If you have a construction business with contracts that extend beyond the end of the current tax year, you may have to use the percentage of completion method for federal income tax purposes. According to the IRS, any contract that spans a year end is considered a long-term contract, even if you started the contract in December and completed it in January.
As pointed out in an article on the Contractors Center Point website, long-term construction contracts would be subject to Internal Revenue Code Section 460. This section requires the use of the percentage of completion method of tax accounting. Under this method, taxable income is determined by comparing total allocated contract costs incurred to date with the total estimated costs of the contract. But there are exceptions to the requirement to use the percentage of completion method for home construction contracts and small construction contracts.
Home construction contracts are for work on buildings with four or fewer dwelling units, where at least 80 percent of the total estimated contract costs are for the construction, improvement, or rehabilitation of the units. All other contracts are classified as general construction contracts.
As explained by Accountants CPA Hartford Connecticut, the exception for small contracts would apply if the contract is expected to be completed within two years and the contractor’s average annual taxable gross receipts for the three preceding taxable years did not exceed $10 million.
The IRS explains that a construction business could use two different accounting methods for tax purposes – either the cash method or the accrual method for short-term contracts, and a different method for long-term contracts. In order to determine the tax accounting method for the long-term contracts, they would have to be classified as home construction contracts or general construction contracts. The home construction contracts would generally be exempt from the requirement of Section 460 to use the percentage of completion method. Other long-term general constructions projects would be subject to this requirement.
To determine the amount of income to be reported for tax purposes under the percentage of completion method, you would take the actual costs incurred on the contract to date and divide that amount by the total estimated contract costs for the whole job. This percentage is multiplied by the total gross profit for the contract, which is the total estimated contract revenue minus the total estimated contract costs. Any gross profit recognized in prior years would be subtracted from the result.
The costs to be included in the calculation would generally be direct labor, materials, and other direct costs, plus indirect costs, or overhead.
Section 460 of the Internal Revenue Code also includes a look-back provision for calculating interest for completed long-term contracts. As explained by Chad Maddox, CPA, CVA, in an article on the Construction CPAs website, since the percentage of completion method involves estimates, the concept of the look-back is for the taxpayer to pay the IRS interest on taxes paid for a year in which the gross profit was underestimated. And the IRS pays the taxpayer interest on taxes paid for a year in which the gross profit was overestimated. This calculation is made on Form 8697.
Accounting for Construction Contracts – Construction Tax Tips, IRS
Chad Maddox, CPA, CVA, Do You Look-Back? IRS Form 8697 and the Look-Back Method, Construction CPAs
Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts
Home Construction Contracts, IRS
Instructions for Form 8697, IRS
Internal Revenue Code Section 460: Navigating the Intricacies, Contractors Center Point
Internal Revenue Code: Sec. 460. Special rules for long-term contracts, Tax Almanac
William Brighenti, CPA, Completed Contracts & Long-Term Contracts Defined, Accountants CPA Hartford Connecticut