonably allocable to construction activities. In addition, a taxpayer may elect, on a contract-by-contract basis, to classify a hybrid contract as a long-term manufacturing contract subject to the [percentage of completion method (PCM)]. De minimis Construction Activities A contract with de minimis construction activities is not a construction contract under IRC 460 if the contract includes the provision of land by the taxpayer and the estimated total contract costs attributable to the construction activities are less than 10% of the contract's total contract price. For purposes of the 10% test, the cost of the land provided to the customer is not included in the allocable contract costs. Treas. Reg (b)(2)(ii). This 10% threshold provides a "bright-line" test. Prior to enactment of the regulation, Notice provided that a contract was a construction contract if the construction activity required by the contract was necessary for the taxpayer to fulfill its contractual obligations. Example: A developer owns 5,000 acres of undeveloped land with a cost basis of $5,000,000. To obtain permission from a local county government to improve this land, a service road must be constructed on this land to benefit all 5,000 acres. In 2001, the developer enters into a contract to sell a 1,000-acre parcel of undeveloped land to a residential developer for $10,000,000. In the sales contract, there is a provision that commits the taxpayer to construct the portion of the service road that benefits the acreage sold, as required by the local county government. The portion of the cost of the service road attributable to the 1,000-acre parcel is estimated to be $10,000. The service road is not completed until Because the estimated total allocable contract costs attributable to 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 for under a long-term contract method

25 Non-Long-Term Contract Activities (e.g., Architect, Engineer Services) Long-term contract methods of accounting apply only to the gross receipts and costs attributable to long-term contract activities. Non-long-term contract activities are defined in Treas. Reg (d)(2). Treas. Reg (d)(2) Non-long-term contract activity. Non-long-term contract 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 the development or implementation of computer software. In addition, performance under a guaranty, warranty, or maintenance agreement is a non-long-term contract activity that is never incident to or necessary for the manufacture or construction of property under a long-term contract. Several revenue rulings have held that contracts for services cannot use a long-term method of accounting: An architect is not entitled to report income from contracts extending over more than one year on the completed contract method because the work is in the nature of personal service. (Rev. Rul , C.B. 117) Engineering services and construction management, unrelated to the construction contractor, are not entitled to use either the completed contract method or percentage of completion method because the contract does not require the taxpayer to construct or build anything, even though the services are functionally related. (Rev. Rul , C.B. 88; Rev. Rul , C.B. 103) A painting contractor cannot use the completed contract method because he provides only painting services. (Rev. Rul , C.B. 129) However, if the performance of a non-long-term contract activity is incident to or necessary for the manufacture, building, installation, or construction of the subject matter of one or more of the taxpayer's long-term contracts, the gross receipts and costs attributable to that activity must be allocated to the long-term contract. Treas. Reg (d) requires allocation of the contract s gross receipts and costs among the activities. Treas. Reg (d) Allocation among activities - - (1) In general. Long-term contract methods of accounting apply only to the gross receipts and costs attributable to long-term contract activities. Gross receipts and costs attributable to long-term contract activities means amounts included in the total contract price or gross contract price, whichever is applicable, as determined under , and costs allocable to the contract, as determined under Gross

26 receipts and costs attributable to non-long-term contract activities (as defined in paragraph (d)(2) of [ ]) generally must be taken into account using a permissible method of accounting other than a long-term contract method. See IRC 446(c) and (c).However, if the performance of a non-long-term contract activity is incident to or necessary for the manufacture, building, installation, or construction of the subject matter of one or more of the taxpayer's long-term contracts, however, the gross receipts and costs attributable to that activity must be allocated to the long-term contract(s) benefited as provided in (b)(4)(i) and (f)(2), respectively. Similarly, if a single long-term contract requires a taxpayer to perform a non-long-term contract activity that is not incident to or necessary for the manufacture, building, installation, or construction of the subject matter of the long-term contract, the gross receipts and costs attributable to that non-long-term contract activity must be separated from the contract and accounted for using a permissible method of accounting other than a long-term contract method. But see [ (g)] for related party rules. Example: A general contractor is hired to design and construct a building for a customer. The design portion of the contract is considered a non-long-term contract activity. However, it is incidental to the construction of the building (the building could not be built without the design), so the entire contract is accounted for under a long-term contract method of accounting. Contracts of Related Parties Treas. Reg (g) extends the reporting of the percentage of completion method to related parties that may not generally be required to report their income on the percentage of completion method. A taxpayer who performs an activity that would normally be considered a non-long term contract activity (e.g., architectural services) must report income on the percentage of completion method if it is incident to or necessary to a related party's long-term contract that must be reported using the percentage of completion method (PCM). Treas. Reg (g) Special rules for activities benefiting long-term contracts of a related party- - (1) Related party use of PCM- - (i) In general. Except as provided in [Reg (g)(1)(ii)], if a related party and its customer enter into a long-term contract subject to the PCM, and a taxpayer performs any activity that is incident to or necessary for the related party's long-term contract, the taxpayer must account for the gross receipts and costs attributable to this activity using the PCM, even if this activity is not otherwise subject to section 460(a). This type of activity may include, for example, the performance of engineering and design services, and the production of components and subassemblies that are