Tax Accounting Methods for
Construction Contractors,
Developers and Homebuilders
A CCH Seminar
Presented by
Eric P. Wallace, CPA
20323
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ABOUT THE SPEAKER
Eric P. Wallace, CPA
In January of 2013, Eric Wallace joined the CPA firm of Boyer & Ritter CPAs.
Eric continues to focus on providing tax expertise in Code Sections 263(a), 263A,
460, depreciation, change in accounting methods, in addition to construction
industry expertise in tax, accounting, auditing, consulting, and teaching to CPAs
and construction and real estate companies. For the prior 20 years, Eric had his
own firm, and was a Partner and headed the Construction & Real Estate Services
Team for Carbis Walker LLP, a regional firm located in Pennsylvania. The focus
of his practice is on all aspects of services to CPA firms and
contractors/developers and the real estate industry. He also provides specialized
professional services, consulting, and teaching to CPA firms, CPA organizations,
and construction and real estate related industries in tax, consulting, and
accounting and auditing.
Eric has been an expert witness in construction related court cases in venues such
as bankruptcy, district, and local courts in various states concerning tax and
accounting issues. He has also represented numerous contractor clients before the
Internal Revenue Service, U.S. Department of Labor, and state revenue
departments of income, employment, and sales tax. Eric is a member of the
American Institute of Certified Public Accounts, and its Council for several years,
past President of the Pennsylvania Institute of CPAs, past Chairman of the CFMA
Tax and Fiscal Affairs Committee, and currently serves on the AGC National Tax
and Fiscal Affairs Committee.
Eric is the author of CCH's two construction books, Construction Guide: Tax and
Advisory Services and Construction-Guide-Accounting-and-KnowledgeBasedAuditsTM. These are extensive treatises of about 2,000 pages each on accounting,
auditing, consulting, and tax for contractors, homebuilders, and real estate
developers. Eric has also written CCH's audit programs on the construction
industry currently in its fifth edition.
SELECTED CCH RESOURCES
Construction Guide: Tax and
Advisory Services, with CD
(2010)
by Eric P. Wallace, CPA
Price: $205.00 (Book #: 0-6329-401)
Construction Guide:
Accounting and KnowledgeBased Audits™, with CD (2010)
by Eric P. Wallace, CPA
Price: $205.00 (Book #: 0-6310-401)
Construction Guide Combo,
with CD (2010)
by Eric P. Wallace, CPA
Price: $275.00 (Book #: 0-6363-401)
To order CALL 1 800 248 3248, Priority Code GCY3146; or
VISIT the Online Store at http://cchgroup.com
MP200001
GCY3146
This presentation and these materials are designed to provide accurate and
authoritative information in regard to the subject matter covered. This presentation
and these materials are provided solely as a teaching tool, with the understanding
that the publisher and the instructor are not engaged in rendering legal, accounting,
or other professional service and that they are not offering such advice in this
presentation and these accompanying materials. Practitioners should always
determine and incorporate all of the material facts and circumstances that apply to a
particular situation and conduct the necessary research to determine whether any
new statutory or regulatory requirements are relevant and should be applied. If legal
advice or other expert assistance is required, the service of a competent
professional person should be sought.
© 2013 CCH. All Rights Reserved.
4025 W. Peterson Avenue
Chicago, IL 60646-6085
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www.CCHGroup.com
Thank you for participating in today’s CCH Seminar!
Please check out additional programs at
http://cchgroup.com/Seminars
PRESENTATION
Tax Accounting Methods for
Construction Contractors,
Developers and Homebuilders
Presented by
Eric P. Wallace, CPA
ewallace@cpabr.com
Boyer & Ritter CPAs and Consultants
Today’s Discussion Topics
What is a long-term construction contract as
defined for tax methods?
What is the real estate requirement?
The difference between “contract” versus
“contractor” wording for tax methods
Construction activities prohibited from employing
long-term methods
What are exempt and non-exempt long-term
contracts and why does it matter?
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Today’s Discussion Topics
How do these methods apply for small or large
contractors?
How do we choose tax methods and what are their
consequences?
Home construction contract rules and issues
Small and large contractor tax advice
Real life examples and current issues, events,
myths, and mistakes
What does the latest IRS Audit Technique Guide
state about construction tax methods?
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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The Environment
One of the most difficult industries to
understand from a tax perspective
The tax rules are not found in one particular
Internal Revenue Code (IRC) section
The rules are a compilation of numerous
laws, regulations, court cases, Rev. Ruls.,
Rev. Procs., etc.
Rules continue to evolve from year to year
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Contractor Tax
Source Documents
IRC Section 460
 (PCM)
IRC Section 460(e)(1)(A)
 (HCC)
IRC Section 460(e)(1)(B)
 Small-contractor exception
IRC Regulations 1.460
 Issued Jan. 11, 2001
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Developers and Homebuilders
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Contractor Tax
Source Documents
IRC Regulation 1.460-6
 Look-back calculations
Notice 89-15
 Prior IRS guidance
Section 471
 (Inventory)
Section 263A
 Uniform capitalization regulations
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Contractor Tax
Source Documents
Revenue Ruling 92-28
 (Exempt and non-exempt contract use at same
time)
Proposed Long-Term Regulations on the HCC
 Note that these were issued in 2008 and are
proposed
 A taxpayer cannot implement a proposed regulation
IRS ATG on contractors (2009)
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Developers and Homebuilders
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Source Documents Related to
Changes in Accounting Methods
Revenue Procedure 97-27
 Non-automatic changes
IRC 1.460 Regulations
 Require the use of the cutoff method in any
long-term contract method
Rev. Proc. 2011-14
 The latest automatic method change
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Source Documents Related to
Changes in Accounting Methods
Code Sec. 481(a)
 How to pick up the change in accounting method
difference(s)
Code Sec. 481(b)
 IRS audit
Rev. Proc. 2004-34
 Defer certain advance payments
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Developers and Homebuilders
A CCH Seminar
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Source Documents Related to
Changes in Accounting Methods
Rev. Proc. 2002-28
 Cash method
 “Safe harbor”
Section 448
 C corporations over $5M
Revenue Procedure 201x-1 (latest is Rev.
Proc. 2013-1)
 Annual revenue procedures that update and set
user fees
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Contractor Tax Method Choices
Contractors, homebuilders and developers—
depending on the size of their overall
revenues and types of construction contracts
and/or service contracts—may be able to
choose
 A method of accounting
 Accounting for long-term contracts
 Other revenue and cost-recognition methods
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Contractor Tax Method Choices
These choices
 Method of accounting
 Choice(s) of method of accounting for long-term
contracts being the second
 And other revenue and cost choices are very
different and distinct choices
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Methods of Accounting
Relates to the basic accounting method
chosen by the contractor and the list of
choices includes
 The cash method
 The accrual method; and, possibly
 The hybrid method(s)
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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The Method of Accounting
for Long-Term Contracts
Method chosen by the contractor or dictated
by code if IRC Section 460 is applicable
 Choices includes
 The completed-contract method (CCM)
 The percentage-of-completion method (PCM) and its
varieties
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Choices of Methods
and Consequences
Selection of accounting method—and the
choice of accounting for long-term
contracts—influences the tax position of a
contractor for many years into the future
There are various permitted methods,
depending on the size and length of the
contract, each with its own benefits and
disadvantages
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Developers and Homebuilders
A CCH Seminar
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Choices of Methods
and Consequences
For tax purposes, there are various permitted
methods
Once a contractor elects a regular method of
accounting, a specific long-term contract
accounting method, and potentially other revenue
and costs methods, the methods must be
consistently applied
Change of methods is only available if permission
has been obtained or an automatic method permits
the contractor to change or unless the contractor is
required by a specific law to change
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Choices of Methods
and Consequences
Electing either (1) a new method for a new type of
revenue or, (2) change in business policy or
situation not previously encountered by the
taxpayer, or (3) new location or division (with
“separate set of books”) does not require a
method-change request
A contractor’s regular tax method of accounting
and its required tax accounting treatment for longterm contracts evolves and changes as the
contractor grows in revenue size and types of
contracts or services performed
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Example of Method Evolution
MNO Contractors might start business as a small
contractor and elect the cash method
If MNO Contractors was incorporated as a C
corporation, once its annual tax receipts average
exceeds $5 million dollars, it will be required to
change its method of accounting to the accrual
method
If MNO also elected an exempt long-term contract
method, such as the CCM, it will have to account
for its long-term contracts under the CCM
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Example of Method Evolution
If MNO enters into a contract that is estimated to
take more than two years to complete, it then has
to elect a non-exempt long-term method
If MNO Contractors obtains a contract with
significant design, architect, engineering, or
construction management elements, it has to
account for the portions of such a contract under
its regular method of accounting; it is prohibited
from using a long-term contract method for those
portions
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Developers and Homebuilders
A CCH Seminar
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Example of Method Evolution
If MNO continues to grow, and its tax gross
receipts exceeds $10 million dollars, it will
be required to start to account for its
uncompleted contracts, obtained after this
tax year, under the non-exempt PCM
Later, if MNO starts a new business type,
and makes separate elections, it may be
able to elect other methods
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Choices of Methods
and Consequences
Once a contractor elects method(s) of
accounting, these methods must be consistently
applied on all subsequent returns
Change of method(s) is only available if
permission has been obtained or unless the
contractor is required by a specific law to
change
Again, electing a new method for a revenue or
situation not previously encountered does not
require a method change request
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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How to Choose
or Elect Tax Methods
Contractor first chooses its regular tax
accounting method when it files its first tax
return
Contractor can also choose or elect its longterm contract accounting method (exempt
and non-exempt are separate elections) in
its first tax year, or, if no method is
elected, it will “default” in the first year
that long-term contract treatment is
applicable to the method it “employs”
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
How to Choose
or Elect Tax Methods
Confused about the difference between a
regular tax method of accounting and the
various elected tax treatments of
accounting for long-term contracts?
 They are not the same
 However—a contractor can employ its regular tax
method of accounting as its tax treatment for exempt
contracts and that will be deemed to be its elected
exempt long-term contract method
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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How to Choose
or Elect Tax Methods
A contractor’s regular tax method of
accounting and its required tax accounting
treatment for long-term contracts evolves
and changes as the contractor grows in
revenue size and types of contracts or
services performed
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
How to Choose
or Elect Tax Methods
A contractor first elects a regular
method of accounting and then elects
(or defaults to) a method of treatment
for long-term contracts when it first
has an uncompleted contract at fiscal
or calendar year-end
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Developers and Homebuilders
A CCH Seminar
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Examples of Methods
Example 1—Facts
Able Contractors always used the cash
method
Over the years it obtained and performed
construction contracts, some that were not
completed by its year-end
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Examples of Methods
Example 1—Analysis
Able elected the cash method
Because Able did not elect a long-term
accounting method in the first year in which
it had a long-term contract, it defaulted to
the use of the cash method to also account
for its (exempt) long-term contracts
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Examples of Methods
Example 2—Facts
Sammy Construction Company employed the
accrual method on its first income tax return
Over time Sammy had contracts that lasted over its
tax year-end
These contracts included both commercial and
residential contracts
Sammy’s revenues have exceeded, from time to
time, $10 million as measured in annual accrual
revenues, but Sammy has never averaged more than
$10 million over a three-tax-year measurement
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Examples of Methods
Example 2—Analysis
Again, Sammy elected the accrual method
for its basic accounting method
Because Sammy did not elect a long-term
accounting method, it defaulted to the use
of the accrual method as its elected exempt
long-term contract treatment, for both
commercial and residential (home
construction) contracts
 Abbreviated as HCCs
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Examples of Methods
Example 3—Facts
XYZ Contractors, an S corporation, has a calendar
tax year and has $5,000,000 in revenues
XYZ installs roofs on commercial buildings and large
custom homes
XYZ also performs service contracts on roofs
Some of its contracts last more than two years
XYZ elected the cash method and employed the
CCM for its uncompleted contracts on its first tax
return years ago, which included both commercial
and HCCs
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Examples of Methods
Example 3—Analysis
XYZ’s basic method of accounting is the cash
method;
 However, when it performs a commercial
contract that does not meet the smallcontractor time limit under Section 460, i.e.,
the contract is expected to take more than two
years to complete, the basic accounting method
that must be matched with a Section 460 PCM is
the accrual method, and XYZ must not employ
its elected (exempt) method on the extendedterm contract (for that contract only—not as an
overall method change)
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Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Examples of Methods
Example 3—Analysis
Cash is XYZ’s elected basic method of accounting,
but the accrual method is dictated, or required, as
the basic method that must be used when a nonexempt long-term accounting method is required to
be employed by Section 460
XYZ must use the CCM to account for its HCCs
because it did not separately elect a different
method for its HCCs on its first return that it had a
HCC
XYZ’s work on custom homes can be reported under
the CCM whether or not the contract is expected to
take more than two years to complete
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Developers and Homebuilders
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Examples of Methods
Example 3—Analysis
For HCCs, the accounting method to recognize its
revenues does not change, only the required job
costs will change, when either the contractor’s
revenues exceed the small contractor exception
(expected to exceed 24 months to complete) or its
business revenues exceed $10 million average over
a three-year tax reporting average (it will have to
then take into account 263A costing for those)
XYZ’s service contracts are not construction
contracts, so only a basic method can be employed
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
General Rule of
IRC Section 460
For any long-term contract, the taxable income
from such contract is to be determined under
the PCM
The exceptions to the general rule are specified
by 460(e), which is titled “Exception for Certain
Construction Contracts” … that are real estate
construction contracts
Each part of the phrase “long-term real estate
construction contracts” has an important
meaning in the tax laws
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Definition of
Long-Term Contract
Any contract for the
manufacture, building,
installation, or construction
of property that is not
completed within the
taxable year the contract is
entered into
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Real Estate Requirement
The “real estate” part of the IRC Section
460(e) phase is equally significant
460(e) uses the wording “construction
contract”
Defines a “construction contract” as “any
contract for the building, construction,
reconstruction, or rehabilitation of, or the
installation of any integral component to, or
improvement of, real property”
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Developers and Homebuilders
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Real Estate Requirement
Example 4—Facts
Clear Window Manufacturing manufactures
large glazing units for high-rise buildings
Clear Window manufactures the glazing
units under a contract
It then sells the units to an unrelated entity,
Instant Installers, to install
Instant installs the units in a building under
a contract
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Real Estate Requirement
Example 4—Analysis
In this scenario, although Clear has a
contract, it is not a construction contract—it
is a manufacturing contract
Instant has a construction contract
In the alternative, if Clear was to
manufacture the glazing units but also then
install them under a contract, it could
choose to classify the contract as a
construction contract
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Real Estate Requirement
Example 5
The following are construction contracts
1. A contract to grade a parcel of land, install drainage
systems, provide and compress road base, and seed
certain areas to prevent erosion;
2. A contract to build an office building on a lot;
3. A contract with subs to install mechanical and electrical
systems in the building;
4. A contract to install sewage and water lines;
5. A contract to grade and install roads and sidewalks; and,
6. A contract to install landscaping at the new building
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Tax Accounting Methods for Construction Contractors,
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Real Estate Requirement
Example 6
The following are also construction
contracts
1. A contract to remove old materials, install new
piping, and fabricate pipe in a steel mill; and,
2. A contract to install electrical and piping in a
brewery
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Real Estate Requirement
Example 6
A contract does not require a
“building” in order to be a
construction contact
 These examples (Example 6)
meet the definition of real
property under the regulations
and are construction contracts
subject to the rules of Section
460
Tax Accounting Methods for Construction Contractors,
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
‘Contract’ vs ‘Contractor’
Wording
460(b) refers to “any long-term contract”
A contractor may report some contracts under
the CCM as permitted by 1.460-4(d), but may be
required to report other contracts under IRC
Sec. 460 using the PCM and yet another under a
basic method of accounting
A method of accounting for long-term contracts
(an “exempt” long-term method), may be
superseded by the requirement to use PCM
reporting under Sec. 460 for some contracts
Tax Accounting Methods for Construction Contractors,
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‘Contract’ vs ‘Contractor’
Wording
Note, therefore, that the 460(b) general
requirement to employ the PCM for long-term
contracts is a tax method requirement that the
contractor is required to employ at each individual
contract level (if the contract is not “exempt” from
the 460(b) rules)
 While it may have elected and employed an exempt longterm accounting method, the 460(b) rule will require the
contractor to use a 460(b) PCM when applicable
 A contractor could elect to also employ the 460(b) method
as its overall tax method for contracts if it follows the
proper change in tax method accounting rules
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
IRC Section 446 and the ‘Clear
Reflection of Income’ Standard
If no accounting method has been regularly used by
the taxpayer, or if the method used does not
clearly reflect income, taxable income shall be
made under such method as, in the opinion of the
IRS does, clearly reflects income
§446 gives the IRS broad discretion
 The courts do not interfere with the IRS’s determination
unless it is clearly erroneous
Before any method is “elected” by the taxpayer, it
must first pass the clear reflection of income
requirements
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Developers and Homebuilders
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Activities that Do Not
Meet the Definitions of LT
Narrow and restrictive definition of what
constitutes a “long-term contract” has been
used by the IRS to deny the use of any longterm contract accounting method(s) to the
following
 Architects
 Engineers, Engineering Services and Construction
Management
 Non-long-term contract activity
Tax Accounting Methods for Construction Contractors,
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Activities that Do Not
Meet the Definitions of LT
Accounting or long-term method these
“activities” should utilize?
 Answer: Their regular, elected method of
accounting only
Why?
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
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Special Rules for Activities
Performed for Related Parties
The final regulations included a section (1.460-1(g))
that addressed the accounting method that is
required if these activities are performed for a
related party and the related party performs longterm contracts using the activities supplied by the
related party
The related entity performing the architecture,
engineering, or construction management must
employ the PCM and not employ its regular
accounting method
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Other Activities Rules
You read above that these types of activities
are not permitted to use the PCM (usually)
However, if the performance of a non-longterm contract activity is incident to or
necessary for the long-term contracts, the
gross receipts and costs attributable to that
activity must be allocated to the long-term
contract(s)
Tax Accounting Methods for Construction Contractors,
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The Small-Contractor
Exception
The 460(e) exceptions to the restrictive
provisions of IRC Sec. 460(b) requiring the
use of the tax PCM under IRC Section 460 …
Permit reporting of long-term contracts
under one of the methods described by Reg.
Sec. 1.460-4 for construction contractors
 Or IRC Sections 471 or 263A for homebuilders
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
The Small-Contractor
Exception (460(e))
A contract is not subject to IRC Section 460 if
 The taxpayer estimates (at the time such contract is
entered into) that such contract will be completed
within the two-year period beginning on the contract
commencement date of such contract, and
 The taxpayer’s average annual [tax] gross receipts
for the three taxable years preceding the taxable
year do not exceed $10,000,000
Both conditions 1 and 2 must be met for the
exception to apply
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The Small-Contractor Exception
Example 7
Able Contractor’s average tax gross receipts
approximate $5,000,000 and it utilizes the CCM
as its elected long-term method
Able performs only commercial contracts
Able obtains a new contract (2013-M) that will
take three years to complete
Contract 2013-M will have to be reported under
a non-exempt 460(b) PCM while Able continues
to report all of its other contracts under the
CCM (its exempt method)
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Two-Year Completion Test
The other part of the two-part test … (the first
was the three-year average tax gross receipts
must be < than $10M)
Determination of the taxpayer’s expected
completion date is based on the facts and
circumstances at the time the contract is
bid or entered into and not the actual
length of the contract
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
53
Two-Year Completion Test
Example 8
On August 27, 20X3, a contractor enters into
a contract that is expected to commence on
November 27 of the same year
The contract documents specify that the
contract must be completed within 22
months following the owner’s notice to
proceed
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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54
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Two-Year Completion Test
The 90 day time between entering into the
contract and starting the work is not
considered in the two-year test
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
55
Two-Year Completion Test
Example 9
Following the same facts as Example 8,
assume the contract included the
fabrication of materials
If the contractor, at his own risk, started
fabricating special assemblies for the
contract on August 31, then the time
between starting fabrication and before
starting work on the contract would most
likely be included in the two-year test
 See IRC Sec. 460(g)
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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56
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Two-Year Completion Test
Example 10
A plumbing contractor enters into a contract
with a general contractor to install plumbing
for an office building
The subcontractor expects that his contract will
be completed within nine months of his
particular work commencement date
 However, the general contract is expected to take 28
months to complete … So which time line are we
required to use?
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
57
Two-Year Completion Test
Example 10
The subcontractor is controlled
by the length of the
subcontract only and is not
affected by the duration of
contracts of other contractors
or the general on the same site
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
58
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
$10 Million Gross Receipts Test
460 regulations require
the aggregation of
gross receipts under
the common control
rules in Regulations
Section 1.263A-3(b)(3)
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
59
We’re Sorry!
CPE credit is not
available on recorded
programs –
Please disregard the
Attendance Validation
Statement currently being
given
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Home Construction Contracts
Final 460 regulations at
1.460-3(b)(2) state the
following
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
61
Home Construction Contracts
A long-term construction contract is a home
construction contract if a taxpayer (including a
subcontractor working for a general contractor)
reasonably expects to attribute 80 percent or more
of the estimated total allocable contract costs
(including the cost of land, materials, and
services), determined as of the close of the
contracting year, to the construction of
 4 or fewer dwelling units (including buildings with 4 or
fewer dwelling units that also have commercial units); and
 Improvements to real property directly related to, and
located at the site of, the dwelling units
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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62
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Home Construction Contracts
i. Townhouses and rowhouses
– Each townhouse or rowhouse is a separate building
ii. Common improvements
—
A taxpayer includes in the cost of the dwelling
units their allocable share of the cost that the
taxpayer reasonably expects to incur for any
common improvements (e.g., sewers, roads,
clubhouses) that benefit the dwelling units and
that the taxpayer is contractually obligated, or
required by law, to construct within the tract or
tracts of land that contain the dwelling units
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
63
Home Construction Contracts
Regarding large
homebuilders greater
than $10,000,000 in
revenue
 Must capitalize the costs
of home construction
contracts under Section
263A
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
64
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Home Construction Contracts that
Meet the Small Contractor’s Exemption
Are exempt (with one exception) from both
the requirements of Section 460 and the
alternative minimum tax requirements of
Section 56(a)(3)
Only requirement not exempt from
 Construction-period interest must be capitalized
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
65
Home Construction Contracts
Example 11
EFG Home Builders builds single-family
homes and townhomes
EFG meets the home construction contract
exception on all of its types of revenues
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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66
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Home Construction Contracts
Example 12
HIJ Roofers installs roofs on
homes, townhomes and
commercial buildings
For its work on homes and
townhomes, HIJ has the HCC
exception
For its work on commercial
roofs, HIJ does not have the
HCC exception
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
67
Home Construction Contracts
Example 14
LMN Site Developers performs land
infrastructure work on home sites and
commercial sites
The methods LMN can utilize are dependent
on who the work is performed for and who
owns LMN
These permitted methods will change if the
proposed HCC regulations are issued as
currently written
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
68
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Home Construction Contracts
Example 15
NOP Builders constructs homes and condos
Currently NOP has the HCC exception for its
work on homes but not on its condo units
If the proposed HCC regulations are adopted
as written, NOP will be able to use the HCC
exception for its condo work as well
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
69
Home Construction Contracts
Example 16
Brian Builders is currently constructing two
homes on Main Street, 101 and 102 Main.
101 Main is under contract with Mr. Smith
102 Main Street is a speculative home
Both homes are exactly alike
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Home Construction Contracts
Example 16—Questions
What accounting methods is
Brian Builders able to elect
for 101 Main Street?
How about 102 Main?
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
71
Home Construction Contracts
Example 16—Answers
101 is reported under Brian’s regular method of
accounting and its method elected for
contracts, considering its HCC
exceptions/elections (if it made them)
102 has to be reported under a cost
accumulation method (like inventory costs are
accumulated, but it is not inventory in that it
cannot be written down to the lower of cost or
market) depending on the average revenues of
Brian)
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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72
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Classifying Contracts
Is also a separate method of accounting
The classification of a contract (e.g., as a
long-term manufacturing contract, longterm construction contract, non-long-term
contract) based on all the facts and
circumstances known no later than the end
of the contracting year
Method of classifying contracts is a method
of accounting under Section 446
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
73
Available Methods When IRC
Section 460 Does Not Apply
When Code Section 460 does not apply,
the available methods generally include
 Cash method
 Hybrid method
 Accrual method
 Accrual method excluding retention
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
74
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Available Methods When IRC
Section 460 Does Not Apply
Completed contract method (CCM)
 Can be matched with cash or accrual
Exempt percentage of completion method
(EPCM)
Percentage-of-completion methods under
460 (PCM)
 Has to be matched with the accrual method
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
75
Available Methods When IRC
Section 460 Does Not Apply
For homebuilders (building speculative homes),
the available methods are
Small homebuilder
 Accrual, with inventories capitalized under
Section 471 and interest capitalized under 263A
Large homebuilder
 Accrual, with inventories and interest
capitalized under Section 263A
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Accrual Excluding
Retention Is a Method
that Does Not Pick Up
Retentions Receivable
Until Paid
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
Completed Contract Method
Is a long-term method (an exempt one)
Contractor has to be entitled to use a longterm contract treatment
It is not a “super completed contract”
Can result in the greatest tax deferral
AMT is applicable
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Completed Contract Method
Contracts are completed when
 Customer uses the subject matter of the
contract and 95% of the total allocable costs
have been incurred, or
 Final completion and acceptance of the subject
matter of the contract has occurred
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
79
Completed Contract Method
Example 17
ABC Contractors is an exempt contractor
and has a $1,000,000 contract to paint the
Barnard Bridge
As part of the contract, ABC has agreed to
remove and refurbish 100 feet of antique
railing on the bridge approaches
In its bid submittal, ABC allocated $950,000
to the bridge painting and $50,000 to the
removal and refurbishing of the approach
railings
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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80
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Completed Contract Method
Example 17
ABC reports on the calendar-year basis and
utilizes the accrual/CCM of accounting
As of December 31, 20X1, ABC has
completed the bridge painting, has invoiced
for this work, but has not completed the
refurbishing of the bridge approaches as the
railing had to be sent out to an outside shop
for special welding
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
81
Completed Contract Method
Example 17
Under the provisions of the regulations of
1.460-1(c)(3)(B), ABC must separate out the
primary subject matter of the contract, the
bridge painting for $950,000, and then account
for the railings under the accrual method
The bridge painting part for $950,000 will be
considered completed as of December 31, 20X1
ABC has shown in its bid documents that the
railings were to be invoiced for $50,000
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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82
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Completed Contract Method
Example 17
This amount will be the revenue for the
secondary item that must be separated out
The costs of the bridge painting, the primary
subject matter of the contract, and the
secondary contract matter must also be
separated out based upon the contractor’s
source documents such as its contract
estimates or bid documents
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
83
Completed Contract Method
If a primary matter of a
contract under the CCM is
completed and reported,
how does the contractor
report the balance of the
contract?
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Completed Contract Method
Under its regular method
of accounting
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
Available Accounting Methods When
IRC Section 460 Is Applicable
Non-exempt methods
Percentage of completion (PCM) under Code Section
460(b)
Percentage of completion capitalized cost method
(PCCM) under 460(a)
Simplified cost-to-cost method
10% Deferral, PCM, under Section 460(b)(5)
PCM with deferral of the subcontractor retainage
payable from the PCM formula until the “all events
test” has been met
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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86
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Master List of Methods Available
to Contractors, Homebuilders
1
Regular Method
2
Exempt long-term methods
3
Non-exempt long-term methods
4
Home construction contracts
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
87
Master List of Methods Available
to Contractors, Homebuilders
5
Various exempt methods with AMT calculations
performed under the regular method
6
Various exempt methods with AMT calculations
performed under the simplified costs POC method
7
Various combinations possible with the use of the
cash method along with the use of a long-term
method (for exempt contracts only)
8
Method of classifying contracts
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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88
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Master List of Methods Available
to Contractors, Homebuilders
9
Method of estimating the length of time
for performance of a long-term contract
The cost-allocation method
10
The particular method chosen for
allocating costs and/or overhead
costs, which is applicable to CCM and
PCM methods (but not to cash or
accrual methods)
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
89
Master List of Methods Available
to Contractors, Homebuilders
11
Indirect cost method chosen for those
utilizing the exempt CCM
12
Determining factors that are used to
determine a contract’s completion factor
(for the CCM)
13
The method of accounting for the
separation of “secondary” items (CCM)
14
Methodology for separating out the revenue
and costs for non-long-term contract
activities (PCM)
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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90
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Contract Costs
Methods to determine revenues are important for sure,
but so are the rules on determining contracts costs
(but only for the CCM and the PCM)
Very specific rules on what contract costs are required to be
defined as
Contractor costing rules can only begin with an analysis that
first considers the contractor’s regular method of accounting
and method of accounting for long-term contracts
Costing rules can only be understood once we consider what
happens with the costs once they are properly classified
For example, are the costs going to be expensed, allocated,
deferred, capitalized, inventoried, or other?
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
91
Contract Costs
Able Contractors incurred the following expenses
for 201X
1. Selling
2. Depreciation on equipment used in the performance of
contracts
3. Depreciation on office equipment
4. Expenses incurred in the construction of its new office
building
5. Expenses incurred in the construction of a speculative
development, and
6. Costs incurred for construction materials kept in the
company’s inventory supplies and used in jobs as needed
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Contract Costs
These costs as of the end of 201X and for the year
201X, were then required to be treated in the
following manner (if Able was either using the CCM
or the PCM) …
1. Expensed
2. Allocated to contract costs
3. Expensed
4. Capitalized
5. Deferred (until the sale of the property), and
6. Inventoried
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
93
Contract Costs—Regulations
Specify contract costs
only for the CCM and the
PCM
Costing rules (of 1.460-5)
are not applicable to all
other exempt
construction contracts
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Contract Costs—Regulations
CCM must job cost (defer) the following
 Direct costs
 Materials, labor, and labor overhead
 Indirect, including
 Interest, repairs and maintenance, utilities, rent, indirect
labor, indirect materials and supplies, non-capitalized tools
and equipment, QC, certain taxes, financial statement
depreciation, insurance, and (maybe) WC and health
insurance
PCM (non-exempt) must job cost all of the
CCM costs plus any typical 263A costs
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
95
Contract Costs—Resolutions
Summary for All Methods
Cash method … all types of costs are
expensed as paid
Accrual method … all expensed based upon
economic performance
CCM
 Contract costs and interest costs are deferred
until the contract is completed, all other cost
types (S, G & A) fall under the accrual method
rules
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
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96
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Contract Costs—Resolutions
PCM
 Contract costs are expensed based upon
economic performance, but are also used in the
cost-to-costs PCM formula
PCM w 10% Deferral
 Defer job costs under 10% completed and then
follow the PCM rules
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
97
We’re Sorry!
CPE credit is not
available on recorded
programs –
Please disregard the
Attendance Validation
Statement currently being
given
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
We’re Sorry!
The live Question and
Answer Session is not
available for recorded
programs.
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
CONCLUSION
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Thank You for
Attending Today’s Seminar
For further information,
please contact Eric at:
ewallace@cpabr.com or cell at 412-977-6644
Please also ask Eric to
join with you on LinkedIn®
to get his latest articles,
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
A CCH Seminar
A CCH Seminar
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
OUTLINE
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
(2013-5-18)
Summary of the Complicated
Tax Accounting Methods for Construction Contractors
The Environment
 One of the most difficult industries to understand from a tax perspective is construction
contracting, home building, and real estate development.
 The tax rules pertaining to these industries are not found in one particular Internal
Revenue Code (IRC) section.
 The rules are a compilation of various Internal Revenue Codes, Regulations, Procedures,
Notices, Private Letter Rulings, and court cases
 Rules continue to evolve from year to year…
Contractor Tax Source Documents
 IRC Section 460: Generally requires the percentage of completion method (PCM) for all
long-term contracts unless they (a contract or contracts) are covered by an exception
 IRC Section 460(e)(1)(A): Describes the home construction contract (HCC) exception
 IRC Section 460(e)(1)(B): Describes the small-contractor exception to IRC Sec 460
PCM requirement (under $10 million in average tax revenues and the contract
performance is anticipated to be less than two years to complete).
 IRC Regulations 1.460: Issued January 11, 2001, further explained and expanded (and
generally superseded) Notice 89-15. 1.460-1 on 460 details all requirements on how
income from a long-term contract and related activities must be accounted for (revenues
and costs).
 IRC Regulation 1.460-6: Describes the requirements and details the calculations for
look-back calculations applicable to certain contractors and contracts. Look back requires
the contractor to either pay interest or receive it for differences under the PCM from what
was paid compared to the final GP amounts when finalized
 Notice 89-15: Was the prior IRS guidance (before the 460 regulations) but still shows to
be applicable from time to time as issues arise
 IRC Section 471 and Related Regulations: Lists required application of costs and/or
capitalization costing (Inventory) for small home builders (less than $10 million in
average tax revenue and contracts of less than two years in length).
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
 IRC Section 263A: Uniform capitalization regulations that are applicable to speculative
home builders and real estate developers not meeting the small-builder definition.
 Revenue Ruling 92-28: Clarified and reiterated (exempt and non-exempt contract use at
same time) that the contract rules of Section 460(e)(1) permit a taxpayer to use different
methods of accounting for exempt contracts under Section 460(e)(1) (which are not
subject to the mandatory use of the Section 460(b) percentage of completion methods
(PCM)) and contracts under Section 460(a) (which are subject to mandatory use of the
PCM) within the same trade or business.
 Proposed Long-Term Regulations on the HCC: Issued late 2008, focused on changes
to the definition of a “home construction contract” (HCC).
o The Treasury has promised to finalize these proposed regulations over the past
three years, but nothing has been released to date.
o These regulations are on the list for release (have been for several years), and I
have information from individuals with knowledge about the inside Treasury
dealings, that a final regulation document has been circulating for final changes
for some time (several years).
 IRS ATG (audit technique guide) on Construction Contractors: Latest update was
issued in 2009
Source Documents Related to Changes in Accounting Methods:
 Revenue Procedure 97-27, 1997-1 C.B. 680: Rev. Proc. 97-27 continues to be the
source/rules for Section 460 changes (non-automatic changes), even though it has been
modified numerous times.
 IRC 1.460 Regulations: Changed Rev. Proc. 97-27 provisions to require the use of the
cutoff method in any long-term contract method or treatment changes after January 11,
2001.
 Rev. Proc. 2011-14: Is the latest automatic method change Rev. Proc. It is not applicable
to most of the changes to exempt or nonexempt contract methods (but there are some that
are available as an automatic method), because Rev. Proc. 97-27 still applies and requires
most contractor methods to be done via advance consent (see Rev. Proc. 97-27 above). .
 Code Sec. 481(a): Is the Section that addresses issues on how to pick up the change in
accounting method difference(s) (i.e., when not a cut-off method) and what years to pick
that change up under.
 Code Sec. 481(b): Addresses issues when the IRS is changing accounting methods for
taxpayers under IRS audit.
 Rev. Proc. 2004-34: Allows accrual method taxpayers to defer certain advance payments
(mostly applicable to service contracts.) Change to it now happens under a cut-off
method, but prior to 2011, it was under a 481(a) adjustment.
 Rev. Proc. 2002-28: Allows many contractors to use or change back to the cash method
for either regular method of accounting or long-term contract treatments. Qualifying
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
contractors must meet annual gross receipts test and qualifying NAICS codes. This is the
“safe harbor” document for those with revenues < $10M. This is not a “requirement!”
 IRC Section 448: Requires C corporations over $5M in three-year average revenues to
change from the cash method to the accrual method.
 Revenue Procedure 2013-1, 2012-1, 2011-1, etc.: These are the annual revenue
procedures that update and set user fees for non-automatic method changes. The fee prior
to 1-31-2008 was $2,500. The fee after and for year 2009 was $3,800. After 2-1-2010 it
increased to $4,200. Effective 2-5-2012, the fee was raised to $7,000! The fee for
accounting method changes can vary from this amount depending on whether multiple
similar requests are made or ones made by a parent for similar multiple entities and so
forth.
Contractor Tax Method Choices
 Contractors, home builders and developers—depending on the size of their overall
revenues and types of construction contracts and/or service contracts—may be able to
choose:
 A method of accounting,
 A method of accounting for long-term contracts,
 And other revenue and cost-recognition methods.
 These choices of accounting:
 Method of accounting being the first,
 Choice(s) of method of accounting for long-term contracts being the second,
 And other revenue and cost choices are very different and distinct choices.
Methods of Accounting
 Relates to the basic accounting method chosen by the contractor and the list of choices
includes:
 The cash method;
 The accrual method; and, possibly,
 The hybrid method(s).
The Method of Accounting for Long-term Contracts
 Relates to the method chosen by the contractor, or dictated by code if IRC Section 460 is
applicable, in order to account for revenue and cost recognition for long-term contracts.
Choices for the long-term contracts includes:
 The completed-contract method (CCM) and
 The percentage-of-completion method (PCM) and its varieties
A CCH Seminar
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Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
Choices of Methods and Consequences
 The correct or incorrect selection of choice of accounting method, and the choice of
accounting for long-term contracts, influences the tax position of a contractor for many
years into the future.
 For tax purposes, there are various permitted methods, depending on the size and length
of the contract, each with its own benefits and disadvantages.
 For financial statement purposes, there generally is only one accepted method of
accounting for long-term contracts, i.e., the PCM, accrual method.
 For tax purposes there are various permitted methods, depending on the size and length
of the contract, each with its own benefits and disadvantages.
 Once a contractor elects a regular method of accounting, a specific long-term contract
accounting method, and potentially other revenue and costs methods (such as those for
service contracts), the methods must be consistently applied on all subsequent returns
(Rev. Proc. 2011-14).
 Change of methods is only available if permission has been obtained from the IRS to
change or an automatic method permits the contractor to change (such as in Rev. Proc.
2002-28) or, unless the contractor is required by a specific law to change (Rev. Proc.
2011-14, I.R.B. Section 2.02).
 On the other hand, electing a new method for a new type of revenue, change in business
policy or situation not previously encountered by the taxpayer does not require a methodchange request, and usually does not require a specific election process.
 A contractor chooses its regular tax accounting method in its first year of existence, by
filing a return that uses chosen methods.
 A contractor chooses or elects its long-term accounting method in its first year or in the
first year that long-term contract treatment is applicable.
 Unlike other industries, however, a contractor’s regular tax method of accounting and its
required tax accounting treatment for long-term contracts evolves and changes as the
contractor grows in revenue size and types of contracts or services performed.
Example of Method Evolution
 For example, MNO Contractors might start business as a small contractor and elect the
cash method of accounting.
 If MNO Contractors was incorporated as a C corporation, once its annual tax receipts
average exceeds $5 million dollars, it will be required under IRC Section 448 to change
its method of accounting to the accrual method (IRC Section 448(b)(3).
 If MNO not only changed from cash to accrual, but also elected an exempt long-term
contract method, such as the CCM, it will have to account for its long-term contracts
under the CCM
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 If MNO Contractors then enters into a contract that is estimated to take more than two
years to complete, it then has to elect a non-exempt long-term method, such as one of the
PCMs
 Or if MNO Contractors obtains a contract with significant design, architect, engineering,
or construction management elements (generally known in contractor tax rules as “nonlong-term contract activity”), it has to account for the portions of such a contract under its
regular method of accounting, It is prohibited from using a long-term contract method for
those portions.
 If MNO continues to grow, and its three-year annual tax gross receipts average then
exceeds $10 million dollars, it will be required to start to account for its uncompleted
contracts, obtained after this tax year, under the non-exempt PCM chosen under IRC
Section 460(b).
Choices of Methods and Consequences
 Once a contractor elects a regular method of accounting, and/or a specific long-term
contract accounting method, and potentially other revenue and costs methods (such as
those for service contracts) these methods must be consistently applied on all subsequent
returns.
 Change of methods is only available if permission has been obtained from the IRS to
change or an automatic method permits the contractor to change, or unless the contractor
is required by a specific law to change.
 Electing a new method for a revenue or situation not previously encountered by the
taxpayer does not require a method change request, and usually does not require a
specific election process.
How To Choose or Elect Tax Methods
 A contractor chooses its regular tax accounting method in its first year of existence by
filing a return that utilizes chosen methods.
 A contractor chooses or elects its long-term accounting method in its first year or in the
first year that long-term contract treatment is applicable.
 Many contractors and tax preparers are confused about the difference between a regular
tax method of accounting and the various elected tax treatments of accounting for longterm contracts.?? They are not the same.
 However, unlike other industries, a contractor's regular tax method of accounting and its
required tax accounting treatment for long-term contracts evolves and changes as the
contractor grows in revenue size and types of contracts or services performed.
 The contractor, from sole proprietor to partnerships, LLCs to corporations, elects an
overall method of accounting on its first filed federal tax return.
 Again, a contractor first elects a regular method of accounting and then elects a method
of treatment for long-term contracts (could be an election for an exempt or nonexempt
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long-term contract treatment) when it first has an uncompleted contract at fiscal or
calendar year-end.
Examples of Methods
 Example 1: Facts: Able Contractors always used the cash method to report its revenues
and expenses. As it grew over the years it obtained and performed construction contracts,
some that were not completed by its year-end.
 Analysis of Accounting Methods:
 Able elected the cash method for its basic accounting method.
 Because Able did not elect a long-term accounting method in the first year in which it
had a long-term contract, it defaulted to the use of the cash method to also account for
its long-term contracts.
 Example 2: Facts: Sammy Construction Company employed the accrual method on its
first income tax return and has been in business for several years.
 Over this time period Sammy had contracts that lasted over its tax year-end. These
contracts included both commercial and residential contracts.
 Sammy’s revenues have exceeded, from time to time, $10 million as measured in annual
accrual revenues, but Sammy has never averaged more than $10 million over a three-taxyear measurement.
 Analysis of Accounting Methods: Again, Sammy elected the accrual method for its basic
accounting method.
 Because Sammy did not elect a long-term accounting method in the first year in which it
had a long-term contract, it defaulted to the use of the accrual method to also account for
its long-term contracts, both commercial and residential.
 Example 3: XYZ Contractors, an S corporation, has a calendar tax year and has
$5,000,000 in revenues (average tax revenues over the last three years).
 XYZ installs roofs on commercial buildings and large custom homes.
 XYZ also performs service contracts on roofs.
 Some of its contracts last over two years.
 XYZ elected the cash method and employed the CCM for its uncompleted contracts on
its first tax return years ago, which included both commercial and home-construction
contracts (HCC).
 Analysis of Accounting Methods: XYZ’s basic method of accounting is the cash method;
however, if it performs a commercial contract that does not meet the small-contractor
time limit under Section 460, i.e., the contract is expected to take more than two years to
complete, the basic accounting method that must be matched with a Section 460 PCM is
the accrual method, and XYZ must not employ its elected method on the extended-term
contract.
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 Cash is XYZ’s elected basic method of accounting, but the accrual method is the dictated,
or required, basic method that must be used when a non-exempt long-term accounting
method is required to be employed by Section 460.
 XYZ must use the CCM to account for its HCCs because it did not separately elect a
different method for its HCCs on its first return that it had a HCC.
 XYZ’s work on custom homes can be reported under the CCM whether or not the
contract is expected to take more than two years to complete.
 For HCCs the accounting method to recognize its revenues does not change, only the
required job costs will change, when either the contractor’s revenues exceed the small
contractor exception (expected to exceed 24 months to complete) or its business revenues
exceed $10 million average over a three-year tax reporting average.
 XYZ’s service contracts are not construction contracts, so only a basic method can be
employed.
General Rule Of IRC Section 460
 In the case of any long-term contract, the taxable income from such contract is to be
determined under the PCM.
 The exceptions to the general rule of Section 460 are specified by IRC Section 460(e),
which is titled “Exception for Certain Construction Contracts.”
 Each part of the phrase “long-term real estate construction contracts” has an important
meaning in the tax laws
Definition of Long-Term Contract
 IRC Section 460(f) defines “long-term contract” as any contract for the manufacture,
building, installation, or construction of property that is not completed within the taxable
year the contract is entered into.
 This means that a contract started in December and completed in January, for a calendar
year-end filing contractor, is defined as a long-term contract. The contract may only last a
week, but if it lasts over a fiscal or calendar year-end, it is a long-term contract.
 Example of a long-term contract: XYZ, with a calendar tax year-end, performed contract
number 2008-A, which it started January 4, 2008 and finished December 28, 2008. It also
performed contract number 2008-Z, which it started December 24, 2008, and completed
January 6, 2009. Even though contract 2008-Z was shorter in actual time (14 days) for
contract completion than contract 2008-A (358 days), it is a long-term contract because
its performance extended beyond its tax year-end.
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Real Estate Requirement
 The “real estate” part of the IRC Section 460(e) phase is equally significant.
 Section 460(e) uses the wording “construction contract.”
 Section 460(e)(4) defines a “construction contract” as “any contract for the building,
construction, reconstruction, or rehabilitation of, or the installation of any integral
component to, or improvement of, real property.”
 Example 4: Clear Window Manufacturing manufacturers large glazing units for high-rise
buildings. Clear Window manufacturers the glazing units under a contract. It then sells
the units to an unrelated entity, Instant Installers to install. Instant installs the units under
a contract.
 In this scenario, although Clear has a contract, it is not a construction contract, it is a
manufacturing contract.
 Instant has a construction contract. In the alternative, if Clear was to manufacture the
glazing units but also then install them under a contract, it could choose to classify the
contract as a construction contract.
 Example 5: The following are construction contracts: (1) a contract to grade a parcel of
land, install drainage systems, provide and compress road base, and seed certain areas to
prevent erosion; (2) a contract to build an office building on a lot; (3) a contract with subs
to install mechanical and electrical systems in the building; (4) a contract to install
sewage and water lines; (5) a contract to grade and install roads and sidewalks; and (6) a
contract to install landscaping at the new building.
 Example 6: The following are also construction contracts:
(1) a contract to remove old materials, installation of new piping, and pipe fabrication in
a steel mill; and (2) a contract to install electrical and piping in a brewery.
A contract does not require a “building” in order to be a construction contact. These
examples meet the definition of real property under the regulations and are construction
contracts subject to the rules of Section 460.
“Contract” versus “Contractor” Wording
 IRC Section 460(b) refers to “any long-term contract,” rather than referring to the
contractor as a whole. This is an important distinction.
 A contractor, for example, may report some contracts under the CCM as permitted by
1.460-4(d), but may be required to report other contracts under IRC Sec. 460 using the
PCM and yet another under a basic method of accounting.
 Therefore, to summarize, if the contractor elects a method of accounting for long-term
contracts (an “exempt” long-term method), it may be superseded by the requirement to
use PCM reporting under Sec. 460 for some contracts (a “nonexempt” long-term
method), or for all, depending on whether the exceptions of IRC Sec. 460(e) (as further
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outlined and defined in the IRS Regulations and Revenue Procedures) are met, and
provided the method selected clearly reflects income.
 Discussion: In the long-term contract example above, contract 2008-A is not subject to
Section 460 and therefore is only subject to the contractor’s elected basic method of
account (whatever it has elected—cash, accrual, or a hybrid method). Contract 2008-Z is
a long-term contract, and if XYZ is not subject to the rules of Section 460 (i.e., is not a
“large” contractor), then 2008-A is an “exempt” contract and is subject to the contractor’s
exempt long-term method, if it elected one.
IRC Section 446 and the “Clear Reflection of Income” Standard
 The general rule of IRC Sec. 446 states that if no accounting method has been regularly
used by the taxpayer, or if the method used does not clearly reflect income, the
computation of taxable income shall be made under such method as, in the opinion of the
IRS does, clearly reflects income.
 Section 446 gives the IRS broad discretion to require a particular method of accounting.
The courts do not interfere with the IRS's determination under Section 446 unless it is
clearly erroneous.
 So, before any method is “elected” by the taxpayer, it must first pass the clear reflection
of income requirements.
Activities That Do Not Meet the Definitions
 The IRS narrowly defines what a construction contract is, it must be a “contract for
building, construction, … or improvement of real property.”
 This narrow and restrictive definition of what constitutes a “long-term contract” has been
used by the IRS to deny the use of any long-term contract accounting method(s) to the
following:
 Architects, under Rev. Rul. 70-67, 1970-1;
 Engineers, under Rev. Rul. 80-18, 1980-1; Industrial and commercial painting, under
Rev. Rul. 84-32, 1984-1; and, Engineering Services and Construction Management,
under Rev. Rul. 82-134, 1982-2;
 Non-long-term contract activity, under Regulations Section 1.460-1(d)(2).
 What accounting or long-term method, then, should these “activities” utilize? The answer
is their regular, elected method of accounting only (such as cash or accrual) and not a
long-term method such as the CCM or the PCM.
Special Rules for Activities Performed for Related Parties
 Notwithstanding what the regulations say about the denial of a long-term method for
architecture, engineering, and construction management activities, the final regulations
included a section that addressed the accounting method that is required if these activities
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are performed for a related party and the related party performs long-term contracts using
the activities supplied by the related party.
 In these circumstances, the related entity performing the architecture, engineering, or
construction management must employ the PCM (using “fair market value” of the
contract) and not employ its regular accounting method to account for the services
performed for its related contractor.
 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(s) benefited as
provided in Sec. 1.460-4(b)(4)(i) and Sec. 1.460-5(f)(2), respectively.
The Small-Contractor Exception
 The exceptions to the restrictive provisions of IRC Sec. 460(a), (b), (c)(1), and (c)(2)
(requiring the use of the tax PCM under IRC Section 460) are specified by IRC Sec.
460(e)(1)(A) and (B).
 These exceptions permit reporting of long-term contracts under one of the methods
described by Reg. Sec. 1.460-4 for construction contractors (or IRC Sections 471 or
263A for home builders).
 Specifically, a contract is not subject to IRC Section 460 under 460(e)(1)(B) if:
 The taxpayer estimates (at the time such contract is entered into) that such contract
will be completed within the two-year period beginning on the contract
commencement date of such contract, and
 The taxpayer's average annual [tax] gross receipts for the three taxable years
preceding the taxable year do not exceed $10,000,000.
 Both conditions 1 and 2 must be met for the exception to apply.
 If a particular contract exceeds the two-year period required under condition 1 above,
then IRC Sec. 460(b) applies to that contract (requiring the use of the PCM under Section
460), without regard to the contractor's average gross receipts test.
 Example 7: Able Contractor's average tax gross receipts approximate $5,000,000 and it
utilizes the CCM as its elected long-term method. Able performs only commercial
contracts. Able obtains a new contract (2013-M) that will take 3 years to complete. This
contract will have to be reported under the non-exempt PCM while Able continues to
report all of its other contracts under the CCM (its exempt method).
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Two-Year Completion Test
 Determination of the taxpayer's expected completion date is based on the facts and
circumstances at the time the contract is bid or entered into and not the actual length of
the contract.
 A subsequent change in conditions or a change order extending the contract will not, of
itself, cause the contract to come under IRC Sec. 460 if it was previously determined to
qualify for the exclusion. Evidence supporting the estimated completion date could be the
following:
 Completion date in the contract documents
 Scheduling commitments at the time bids were made and/or
 Period of time overhead is budgeted to the job
 Example 8: On August 27, 20X3, a contractor enters into a contract that is expected to
commence on November 27 of the same year. The contract documents specify that the
contract must be completed within 22 months following the owners notice to proceed.
 This contract is not subject to IRC Sec. 460.
 The time between entering into the contract and starting the work is not considered in the
two-year test.
 Example 9: Following the same facts as Example 8, assume that the contract included the
fabrication of materials.
 If the contractor, at his own risk, started fabricating special assemblies for the contract on
August 31 (the time between starting fabrication and before starting work on the
contract), would most likely be included in the two-year test. See IRC Sec. 460(g).
 Example 10: A plumbing contractor enters into a contract with a general contractor to
install plumbing for an office building.
 The subcontractor expects that his contract will be completed within nine months of his
commencement date. However, the general contract is expected to take 28 months to
complete.
 The subcontractor is controlled by the length of the subcontract only and is not affected
by the duration of contracts of other contractors or the general on the same site.
 Example: A contractor starts work on a project on July 30, 20X1. The contractor and
owner are unable to reach an agreement on all terms of the contract and the contract is
finally entered into on November 3, 20X1.
 The contract is completed on May 10, 20X3.
 The contractor would be required to demonstrate that at the time he commenced the
contract he did not expect the contract to have a duration of more than 24 months in order
to be excepted from IRC Sec. 460.
 Under the circumstances described, the contract is deemed to have been entered into
effective with starting work, July 30, 20X1.
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$10 Million Gross Receipts Test
 The 460 regulations require the aggregation of gross receipts under the common control
rules in Regulations Section 1.263A-3(b)(3), other than the rules applicable to single
employers under section 414(m) and the regulations thereunder. In addition, the
regulations require the attribution of construction-related gross receipts of persons that
own, or are owned by, the taxpayer, but that are not subject to Reg. Sec. 1.263A-3(b)(3).
 Example 12: If construction company A with $8,000,000 average annual volume enters a
joint venture, AB, in which it owns a 30% interest and the venture performs a $2,000,000
construction contract during the year, the aggregate annual gross receipts for A is
considered to be $8,600,000.
 Q: If the partner, B, owning the 70% interest, is also a construction company with
average gross receipts of $9,000,000, what are the gross receipts of the joint venture and
of B?
 Gross receipts of joint venture AB, for this test, are $10,400,000, and the joint venture is
not eligible for the small-contractor exemption.
 Note that this example has a twist in it. The first calculation asks and answers what the
gross receipts of A are, which is calculated as 100% of $8 million plus 30% of $2
million, or $8.6 million.
 The next question looks at the situation from a different perspective and asks what the
gross receipts of the joint venture AB are. The gross receipts of the joint venture AB are
not calculated based upon the gross receipts of the joint venturers plus the gross receipts
of the JV…
 Rather, the gross receipts of the JV are calculated as the gross receipts of the JV times the
majority owner’s percentage plus 100% of the gross receipts of any joint venturers
owning more than 50% of the JV.
 This calculation would result in the following numbers for AB: 70% of $2,000,000 is
$1,400,000, plus $9,000,000 equals $10,400,000.
 The gross receipts of B are calculated as $9,000,000 plus 100% of the JV of $2,000,000,
which totals $11,000,000.
Home Construction Contracts
The final 460 regulations at 1.460-3(b)(2)specifically state the following:
 A long-term construction contract is a home construction contract if a taxpayer (including
a subcontractor working for a general contractor) reasonably expects to attribute 80
percent or more of the estimated total allocable contract costs (including the cost of land,
materials, and services), determined as of the close of the contracting year, to the
construction of:
 4 or fewer dwelling units (including buildings with 4 or fewer dwelling units that also
have commercial units); and
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 (B) Improvements to real property directly related to, and located at the site of, the
dwelling units.
 (ii) Townhouses and rowhouses. Each townhouse or rowhouse is a separate building.
 (iii) Common improvements. A taxpayer includes in the cost of the dwelling units their
allocable share of the cost that the taxpayer reasonably expects to incur for any common
improvements (e.g., sewers, roads, clubhouses) that benefit the dwelling units and that
the taxpayer is contractually obligated, or required by law, to construct within the tract or
tracts of land that contain the dwelling units.
 Regarding large home builders greater than $10,000,000 in revenue or two years in
length of contract, the final 460 regulations state that:
o 1.460-5(d)(3) Large home builders. A taxpayer must capitalize the costs of home
construction contracts under section 263A and the regulations thereunder.
Home Construction Contracts That Meet the Small Contractor's Exemption
 Those HCCs that meet the small contractor's exemption in Section 460(e)(1)(B) are
exempt (with one exception) from both the requirements of Section 460 and the
alternative minimum tax requirements of Section 56(a)(3).
 The only requirement or exception for small HCCs under Section 460 is that construction
period interest must be capitalized in accordance with Section 460(c)(3).
Home Construction Contracts Examples
 Example 11: EFG Home Builders builds single-family homes and townhomes. EFG
meets the home construction contract exception on all of its types of revenues.
 Example 12: HIJ Roofers installs roofs on homes, townhomes and commercial buildings.
For its work on homes and townhomes, HIJ has the HCC exception. For its work on
commercial roofs, HIJ does not have the HCC exception.
 Example 14: LMN Site Developers performs land infrastructure work on home sites and
commercial sites. The methods that LMN can utilize are dependent on who the work is
performed for and who owns LMN. These permitted methods will change if the proposed
HCC regulations are issued as currently written.
 Example 15: NOP Builders constructs homes and condos. Currently NOP has the HCC
exception for its work on homes but not on its condo units. If the proposed HCC
regulations are adopted as written, NOP will be able to use the HCC exception for its
condo work as well.
 Example 16: Brian Builders is currently constructing two homes on Main Street. 101
Main Street is under contract with Mr. Smith. 102 Main Street is a speculative home.
Both homes are exactly alike. What accounting methods is Brian Builders able to elect
for 101 Main Street? How about 102 Main? A: 101 is reported under Brian’s regular
method of accounting and its method elected for contracts, considering the HCC
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exception. 102 has to be reported under a cost accumulation method (like inventory, but
not inventory, depending on the average revenues of Brian.
Classifying Contracts
 Is a method of accounting:
 1.460-1(f)(1): Classifying contracts: A taxpayer must determine the classification of a
contract (e.g., as a long-term manufacturing contract, long-term construction contract,
non-long-term contract) based on all the facts and circumstances known no later than the
end of the contracting year.
 1.460-1(f)(3): Method of accounting. A taxpayer’s method of classifying contracts is a
method of accounting under section 446 and, thus, may not be changed without the
Commissioner’s consent. If a taxpayer’s method of classifying contracts is unreasonable,
that classification method is an impermissible accounting method.
SUMMARY: Available Methods When IRC Section 460 Does Not Apply
When Code Section 460 does not apply (i.e., the contractor or home builder is not required to use
the PCM under Section 460(b)), the available methods generally include:

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


Cash method.
Hybrid method.
Accrual method.
Accrual method excluding retention.
Completed contract method (CCM) (can be matched with cash or accrual).
Exempt percentage of completion method (EPCM).
Percentage-of-completion methods under 460 (PCM) (has to be matched with the accrual
method)
For home builders (building speculative homes), the available methods are (all of the methods
listed above are also available for home builders that are building contracted homes):
 Small home builder. Accrual, with inventories capitalized under Section 471 and interest
capitalized under 263A.
 Large home builder. Accrual, with inventories and interest capitalized under Section
263A.
Accrual Excluding Retention is a method that does not pick up retentions receivable until
paid
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Completed Contract Method

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





Is a long-term method (an exempt one)
Contractor has to be entitled to use a long-term contract treatment
It is not a “super completed contract”
Can result in the greatest tax deferral
AMT is applicable for the difference between the PCM and CCM deferred GP
Contracts are completed when:
 Customer uses the subject matter of the contract and 95% of the total allocable costs
have been incurred, or
 Final completion and acceptance of the subject matter of the contract has occurred
Example 17: ABC Contractors has a $1,000,000 contract to paint the Barnard Bridge. As
part of the contract, ABC has agreed to remove and refurbish 100 feet of antique railing
on the bridge approaches. In its bid submittal, ABC allocated $950,000 to the bridge
painting and $50,000 to the removal and refurbishing of the approach railings. ABC
reports on the calendar year basis and utilizes the accrual/CCM of accounting. As of
December 31, 20X1, ABC has completed the bridge painting, has invoiced for this work,
but has not completed the refurbishing of the bridge approaches as the railing had to be
sent out to an outside shop for special welding.
Under the provisions of the final regulations of 1.460-1(c)(3)(B), ABC must separate out
the primary subject matter of the contract, the bridge painting for $950,000, and then
account for the railings under the accrual method. The bridge painting part for $950,000
will be considered completed as of December 31, 20X1. ABC has shown in its bid
documents that the railings were to be invoiced for $50,000. This amount will be the
revenue for the secondary item that must be separated out. The costs of the bridge
painting, the primary subject matter of the contract, and the secondary contract matter
must also be separated out based upon the contractor’s source documents such as its
contract estimates or bid documents.
Q: If a primary matter of a contract under the CCM is completed and reported, how does
the contractor report the balance of the contract”
A: A contractor reports the balance of its contract under its regular method of accounting.
Under example 18, ABC would report the balance of the contract and its costs on the
subject matter, other than its primary subject matter, under the accrual method.
Available Accounting Methods When IRC Section 460 Is Applicable
When IRC Section 460(b) (the requirement to use nonexempt PCM) is applicable, the following
methods may be available to a contractor, if they are properly elected.
These are generally known as nonexempt methods:
 Percentage of completion (PCM) under Code Section 460(b).
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Percentage of completion capitalized cost method (PCCM) under 460(a).
Simplified cost-to-cost method.
10% Deferral, PCM, under Section 460(b)(5).
PCM with deferral of the subcontractor retainage payable from the PCM formula until
the “all events test” has been met
Master List of Method Available to Contractors, Home Builders
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Regular method of accounting
Exempt long-term methods
Non-exempt long-term methods
Home construction contracts
 with costs accumulated under Section 471
 with costs deferred under the CCM
 with costs accumulated as capitalized costs, under Section 263A
 with contracts recognized under a long-term method as capitalized costs
Continued List of Methods
 The various exempt methods, listed above, with AMT calculations performed under the
regular method
 The various exempt methods, listed above, with AMT calculations performed under the
simplified costs POC method
 Various combinations possible with the use of the cash method as the regular method of
accounting along with the use of a long-term method, as suggested by Announcement
2002-45.
 The contractor’s method of classifying contracts (as a construction contract, a
manufacturing contract, a service contract, etc.)
 The method of estimating the length of time for performance of a long-term contract
(applicable for IRC Section 460 exceptions, i.e., applicable to various construction
contractor method elections for long-term contract and home builder method elections).
 The cost-allocation method: The particular method chosen for allocating costs and/or
overhead costs, which is applicable to CCM and PCM methods
 The indirect cost method chosen for those utilizing the exempt CCM:
 A contractor who has chosen the CCM can choose either
 the indirect cost method as prescribed 1.460-5(d) in the regulations referring to
1.263A-1(e)(3) (this method includes the requirement to defer worker’s compensation
and health insurance) or
 (2) those indirect costs as provided for in 1.460-5(d)(2) (which excludes allocation or
deferral of worker’s compensation and health insurance).
 Determining factors that are used to determine a contract’s completion factor for
percentage of completion method (1.460-4(b)(5));
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 The method of accounting for the separation of “secondary” items, including the grosscontract price and the allocable contract costs, for a contract accounted for using the
CCM, when the contract primary subject matter is used and at least 95% of the total
allocable contract costs attributable to the primary subject matter have been incurred (in
accordance with the regulations of 1.460-1(c)(3)).
 Methodology for separating out the revenue and costs for non-long-term contract
activities
 Possibly other home builder, home construction contract, or land developer elections
Contract Costs
 The tax code has very specific rules on what contract costs are required to be.
 The discussion of contractor costing rules can only begin with an analysis that first
considers the contractor’s regular method of accounting and method of accounting for
long-term contracts.
 Costing rules can only be understood once we consider what happens with the costs once
they are properly classified.
 Are the costs going to be expensed, allocated, deferred, capitalized, inventoried, or other?
Contract Costs - Example
 Able Contractors incurred the following expenses for 201X: (1) selling, (2) depreciation
on equipment used in the performance of contracts, (3) depreciation on office equipment,
(4) expenses incurred in the construction of its new office building, (5) expenses incurred
in the construction of a speculative development, and (6) costs incurred for construction
materials kept in the company’s inventory supplies and used in jobs as needed.
 These costs as of the end of 201X and for the year 201X, were treated in the following
manner: (1) expensed, (2) allocated to contract costs, (3) expensed, (4) capitalized, (5)
deferred (until the sale of the property), and (6) inventoried.
Contract Costs - Regulations
 Specify contract costs only for the CCM and the PCM
 Costing rules (of 1.460-5) not applicable to all other exempt construction contracts
 CCM must job cost (defer) the following:
 Direct costs (materials, labor, and labor overhead)
 Indirect, including: interest, repairs and maintenance, utilities, rent, indirect labor,
indirect materials and supplies, non-capitalized tools and equipment, QC, certain
taxes, financial statement depreciation, insurance, and (maybe) WC and health
insurance
 PCM (non-exempt) must job cost all of the CCM costs plus typical 263A costs.
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Contract Costs - Resolutions
 Cash method, all types of costs are expensed as paid
 Accrual method, expensed based upon economic performance
 CCM: contract costs and interest costs are deferred until the contract is completed, all
other cost types (S, G & A) fall under the accrual method rules
 PCM: contract costs are expensed based upon economic performance, but are also used in
the cost-to-costs PCM formula
 PCM w 10% Deferral: Defer job costs under 10% completed and then follow the PCM
rules.
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SUPPLEMENTAL
MATERIALS
General Overview of Tax Rules and Methods
Chapter 1
Introduction
Certainly, one of the most difficult industries to understand from a tax perspective is construction
contractors. The tax rules related to contractors are not found in one particular Internal Revenue
Code Section, but rather the rules are a compilation of various Internal Revenue Codes,
Regulations, Procedures, Notices, Private Letter Rulings, and various court cases. These rules
continue to evolve from year to year.
In general, a construction tax advisor must be familiar with:

IRC Reg. 1.460 (which superceded the 1.451-3 regulations as of January 11,
2001): Regulations regarding accounting for long-term contract treatment. These
regulations discuss the completed contract method (CCM) and the percentage of
completion methods (PCM). In addition, these also present the costing rules in
section 1.460-5 for non-extended period contracts (less than two years to
complete and applicable to contractors with less than $10 million in three year's
average tax revenues) and extended period contracts (greater than two years to
complete a contract and applicable to large contractors with over $10 million in
average tax revenues).

IRC 460: Effective for contracts after 1986, generally requires the PCM for all
long-term contracts unless they (a contract or contracts) are covered by an
exception. The difference between the PCM method under 460 and the PCM
under the 1.451-3 regulations relates to the types of job costs. Under IRC 460
many types of indirect contract costs are added to the formula in determining the
percentage complete.

IRC 460(e)(1)(A): Describes the home construction contract exception to IRC
460 PCM requirement.

IRC 460(e)(1)(B): Describes the small contractor exception to IRC Sec 460 PCM
requirement.

IRC Reg. 1.460-6: Describes the requirements and details the calculations for
look-back calculations applicable to certain contractors. Look-back rules were
implemented in IRC Section 460 in order to prevent contractors from
manipulating their percentage of completion recognition. The look-back rules
require the contractor to either pay interest or receive interest for differences in
the taxes that were paid on what was estimated as percent complete on prior filed
tax returns, compared to the hypothetical taxes that should have been paid once
the contract is completed and final gross profit amounts are known.
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Chapter 1


Notice 89-15: This is the prior IRS guidance with respect to how, what, when,
why and who of the application of IRC Section 460, including the percentage of
completion contract treatment, changes to methods, home construction exception,
residential contract definition, small contractor definition, and more. This was the
basic source for most of the knowledge about Section 460 prior to the final 460
regulations., This Notice remains applicable unless a specific item has been
superceded.
IRC 471 and Related Regulations: Lists required application of capitalization
costing for small home builders (less than $10 million in average tax revenues and
less than two years in length). Home builders’ real estate costs are capitalized, not
inventoried, even though the treatments are similar in many respects.

IRC Section 263A: Uniform capitalization regulations that are applicable to
speculative homebuilders not meeting the small homebuilder definition. This
Section also details the applicability of interest capitalization and allocation to
contractors. In general, the indirect cost allocations under IRC Section 263A are
similar to the indirect costs applicable to IRC Section 460, as described in 1.460-5
Regulations (which describes the allocation manner that direct and indirect costs
are capitalized to property produced by a taxpayer under Reg. Sec. 1.263A-1(e)
through (h)).

Revenue Ruling 92-28: Clarified and reiterated that Section 460(e)(1) permits a
taxpayer to use different methods of accounting for exempt contracts under
Section 460(e)(1) (which are not subject to mandatory use of the Section 460(b)
percentage of completion methods (PCM)) and contracts under Section 460(a)
(which are subject to mandatory use of the PCM) within the same trade or
business. Accordingly, a contractor with both exempt contracts and non-exempt
contracts within the same trade or business may use a method of accounting other
than the section 460(b) PCM for all exempt contracts, even though the taxpayer
must use the Section 460(b) PCM for all non-exempt contracts. 1

Final 460 Regulations: Issued January 11, 2001, further explains Notice 89-15
and details all Section 460 requirements on how income from a long-term contract
and related activities must be accounted for. Many new provisions were
introduced. Many prior laws were changed, supplemented, and eliminated.
These regulations will be a significant source of reference for this guide.
Related to Changes in Accounting Methods:

1
Revenue Procedure 97-27: Issued early in 1997 this revenue procedure
superceded the provisions of Rev. Proc. 92-20 that basically reiterated the
position of Notice 89-15. That prior position was summarized in a statement – if
you misapplied, neglected to apply, or mistakenly applied Code Section 460, you
had to go back and amend the earliest open year and pay interest and penalties.
Rev. Proc. 97-27: introduced the opportunity to obtain a 4-year 481(e) adjustment
Revenue Ruling 92-28,I.R.B. 1992-15.41
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Chapter 1
for positive and negative adjustments for changes in long-term contract treatment
for voluntary changes and immediate recognition for mandatory errors with the
Code Section 460 implementation. Rev. Proc. 97-27 continues to be the
source/rules for section 460 changes, even though it has been modified numerous
times.

Final 460 Regulations: Changed Rev. Proc. 97-27 provisions to require cut-off
implementations in any long-term contract method or treatment changes effective
January 11, 2001.

Rev. Proc. 2002-9: Portion applicable to contractors is Section 7A, and was
issued to enable automatic compliance with Final 460 regulations. Not applicable
to exempt contract method changes, as Rev. Proc. 97-27 still applies. Modified
by Rev. Proc. 2002-19 permitting a one-year spread for negative 481(e)
adjustments.

Revenue Procedure 2002-28: Allows many contractors to use or change back to
the cash method for either regular method of accounting or, for long-term contract
treatments. Qualifying contractors must meet Annual Gross Receipts test and
qualifying NAICS codes. Effective for years December 31, 2001, and later and
can use automatic provisions of Rev. Proc. 2002-9, as modified.

Revenue Procedure 2004-1: Annual revenue procedure that updates applicable
user fee for non automatic method changes. Fee as of year 2004 was $1,500.00
Contractor Tax Method Choices
A contractor, depending on the size of revenues and types of contracts, may be able to choose a
method of accounting and a method of accounting for long-term contracts. You will note that
these choices of accounting, method of accounting being the first, and choice of method of
accounting for long-term contracts being the second, are very different and distinct choices. The
reference to method of accounting relates to the basic accounting method chosen by the
contractor and the list of choices is: (1) the cash method; (2) the accrual method; and, possibly
(3) the hybrid method(s). The method of accounting for long-term contracts relates to the method
chosen by the contractor (or dictated by code if IRC Section 460 is applicable) in order to
account for revenue and cost recognition for long-term contracts. The list of choices includes the
completed contract method (CCM), or the percentage of completion method (PCM), and its
varieties.2
The correct or incorrect selection of choice of accounting method, and the choice of accounting
for long-term contracts, will influence the tax position of a contractor for many years into the
future. For financial statement purposes, there generally is only one accepted method of
accounting for long-term contracts, i.e. the percentage of completion, accrual method. For tax
2
Section 1.460-1(b)(10)
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General Overview of Tax Rules and Methods
Chapter 1
purposes there are various permitted methods, depending on the size and length of the contract,
each with its own benefits and disadvantages. Once a contractor elects a regular method of
accounting and a specific long-term contract accounting method, these methods must be
consistently applied on all subsequent returns.3 Change of methods is only available if
permission has been obtained from the IRS to change, or an automatic method permits the
contractor to change such as in (Rev. Proc. 2002-28), or unless the contractor is required by a
specific law to change.4
A contractor chooses its regular tax accounting method and its tax treatment of accounting for
long-term contracts in the first year of existence by filing a return utilizing chosen methods, or in
the first year long-term contract treatment is applicable. However, unlike other industries, a
contractor’s regular tax method of accounting and its required tax accounting treatment for longterm contracts will evolve and change as the contractor grows in revenue size and types of
contracts performed. For example, a contractor might start business as a small contractor and
elect the cash method of accounting. If the contractor incorporates as a C corporation, once its
annual tax receipts average exceeds five million dollars, it will be required under IRC Section
448 to change its method of accounting to the accrual method.5 If the contractor continues to
grow, and its three year annual gross tax receipts average exceeds ten million dollars, it will be
required to start to account for its uncompleted contracts, obtained after this tax year, under the
PCM under IRC Section 460(b).6 If a contractor obtains a contract that is estimated to take more
than 2 years to complete, or if a contractor obtains a contract with significant design, architect,
engineering, or construction management elements, (non-long term contract activity) accounting
for such a contract may vary from the contractor’s chosen or elected accounting method or longterm contract accounting methods. (For non-long term contract activities, the contractor may be
required to use a regular method of accounting, or prohibited from using a long-term contract
treatment.)
A contractor tax advisor must understand the permitted, preferable, and correct elected tax
methods of accounting and choices for long-term contract treatment, the incorrect methods, and
the ways to address the needed changes. This guide enables the advisor to do so.
The contractor, from sole proprietor to partnerships, LLCs to corporations, elects an overall
method of accounting on its first filed federal tax return. Many contractors and tax preparers are
confused about the difference between a regular tax method of accounting and elected tax
treatments of accounting for long-term contracts. They are not the same. Again, a contractor
first elects a regular method of accounting and then elects a method of treatment for long-term
contracts when it first has an uncompleted contract at fiscal or calendar year end.
General Rule of IRC Section 460
3
Rev. Proc. 2002-9,I.R.B. 2002-3, Section 2.01(2)
IBID, Section 2.02
5
Section 448(b)(3)
6
Section 460(b)
4
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General Overview of Tax Rules and Methods
Chapter 1
IRC Section begins by stating that in the case of any long-term contract, the taxable income from
such contract shall be determined under the PCM.7 The exceptions to the general rule of Section
460 are specified by IRC Section 460(e) which is titled “Exception for Certain Construction
Contracts.”8 Each part of the phrase “long-term real estate construction contracts”9 has an
important meaning in the tax laws and will be addressed in the following sections.
7
Section 460(a)
Section 460(e)
9
Section 1.460-3(a)
8
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Chapter 1
Definition of Long-Term Contract
IRC Sec. 460(f) defines “long-term contract” 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 into.10 This means that a contract started in December and
completed in January, for a calendar year end filing contractor, is defined as a long-term
contract. The contract may only last a week, but if it lasts over a fiscal or calendar year end, it is
a long-term contract. This negates any concept that a contract has to be longer than twelve
months to be a long-term contract for construction contractors.11
Real Estate Requirement
The “real estate” part of the IRC Sec. 460(e) phase is equally significant. 460(e) uses the
wording “construction contract.” Section 460(e)(4) defines a “construction contract” as “any
contract for the building, construction, reconstruction, or rehabilitation of, or the installation of
any integral component to, or improvement of, real property.”12 Thus, a contract to install an
integral component to real property can be subject to Section 460 PCM even if the installation
activity is not accompanied by any construction activity.
As stated by Section 1.460-3(a), real property means land, buildings, and inherently permanent
structures, (which is defined in detail in the Regulations Section 1.263.A-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 intended to be permanently affixed to the real
property, such as elevators and central heating and cooling systems. Thus, for 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.13
Regulations 1.253A-8(c)(3) defines real property:
Real property includes land, unsevered natural products of land, buildings,
and inherently permanent structures. Any interest in real property of a
type described in this paragraph (c), including fee ownership, coownership, leasehold, an option, or a similar interest is real property under
this section. Real property includes the structural components of both
buildings and inherently permanent structures, such as walls, partitions,
doors, wiring, plumbing, central air conditioning and heating systems,
pipes and ducts, elevators and escalators, and other similar property.
Tenant improvements to a building that are inherently permanent or
10
11
12
13
Section 460(f), Section 1.460-3(a)
This concept may have been misinterpreted based upon Section 460(f)(2)(B), under the Section 460(f)(2)(A)
titled “Special Rule for Manufacturing Contracts.” Section 460(f)(2)(B) states “Any item which normally
requires more than 12 calendar months to complete.” The time concept of 12 months applies to certain
manufacturing contracts and not construction contracts.
Section 460(e)(4)
Section 1.460-3(a)
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General Overview of Tax Rules and Methods
Chapter 1
otherwise classified as real property within the meaning of this paragraph
(c)(1) are real property under this section. However, property produced
for sale that is not real property in the hands of the taxpayer or a related
person, but that may be incorporated into real property by an unrelated
buyer, is not treated as real property by the producing taxpayer (e.g.,
bricks, nails, paint, and windowpanes).
“Contract” Verses “Contractor” Wording
IRC Section 460(b) refers to “any long-term contract,” rather than referring to the contractor as a
whole. This is an important distinction. A contractor, for example, may report some contracts
under the CCM as permitted by 1.460-4(d), but may be required to report other contracts under
IRC Sec. 460 using the PCM. Therefore, to summarize, if the contractor elects a method of
accounting for long-term contracts, it may be superceded by the requirement to use PCM
reporting under Sec. 460 for some contracts, or for all, depending on whether the exceptions of
IRC Sec. 460(e) (as further outlined and defined in the IRS Regulations and Revenue
Procedures) are met, and provided the method selected clearly reflects income. (See following
section on Code Section 446.)
Code Section 446 and the “Clear Reflection of Income” Standard
General rule of IRC Sec. 446 states that if no accounting method has been regularly used by the
taxpayer, or if the method used does not clearly reflect income, the computation of taxable
income shall be made under such method as, in the opinion of the IRS does, clearly reflects
income.14
Section 446 gives the IRS broad discretion to require a particular method of accounting. The
courts do not interfere with the IRS’ determination under Section 446 unless it is clearly
erroneous.15
14
Section 446(b)
15
RACMP Enterprises, Inc. v. Commissioner, 114 TC 211, March 30, 2000, presents the following analysis on this
issue: The Commissioner is granted broad discretion in determining whether a taxpayer's use of a method of
accounting clearly reflects income. See sec. 446(b) ; United States v. Catto , 384 U.S. 102, 114 & n.22 (1967);
Commissioner v. Hansen, 360 U.S. 446, 468 & n.12 (1959); Lucas v. American Code Co. 280 U.S. 445, 449 (1930).
A prerequisite to the Commissioner's exercise of authority to require a taxpayer to change its present method of
accounting is a determination that the method used by the taxpayer does not clearly reflect income. See sec. 446(b) ;
Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26, 31 (1988).
Whether an abuse of discretion has occurred depends upon whether the Commissioner's determination is without
sound basis in fact or law. See Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 371 (1995); Ford
Motor Co. v. Commissioner, 102 T.C. 87, 91-92 (1994), affd. 71 F.3d 209 (6th Cir. 1995). The reviewing court's
task is not to determine whether, in its own opinion, the taxpayer's method of accounting clearly reflects income but
to determine whether there is an adequate basis in law for the Commissioner's conclusion that it does not. See
Ansley-Sheppard-Burgess Co. v. Commissioner, supra at 371; Hospital Corp. of Am. v. Commissione, T.C. Memo.
1996-105. Consequently, section 446 imposes a heavy burden on the taxpayer disputing the Commissioner's
determination on accounting matters. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979). To
prevail, a taxpayer must establish that the Commissioner's determination was "clearly unlawful" or "plainly
arbitrary.” Id.
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General Overview of Tax Rules and Methods
Chapter 1
So, before any method is “elected” by the taxpayer, it must first pass the clear reflection of
income requirements. For contractors, prior to the release of Rev. Proc. 2002-28 in May of
2002, this generally was focused on the use of the cash method. (The detailed discussion of this
issue is covered in the Cash Method Chapter.) The IRS’s current position of “clear reflection of
income” standard focuses on the contractor’s overall revenue recognition methods (i.e. whether it
is a permitted method (s)), cost allocation methods, and the contractor’s adherence to generally
known accounting tax practices, i.e. no tax shelter schemes.
Activities Which do not Meet The Definitions
The IRS narrowly defines what a construction contract is. As noted previously, it must be a
contract for building, construction, . . . or improvement of real property.16 Real property was
also defined in the regulations found at 1.263A-8. This narrow and restrictive definition of what
constitutes a “long-term contract” has been used by the IRS to deny the use of any long-term
contract accounting method(s) to:

Architects, under Rev. Rul. 70-67, 1970-1;

Engineers, under Rev. Rul. 80-18, 1980-1;

Industrial and commercial painting, under Rev. Rul. 84-32, 1984-1; and,
Engineering Services and Construction Management, under Rev. Rul. 82-134,
1982-2

Non-long-term contract activity, under Section 1.460-1(d)(2)
What accounting or long-term method then, should these “activities” utilize? The answer is their
regular, elected method of accounting only (such as cash or accrual) and not a long-term method
such as the CCM or the PCM.17 A contractor who qualifies (generally this is exempt Section
460(e) contractors) under the provisions of Rev. Proc. 2002-28 may be able to make a change in
their regular method of accounting, and long-term contract method or treatment, under an
automatic change.18 (See also the Chapter in this Guide on Changing Accounting Methods.)
Review the reasoning and IRS points of view below related to activities that do not meet the
definitions:
16
Section 460(e)(4)
Section 1.460-1(d) “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
method.”
18
See IRS Announcement 2002-45, I.R.B. 2002-18, (April 12, 2002) Where it states:
“Several commentators requested additional guidance on the treatment of specific methods of accounting for
particular items (such as specific methods for long-term contracts) for taxpayers using one of the options under
Rev. Proc. 2002-28. In response, the final revenue procedure clarifies that taxpayers may, in some cases, be able
to retain their specific method of accounting even when they use one of the options under the revenue
procedure.”
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General Overview of Tax Rules and Methods
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Revenue Ruling 70-67, holds that an architect, who does not build or construct anything
but simply draws the plans and supervises the work of construction, is not entitled to
report income from contracts extending over more than one year on the completed
contract method. The work done by the taxpayer is in the nature of personal service.
Revenue Ruling 80-18, holds that a taxpayer engaged in the business of providing
engineering and related services, like the architect in Revenue Ruling 70-67, did not
contract to construct or build anything and is not entitled to adopt or use either of the
long-term contract methods provided under (prior) Reg. Sec. 1.451-3.
Regarding construction managers, Revenue Ruling 82-134,1982-2, summarizes these
situations where it stated “A general contractor is responsible for the final product and
must correct any mistakes. This responsibility entails control over every element of the
contract, not only as to results but also as to the details and means by which the result is
achieved.” See Kurio v. United States, 281 F. Supp. 252 (S.D. Tex. 1968). These are the
types of responsibilities required in order to use the completed contract method. The
services that the taxpayer performs are primarily engineering services, architectural
services, and supervision of construction. Like the architect in Rev. Rule. 70-67 and the
engineer in Rev. Rule. 80-18, the taxpayer is not required to actually construct, build, or
install anything, even though the taxpayer's services are functionally related to activities
that may be the subject of long-term contracts as defined in prior section 1.451-3(b)(1)(i)
of the regulations.
Usually, a general contractor is responsible for control over every element of the contract,
not only as to the results but also as to the details and means by which the result is
achieved. Those are the types of responsibilities required in order to use the completed
contract method or any other long-term method. If the services that the taxpayer
performs are primarily engineering services, architectural services, and supervision of
construction, (like the architect in Revenue Ruling 70-67 and the engineer in revenue
Ruling 80-18), the taxpayer is not required to construct, build, or install anything, even
though the taxpayer’s services are functionally related to activities that are the subject
matter of long-term contracts as defined in prior Reg. Sec. 1.451-3(b)(1)(i).
Reason for Denial of Long-term Treatment
The long-term accounting methods only are available to contractors who meet the exception
provision of IRC 460(e). The IRS is very strict in permitting the usage of the exception to only
those qualified contractors. The narrow definition of a construction contract has caused the IRS
to prohibit the use of any long-term methods to architects, engineers, industrial and commercial
painters, and construction managers. The basis of this prohibition is the conclusion that the
majority of contract costs are labor related in the nature of personal services.
This reasoning may seem logical when applied to the work of architects, engineers, and maybe
even to construction managers, but when the IRS stretched this prohibition to encompass
commercial painters under Rev. Rul. 84-32, many contractors saw this as a dangerous precedent.
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General Overview of Tax Rules and Methods
Chapter 1
In its July 1984 Newsletter, The Construction Financial Managers Association, (CFMA) called
for action:
In February, the IRS issued Revenue Ruling 84-32 which effectively
denied the use of any long-term contract method of accounting (completed
contract or percentage of completion) to painting contractors. The IRS
position was that a painting contractor was, in fact, not a contractor as
contemplated by the regulations since he does not construct, build or
install anything, but rather only provides painting services. This new
ruling significantly expands the IRS position of “service” contracts and
your Association believes that it is an attempt by the IRS to fragment the
construction industry further . . .
We strongly urge the immediate revocation of Revenue Ruling 84-32 and
your Association through its Tax, Accounting and Reporting Committee
will express our disapproval to the IRS and the House Ways & Means
Committee. We encourage Association members to do the same . . .
The painting construction industry has had a long-standing tradition within
our industry and has always been included as such in the various
government regulations and classifications. We, therefore, disagree with
the IRS approach in attacking this construction industry segment. To
further prohibit the painting contractors from spreading the financial
impact over a maximum of ten years, when a change of accounting
method is made after an IRS audit, we feel is unjustified and unwarranted.
However, in practice, the IRS has not been applying the strict conclusions of Rev. Rul. 84-32 to
painting contractors. In a 1998 application to change accounting methods submitted to the IRS,
the IRS struggled with its conclusion, but permitted the continued use of a long-term method
(specifically the CCM) for a painting contractor. The IRS told this author that Rev. Rul. 84-32 is
a “bad ruling” and that although they would like to revoke it; they will just generally work
around it. The IRS will permit the use of a long-term method for a painting contractor if the
contractor can assert and support by its facts and circumstances, that job costs, other than just
labor, are an important element to contract performance. For many painting contractors this is
certainly the case today as costs of material and equipment are usually significant.
Note: With the issuance of Revenue Procedure 2002-28 in May of 2002, the IRS has taken a new
approach for “service” providers. Under this new IRS policy, service providers (i.e., taxpayers
meeting defined business codes), specifically construction contractors, will be permitted to use
the cash method of accounting for both elected regular methods of accounting and for long-term
contract treatment. One should consider that this recent issuance does not supercede or change
the IRS position of “activities” which do not meet the definition of what a construction contract
is. That is an entity may qualify under Revenue Procedure 2002-28 criteria to be able to use the
cash basic accounting method, but be prohibited by the criteria of the definition of a construction
contractor to be able to utilize a long-term contract treatment. (See Chapters on Cash Method for
a complete discussion and on changing accounting methods.)
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General Overview of Tax Rules and Methods
Chapter 1
Even though many of those Revenue Rulings dealing with the definition of “activities” appear to
be out of date, the IRS adheres to its conclusions as outlined in the final IRC Sec. 460
regulations. The IRS defined these services (i.e. architecture, engineering, etc.), in 1.4601(d)(2), as discussed above, as “non-long-term contract activities.” Not only is the denial of
long-term treatment applicable to these services, it is also applicable to contractors that perform
these activities. 1.460-1(d)(2) defines and explains this in detail: “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 construction software. In
addition, performance under a guaranty, warranty, or maintenance agreement is a non-long-term
contract activity that is never incidental to or necessary for the manufacture or construction of
property under a long-term contract.”19
The final 460 regulations added a new provision about these activities that is described as a
“clarification.” If a construction contract includes the performance of any activity other than
construction (e.g., engineering and design, construction management, or architectural services)
that is not incidental to or necessary for a long-term construction contract, the contractor must
allocate a portion of the contract revenue and costs attributable to that activity. And, the
contractor would have to account for this activity under a permissible method of accounting
other than a long-term contract method (typically, the straight accrual method). Regulations
Section 1.460-1(d)(1) state:
“Gross receipts and costs attributed to non-long-term contract
activities generally must be taken into account using a permissible
method of accounting other than a long-term contract method.
See section 446(c) and 1.446-1(c). However, if the performance of
a non-long-term contract activity is incidental 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(s) benefited.”
The Small Contractor Exception
The exceptions to the restrictive provisions of IRC Sec. 460(a), (b), (c)(1), and (c)(2) (requiring
the use of the tax PCM under Code Section 460) are specified by IRC Sec. 460(e)(1)(A) and (B).
These exceptions permit reporting of long-term contracts under one of the methods described by
Reg. Sec. 1.460-4 for construction contractors (or IRC Sections 471 or 263A for home builders.)
Specifically, a contract is not subject to Code Section 460 under 460(e)(1)(B) if:

19
(1) the taxpayer estimates (at the time such contract is entered into) that such
contract will be completed within the two-year period beginning on the
Section 1.460-1(d)(2)
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contract commencement date of such contract, and

(2) the taxpayer’s average annual [tax] gross receipts for the three taxable
years preceding the taxable year do not exceed $10,000,000.20
Both conditions one and two must be met or the exception does not apply.
If a particular contract exceeds the two-year period required under condition (1) above, then IRC
Sec. 460(b) applies to that contract (requiring the use of the PCM under Section 460), without
regard to the contractor’s average gross receipts test.
Example: Able contractor’s average gross receipts approximate $5,000,000 and it utilizes the
CCM as its elected long-term method. Able obtains a new contract (number 05-B), that will take
4 years to complete. Contract number 05-B will have to be reported under the PCM while Able
continues to report all of its other contracts under the CCM.
If a contractor can avoid using the PCM under IRC Sec. 460 for its contracts, because
it meets the exception defined under 460(e)(1)(B), then the following methods are available to
the contractor for use in reporting its long-term contracts: cash, accrual, accrual excluding
retentions, the long-term methods under Reg. Sec. 1.460-4 (the PCM and CCM and their
varieties),21 and possible combinations of the regular methods and long-term methods.
2 Year Completion Test
Determination of the taxpayer’s expected completion date is based on the facts and
circumstances at the time the contract is bid or entered into.22 A subsequent change in conditions
or a change order extending the contract will not of itself cause the contract to come under IRC
Sec. 460 if it was previously determined to qualify for the exclusion. The burden of proof is on
the taxpayer to document that at the time he or she entered into the contract, he or she expected
the contract to be completed within 2-years from the commencement date. Evidence supporting
the estimated completion date would be:

Completion date in the contract documents,
20
Section 1.460-3(b)(ii)
Section 1.460-4(c)
22
Section 1.460-3(b)(1)(ii) The Regulations defines “Date contract entered into” in Section 1.460-1(c) (2):
“A taxpayer enters into a contract on the date that the contract finds both the taxpayer and the customer under
applicable law, even if the contract in subject to unsatisfied conditions not within the taxpayer’s control (such as
obtaining financing.” In addition regarding options and change orders, under Section 1.460-1(c)(2)(ii), “a
taxpayer enters into a new contract on the date that the customer exercises an option or similar provision in a
contract if that option or similar provision must be several from the contract under paragraph (e) of this section.
Similarly, a taxpayer enters into a new contract on the date that it accepts a change order or other similar
agreements if the change order or other similar agreement must be several from the contract under paragraph (e)
of this section.”
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General Overview of Tax Rules and Methods
Chapter 1

Scheduling commitments at the time bids were made, and

Period of time overhead is budgeted to the job
Examples:
a.
A contractor enters into a contract on August 27, 20X1 and the contract is expected to
commence on November 17 of the same year. The contract documents specify that the
contract must be completed within 22 months following the owners notice to proceed.
This contract is not subject to IRC Sec. 460. The time between entering into the contract
and starting the work is not considered in the two year test.
b.
Following the same facts as “a” above, assume that the contract included the fabrication
of materials. If the contractor, at his own risk, started fabricating special assemblies for
the contract on August 31, the time between starting fabrication and before starting work
on the contract would most likely be included in the two year test. See IRC Sec. 460(g).
c.
Assume a contractor entered into a contract to construct a building for a developer and at
the time the contract was entered into, the contractor was aware that the developer
intended to build two additional buildings, substantially identical to the first, on the same
site within the next two years. Subsequently, the contractor and developer did enter into
two additional contracts to construct the additional buildings. Each building is
constructed in a period of 16 months. All three buildings are constructed within a period
of 36 months. If the contracts are aggregated, the construction period of 36 months is
controlling. If the contracts are not aggregated, the 16 month period is controlling and
the contracts are excepted from IRC Sec. 460. Whether or not aggregation is appropriate
is a matter of facts and circumstances, and the provisions of the final 460 regulations,
(See Section on Contract Severing and Combining under Section 460 Final Regulations.)
Assume the same facts as “c”, except that the two additional buildings are constructed
pursuant to change orders to the primary contract. The contractor must demonstrate that,
at the time the first contract was entered into, he did not anticipate constructing the
additional buildings. His best position might be to treat the additional buildings as
separate contracts under the segregation rules of IRC Sec. 460(f)(3)(B). (See Section on
Contract Severing and Combining under Section 460 Final Regulations.)
d.
A plumbing contractor enters into a contract with a general contractor to install plumbing
for an office building. The subcontractor expects that his contract will be completed
within 9 months of his commencement date. However, the general contract is expected
to take 28 months to complete. The subcontractor is controlled by the length of the
subcontract only and is not affected by the duration of contracts of other contractors or
the general on the same site.
e.
Assume the same facts as in example “e” but the plumbing contractor is considered a
“related party” with the general contractor. The plumbing contractor would not be
excepted from IRC Sec. 460 under subsection (e)(l)(B)(i). See Q&A 8 of Notice 89-15.
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f.
A contractor starts work on a project on July 30, 20X1. The contractor and owner are
unable to reach an agreement on all terms of the contract and the contract is finally
entered into on November 3, 20X1. The contract is completed on May 10, 20X3. The
contractor would be required to demonstrate that at the time he commenced the contract
he did not expect the contract to have a duration of more than 24 months in order to be
excepted from IRC Sec. 460. Under the circumstances described, the contract is deemed
to have been entered into effective with starting work.
The final regulations address the issue of completion under Section 1.460-1(f) under a Section
titled “Classifying Contracts.” This section requires the taxpayer to determine (or choose) the
classification of a contract (e.g., as a long-term manufacturing contract, long-term construction
contract, non-long-term contract) based on all the facts and circumstances known no later than
the end of the original contracting year.23 Classification is determined on a contract-by-contract
basis.
1.460-1(f)(4) use of Estimates-(i): Estimating length of contract. A taxpayer
must use a reasonable estimate of the time required to complete a contract when
necessary to classify the contract (e.g., to determine whether the five-year
completion rule for qualified ship contracts under § 1.460-2(d), or the two-year
completion rule for exempt construction contracts under § 1.460-3(b), is satisfied;
but, not to determine whether a contract is completed within the contracting year
under paragraph (b)(1) of this section).
To be considered reasonable, an estimate of the time required to complete the
contract must include anticipated time for delay, rework, change orders,
technology or design problems, or other problems that reasonably can be
anticipated considering the nature of the contract and prior experience.
A contract term that specifies an expected completion or delivery date may be
considered evidence that the taxpayer reasonably expects to complete or deliver
the subject matter of the contract on or about the date specified, especially if the
contract provides bona fide penalties for failing to meet the specified date.
If a taxpayer classifies a contract based on a reasonable estimate of completion
time, the contract will not be reclassified based on the actual (or another
reasonable estimate of) completion time. A taxpayer’s estimate of completion
time will not be considered unreasonable if a contract is not completed within the
estimated time primarily because of unforeseeable factors not within the
taxpayer’s control, such as third-party litigation, extreme weather conditions,
strikes, or delays in securing permits or licenses.
23
Section 1.460-1(f)
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$10,000,000 Gross Receipts Test
The 460 regulations require the aggregation of gross receipts under the common control rules in
§ 1.263A-3(b)(3), other than the rules applicable to single employers under section 414(m) and
the regulations thereunder.24 In addition, the regulations require the attribution of constructionrelated gross receipts of persons that own, or are owned by, the taxpayer, but that are not subject
to § 1.263A-3(b)(3).25 The $10,000,000 rules are similar to those that applied to the $25,000,000
gross receipts test under prior law (prior to 1986) and the final 460 regulations specifically states:
1.460-3(b)(3) $10,000,000 gross receipts test— (i) In general. (Except as
otherwise provided in paragraphs (b)(3)(ii) and (iii) of this section.) The
$10,000,000 gross receipts test is satisfied if a taxpayer’s (or predecessor’s)
average annual gross receipts for the 3 taxable years preceding the contracting
year do not exceed $10,000,000, as determined using the principles of the gross
receipts test for small resellers under § 1.263A-3(b).
The only previous guidance available, Notice 89-15, Q & A 45, stated that the (superceded)
Regulation 1.451-3(b)(3)(iii) should be applied to the Average Gross Receipts (AAGR) test to
the extent it is not inconsistent with the rules set forth in the Notice. The cited regulation was
developed to identify contracts required to be reported as “extended period long-term contracts”
under TEFRA in 1982 [Public Law No. 97-248 Section 229(b)] whose language is virtually
identical to “new” IRC Sec. 460(e). Prior to the release of the 460 regulations, three sources of
authority provided guidance in both planning and compliance – (1) IRC Sec. 460(e) with its
legislative history, (2)Reg. 1.451-3(b)(3)(iii), and (3) Notice 89-15, Q & A 45.
“Gross receipts” for purposes of this test (the AAGR test) include receipts from the active
conduct of any trade or business, and must be the gross receipts for the taxable year in which
such receipts are recognized properly under the current tax accounting method of the taxpayer.
“Gross receipts” shall not include amounts properly classified as interest, dividends, rents,
royalties, annuities or any of the amount realized from the sale or exchange of property used in
the trade or business or held for the production of income.
The complete definition of “Gross Receipts” under 1.263A-3(b)(2) states:
24
25
Section 1.460-3(b)(3)
Specifically, the aggregation rules under Section 1.460-3(b)(3)(ii) and (iii) state:
“(ii) Single employer. To apply the gross receipts test, a taxpayer is not required to aggregate the gross receipts
of persons treated as a single employer solely under section 414(m) and any regulations prescribed under
section 414. (iii) Attribution of gross receipts. A taxpayer must aggregate a proportionate share of the
construction-related gross receipts of any person that has a five percent or greater interest in the taxpayer. In
addition, a taxpayer must aggregate a proportionate share of the construction-related gross receipts of any
person in which the taxpayer has a five percent or greater interest. For this purpose, a taxpayer must determine
ownership interests as of the first day of the taxpayer’s contracting year and must include indirect interests in
any corporation, partnership, estate, trust, or sole proprietorship according to principles similar to the
constructive ownership rules under sections 1563(e), (f)(2), and (f)(3)(A). However, a taxpayer is not required
to aggregate under this paragraph (b)(3)(iii) any construction-related gross receipts required to be aggregated
under paragraph (b)(3)(i) of this section.”
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Developers and Homebuilders
General Overview of Tax Rules and Methods
Chapter 1
“definition of gross receipts”--(i) In general. Gross receipts are the total amount, as
determined under the taxpayer's method of accounting, derived from all of the taxpayer's
trades or businesses (e.g., revenues derived from the sale of inventory before reduction for
cost of goods sold). (ii) Amounts excluded. For purposes of this paragraph (b), gross receipts
do not include amounts representing:
(A) Returns or allowances;
(B) Interest, dividends, rents, royalties, or annuities, not derived in the ordinary course of a
trade or business;
(C) Receipts from the sale or exchange of capital assets, as defined in section 1221;
(D) Repayments of loans or similar instruments (e.g., a repayment of the principal amount of
a loan held by a commercial lender);
(E) Receipts from a sale or exchange not in the ordinary course of business, such as the sale
of an entire trade or business or the sale of property used in a trade or business as defined
under section 1221(2); and
(F) Receipts from any activity other than a trade or business or an activity engaged in for
profit.
(3) Aggregation of gross receipts--(i) In general. In determining gross receipts, all persons
treated as a single employer under section 52(a) or (b), section 414(m), or any regulation
prescribed under section 414 (or persons that would be treated as a single employer under
any of these provisions if they had employees) shall be treated as one taxpayer. The gross
receipts of a single employer (or the group) are determined by aggregating the gross receipts
of all persons (or the members) of the group, excluding any gross receipts attributable to
transactions occurring between group members.
(ii) Single employer defined. A controlled group, which is treated as a single employer under
section 52(a), includes members of a controlled group within the meaning of section 1563(a),
regardless of whether such members would be treated as component members of such group
under section 1563(b). (See §1.52-1(c).) Thus, for example, the gross receipts of a franchised
corporation that is treated as an excluded member for purposes of section 1563(b) are
included in the single employer's gross receipts under this aggregation rule, if such
corporation and the taxpayer were members of the same controlled group under section
1563(a).
(iii) Gross receipts of a single employer. The gross receipts of a single employer for the test
period include the gross receipts of all group members (or their predecessors) that are
members of the group as of the first day of the taxable year in issue, regardless of whether
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General Overview of Tax Rules and Methods
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such persons were members of the group for any of the three preceding taxable years. The
gross receipts of the single employer for the test period do not, however, include the gross
receipts of any member that was a group member (including any predecessor) for any or all
of the three preceding taxable years, and is no longer a group member as of the first day of
the taxable year in issue. Any group member that has a taxable year of less than 12 months
must annualize its gross receipts in accordance with paragraph (b)(1)(ii) of this section.
(iv) Examples. The provisions of this paragraph (b)(3) are illustrated by the following
examples:
Example 1. Subsidiary acquired during the taxable year. A parent corporation, (P), has
owned 100% of the stock of another corporation, (S1), continually since 1989. P and S1 are
calendar year taxpayers. S1 acquires property for resale. On January 1, 1994, P acquires
100% of the stock of another calendar year corporation (S2). In determining whether S1's
resale activities are subject to the provisions of section 263A for 1994, the gross receipts of
P, S1, and S2 for 1991, 1992, and 1993 are aggregated, excluding the gross receipts, if any,
attributable to transactions occurring between the three corporations.”
Example 2. Subsidiary sold during the taxable year. Since 1989, a parent corporation, (P),
has continually owned 100% of the stock of two other corporations, (S1) and (S2). The three
corporations are calendar year taxpayers. S1 acquires property for resale. On December 31,
1993, P sells all of its stock in S2. In determining whether S1's resale activities are subject to
the provisions of section 263A for 1994, only the gross receipts of P and S1 for 1991, 1992,
and 1993 must be aggregated, excluding the gross receipts, if any, attributable to transactions
occurring between the two corporations.
Gross receipts from contracting activities must be gross revenue from contracts as determined by
the taxpayer’s current method of accounting for income tax reporting (and not GAAP and/or
PCM reporting, unless the PCM is the taxpayer’s elected or required accounting method.)
Where a contractor enters into a contract that provides for direct materials to be supplied by the
party for whom the contract is being performed, and the cost therefore is not included in the
gross contract price, gross receipts do not include the cost of such direct materials, unless a
principal purpose of the arrangement was reducing the contractor’s gross receipts.
Gross revenue from contracts is combined with gross receipts from all other trades or businesses
under common control with the taxpayer, within the meaning of section 52(b), and all members
of any controlled group of corporations of which the taxpayer is a member. Trades or businesses
subject to these rules may be corporations, trusts, estates, partnerships, or proprietorships and
might be structured as parent-subsidiary groups, brother-sister groups, or a combined group.
Note that discussion of “gross receipts” under the 460 code and regulations refers to trade or
business gross receipts as reported under the contractor’s regular tax reported revenues.
Financial Statement or GAAP Percentage of Completion revenues or, PCM revenues calculated
under Sec. 460 do not enter into this calculation. For example, if the contractor reported
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General Overview of Tax Rules and Methods
Chapter 1
revenues under the CCM on their tax return of $7 million, $9 million and $13 million over the
last three years, their average gross receipts for this test is calculated as
($7 + $9 + $13 = 29,000,000 ÷ 3 =) $9,666,667.
Therefore, for purposes of the $10MM test, the contractor could continue to utilize the CCM of
accounting because their average “gross receipts” was under $10,000,000. If this same
contractor reported financial statement PCM income under GAAP principles on their financial
statements of $8 million, $10 million and $14 million, which averages $10,666,667, it would not
influence the calculation for the $10,000,000 limitation requirement for tax purposes.
Effective with the issuance of Revenue Procedure 2002-28, in May of 2002, for tax years ending
effective December 31, 2001, or thereafter, Rev. Proc. 2002-28 permits certain defined taxpayers
that must meet certain criteria, to be able to retain or automatically change to the cash method of
accounting. (See Chapter on Cash Accounting Method for a full discussion). One of the criteria
specified by Revenue Proc. 2002-28 is that the “average annual gross receipts” of the taxpayer
cannot exceed $10,000,000. However, the “average annual gross receipts” terminology utilized
in Rev. Proc. 2002-28 is not the same as the “gross receipts” defined above for Code Section 460
(e) exemption. Rev. Proc. 2002-28 “average annual gross receipts” is defined as all revenue or
receipts from all sources including non-trade or business receipts, which could include interest,
rents, and dividends, for example.
An advisor to contractors must understand this difference and inconsistency between the
definition of AAGR for Code Section 460 and Rev. Proc. 2002-28. Again, in summary, Code
Section 460 “gross receipts” for the Code Section 460(e) exclusion test are considered trade or
business receipts, whereas the Rev. Proc. 2002-28 “gross receipts” test for purposes of the
permissions of the cash method, are based on all receipts including non-trade or business
receipts.
Concerning gross receipts of potential related or controlled groups, a controlled group of
corporations has the meaning given such term by section 1563(a) except that “more than 50%” is
substituted for “at least 80%” each place that it appears in section 1563(a)(1), and the
determination is made without regard to subsections (a)(4) and (e)(3)(C) of section 1563.26
For this purpose, persons are treated as members of controlled groups, within the meaning of
section 1563(a), regardless of whether those persons would be treated as “component members”
of the group under section 1563(b). [See Regulation Section 1.52-1(c).] For example, gross
receipts of a foreign corporation treated as an excluded member for purposes of section 1563(b)
would be included for purposes of the aggregation rules for the gross receipts test under IRC Sec.
460(e) if that corporation and the taxpayer are members of the same controlled group under IRC
Sec. 1563(a).
Identifying a brother-sister controlled interest involves a couple of tests. The first, the effective
control test, calculates whether or not five or fewer persons own more than 50% of the control
26
Section 460 (e)(3)(A)
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attributes of the corporations, with ownership of each person taken into account only to the
extent that person’s ownership is identical with respect to each corporation.
For the second, controlling interest test, ownership of the same persons meeting the effective
control test is predetermined taking into account total ownership in each organization. For
purposes of the controlling interest test, those five or fewer persons must own at least 80% of the
total control attributes. Both the effective control and controlling interest tests must be met in
order for the group to be classified as a brother-sister group under common control.
Gross receipts of the contractor are determined by aggregating the gross receipts of all members
of the group, whether they are contractors or not and excluding gross receipts attributable to
transactions occurring between group members. When determining gross receipts of any
member of the group for a taxable year of less than 12 months, the gross receipts shall be
annualized by (i) multiplying the gross receipts for the short period by 12, and (ii) dividing the
result by the number of months in the short period.
When determining the Adjusted Annual Gross Receipts of the group for the three taxable years
preceding the taxable year in which the contract is entered into, the gross receipts of all persons
(or their predecessors) who are members of the group as of the first day of the taxable year in
which the contract is entered into are included regardless of whether such persons were members
of the group for any of the preceding taxable years. Gross receipts of persons who were
members of the group for any or all of the three preceding taxable years, but who (including their
successors) are not members of the group as of the first day of the taxable year in which the
contract is entered into, are not included.
Examples:
a.
Assume that a parent corporation (P) has continuously owned 100 percent of the
stock of another corporation (S1) since 1983, and that P and S1 are calendar year
taxpayers. S1 enters into a long-term contract in March of 1992. In addition, P
acquired 100 percent of the stock of another calendar-year corporation (S2) as of
the beginning of business on January 1, 1992.
In determining whether S1’s long-term contract is subject to the provisions of IRC
Sec. 460, the gross receipts of P, S1, and S2 for 1989, 1990, and 1991 must be
aggregated, excluding the gross receipts attributable to transactions occurring
between the three corporations. The gross receipts of S2 are taken into account
because it was a member of the group on January 1, 1992.
b.
Assume that a parent corporation (P) has continually owned 100 percent of the
stock of two other corporations, (S1) and (S2), since 1983, and that the three
corporations are calendar-year taxpayers. S1 enters into a long-term contract in
April of 1992. On December 31, 1991, P sold all of its stock in S2.
c.
In determining whether S1’s long-term contract is subject to the provisions of IRC
Sec. 460 for the taxable year beginning January 1, 1992, only the gross receipts of
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P and S1 for 1989, 1990, and 1991 shall be aggregated, excluding the gross
receipts attributable to transactions occurring between the two corporations. The
gross receipts of S2 are not taken into account because it was not a member of the
group on January 1, 1992. Gross receipts attributable to transactions between S1
and S2 during the base years are not excluded.
Under the rules of regulation 1.451-3(b)(3)(iii)(C)(3), severe attribution rules aggregate 100
percent of the gross trade or business receipts of more than 50% commonly controlled entities,
whether incorporated or not.. That portion of the regulations describes and requires the
attribution of construction gross receipts to or from individuals, proprietorships, corporations,
partnerships, trusts and estates not otherwise under common control. Family members include
spouses and lineal family members regardless of age.
Where ownership, direct or indirect, of another entity is between 5% and 50%, only the
proportionate share from construction receipts of the commonly owned businesses is aggregated
with other entities for purposes of the gross receipts test.
For example, if a construction company with $8,000,000 average annual volume enters a joint
venture in which it owns a 30% interest and the venture performs a $2,000,000 construction
contract, during the year, the Aggregate Annual Gross Receipts for the construction company is
$8,600,000. However, assume the partner owning the 70% interest is also a construction
company with average gross receipts of $9,000,000. Gross receipts of the joint venture, for this
test, is $10,400,000 and the joint venture is not eligible for the small contractor exemption.
(Please note that the paragraph has a twist in it. The first calculation asks and answers what the
gross receipts of the first construction company is and that is easily calculated as 100% of $8M
plus 30% of $2M r $8.6M. The next question and answer twists the situation and asks what the
gross receipts of the joint venture is, not what the gross receipts of the second construction
company would be considered. The gross receipts of the joint venture are not calculated based
upon the gross receipts of the joint venturers are plus the gross receipts of the JV. Rather the
gross receipts of the JV are calculated as the gross receipts of the JV times the majority owner's
percentage plus 100% of the gross receipts of any joint venturers owning more than 50% of the
JV. This calculation would result in the following numbers: 70% of 2,000,000 is 1,400,000 plus
$9,000,000 equals $10,400,000.)
The 3-year period preceding the taxable year in which the contract is entered into is the test
period, but can be shorter if the taxpayer has been in business for less than 3 years. The Revenue
Reconciliation Act of 1989 clarified that the 3-year test must include any predecessor of the
taxpayer or other person described in IRC Sec. 460(e)(2) subsections (A) or (B):
“460(e)(2)(C) any predecessor of the taxpayer or a person described in subparagraph (A)
or (B), for the 3 taxable years of such persons preceding the taxable year in which the
contract described in paragraph (1) is entered into shall be included in the gross receipts
of the taxpayer for the period described in paragraph (1)(B). The Secretary shall
prescribe regulations which provide attribution rules that take in account, in addition to
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General Overview of Tax Rules and Methods
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the persons and entities described in the preceding sentence, taxpayers who engage in
construction contracts through partnerships, joint ventures, and corporations.”
The Final 460 regulations also addressed consolidated groups and controlled groups in
Section 1.460-4(j): Consolidated groups and controlled groups--(1) Intercompany
transactions--(i) In general. Section 1.1502-13 does not apply to the income, gain,
deduction, or loss from an intercompany transaction between members of a consolidated
group, and section 267(f) does not apply to these items from an intercompany sale
between members of a controlled group, to the extent-(A) The transaction or sale directly or indirectly benefits, or is intended to benefit,
another member's long-term contract with a nonmember;
(B) The selling member is required under section 460 to determine any part of its gross
income from the transaction or sale under the percentage-of-completion method (PCM);
and
(C) The member with the long-term contract is required under section 460 to determine
any part of its gross income from the long-term contract under the PCM.
(ii) Definitions and nomenclature. The definitions and nomenclature under §1.1502-13
and §1.267(f)-1 apply for purposes of this paragraph (j).
(2) Example. The following example illustrates the principles of paragraph (j)(1) of this
section.
Example. Corporations P, S, and B file consolidated returns on a calendar-year basis. In
1996, B enters into a long-term contract with X, a nonmember, to manufacture 5
airplanes for $500 million, with delivery scheduled for 1999. Section 460 requires B to
determine the gross income from its contract with X under the PCM. S enters into a
contract with B to manufacture for $50 million the engines that B will install on X's
airplanes. Section 460 requires S to determine the gross income from its contract with B
under the PCM. S estimates that it will incur $40 million of total contract costs during
1997 and 1998 to manufacture the engines. S incurs $10 million of contract costs in 1997
and $30 million in 1998. Under paragraph (j) of this section, S determines its gross
income from the long-term contract under the PCM rather than taking its income or loss
into account under section 267(f) or §1.1502-13. Thus, S includes $12.5 million of gross
receipts and $10 million of contract costs in gross income in 1997 and includes $37.5
million of gross receipts and $30 million of contract costs in gross income in 1998.
(3) Effective dates--(i) In general. This paragraph (j) applies with respect to transactions
and sales occurring pursuant to contracts entered into in years beginning on or after July
12, 1995.
(ii) Prior law. For transactions and sales occurring pursuant to contracts entered into in
years beginning before July 12, 1995, see the applicable regulations issued under sections
267(f) and 1502, including §§1.267(f)-1T, 1.267(f)-2T, and 1.1502-13(n) (as contained in
the 26 CFR part 1 edition revised as of April 1, 1995).
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(4) Consent to change method of accounting. For transactions and sales to which this
paragraph (j) applies, the Commissioner's consent under section 446(e) is hereby granted
to the extent any changes in method of accounting are necessary solely to comply with
this section, provided the changes are made in the first taxable year of the taxpayer to
which the rules of this paragraph (j) apply. Changes in method of accounting for these
transactions are to be effected on a cut-off basis.”
Home Construction Contracts
Section 460(e)(6) provides that a construction contract is a home construction contract if the
taxpayer (including a subcontractor working for a general contractor) reasonably expects to
attribute 80 percent or more of the estimated total contract costs, determined at the close of the
contracting year, to the construction of

Dwelling units or a building containing four or fewer dwelling units and, or 27

Improvements to real property directly related to the dwelling units and
located on the site of the dwelling units.28
For this purpose, a dwelling unit means a house or an apartment used to provide living
accommodations in a building or structure, but does not include a unit in a hotel, motel, or other
establishment more than one-half of the units in which are used on a transient basis.
The final 460 regulations provide that a taxpayer includes in the cost of the dwelling units their
allocable share of the cost of any common improvements (e.g., sewers, roads, clubhouses) that
benefit the dwelling unit and that the taxpayer is contractually obligated, or required by law, to
construct within the tract or tracts of land containing the dwelling units.
The final 460 regulations specifically state:
1.460-3(b)(2): Home construction contract—(i) In general. A long-term
construction contract is a home construction contract if a taxpayer (including a
subcontractor working for a general contractor) reasonably expects to attribute 80
percent or more of the estimated total allocable contract costs (including the cost
of land, materials, and services), determined as of the close of the contracting
year, to the construction of—
(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I), contained in
buildings containing 4 or fewer dwelling units (including buildings with 4 or
fewer dwelling units that also have commercial units); and
(B) Improvements to real property directly related to, and located at the site of,
27
28
Section 460(e)(6)(A)(i)
Section 460 (e)(6)(A)(ii)
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Chapter 1
the dwelling units.
(ii) Townhouses and rowhouses. Each townhouse or rowhouse is a separate
building.
(iii) Common improvements. A taxpayer includes in the cost of the dwelling
units their allocable share of the cost that the taxpayer reasonably expects to incur
for any common improvements (e.g., sewers, roads, clubhouses) that benefit the
dwelling units and that the taxpayer is contractually obligated, or required by law,
to construct within the tract or tracts of land that contain the dwelling units.
(iv) Mixed use costs. If a contract involves the construction of both commercial
units and dwelling units within the same building, a taxpayer must allocate the
costs among the commercial units and dwelling units using a reasonable method
or combination of reasonable methods, such as specific identification, square
footage, or fair market value.
The final 460 regulations state, regarding large homebuilders greater than $10,000,000 in
revenue, or 2 years in length of contract), that:
1.460-5(d)(3) Large homebuilders. A taxpayer must capitalize the costs of home
construction contracts under section 263A and the regulations thereunder, unless
the contract will be completed within two years of the contract commencement
date and the taxpayer satisfies the $10,000,000 gross receipts test described in
§1.460-3(b)(3).
For a complete discussion of home construction issues refer to the
chapter on homebuilders and developers.
Home Construction Contracts that Meet the Small Contractor’s Exemption
Those home construction contracts that meet the small contractor’s exemption in code Section
460(e)(1)(B) are exempt (with one exception) from both the requirements of Code Section 460
and the alternative minimum tax requirements of Code Section 56(a)(3).29 The only requirement
or exception for small home construction contractors under Code Section 460 is that construction
period interest must be capitalized in accordance with code Section 460(c)(3) when computing
regular tax: Section 1.460-5(b)(2)(v): (v) Interest—(A) In general. If property produced under a
long-term contract is designated property, as defined in Section 1.263A-8(b) (without regard to
the exclusion for long-term contracts under Section 1.263A-8(d)(2)(v)), a taxpayer must allocate
interest incurred during the production period to the long-term contract in the same manner as
interest is allocated to property produced by a taxpayer under section 263A(f). See Sections
1.263A-8 to 1.263A-12 generally.
(B) Production period. Notwithstanding Section 1.263A-12(c) and (d), for purposes of this
paragraph (b)(2)(v), the production period of a long-term contract – (1) Begins on the later of –
29
Section 1.460-4(f)(1)
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(i) The contract commencement date, as defined in Section 1.460-1(b)(7); or (ii) For a taxpayer
using the accrual method of accounting for long-term contracts, the date by which 5 percent or
more of the total estimated costs, including design and planning costs, under the contract have
been incurred; and (2) Ends on the date that the contract is completed, as defined in Section
1.460-1(c)(3).
Home Construction Contracts that do not Meet the Small Contractor’s Exemption
The tax accounting requirements for home construction contracts that are not exempt under Code
Section 460(e)(1)(B) are, in general, as follows:
a.
Production period interest must be capitalized in accordance
with Code Section 460(c)(3), and
b.
Other costs must be allocated to the contracts in accordance
with the uniform capitalization rules of Code Section 263A.30
Distinction Between Homebuilder Working on a Speculative Home Compared to a
Contracted Home
A speculative home process is one where the contractor builds the home on a lot that the
contractor owns of which the home is not under a contract for sale. The rules above for
contractors apply to such a homebuilder. However, if a homebuilder builds a home, under a
contract, on a lot owned by another (or owned by contractor), he/she essentially operates as a
contractor. As such a contractor, the homebuilder, if meeting the small contractor exemption,
can utilize the: accrual method with use of inventories capitalized under Section 471, the CCM,
the EPCM, and various hybrids of such. As such a contractor, if operating as or subject to
treatment as a large homebuilder, can utilize the accrual method with use of inventories under
Section 263A, the completed contract method with deferral of costs under 263A or the Section
460 PCM. (See Chapter on Home Builder Tax Rules.)
IRS has issues with the definition of what qualifies as a HCC. The IRS has identified what it
perceives as an abuse related to the benefits that a taxpayer can obtain in qualifying a contract as
HCC. See the Chapter on homebuilders for a complete discussion.
Contracts of Less Than Substantial Duration (removed by final 460 regulations)
The prior, superceded regulations under 1.451-(3)(a)(1) permitted a contractor with “long-term
contracts of less than substantial duration” to account for those contracts using “another proper
method of accounting.” Review the actual regulation below: (Note that 1.451-3 regulations were
superceded by the final 460 regulations).
30
Section 1.460-5(d)(3)
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1.451-(3)(a)(1) In general. Income from a long-term contract (as defined in
paragraph (b)(1) of this section) may be included in gross income in accordance
with one of the two long-term contracts methods, namely, the percentage of
completion method (as described in paragraph (c) of this section) or the
completed contract method (as described in paragraph (d) of this section), or any
other method. Whichever method is chosen must, in the opinion of the
Commissioner, clearly reflect income. See § 1.446-1(a)(2) and (c).
In addition, it must be applied consistently to all long-term contracts within the
same trade or business except that a taxpayer who has long-term contracts of
substantial duration and long-term contracts of less than substantial duration in
the same trade or business may report the income from all the contracts of
substantial duration on the same long-term contract method and report the income
from the contracts of less than substantial duration pursuant to another proper
method of accounting.
For example, if a manufacturer of heavy machinery has special-order contracts of
a type that generally take 15 months to complete and also has contracts of a type
that generally take 3 months to complete, the manufacturer may use a long-term
contract method for the 15-month contracts and a proper inventory method
pursuant to section 471 and the regulations thereunder for the 3-month contracts.
Similarly, if a construction contractor has construction contracts of a type that
generally take 15 calendar months to complete and other construction contracts
that take only 5 months to complete but are long-term contracts because they are
not completed in the taxable years in which they are entered into (pursuant to
paragraph (b)(1)(i) of this section), such contractor may either use a long-term
contract method for all the contracts of both types or use a long-term contract
method for the 15-month contracts and another proper method of accounting for
the 5-month contracts. If a taxpayer distinguishes between contracts of
substantial duration and other long-term contracts of less than substantial
duration, he must adhere to a consistently applied standard for determining
substantial duration.
This did not mean that a contractor could use two different long-term contract methods, as it
relates to “long-term contracts of less than substantial duration.” A contractor may not use two
different methods of long-term contract accounting except to comply with code Section 460 (See
examples described in Rev. Rul. 92-28). Previously, for contracts of less than substantial
duration, where the regular contracts are reported under the EPCM, the method utilized must be
the straight accrual method with contract costs deferred or capitalized under IRC Section 471.
For large contractors, the proposed 460 regulations issued in January of 2002, seem to address
this issue under the subject of “classifying long-term contracts.” Review Proposed sections
1.460-1(f)(1) and 1.460-1(f)(3):
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1.460-1(f)(1) Classifying contracts: A taxpayer must determine the classification
of a contract (e.g., as a long-term manufacturing contract, long-term construction
contract, non-long-term contract) based on all the facts and circumstances known
no later than the end of the contracting year.
1.460-1(f)(3) Method of accounting. A taxpayer’s method of classifying contracts
is a method of accounting under section 446 and, thus, may not be changed
without the Commissioner’s consent. If a taxpayer’s method of classifying
contracts is unreasonable, that classification method is an impermissible
accounting method.
Without specifically addressing the issue of contracts of less than substantial duration, the
proposed regulations stated that if you start such a classification, you will need to continue as
such unless the taxpayer receives permission to change.
Following the same theme, then, as the superceded 1.451-3 regulations did, it would seem that if
a large contractor had contracts of less than substantial duration, they would be at least required
to account for these under the accrual method along with costs inventoried under 263A rules and
not Section 471.
The problem with the issue of “contracts of less than substantial duration” was always one of
identification. It is rare that a contractor can say or prove with certainty that they have a group of
contracts that are distinguishable based upon time length (usually contractor contracts lengths
vary, but are not able to be clearly broken into time groups), or if the contractor could track such,
that they have treated or tracked those contracts as such an accounting method consistently to
qualify as an accounting method.
Also, note that “contracts of less than substantial duration” are not to be distinguished based
upon size of contract, but rather only on length of term. The final regulations, in the
“Explanation of Provisions,” the preamble to the actual regulations, laid to rest any further
potential use of the “contracts of less than substantial duration” method when it stated that: “one
commentator suggested that the final regulations incorporate the rule under Sec. 1.451-3(a)(1)
that allows a taxpayer to account for long-term contracts of less-than-substantial duration using a
method of accounting other than a long-term contract method of accounting. The IRS and
Treasury Department did not adopt this suggestion because such a rule would be inconsistent
with the statutory definition of “long-term contract.” Therefore, if a contractor is currently
employing such a method, the contractor must utilize the [automatic] provisions of Rev. Proc.
2002-9 in order to change and eliminate the method.
Summary: Available Methods when IRC Section 460 does not Apply
For a contractor or home construction contractor in general, the available methods include
(subject to IRC Section 446, clear reflection of income doctrine) as authorized by 1.460-1, the:
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Chapter 1







Cash Method
Hybrid Method
Accrual Method
Accrual Method Excluding Retention
Completed Contract Method (CCM)
Exempt Percentage of Completion Method (EPCM)
Percentage of Completion Method under 460 (PCM)
For Homebuilders (building speculative homes), the available methods are (again subject to IRC
Section 446) (all of the methods listed above are available for home builders that are building
contracted homes):
Small Homebuilder:

Accrual, with inventories capitalized under Section
471 and interest capitalized under 263A31
Large Homebuilder:

Accrual, with inventories and interest capitalized
Under Section 263A32
Available Accounting Methods when IRC Section 460 is Applicable
When IRC Section 460 is applicable, a contractor may have available the following methods:

Percentage of Completion (PCM) under Code Section
460(b)33

Percentage of Completion Capitalized Cost Method
(PCCM) under 460(a)34

Simplified Cost-to-Cost Method35

10% Deferral, PCM, under Section 460(b)(5)36
31
Section 1.460-1(a)(2), 1.460-4(c)
Section 1.460-1(a)(2), 1.460-5(d)(3)
33
Section 1.460-4(b)
34
Section 1.460-3(c), 1.460-4(e)
35
Section 1.460-5 (c)
36
Section 1.460-4(b)(g)
32
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FOOTNOTES:
1
General Overview of Tax Rules and Methods
Chapter 1
Appendix 1-A - APPLICATION OF CODE SECTION 460 AS OF APRIL 12, 2002
(After Issuance of Rev. Proc. 2002-28)
No
Yes
Does the taxpayer have
any long-term contracts?2
Yes
Yes
Are any of the contracts
“home construction contracts”3
Meet Qualifying Small
Business Exception of
Rev. Proc. 2002-28?
No
Is the small contractor’s
exemption in Sec.
460(e)(1)(b) met?
No
Yes
Speculative homes
constructed?
No
Is the small contractor’s
exemptions in Section
460(e)(1)(b) met?4
No
Has the taxpayer elected
the percentage-ofcompletion method?
No
Yes
Section 1.460-1(d)(2)
Section 1.460-1(b)
3
Section 1.460-3(b)(1)(i)
4
Section 1.460-3(b)(1)(ii)
5
Section 1.460-6
6
Section 1.460-4(f)
7
Section 1.460-6(b)(4)
8
Section 1.460-6(b)(2)
2
Yes
Speculative homes
constructed?
Yes
Were any of the contracts
“residential construction
contracts?”
No
Yes
No
No
Yes
Yes
Exempt from
Code Section
460 and Reg.
Section
1.460-1.
Methods can
be cash,
accrual or
hybrids,
subject to
Code Sec.
446 clear
reflection of
income.1
Can use
cash
method for
regular
accounting
method or
for longterm
contract
treatment.
A CCH Seminar
The 70/30 PCCM method can
be elected in accordance with
Code Section 460(e)(5):
Look-back is applied to the
70%.
AMT is computed using the
100% PC method.
PC method must be
applied with Code
Sec. 460.
Look-back must be
applied to each
contract. 5
RRA “89 allows the
tax-payer to postpone
the use of the PC
method until 10% of
the cost has been
incurred.
Simplified cost
method also available.
The rules found in
1.460-5 apply
except:
Production period
interest must be
capitalized.
AMT is computed
using the 100% PC
method. 6
Look-back must be
applied to the AMT
calculation. 7
27
Exempt from
Code Sec. 4603;
however the
following rules
apply:
Production period
interest must be
capitalized.
Uniform
capitalization
rules in Section
263A apply.
AMT is not
required.
Exempt from Code
Sec. 4603; however
Accrual method
applies.
Can elect PCM or
CCM methods
AMT does not
apply
Capitalize interest
under 460(c)(3)
Exempt from
Code Sec. 460;
however the
following rules
apply3:
Production period
interest must be
capitalized.
AMTdoes not
apply.
Can elect cash,
accrual,
completed
contract or PCM.
Exempt from
Code Sec. 460;
however the
following rules
apply3:
Production period
interest must be
capitalized.
Accrual method
applicable with
inventories
capitalized under
Sec. 471.
AMT does not
apply.
Tax Accounting Methods for Construction Contractors,
Developers and Homebuilders
General Overview of Tax Rules and Methods
Chapter 1
Appendix 1-B Revenue and Cost Recognition for Contractor Tax Methods
Method
Revenue Recognition
Cost Recognition
Cash

As billings are received

As expenses are paid,
except for depreciation and
capitalization rules
Accrual
(SAM)

Based upon billing
entitlement, or
practically, as
Based upon billings
issued37

Based upon economic
performance regulations of
IRC Sec. 461(h)
Based upon billing
entitlement or billings
less retainages deferred
under the contract
Recognition of
retainages, once entitled
to receive38

Based upon economic
performance regulations of
IRC Sec. 461(h)
Billings or total contract
price once contract is
finished and accepted39

Costs are deferred as
incurred. Specific costs are
outlined in Regs. 1.460-5
Once completed, costs are
closed out to expense
SG&A costs are expensed
as incurred
See CCM Chapter for
expense recognition for
disputed contracts

Accrual Excluding
Retention


Completed Contract
(CCM)





See CCM Chapter for
revenue recognition for
disputed contracts
37
See Chapter on Accrual Method
See Chapter on Accrual Method
39
Section 1.460-4(d)(1)
38
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Appendix 1-B (Cont’d.)
Method
Revenue Recognition
Exempt Percentage of  Contract price (including 
Completion (EPCM)
change orders) multiplied
by percent complete
 Percent complete

determined by various
alternative methods, such 
as
 Cost-to-cost
 Labor hours to total
labor hours
 Various other
permitted input
and/or output
measurements40
Section 460(b)
Percentage of
Completion (POC)

Revenues determined by
only one formula, the
cost-to-cost POC
formula41



Section 460
Simplified Cost-toCost Method
460(b)(3)

Same formula as Sec.
460(b), except costs are
determined as outlined
by 460(b)(4)



40
41
Cost Recognition
Based upon economic
performance regulations of
IRC Sec. 461(h)
Costs determined by Reg.
1.460-5
All costs are expensed as
incurred
Based upon economic
performance regulations of
IRC Sec. 461(h)
Costs determined by Reg.
1.460-5
All costs are expensed as
incurred
Based upon economic
performance regulations of
IRC Sec. 461(h)
Job costs are direct material,
direct labor and
depreciation, amortization,
and cost recovery on
equipment directly used
All costs are expensed as
incurred
Section 1.460-4(c)(2)
Section 1.460-4(b)
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Percentage of
completion
capitalized cost
method (residential
contractors)
(PCCM)

70 % Section 460(b)
POC, 30 % exempt
contract method42




10 Percent Deferral
Method

Same as Sec. 460(b)

above, except that
revenues and billings on
all contracts with less

than 10% complete,
determined by cost-to
cost formula, are deferred
until greater than 10%
complete43
Chapter 1
70% based upon economic
performance regulations of
IRC Sec. 461(h)
Costs determined by Reg.
1.460-5
All costs are expensed as
incurred
30 % exempt contract cost
recognition
Based upon economic
performance regulations of
IRC Sec. 461(h)
All costs are expensed as
incurred
All costs on contracts less
the 10% complete are not
expensed as incurred, but
rather are deferred in an
account similar to an
inventory account (but
rather are capitalized in this
account.)
Note: Revenue Procedure 2002-28 generally permitting the use of the cash method, as clarified
by IRS Announcement 2002-45 (April 15, 2002), also permits the use of the cash method even
when a specific method (i.e. long-term contract treatment or method) is retained. This introduces
the possibility of a contractor using the cash completed contract method for example, or cashPOC method. Under these methods the cash method is utilized for all completed contracts, that
were never uncompleted as of any filing year-end, and the long-term method (CCM or PCM),
based on an accrual underlying foundation, is utilized for any uncompleted contracts, as of year
end. Further explanation regarding accounts receivable (AR) and payable (AP) is that AR and
AP related to completed contracts would not be recognized under the cash method as long as the
completed contract was not uncompleted as of the beginning of the year but the AR or AP
related to uncompleted contracts would be recognized.
42
43
Section 1.460-4(e)
Section 1.460-4(b)(6)
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Appendix 1-C – Retainage Reporting Timing
Percentage Retained: It is typical in both fixed-price and cost-plus type contracts for various
amounts of retainages to be included in the contract. For example, a typical contract may
provide for a retention of 10 percent of the contract price until the contract is completed and
accepted. The tax treatment of the percentage retained will be governed by the method of
accounting being used.
Method:
Recognition Criteria
Cash
Contract retainages are reportable by the taxpayer when
they are actually or constructively received.
Accrual
Contract fee retainages are includable in the gross income of
a contractor when the retainages are billable. In Rev. Rul.
69-314, 1969-1 C.B. 139, the Service indicated that an
accrual basis taxpayer need not include fee retainages in
gross income until the taxpayer has an unconditional right to
receive such retainages. The ruling further provides that if a
taxpayer must switch from the current accrual to the deferral
of retainages, such change constitutes a change in the
method of accounting for which prior consent of the
Commissioner must be obtained. But the language in the
ruling suggests that the current accrual of retainages is
permissive rather than mandatory.
Percentage of
Retainages are considered part of the overall gross contract
Completion
price. Therefore, they are reported in income as a
percentage of the contract becomes complete under the
POC formula..44
Completed Contract Fee retainages under the completed contract method are
reportable as income when the contract is finally completed
and accepted.45
Note: Some accounting firms are trying to sell an “opportunity,” the IRS refers to as a “tax
shelter.” The idea is that revenue recognition can be deferred based upon an assertion that
retainage payable is not to be recognized as a job cost until paid. Their argument continues that,
based upon the POC formula of cost-to-date divided by total estimated job costs, a lesser
percentage of completion factor would result, thereby reducing the revenue earned. The IRS has
responded that they will not recognize such a position as legitimate, as retainage payable
becomes a job cost based upon the economic performance regulation of Code Section 461.
Under Code Section 461, the economic performance occurs, with regard to a service, either when the services are
provided or payment occurs, depending on what event occurs first. IRS states that because the services were already
provided (retention of a certain payment amount does not change the fact that services were provided) and as such
44
45
Section 1.460-4(b)(4)
Section 1.460-4(d)(3)
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must be recognized as a job cost to date in the POC formula. Any accounting method change made without
46
permission will be considered an impermissible method and will require amended returns to correct.
“Filing a change in accounting method application for the deferral of subcontractor retainages until “all
events” test has been met is not a certainty-it must match the underlying facts and circumstances. The
appropriate treatment is determined by the “all events” test as outlined in Reg. Section 1.461-1 (a) (2) (i)
and IRS Section 461 (h). Note the key wording of the CIP cited above: “owner has accepted the work” and
“if there is no dispute as to acceptance, economic performance has occurred and the retainages payable
must be recognized as contract costs.” If under the contract between the contractor and the subcontractor,
the contractor is liable for payment to the subcontractor once the contractor has submitted its bill to the
owner for example, then such a subcontractor bill or retainages payable must be included in the contractors’
POC formula. On the other hand, if the contractor’s liability to the subcontractor were conditioned upon
the owner’s acceptance, deferral of inclusion of the subcontractor’s billing in the POC formula, until the
acceptance, would be appropriate.
If a contractor has missed this opportunity before, where the con tract terms are conditioned upon the
owner’s acceptance, a change in accounting method, form 3115, will be required in order to defer these
costs from the POC formula. On the other hand, if the underlying terms of the contract are changed, a
contractor can claim a change in underlying facts and circumstances and avoid a change request as long as
treatment is consistently applied. This means that a contractor can defer the subcontractor retainage payable
when facts support the deferral and include them on other contractors when facts require it.”
46
Coordinated Issue Paper: Appeals Industry Specialization Program. Construction/Real Estate Industry –
Retainage Payable, Coordinated Issue Paper, March 08, 2002.
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Appendix 1-D – Severing and Combining Contracts under
Section 460 Final Regulations
The IRS issued final regulations under Regulation Section 1.460-1(e) providing guidance on
allocating, severing, and aggregating long-term contracts.
The regulations allow the IRS, and generally require a taxpayer, to sever and aggregate contracts
when necessary to clearly reflect income. More specifically, the regulations modify prior
severing and aggregation rules to emphasize pricing and to prevent severance by taxpayers of
contracts accounted for using the percentage of completion method (PCM) of accounting without
obtaining the commissioner’s prior written consent.
Prior Rules and Regulations
(Note: The following section was superceded by Reg. Sec. 1.460-1(e) effective January 11,
2001. (This explanation is retained as prior rules and regulations still govern transactions
and situations prior to January 11, 2001.))
When applying long-term accounting methods, a taxpayer could treat several agreements that are
interdependent (by reason of pricing or otherwise) as one contract or can sever one agreement
into several contracts. The IRS could also require taxpayers to aggregate or sever contracts.
(See Code Section 460(f)(3) and Notice 89-15, Q&A 38 & 39.)
The combination or severance of long-term contracts is allowed to determine contract
completion dates in order to ensure that the chosen accounting method properly reflects the
income received. Per regulation 1.451-3(e)(1), contracts may be severed or aggregated by the
IRS to prevent the taxpayer from unreasonably deferring income or from prematurely claiming a
deduction for loss. This treatment is not meant to be used as a means of separating elements of
an agreement that are ineligible for long-term contract accounting from those that are eligible.
The factors applicable to the determination to combine or sever a contract are distinct from those
considered with respect to ineligibility.
The combination or severing of a long-term contract depends on all of the facts and
circumstances relevant, including (but not limited to) the following factors:
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whether the parties have agreed to separately deliver or
accept each of the units to be completed under the contract;

whether the units are independently priced;
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(Note: The following section was superceded by Reg. Sec. 1.460-1(e) effective January 11,
2001)

whether there is a business purpose for entering into one
agreement rather than several, or several contracts rather
than one;

whether the customary commercial practice is to make
single or separate contracts;

whether the parties have afforded similar treatment to any
previous arrangements that they made with each other;

whether the nature of the subject matter of the contract is
such that the units to be completed are distinct from each
other or are interrelated;

whether the parties subsequently increase the total number
of units to be constructed, manufactured, or installed under
the original contract; and

whether the anticipated time lapse between the completion
of each unit is brief or lengthy.
For example, if the price to be paid for similar units is determined under different terms or
formulas, then the difference in pricing terms or formulas may indicate that the agreement should
be treated as several contracts.
The above factors do not all need to be present (or absent) for a contract to be combined or
severed, rather the determination is made by balancing these factors in a consideration of each
particular situation.
Generally, Regulation Section 1.451-3(e)(1) says one agreement is not required to be treated as
several contracts unless at least one of the following is present:


The agreement contemplates the separate delivery or
acceptance of portions of the subject matter.
A business purpose exists for entering into several
contracts, but not for making a single agreement.
The existence of either of the above factors does not automatically require that the agreement be
severed when other contrary factors are present. Additional factors are the primary subject
matter of the agreement(s) and the business purpose.
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(Note: The following section was superceded by Reg. Sec. 1.460-1(e) effective January 11,
2001)
Primary vs. No Primary Subject Matter
The fact that one agreement covers more than one item, but has no primary subject matter, is
evidence that there is no business purpose for entering into a single agreement rather than several
contracts. When there is a primary subject, the agreement may be divided if, at the end of the tax
year, the agreement has been completed with respect to the primary subject, but not the other
items.
Example: In 20X1, XYZ engaged ABC Construction to build a four-story office building. One
year later, ABC finished the building structure, plus the finish on the first two floors. XYZ
accepted the completed floors and moved its offices into them. Construction continued on the
remaining floors and was completed and accepted in 20X2.
Even though various portions of the building were accepted on different dates, the IRS found that
the subject of the contract was to complete both the building structure and each floor, there being
no primary and secondary subject matter. Moreover, the parties had a business purpose to enter
into a single contract (i.e., the construction of an entire office building), rather than several
agreements. Consequently, the agreement ordinarily would not be severed into separate
contracts for applying ABC’s long-term contract accounting method.
Logical Business Purpose
The following information was superceded:
Several interdependent agreements usually are not combined unless there is a business purpose
for entering into a single contract, rather than for entering into separate agreements. For
example, a party who makes two related agreements is deemed to have a business purpose to
form a single contract if, under similar circumstances, a reasonable business person would not
have made one agreement without entering into the other.
Additionally, a party may make one agreement despite its low profit margin if the party also
makes a second agreement with the same person, but with more favorable terms that increase the
potential profit overall. This is evidence that the agreements should be considered as one
contract for applying the long-term contract method of accounting.
In making the combination determination, the order in which the agreements were entered into or
performed, as well as the feasibility of performing one agreement without the prior, or
contemporaneous performance of the other, is disregarded. The date of completion, therefore,
does not depend on whether the parties make the more favorable agreement first or whether the
performance of one agreement will assist in the completion of the other.
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Example: In 20X1 DEFG Contractors, Inc. and the State of Ohio entered into two agreements at
about the same time and as a result of the same series of negotiations. Each contract required
(Note: The following section was superceded by Reg. Sec. 1.460-1(e) effective January 11,
2001)
DEFG to construct a bridge of the same size, type and specifications: one to be completed in
20X8 and the second in 20X9.
Because DEFG, Inc. had not previously built this type of bridge, the parties anticipated that the
costs DEFG would incur for the first bridge would be substantially higher than those costs for the
second. Therefore, the first agreement could result in little or not profit, while the second could
provide substantial profits. A reasonable business person would not have entered into the
agreement to construct the first bridge at the price specified without also making the second
agreement. If necessary to clearly reflect income, DEFG must combine the two agreements and
treat them as one long-term contract for applying a long-term contract method of accounting.
Expectation is Not Sufficient
The following information was superceded:
Interdependent contracts are not treated as a single agreement simply because the parties expect
to execute a second agreement after making the first. Merely expecting that the parties will enter
into a second agreement is not evidence that the two agreements should be aggregated.
Example: Under a contract executed in 20X0, MNOP, Inc. agreed to construct 100 miles of
highway for the State of West Virginia by 20X2. When the initial agreement was made, MNOP,
Inc. anticipated that the state would contract for 200 more miles of highway on the same
interstate over the next 5 years. In negotiating the price of the first contract, the parties
accounted only for the total cost expected for constructing the first 100 miles, the risks and the
opportunities associated with the initial agreement, and any other factors that the parties
considered relevant.
MNOP, Inc. decided to enter into the agreement regardless of whether the parties would actually
make future agreements. However, MNOP, Inc. would most likely not have made the agreement
but for the expectation that the parties would enter into additional contracts.
In 20X2 MNOP, Inc. completed and opened 100 miles of highway. That same year, the parties
agreed to a new contract by which MNOP, Inc. would construct 100 more miles. In negotiating
the price for the new contract, the parties considered the fact that the expected costs for the new
contract would differ from those costs for the previously completed miles.
The price for each one of the two contracts took into account the expected total costs and the
inherent risks attendant to that particular contract. Also, the terms agreed on for each contract
were independent of the terms agreed on for the other. Despite the related subject matter and the
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expectations of the parties, the two contracts cannot be aggregated into one agreement for
applying MNOP, Inc.’s long-term contract method.
Identical Parties
Interdependent contracts negotiated and entered into over several years and whose contracting
parties are not identical cannot be aggregated.
Prior IRS Rules
IRC Section 460 rules and superceded Reg. 1.451-3(e) stated that the IRS alone is authorized to
treat one agreement as several contracts or to treat several agreements as one contract for
extended period long-term contracts. Thus, a taxpayer entering into one agreement cannot treat
that agreement as several separate contracts unless the agreement is actually changed into several
agreements. An agreement may be changed into several agreements if the number of items to be
supplied under the agreement is increased by the exercise of an option or the issuance of a
change order. (See current treatment below).
Final 460 Regulations – Current Treatment After January 11, 2001:
The final 460 regulations define and explain the existing code concerning the allocation,
severing, and aggregation of long-term contracts, receipts and costs.
Must be Long-Term Contracts
The long-term contract methods of accounting apply only to the gross receipts and costs
attributable to long-term contract activities.47 Gross receipts and costs attributable to long-term
contract activities are amounts included in either the total or gross contract price (whichever is
applicable) and costs allocable to the contract.48 Generally, non-long-term contract activity must
be taken into account using permissible methods of accounting other than a long-term contract
method, such as the cash or accrual method.49
The exception to this rule, of prohibition of the use of a long-term contract method, is that if the
performance of a non-long-term contract activity is incidental to or necessary for the 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 longterm contract benefited.50
47
1.260-1(b)(10), 1.460-1(d)(1).
1.460-1(d)(1).
49
Ibid.
50
Ibid
48
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Also, the opposite is true, such as where a single long-term contract requires a taxpayer to
perform a non-long-term contract activity that is not incidental to or necessary for the 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 (accrual or cash), other than a longterm contract method.51
Non-long-term contract activity is defined as the performance of an activity other than building,
installation, or construction (examples are the provision of architectural, design, engineering, and
construction management services); and/or the performance under a guarantee, warranty, and
maintenance agreement.52
Severing and Aggregation
After allocations to non-long-term contract activities, if any, the severing and aggregating rules
of the 460 regulations are applied by either the IRS or the taxpayer, as necessary, to clearly
reflect income. The purpose of the severing and/or aggregation rules is to prevent the
unreasonable deferral or acceleration of income on the premature recognition or deferral of
loss.53 A taxpayer generally must determine whether to sever an agreement or to aggregate two
or more agreements based on all the facts and circumstances known at the end of the contracting
year. Whether an agreement should be severed, or two or more agreements should be aggregated
depends on several factors:54

Independent pricing of items in a single agreement is necessary for the agreement to be
severed into two or more contracts. In the case of an agreement for several similar items,
if the price to be paid for the items is determined under different terms or formulas, the
difference in the pricing terms or formulas indicates that the items are independently priced.
(For example, if some items are priced under a cost-plus incentive fee arrangement and later
items are priced under a fixed-price arrangement, the items are considered to be
independently priced.)55

Interdependent pricing of items in separate agreements is necessary for two or more
agreements to be aggregated into one contract. A single price negotiation for similar
items ordered under one or more agreements indicates that the items are independently
priced.56

An agreement may not be severed into two or more contracts unless the agreement
provides for separate delivery or separate acceptance of items that are the subject
51
Ibid.
1.460-1(d)(2).
53
1.460-1(e)(1).
54
1.460-1(e)(2).
55
1.460-1(e)(2)(i).
56
Ibid.
52
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matter of the agreement. However, the separate delivery or separate acceptance of items by
itself does not necessarily require an agreement to be severed.57

Two or more agreements to perform construction activities may not be aggregated into
one contract unless a reasonable business person would not have entered into one of the
agreements for the terms agreed upon without also entering into the other agreements.
Similarly, an agreement to perform construction activities may not be severed into two or
more contracts if a reasonable business person would not have entered into separate
agreements containing terms allocable to each severed contract. Analyzing the reasonable
business-person standard requires an analysis of all the facts and circumstances of the
business arrangement between the taxpayer and the customer. For this reasonable businessperson test, a taxpayer’s expectation that the parties would enter into another agreement,
when agreeing to the terms contained in the first agreement is not relevant.58
General Rules
Notwithstanding the above criteria for severing and aggregating, two general rules apply under
the 460 regulations:

A taxpayer may not sever a long-term contract that would be
accounted for using the PCM without obtaining the commissioner’s
prior written consent.59

Options and Change Orders – except for the PCM, a taxpayer must
sever an agreement that increases the number of units to be supplied to
the customer, such as through the exercise of an option or the
acceptance of a change, if (1) the agreement provides for separate
delivery or (2) separate acceptance of the additional units.60
Examples of Severance or Aggregation from the Final Regulations:
Severance. On January 1, 2001, C, a construction contractor, and B, a real estate investor, enter
into an agreement requiring C to build two office buildings in different areas of a large city. The
agreement provides that the two office buildings will be completed by C and accepted by B in
2002 and 2003, respectively, and that C will be paid $1,000,000 and $1,500,000 for the two
office buildings, respectively. The agreement will provide C with a reasonable profit from the
construction of each building. Unless C is required to use the PCM to account for the contract, C
is required to sever this contract under paragraph (e)(2) of this section because the buildings are
independently priced, the agreement provides for separate delivery and acceptance of the
57
1.460-1(e)(2)(ii).
1.460-1(e)(2)(iii).
59
1.460-1(e)(3)(i).
60
1.460-1(e)(3)(ii).
58
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buildings, and, as each building will generate a reasonable profit, a reasonable businessperson
would have entered into separate agreements for the terms agreed upon for each building.61
Severance. C, a large construction contractor whose taxable year ends December 31, accounts for
its construction contracts using the PCM and has elected to use the 10-percent method described
in §1.460-4(b)(6). In September 2001, C enters into an agreement to construct four buildings in
four different cities. The buildings are independently priced and the contract provides a
reasonable profit for each of the buildings. In addition, the agreement requires C to complete one
building per year in 2002, 2003, 2004, and 2005. As of December 31, 2001, C has incurred 25
percent of the estimated total allocable contract costs attributable to one of the buildings, but
only five percent of the estimated total allocable contract costs attributable to all four buildings
included in the agreement. C does not request the Commissioner’s consent to sever this contract.
Using the 10-percent method, C does not take into account any portion of the total contract price
or any incurred allocable contract costs attributable to this agreement in 2001. Upon examination
of C’s 2001 tax return, the Commissioner determines that C entered into one agreement for four
buildings rather than four separate agreements each for one building solely to take advantage of
the deferral obtained under the 10-percent method. Consequently, to clearly reflect the taxpayer’s
income, the Commissioner may require C to sever the agreement into four separate contracts
under paragraph (e)(2) of this section because the buildings are independently priced, the
agreement provides for separate delivery and acceptance of the buildings, and a reasonable
businessperson would have entered into separate agreements for these buildings.62
Aggregation. In 2001, C, a shipbuilder, enters into two agreements with the Department of the
Navy as the result of a single negotiation. Each agreement obligates C to manufacture a
submarine. Because the submarines are of the same class, their specifications are similar.
Because C has never manufactured submarines of this class, however, C anticipates that it will
incur substantially higher costs to manufacture the first submarine, to be delivered in 2007, than
to manufacture the second submarine, to be delivered in 2010. If the agreements are treated as
separate contracts, the first contract probably will produce a substantial loss, while the second
contract probably will produce substantial profit. Based upon these facts, aggregation is required
under paragraph (e)(2) of this section because the submarines are interdependently priced and a
reasonable businessperson would not have entered the first agreement without also entering into
the second.63
Aggregation. In 2001, C, a manufacturer of aircraft and related equipment, agrees to manufacture
10 military aircraft for foreign government B and to deliver the aircraft by the end of 2003.
When entering into the agreement, C anticipates that it might receive production orders from B
over the next 20 years for as many as 300 more of these aircraft. The negotiated contract price
reflects C’s and B’s consideration of the expected total cost of manufacturing the 10 aircraft, the
risks and opportunities associated with the agreement, and the additional factors the parties
considered relevant. The negotiated price provides a profit on the sale of the 10 aircraft even if C
does not receive any additional production orders from B. It is unlikely, however, that C actually
61
1.460-1(j).
Ibid.
63
Ibid.
62
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would have wanted to manufacture the 10 aircraft but for the expectation that it would receive
additional production orders from B. In 2003, B accepts delivery of the 10 aircraft. At that time,
B orders an additional 20 aircraft of the same type for delivery in 2007. When negotiating the
price for the additional 20 aircraft, C and B consider the fact that the expected unit cost for this
production run of 20 aircraft will be lower than the unit cost of the 10 aircraft completed and
accepted in 2003, but substantially higher than the expected unit cost of future production runs.
Based upon these facts, aggregation is not permitted under paragraph (e)(2) of this section.
Because the parties negotiated the prices of both agreements considering only the expected
production costs and risks for each agreement standing alone, the terms and conditions agreed
upon for the first agreement are independent of the terms and conditions agreed upon for the
second agreement. The fact that the agreement to manufacture 10 aircraft provides a profit for C
indicates that a reasonable businessperson would have entered into that agreement without
entering into the agreement to manufacture the additional 20 aircraft.64
The newest Audit Technique Guide for Construction, released in late 2004, provided the
following statements and examples on this overall issue:
Severing and Aggregating Contracts
Under IRC § 460(f)(3), contractors are permitted and may be required to sever or aggregate contracts.
Severance treats one agreement as two or more contracts. Aggregation treats two or more agreements as
one contract. Whether an agreement should be severed, or two or more agreements should be aggregated,
depends, with certain exceptions, on the following factors as provided in Treas. Reg. § 1.460-1(e):
Pricing. Independent pricing of items in an agreement is necessary for the agreement to be severed into two
or more contracts.
Separate delivery or acceptance. An agreement may not be severed into two or more contracts unless it
provides for separate delivery or separate acceptance of items that are the subject matter of the agreement.
The separate delivery or separate acceptance of items by itself does not, however, necessarily require an
agreement to be severed.
Reasonable business person. Two or more agreements to perform manufacturing or construction activities
may not be aggregated into one contract unless a reasonable business person would not have entered into
one of the agreements for the terms agreed upon without also entering into the other agreement(s).
A taxpayer may not sever a long-term contract that would be subject to the percentage of completion
method without obtaining the Commissioner's prior written consent.
Treas. Reg. § 1.460-1(e)(3). Exceptions- - (i) Severance for PCM. A taxpayer may not sever under this
paragraph (e) a long-term contract that would be subject to the PCM without obtaining the
Commissioner's prior written consent.
In the case of options and change orders, subject to the above Treasury Regulation, a taxpayer must sever
an agreement that increases the number of units to be supplied to the customer, such as through the exercise
of an option or the acceptance of a change order, if the agreement provides for separate delivery or separate
acceptance of the additional units.
Example of Severance:
64
Ibid.
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On January 1, 2001, a construction contractor enters into an agreement to build two office buildings in
different areas of a large city. The agreement provides that the two office buildings will be completed and
accepted by the customer in 2002 and 2003, respectively, and that the contractor will be paid $1 million
and $1.5 million for the two office buildings, respectively. The agreement will provide a reasonable profit
from the construction of each building. Unless the contractor is required to use the PCM to account for the
contract, the contractor is required to sever this contract because the buildings are independently priced, the
agreement provides for separate delivery and acceptance of the buildings, and, as each building will
generate a reasonable profit, a reasonable business person would have entered into separate agreements for
the terms agreed upon for each building.
Example of Aggregation:
In 2001, a contractor enters into two separate contracts, as the result of a single negotiation, to construct
two identical special use buildings (i.e. nuclear plant). Because the contractor has never constructed this
type of building before, the contractor anticipates that it will incur substantially higher costs to construct the
first building. If the agreements are treated as separate contracts, the first contract probably will produce a
substantial loss, while the second contract probably will produce substantial profit. Based upon these facts,
aggregation is required because the buildings are interdependently priced and a reasonable business person
would not have entered the first agreement without also entering into the second.
Example of Contract Options:
A contractor enters into a contract with a developer to construct 10 homes on land owned by the developer
to be built in year 1. The contract provides an option in which the contractor is to build an additional 10
homes. In year 2, the option is exercised and the additional homes are built. The option would be severed
from the original contract.
Disclosure
Previously, taxpayers severing or aggregating long-term contracts were not required to disclose
this on their income tax returns.
The Final 460 Regulations Require Disclosure
Per 1.460-1(e)(4) if a taxpayer severs an agreement or aggregates two or more agreements during
the tax year, the taxpayer must attach a statement to its original federal income tax return for that
year. This statement must contain the following information:

the legend, “NOTIFICATION OF SEVERANCE OR
AGGREGATION UNDER SEC. 1.460-1(e);

the taxpayer’s name; and
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the taxpayer’s employer identification number or social
security number.
The proposed 460 Regulations had required the following additional information, but the final
regulations no longer require agreement specific information.

the identity of each agreement being severed or aggregated;

the method of accounting used for each contract; and

a description of the reason or reasons for severance or
aggregation.
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Appendix 1-E - Example of Reasonable Compensation Issues
for an “S” Contractor
Reasonable compensation issues, and the IRS assertion of them, is a frequent audit proposed
adjustment. Advisors to contractors should be prepared to address and assist contractors in
planning for this possible IRS concern. The following is an example of a discussion of
reasonable compensation for ABC Company, an “S” corporation construction company.
Summary of ABC’s Statistics
Fiscal Year
Ending 3/31
2000
1999
1998
1997
1996
1995
Sales
27,382,000
23,433,000
21,456,000
21,081,000
17,049,000
21,549,000
Net Income
1,488,000
1,148,000
402,000
691,000
611,000
1,187,000
Total Compensation:
Bill
Bob
595,761
543,111
444,911
442,311
415,643
343,043
194,935
149,473
164,929
126,465
164,832
124,347
Total
1,138,872
887,222
758,686
344,408
291,394
289,179
Reasonable Compensation
The Internal Revenue Service raises the issue of reasonable compensation more often in
subchapter C corporation situations rather than in S corporation environments. (ABC is an S
corporation.) This is due to the potential of reclassification by theirs of compensation paid to
dividends. In a C corporation dividends are non-deductible at the corporate level and taxable at
the individual level. Under this situation, the Service achieves a double assessment, raising the
taxes on the corporation while also taxing the individual on the dividends. This situation does
not occur in an S corporation. In an S environment, the issue of reasonable compensation is
often one of unreasonably low compensation, where the owners seek to avoid payroll taxes on
wages paid. Where this circumstance does not exist of unreasonably low wages, challenges to
the reasonableness of compensation rarely arise in the context of an S corporation because the
income of the corporation is taxed directly to its shareholders. However, the issue of reasonable
compensation may still be an issue in an S corporation when the Service believes that
compensation paid is being used to alter the ratio of income to deductions among shareholders.
For example, there may be an attempt to increase the compensation, and thus the taxable income,
of one shareholder/employee so that another shareholder/employee in a higher personal tax
bracket has a lower taxable income. (See Krahenbuhl v Commr, TC memo 1968-34, 27 TCM
155.) Although there is this shift in emphasis in the case of an S corporation, with the Service
trying to keep salaries up to a reasonable limit rather than down, the factors used to determine
reasonableness remain the same. (See Summit Sheet Metal Co v Commr, TC Memo 1996-563,
72 TCM 1606.)
There are two relevant and recent construction company court cases that one can consider and
review concerning the factors used to determine reasonableness of compensation. (See Choate
Construction Co v Commr, TC Memo 1997-495, 74 TCM 1092, and Summit Sheet Metal.)
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Choate is a C corporation and Summit is an S corporation, however, as noted above, the factors
considered for reasonable compensation are the same. In addition, both of these cases are
construction companies; therefore the consideration of the pertinent reasonableness factors has
high applicability to contractors in general.
Reasonable Compensation Factors
The factors considered by these courts in deciding if compensation is reasonable in amount are
(1) employee’s qualifications; (2) nature and scope of the employee’s work; (3) the size and
complexity of the business; (4) general economic conditions; (5) the employer’s financial
condition; (6) a comparison of salaries paid with sales and net income; (7) distributions to
shareholders and retained earnings; (8) whether the employee and employer dealt at arm’s
length, and if not, whether an independent investor would have approved the compensation; (9)
the employer’s compensation policy for all employees; (10) prevailing rates of compensation for
comparable positions in comparable companies; (11) compensation paid in prior years; and (12)
whether the employee guaranteed the employer’s debt. The factors are not considered by the
court in any particular priority order or significance. Rather, the preponderance of factors and
overall the facts and circumstances determines the reasonableness issue. Each factor will be
discussed as it relates to ABC and Bill and Bob.
Factor (1) Employee’s Qualifications
An employee’s superior qualifications for his position with the business may justify high
compensation. Both Bill and Bob are well qualified for his position. All performed successfully
for ABC for many years.
This factor tends to show that the compensation at issue was reasonable.
Factor (2) Nature, Extent, and Scope of Duties
The position held by the employee, hours worked, duties performed, and the importance of the
employee to the success of the company may justify high compensation. Each officer was
responsible for an important part of ABC’s operations over the past several years. Anyone
would concede that both contributed significantly to ABC’s success over the years. By year
2000, ABC was a well-established and stable business. Bill and Bob worked less over the years
as the business became more stable but this was expected and normal in a business evolution.
This factor tends to show that the compensation at issues was reasonable.
Factor (3) Business Size and Complexity
The size and complexity of a business can indicate whether compensation is reasonable. ABC is
considered a large specialty construction contractor. There are very few contractors doing
ABC’s types of work with the amount of sales that ABC has achieved. ABC has various lines of
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work that each requires specialization. ABC achieved about $27 million in sales for last fiscal
year with significant assets and equity on its balance sheet.
There is no doubt that this factor would be concluded that it adds support to the reasonableness
of the compensation.
Factor (4) General Economic Conditions
General economic conditions may affect a company’s performance and thus show the extent of
the employee’s effect on the company. ABC’s sales over the six-year period listed above have
increased almost 30% from 1995 and 60% over 1996. Construction industry has become more
and more competitive but yet ABC has become more successful. However, the general economy
has grown significantly over this same time period.
These facts tend to show that this factor is, at worse, neutral for supporting the compensation
issue.
Factor (5) Employer’s Financial Condition
The past and present financial condition of a company is relevant to deciding whether
compensation was reasonable. ABC grew from total equity of less than $100,000 several years
ago to equity, after management fees, as of March 31, 2000, of around $5,500,000. ABC has
always made a profit for many years. ABC’s gross profit margins for the fiscal years ended
March 31, 2000, 1999, 1998, 1997 and 1996 were 19.8%, 18.5%, 15.8%, 14.5% and 12.8%
respectively. Net profit margins (or return on sales) for these same years were 5.4%, 4.9%,
1.88%, 3.28%, and 3.59% respectfully.
Outside data and comparisons are available. Robert Morris Associates data show that
commercial construction contractors with receipts of $10 million to $50 million average gross
profit margins and net profit margins of 9.8% and 1.6% compared to ABC’s margins of 16.7%
and 2.58%.
These statistics would tend to support the reasonableness of the compensation.
Factor (6) Comparison of Compensation Paid with Sales and Net Income
Courts have compared sales and net income to amounts of compensation in deciding reasonable
compensation. Bill and Bob’s compensation, especially the average over the five or six year
prior period, was a small percentage of ABC’s gross sales. This factor favors a positive result.
Factor (7) Distributions to Shareholders and Retained Earnings
Courts consider the amount of distributions to shareholders in deciding reasonableness of
compensation. The failure to pay more than a minimal amount of dividends may suggest that
some of the amounts paid as compensation to a shareholder/employee are dividends. ABC
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regularly paid dividends to its shareholders, paying out over $400,000 in the last fiscal year. The
Choate decision more or less stated that an S election has no effect on this factor.
This factor again favors the support for reasonable compensation.
Factor (8) Whether an Independent Investor would have Approved the Compensation
If the employer and the employee did not deal at arm’s length, as is the case here in ABC as
these employees in question controlled 100% of the company; the amount of compensation may
be unreasonable. The issue then becomes a question of whether an independent investor would
have approved the compensation in view of the nature and quality of the services performed and
the effect of those services on the investor’s return on his investment. Here, an independent
investor would have received a 10.7% return on equity over this five year period through year
2000 and a much larger return over the company’s life. One could reasonably conclude that an
independent investor would approve these officer’s compensations because of the successful
leadership of the company.
Factor (9) The Employer’s Compensation Policy for all Employees
Courts have considered the taxpayer’s compensation policy for other employees of the business
in deciding this issue. This factor focuses on whether the entity pays top dollar to all of its
employees, including both shareholders and nonshareholders. One could also argue that ABC’s
employees were paid at or near the high end of the compensation range. ABC is currently
conducting a salary and compensation survey to review the current situation.
This factor again favors the compensation as paid.
Factor (10) Prevailing Rates of Compensation for Comparable Positions in Comparable
Companies
The courts, in deciding this issue of reasonable pay, compare the company’s compensation paid
to persons holding comparable positions in comparable companies. The year 2000 CFMA
Construction Industry Annual Financial Survey reports that for specialty trade contractors in
ABC’s revenue range, that 9% of CEOs were paid less than $100,000, 42% were paid between
$100,000 and $250,000, 31% were paid between $250,000 and $500,000, 12% were paid
between $500,000 and $1 million, and 6% were paid in excess of $1 million. For ABC, Bill and
Bob were paid individually an average of $434,147 over the last six years. For the year 2000
alone, Bill and Bob were each paid over a $1 million, but according to the CFMA survey so were
the CEOs of 6% of the companies that participated in the survey.
A comparison of ABC’s CEO’s salaries to the industry averages and range of salary tends to
show that the compensation was reasonable.
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Factor (11) Compensation Paid in Prior Years
An employer may deduct compensation paid in a year for services rendered in prior years. ABC
can easily assert that the compensation paid in the year 2000 included catch-up pay for prior
years. Noting the list of pay in prior years and the lower amounts paid, Bill and Bob could
certainly defend the payment of catch up pay. There is no documentation, however, that
supports this assertion. The courts have concluded that a taxpayer may deduct catch up pay and
the fact that ABC could provide catch up pay is another measure of ABC’s success.
Factor (12) Whether the Employee Guaranteed the Employer’s Debt
Courts have considered this issue of personal guaranties. However, here in ABC’s situation,
with the amount of equity and liquidity, there was no need for the shareholders to guarantee the
company’s debt. In the early years of the company, Bill and Bob did guarantee the debt, there
just was no recent need for this.
Conclusion
Based upon the above factors and analysis and statistics, one could conclude that the
compensation of ABC’s officers in the year 2000 was reasonable because of their qualifications;
scope of their duties; company’s size, growth, and financial success; the officer’s compensation
in relation to the company’s sales; and the fact that according to outside statistics, the company
performed well compared to other reasonably comparable firms.
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Appendix 1-F – Types of Contracts
The AICPA Audit and Accounting Guide for Construction Contractors asserts that a contractor’s
risk exposure varies with the type of contract. In general, there are considered to be four basic
types of contracts, each of which can include provisions for incentives and penalties, and many
other contract specifications:
a. A fixed price or lump sum contract that usually provides for a single price for the total
amount of work contracted to be performed under a specific contract,
b. A unit price contract is a contract that contains provisions that a contractor will construct a
certain project at a specified price per unit of output,
c. A cost type contract (including varieties such as cost-plus) provides for reimbursement of
specified and defined costs incurred by the contractor plus a fee for the contractor’s
services.
d. A time and material contract generally is not a written agreement but usually is performed
by contractors for small services of a short duration. Under such an arrangement, the
contractor performs the work and bills for labor, materials, equipment usage, an overhead
rate for indirect costs, and a profit provision.
But what about the consequences of these various contract types for tax purposes? A search of
the section 460 regulations for the words that identify these contract types: “fixed-price”, “unitprice”, “cost type”, or “time and material” finds no matches. Rather, in the code and regulations,
contracts are defined by separation of definition between construction contracts and services
(such as architectural, design, engineering, and construction management services). The code
does not distinguish contract types but rather does by activity (or type of service performed).
Review the wording of 1.460-1:
(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.65
In addition, there may be considered another type of contract, and that is a “service maintenance
agreement or contract”. Under a service maintenance agreement, the contractor agrees to supply
labor and possibly materials for a certain time period for a certain hourly rate or fixed fee.
However, in classifying or specifying that a maintenance agreement is a non-long-term contract
activity, the service has taken the option of accounting for service maintenance agreements or
contracts under either the percentage-of-completion or completed contract method out of
consideration. Many heating and air-conditioning contractors provide services under service or
maintenance agreements. (Other examples of types of construction service agreements are those
provided under electrical, uninterrupted power source, plumbing, general maintenance, and
65
Section 1.460-1(d)(2)
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landscaping.) Accounting for these contracts is limited to the basic accounting methods of
accrual or cash (also cash under Rev. Proc. 2002-28 if the contractor reasonably determined that
its principal business activity was construction maintenance services, which is not described in
an ineligible NAICS code under section 4.01(1)(a)(i) -(v) of the Rev. Proc. 2002-28). Under the
accrual method, income under service agreements is controlled by code section regulations
1.451-1(a) and 1.446-1(c)(1)(ii) where, generally, income is recognized when all events have
occurred which fix the right to receive such income and the amount can be determined with
reasonable accuracy. Service maintenance contractors may want to change its income
recognition to that of a deferral under the appropriate IRS authority. Prior to the issuance of Rev.
Proc. 2004-34, I.R.B. 2004-22, issued May 6, 2004, any prior revenue deferral was based upon
Rev. Proc. 71-21, 1971-2 C.B. 549. These authorities permit an election where it may be
possible to defer a certain amount of advance payments. For example, many mechanical
contractors sell service maintenance agreements. Often these agreements are billed in advance
for a year or two time period. Under Rev. Proc. 71-21 if a deferral election was made in the first
year that advance payments are received, for services to be provided in the future, not exceeding
one year, under Rev. Proc. 71-21, it was possible to defer payments received until earned. For
example, if a service maintenance contractor is paid in December for services to be provided
over the following twelve months, deferral of eleven months of revenue is possible under a Rev.
Proc. 71-21 election.
Rev. Proc. 2004-34 also allows taxpayers a limited deferral beyond the taxable year of receipt for
certain advance payments. Inclusion in gross income of these advance payments may generally
be deferred to the next taxable year, to the extent the advanced payments are not recognized in
revenues in the taxable year of receipt. Rev. Proc. 2004-34 modifies Rev. Proc. 71-21 by
permitting an additional taxable year of deferral in the case of certain short taxable years. Thus,
if the next succeeding taxable year is a short one, a taxpayer using the deferral method must
include in gross income for the short taxable year the portion of the advanced payment
recognized for financial reporting purposes in the short taxable year. Any remaining amount
must be included in gross income for the following taxable year. Other than under these
circumstances, however, the limited one-year deferral of income is retained. The Rev. Proc. 7121 provision that requires the acceleration of inclusion in gross income if a taxpayer dies or
ceases to exist or if the taxpayer's obligation related to the advance payment otherwise ends is
retained. A provision similar to one found in Rev. Proc. 71-21, Section 3.06, was incorporated
into Rev. Proc. 2004-34, allowing taxpayers who do not have appropriate financial statements to
use statistical basis to determine when an advance payment is earned through performance.
However a taxpayer who wishes to use statistical basis to determine the amount deferred, the
taxpayer must use advance consent procedures for a change of accounting. Taxpayers wishing to
allocate advance payments generally must use the advance consent procedures for a change of
accounting method set forth in Rev. Proc. 97-27. Rev. Proc. 2004-34, however, includes a safe
harbor allocation for which the taxpayer may use the automatic change of accounting method
procedures in Rev. Proc. 2002-9. Under this safe harbor, an allocation will be deemed to be
based on objective criteria if a taxpayer bases the allocation on payments the taxpayer regularly
receives for an item or items it regularly provides separately.
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The differences between the two revenue procedures are shown in the following example: ABC
Mechanical Contractors sells two service maintenance agreements, one for a one year period
ending on November 30, 20x1 on December 1, 20x1, and the other for a two year period starting
December 1, 20x1 to a separate customer. Under Rev. Proc. 71-21, ABC can defer the advance
payment received on contract one but cannot on contract two. Under Rev. Proc. 2004-34, ABC
can defer the advance payments on both contracts. If the second agreement was for a three year
period of time, however, Rev. Proc. 71-21 would not have allowed any revenue deferral,
whereas, Rev. Proc. 2004-34 will still allow a one year deferral. For ABC, for a three year
maintenance contract, the second and third year revenue would all be recognized in the second
year.
Clearly, there is a different accounting treatment available and required for long-term contracts
verses certain defined non-long-term contract activities. Long-term construction contracts are
available or required to use the long-term methods of percentage-of-completion and completed
contract. Non-long-term contract activities must utilize a regular accounting method and are
prohibited from using a long-term contract treatment.66
So, what are the consequences in tax law for different contract types such as fixed price, unit
price, cost-plus, and time and material? The answer may be uncovered by considering the
revenue and cost recognition of each contract type, in look-back requirements, and in
considerations of contract aggregation or segregation.
Fixed Price Contract Considerations:
a. Revenue recognition: Revenue recognition is generally found in the regulations under
§1.460-4 “Methods of accounting for long-term contracts.” Fixed price contracts are
generally considered the foundation or the type of contract that one has in mind when
considering the tax rules about revenue recognition. There is nothing special or different
about the consideration of fixed price contracts and the tax revenue recognition rules.
b. Cost recognition: Cost recognition is generally found in the regulations under §1.460-5
“Cost allocation rules.” Fixed price contracts are again generally considered the foundation
or the type of contract that one has in mind when considering the tax rules about cost
recognition.
c. Look-back: Look-back for fixed price contracts is covered in the regulations under §1.4606 “Look-back method.” The whole creation or thought of look-back had fixed price
contracts in mind when created or written. We would not have look-back considerations
without the estimates required in fixed price contracts.
66
Regulation Section 1.460-1(d)(1): “Similarly, if a single long-term contract requires a taxpayer to perform a nonlong-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-longterm contract activity must be separated from the contract and accounted for using a permissible method of
accounting other than a long-term contract method.”
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d. Aggregation and segregation: The rules for severing and aggregating are found in
regulation section 1.460-1(e) “Severing and aggregating contracts.” Fixed price contracts
are subject to the rules of severing and aggregating.
Unit Price Contract Considerations:
a. Revenue recognition: The revenue recognition rules of the regulation section 1.460-4 also
apply to unit price contracts.
b. Cost recognition: Cost recognition rules of section 1.460-5 also apply to unit price
contracts.
c. Look-back: Look back rules of 1.460-6 also apply to unit price contracts but generally have
lesser significance, as unit price contracts are usually contracts of lesser duration than fixedprice contracts.
d. Aggregation and segregation: Unit price contracts are usually very easy to segregate. The
general rules of 1.460-1(e) apply but are seldom needed to be applied in unit price
contracts.
Cost Type Contract Considerations:
a. Revenue recognition: The revenue recognition rules of section 1.460-4 also apply to cost
type contracts. The issues with cost type contracts usually focus on what activity type of
contract the contractor is subject to – a long-term construction contract or a construction
management contract. Cost type contracts usually have provisions that could qualify the
contract under either a long-term contract or a construction management contract. Of
course, classification as a long-term contract means that the long-term contract methods
apply but classification as an activity, as a construction management contract, would
require the application of the regular method of accounting only.67 The contractor’s
methodology of: (1) allocation among activities under 1.460-1(d), (2) severing and
aggregating contracts, and (3) contract classification under 1.460-(f) are very important
considerations in a cost type contract consideration. If final classification as a long-term
construction contract is conclusive, cost type contract revenue will be driven by the details
and specifics of the cost type contract. For example, if the details of the cost type contract
have similar characteristics or definition as a “Cost-plus-fixed-fee” contract – a contract
under which the contractor is reimbursed for costs plus the provision for a fixed fee - and
the contractor is on the PCM under section 460 revenue recognition, the revenue
recognition formula would be based upon the cost-to-cost formula. Gross profit would be
calculated as the fixed fee times the costs incurred to date divided by the total estimated
contract costs. Revenue recognized in the current period would be a formula of costs
incurred to date plus the fixed fee earned less revenue recognized in prior periods. Costs
incurred to date would be all costs that are allocable to the contract, whether required to be
reimbursed under the contract terms or not.
b. Cost recognition: Cost recognition depends on the results of the contractor’s methodology
for contract allocation, severing and aggregating, and contract classification. If determined
67
Code Section 1.460-1(b)(10)
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to be a long-term construction contract, the rules of 1.460-5 apply. If determined to be an
activity, the general rules of the basic accounting method apply.
c. Look-back: rules generally do not have much practical applicability to cost type contracts
but certainly the rules of section 1.460-6 still apply. Usually, look-back is not applied due to
the working of the cost type contracts, that there are no significant fluctuations in revenue
and gross profit recognition estimates form period to period, unless the contract is subject to
incentives that were either missed or ignored in prior periods.
d. Aggregation and segregation: Cost type contracts are subject to the severing and
aggregating rules of 1.460-1(e).
Time and Material Contract Considerations:
a. Revenue recognition: Revenue recognition for time and material contracts is theoretically
subject to the same rules as the other types of contracts. However, due to the way revenue is
calculated for time and material contracts, revenue recognition under either the percentage
of completion, completed contract, or the accrual method will give the same result. Time
and material contracts are typically billed no later than on a daily, weekly, or monthly basis.
The usual cost components of time and material jobs are accumulated either in a work in
process account and then removed when invoiced or just expensed when incurred and the
costs expensed are used to calculate the appropriate billing. Progress billings are usually not
done in time and material jobs. Profit is recognized when billed. Therefore, based upon
these typical procedures and attributes, time and material contract revenue recognition is
not a significant issue.
b. Cost recognition: Although the cost recognition provisions of 1.460-5 apply to time and
material contracts, due to the brevity of the contract length, usually the only costs allocated
to time and material contracts are labor and labor overhead, material, equipment, and, at
times, general overhead percentage and profit percentage.
c. Look-back: Look-back does not apply to time and material contracts, not because the law
excludes them, but rather due to the brevity of the contract length. Look-back cannot be
applied to a contract that is completed by month’s end with no chance of future application
or allocation of revenue increases or cost additions. In addition, even if the time and
material contract did have subsequent revenue or costs applied, the significance of the
contract would generally exclude it from the exclusion rules of the look-back exception
1.460-6(b)(3). Not all time and material contracts are small contracts. For example, a large
industrial mechanical contractor receives a purchase order from a large steel manufacturer
to retrofit portions of a steel plant in the amount of $8.5 million under a time and material
contract. The contractor submitted its labor rates with labor overhead costs to the steel
company, agreed to a mark up rate on materials, an overhead rate for equipment, an
overhead rate for general overhead and a profit markup. The contractor is able to bill
monthly and payment is contracted to be paid by the following 20th of each month. Is this a
contract for $8.5 million or many time and material contracts? The practical answer is that
this is many time and material jobs. Every monthly billing can be considered a separate
contract. Even under the aggregation rules, the practical answer will result in the same
answer as the gross profit on each separate time and material invoice should be similar. It is
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this methodology that supports the conclusion that look-back rules have no practical
applicability to time and material contracts.
d. Aggregation and segregation: See discussion above. The rules of aggregation and
segregation have no practical application to time and material contracts.
Even though the types of contracts are not defined within the code or regulations, the practical
applications and inherent attributes of each type has a large effect on its revenue and cost
recognition, look-back effects, and needs for aggregation and segregation concerns.
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Appendix 2-B – Cost Allocation Rules as of January 11, 2001
Does the taxpayer have
any long-term contracts?
no
yes
Are any contracts
“Residential contracts”
no
no
yes
If the PC method is used,
has the taxpayer elected the
simplified PC method?
yes
Percentage of
completion of
determined in
accordance with
70%
Code Sec.
460(b)(3)(A).
Those rules are
explained at IRS
Notice 89-15. Q&A
22 or Regs. At
1.460-5(c). Only
the following costs
are considered when
computing PC:
 Direct material
 Direct labor
 Depreciation
Allocation rules at
Code Section 460(c),
which are the same as
extended period
contract rules at Reg.
Sec. 1.460-5(b),
modified as follows:
 Production period
interest rules also
apply
 Costs identified
on cost-plus or
government
contracts must be
capitalized
 Past service
pension costs
must be
capitalized.
no
yes
Is the small
contractor’s exemption
in Code Section
460(e)(1)(B) met?
yes
no
Has contractor elected a long-term method,
such as:
yes
yes
yes
Capitalization rules at
Code Section 263A or
contained in Reg. for
Sec. 263A. Those rules
are basically the same as
the allocation rules in
Code Sec. 460(c)
Production period interest
rules also apply.
460(b) PCM
Simplified costing
rules of
460(b)(3)(A).
yes
Completed
contract method
(CCM)
yes
yes
yes
Allocation rules at Reg.
Section 1.460-5(d)(5),
and:
Production period interest
rules also apply. Has
contractor elected
indirect costing as
provided in 1.263A1(e)(3)?
no
Use indirect costs as
provided by 1.4605(d)(2)
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no
Is the small
contractor
exemption in
Code Section
460(e)(1)(B) met?
no
no
30%
yes
Are any contracts “home
construction contracts”.
55
Exempt-percentage of
completion method(EPCM)
Not covered by
the long-term
cost allocation
rules in Code
Sec. 460 or in
Reg. Sec.
1.460-5,
subject to
economic
performance
requirements of
461(h), and
Section 162,
reasonable and
necessary
business
expenses.
Tax Accounting Methods for Construction Contractors,
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