Construction Industry - Audit Technique Guide - Uncle Fed's Tax ...

Contracts Subject to IRC § 460Under IRC § 460(b)(1), taxpayers must use the percentage of completion method toreport taxable income from long-term contracts. The degree of completion is generallydetermined by comparing the total allocated contract costs incurred to date with the totalestimated contract costs, otherwise known as the “cost-to-cost method.” Engineeringestimates or other approaches to determine the degree of completion may not be usedif the contractor is subject to the PCM under IRC § 460. If a contractor is able to meetthe exemptions of IRC § 460(e), the use of the engineering estimates (or any otherrecognized output methods) or any appropriate method, meeting the definition ofsection 460, is allowed. See Chapter 4 (Large Contractors) for additional informationregarding contracts subject to IRC § 460.Contracts Exempt from IRC Section 460IRC § 460(e) provides two exceptions for long-term construction contracts to therequired use of the percentage of completion rules and the application of look-back:1. Any home construction contract (defined in IRC § 460(e)(6)(A)) entered into afterJune 20, 1988. Home construction contractors not meeting the small contractorexception (discussed below) are required, under IRC § 460(e)1)(B), to capitalizecosts using IRC § 263A. See Chapter 7 (Home Builders and Land Developers)for additional information regarding these home construction contracts.2. Small construction contracts, as defined in IRC § 460(e)1)(B), require that at thetime the contract was entered into, it was estimated that such contract would becompleted within a 2-year period beginning on the commencement date of suchcontract; and the contractor's average annual taxable gross receipts for the 3taxable years preceding the year in which such contract was entered into did notexceed $10 million. See Chapter 3 (Small Contractors) for additional informationregarding these types of contracts.Example:A contractor enters into two long-term contracts during the taxable year, neitherwhich are home construction contracts. The average annual taxable grossreceipts for the prior 3 taxable years are $9,000,000. Job 1 is expected to becompleted within 18 months and Job 2 is expected to be completed within 30months. Job 1 is exempt from the percentage of completion and look-backrequirements of IRC § 460 and may be accounted for under the taxpayer’selected method of accounting for long-term contracts (e.g. completed contract,accrual). However, Job 2 must be accounted for using the percentage ofcompletion method and look-back may be required upon the completion of the2-2