At nearly 75,000 pages the Internal Revenue Code is the bane of most industries, but none more so than the construction industry which has a whole section of the code targeting its accounting procedures. IRC Section 460, created in 1986, is as complex a section as there is, especially where it concerns the treatment of income from long-term contracts. However, for construction contractors who take the time to understand the intricacies Sec. 460, there are many tax planning opportunities to be found which can substantially improve their cash flow situation.
IRC Section 460 Treatment of Long-Term Contracts
Sec. 460 establishes the methods by which taxpayers must treat income generated from long-term contracts. Generally, it requires that contractors working with long-term contracts (contracts not completed within the tax year of origination) use the percentage-of-completion method to determine when the taxable income is to be recognized. Essentially, the method calculates the cumulative percentage of the contract that is completed and comparing allocated costs to costs incurred before the end of the tax year to come up with a ratio. The ratio is multiplied by the contract price to determine how much income is to be recognized in a given accounting period.
Exceptions to the Rule
The obvious disadvantage of the percentage-of-completion method is that it requires the payment of taxes on income that has yet to be received. However, as with many other provisions of the tax code, there are exceptions to the rule. Sec. 460 does include several exemptions which, if eligible, would allow contractors to change their accounting method resulting in a deferral of income recognition until the contract is completed. The completed-contract method would be preferable to all contractors, but it can only be triggered if certain parameters are met. Here are some examples of when contractors would be exempt from the percentage-of-completion method
Small contractors: Contracts that are expected to be completed within two years and the contractor’s average annual gross income is less than $10 million for the past three tax years.
Home construction: Contracts in which at least 80% of the estimated cost is going to the construction of a building with four or less dwelling units.
Residential construction: Contracts for the construction of buildings containing five or more dwelling units (except for hotels or motels), are allowed to use a hybrid accounting method where 70% is reported under the percentage-of-completion method and 30% is reported under the completed contract method.
Incomplete construction: Contracts that are less than 10% complete at the end of the tax year are allowed to defer income reporting into the next year.
Contract retainage: Contracts started and completed in the same year, but that include retainage, may defer reporting of the retainage income until the contract is completed.
These are just a few examples of how provisions of Sec. 460 can be used to improve your cash flow. However, it is critically important to note that utilizing any of these methods could require a change in your accounting method. Once you change your accounting method, you are required to use it going forward. It would be important to work with your accountant to assess your overall tax and cash flow situation to determine the cost-benefit of any changes.