Many contractors sign contracts with customers that commence in one year but are completed the following. These are known as long-term contracts. If long-term contracts include the construction of property, Internal Revenue Code (IRC) Section 460 requires the use of the percentage of completion method (PCM) to calculate taxable income. However, there are exceptions for certain contracts that do not require PCM. In this article, we will discuss the requirements of PCM, the exceptions and the advantages and disadvantages of available methods.

Percentage of Completion

Revenue Recognition

1. Revenue is recognized based on comparing incurred costs with estimated total costs. The percentage of costs incurred compared with total estimated costs is multiplied by the contract price for revenue recognition. Direct and indirect costs allocated to the job are recognized as incurred.

2. There is an election available to exclude the first 10% of contract revenue and costs.

Advantages

1. Income is recognized over the life of the contract eliminating fluctuations of income.

2. Contract losses can be recognized immediately.

Disadvantages

1. Revenue is taxed before the job is completed.

2. Cash needed for income taxes could be used to fund other projects.

Percentage of Completion Exceptions

Internal Revenue Code (IRC) Section 460 provides two exceptions for contractors who are not required to use PCM for tax purposes. If contractors meet ONE of these exceptions, their contracts are exempt from PCM.

• Home construction contractors,
  • Any construction contract where 80% of the costs are attributable to dwelling units, or
• Eligible Small Contactor
  • Prior 3-year average gross receipts are under $26 million, AND
  • Estimated contract will be completed within two years.

Methods Available for Contracts Exempt from PCM

Taxpayers may choose any method available for contracts not subject to PCM. However, the method applied to the first exempt contract must be applied to all exempt contracts. Determining which method is most advantageous requires professional expertise.

1. Completed Contract Method

Revenue Recognition

• Revenue is recognized once the contract is completed. Direct and indirect expenses allocated to the job are deferred until the job is completed.
• Contracts are considered complete when 95% of estimated total costs are incurred.

Advantages

• Tax deferment of income.
• Additional cash on hand for new projects instead of paying income taxes.

Disadvantages

• Losses are not recognized until the job is complete.
• Significant fluctuations of income.

2. Cash Method

Revenue Recognition

• Revenue is recognized once cash is collected. Direct and indirect expenses allocated to the job are expensed as paid.

Advantages

• Taxable income follows cash flows.
• Simplified tax planning opportunities.

Disadvantages

• Profitability can be misleading.
• Advance payments from customers considered income.

3. Accrual Method

Revenue Recognition

• Revenue is recognized once revenue is earned. Generally, this follows when bills are issued. Direct and indirect expenses allocated to the job are expensed as incurred.

Advantages

• Represents economic reality.
• Flexibility in revenue recognition.

Disadvantages

• Taxable income doesn’t match cash flows.
• Complexity of revenue and cost recognition.

Alternative Minimum Tax (AMT)

Exempt contracts that are not reported under PCM are subject to AMT adjustments. Under AMT, taxpayers are required to recognize revenue for PCM. The difference between the exempt method used and PCM is added or subtracted for AMT. Home construction contractors are NOT subject to this AMT adjustment.

Please consult with your Lutz Representative or contact us if you have any questions. You can also learn more about our construction accounting services or read related topics by visiting our blog.