Navigating the IRS rules and regulations can be like building a skyscraper without a blueprint. Therefore, Internal Revenue Code Section 460 equips construction companies with essential tools and tax treatments to improve cash flow, support daily operations, and manage tax liabilities. In this blog, we explore how long-term contracts, specific accounting methods, and various exemptions serve as the blueprints that enable contractors to build a financial foundation as sturdy as a well-poured concrete slab of a skyscraper.
Navigating Code Section 460 and Long-Term Contracts
Code Section 460 pertains to long-term contracts, which are contracts spanning more than one tax year related to the manufacture, building, installation, or construction of property. For example, if a contractor with a December 31 year-end enters a contract on December 1 and does not complete it by December 31, the contract is considered long-term.
Choosing the Right Accounting Method
Percentage-of-Completion Method (PCM): This commonly required method for large contractors with long-term contracts recognizes revenue and expenses as the contract progresses. It requires taxable income to be reported based on the percentage of the contract completed, determined by the ratio of total cost to date over the total estimated cost. The taxpayer includes in gross income the portion of the contract price corresponding to the project's completion percentage, potentially leading to tax on income not yet received.
Completed-Contract Method (CCM): Contractors can defer reporting income and expenses until the completion of the contract. It is generally limited to smaller contractors or those with shorter-term contracts. Contracts are not considered “complete” and included as part of taxable income until at least 95 percent of the total allocable contract costs have been incurred.
Percentage of Capitalized Cost Method (PCCM): A residential contract is similar to a home construction contract (defined later) but involves buildings with more than four dwelling units, excluding hotels, motels, or transient establishments. For these contracts, a hybrid method allows taxpayers to treat 70 percent of the contract as being reported under PCM, and 30 percent can use an exempt method, such as CCM. Examples of residential contracts include general contractors and subcontractors working on apartments, condominiums, dorms, assisted living facilities, barracks, and prisons.
Accrual with Deferral of Retainage: For contracts started and completed within the same year, a contractor may defer reporting retainage receivable as income until it becomes billable, usually at the end of the project. For long-term contracts, retainage payable is not included in contract costs until the retention is payable to the subcontractor, as defined in the contract. This exemption can lower the overall percentage of the project deemed complete, reduce the income to be recognized, and help contractors manage cash flow more effectively.
Election to Use the 10 Percent Method: If the contractor is required to use PCM, there is an election that allows them to defer income if, at the end of the year, the contract is less than 10 percent complete.
Home Construction Contracts: A home construction contract refers to any agreement where 80 percent or more of the estimated costs are allocated to building dwelling units, such as single-family homes or townhomes, with four or fewer units and associated property improvements. Under this exemption, the contractor is not required to report contracts under PCM. Instead, the contractor can use CCM. This exemption benefits smaller homebuilders by simplifying tax reporting, deferring tax liabilities, and helping to manage cash flow effectively.
Small Contractor’s Exemption: A small contractor can bypass Section 460 and avoid using PCM for long-term contracts if the contract is completed within two years and the average annual gross receipts for the three previous tax years are less than $25 million. Allowable tax methods for exempt small contractors include accrual, accrual with the option to exclude retainage, cash, and completed contracts.
Tax Allocation of Direct and Indirect Costs: Direct and indirect costs should be allocated to contracts based on a burden rate or another reasonable method. The cost allocation lowers the overall completion percentage of the project, reducing taxable income and tax liabilities. This concept is similar to the deferral of retainage for long-term contracts.
Leveraging Exemptions and Elections for Contractors
Section 460 can be complex, with many exemptions and elections for businesses that meet specific parameters. For instance, service contracts, including those for architects, engineers, construction managers, and commercial painters, are exempt.
Generally, as stated above, PCM is required, except for the exceptions mentioned above. These techniques may require a change in accounting method and approval by the IRS.
Experts in Construction Advisory Services
When dealing with long-term contracts, specific accounting methods, and various exemptions, Code Section 460 is the blueprint. Let Berman Hopkins guide you in constructing your financial skyscraper. As one of the Top 50 Construction Accounting Firms in the United States (Construction Executive 2021, 2022, & 2023), we build long-term, value-added relationships and provide solid solutions that help positively impact your construction business. With over 66 years of leadership, experience, and expertise, our talented team of CPAs and advisors fully understand the nuances of the construction industry and provide resources beyond the traditional audit, accounting, and tax services to construction businesses throughout the country, with revenues ranging from $5 million to $500 million.
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Partner with us to unlock the full potential of your construction business and embark on a journey of sustainable growth and success. Contact us today to begin building a brighter future.
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