The IRS Large Business and International (LB&I) Division is currently pursuing a “compliance campaign” against large land developers of residential communities for improper use of the more taxpayer-friendly completed contract method (CCM) of accounting. The IRS believes some developers are deferring profits that should be recognized — and taxed — earlier. Here’s what you need to know to protect yourself.
Long-term Contracts and the Recognition of Taxable Income and Expense
For federal income tax purposes, long-term contracts are those that span a year-end. For example, if you enter into a contract on December 29, but don’t complete work until January 20, you have a long-term contract.
The CCM allows developers to defer the recognition of taxable income and expense until the year a long-term construction contract is completed and accepted by the customer. That way, the profit is not taxed until the year the project is completed.
The alternative way to account for long-term construction contracts is the percentage of completion method (PCM). Under the PCM, taxable income is recognized over the life of the contract based on the percentage of total costs incurred to date. For example, if a contract is 30% complete at the end of the taxable year, you would have to include 30% of the projected profit in taxable income by the end of that year.
Developers generally prefer the CCM for income tax purposes, because it’s simpler and allows income to be recognized later than under the PCM. By electing to use the CCM, large developers potentially could defer recognizing millions of dollars of income for tax purposes.
The CCM is permitted for the following:
Home construction contracts. These are contracts for work on buildings that have four or fewer dwelling units. At least 80% of the estimated total contract costs must be for the construction, improvement or rehabilitation of these units. Contracts to build apartment buildings with more than four units would not be home construction contracts. If a contract isn’t a home construction contract, the IRS classifies it as a general construction contract.
Small contractors. Small contractors may be eligible to use the CCM for general construction contracts if:
The contract will be completed within two years, and
The contractor’s average annual gross receipts don’t exceed $25 million for the three taxable years preceding the taxable year into which the contract is entered.
The Tax Cuts and Jobs Act (TCJA) increased the gross receipts threshold for using the CCM for general construction contracts from $10 million to $25 million for taxable years beginning after 2017. So, more developers and subcontractors may be eligible for the CCM starting in 2018. One cautionary note is that the rules require you to aggregate gross receipts of related businesses. These rules of aggregation can be complex when a taxpayer has multiple businesses.
Despite the TCJA liberalization of the CCM, the IRS is still on the lookout for land developers and the subcontractors who misclassify land development contracts as home construction contracts. As part of the LB&I campaign targeting the incorrect use of the CCM, the IRS will employ “soft letters” and conduct issue-based examinations.
Accounting for Construction Contracts
How does your firm account for construction contracts? Proactive measures can help reduce your odds of a costly audit. If you use the CCM, review contracts for compliance with the eligibility requirements under today’s tax law.
If you discover you’re impermissibly using the CCM, determine the appropriate corrective action, such as amending a tax return or changing accounting methods. Then determine the tax implications of making the change to the proper method, and adjust your tax planning accordingly.
Changing from the CCM Accounting Method
The IRS considers the timing of income recognition on long-term contracts a “method of accounting.” An examiner who determines a developer isn’t permitted to use the CCM will initiate an “involuntary” change in accounting method.
But developers don’t need to wait for the IRS to take action. A developer that wants to change to or from the CCM also can apply for a change in accounting method. A voluntary change in accounting method must be made on a cutoff basis, meaning it will apply to contracts entered into on or after the first day of the year of the change.
A voluntary change won’t necessarily prevent the IRS from investigating the issue in previous taxable years. However, the IRS has indicated taxpayers that voluntarily correct their accounting methods generally will be protected from examination of the issue for years the taxpayer wasn’t yet under audit.
The IRS is clearly taking the CCM issue seriously. A “wait-and-see” approach could make your company vulnerable to an audit that could be costly. If you currently use the CCM, work with your tax advisors to determine whether you’re in compliance with the rules. If you don’t currently use this method, determine whether you might be one of the lucky contractors able to switch to it method under the TCJA’s new eligibility requirements.
Sidebar: What is an IRS Compliance Campaign?
The IRS initiative targeting large land developers is part of a series of “compliance campaigns” launched in January 2017 that focus on easy ways to boost tax revenue. The campaigns include the development of dedicated practice units and specialized staff training, the release of new guidance, and the use of “soft letters” and issue-based examinations to achieve compliance.
A soft letter is sent to a taxpayer to inquire about a tax position. It isn’t an examination and doesn’t request books or records — it simply seeks additional information. These letters are intended to encourage voluntary self-correction, if necessary. Taxpayers aren’t required to respond, but failure to do so could result in an examination.
An issue-based examination essentially is a narrow audit focused on a specific issue, likely with greater scrutiny than in an ordinary audit. For a large land developer, the examiner might concentrate on whether construction contracts qualify for the completed contract method of accounting.
Please contact a member of your service team, or contact Dan Sexton at firstname.lastname@example.org or Lisa Loychik at email@example.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.