by Adam Polakov
November 2, 2011

Many contractors on long-term contracts use a tax accounting method requiring them to calculate estimates of total costs and revenue to arrive at a yearly estimated gross profit (or loss).

A long-term contract is one that begins in one taxable year and ends in another. The duration may only be one month, but a construction contract could be considered long-term for tax purposes if it begins in one tax year and ends in another. Upon completion of the contract, gross profit for each year is recomputed using actual total contract price and costs. Contractors, therefore, have to look-back, and determine if there was an under or overpayment of taxes in prior years by comparing the reported estimated gross profit to actual gross profit. This process is applied separately to each contract completed during the year. This tax accounting method is referred to as percentage of completion.

Embedded in the Tax Reform Act (TRA) of 1986 was the mandatory use of the percentage of completion method (PCM) for the majority of long-term construction contracts. The look-back rule was enacted as part of this legislation as a mechanism to true up estimates made in computing the percentage of completion formula for long-term contracts. Bottom line, the Internal Revenue Service (IRS) is looking to avoid providing interest-free loans to contractors resulting from inaccurate estimates made in prior years. This would occur if a contractor underestimated profit for a year and, therefore, did not pay taxes on the amount of profit between their estimation and the true amount. The IRS requires interest to be remitted on the understatement of income.

Percentage of Completion Method

The PCM requires that income on a long-term construction contract be reported in proportion to the percentage of costs incurred to date when compared to total anticipated costs for the contract. This method allows contractors to take full advantage of the favorable graduated tax rates since income is only recognized as the work is performed.

Pursuant to the PCM, gross profit to be recognized on any contract during a taxable year, regardless of whether it is completed at year-end or a contract in progress at year-end, is calculated below:

Calculating Gross Profit

Total contract income (total estimated revenue from the contract)

X   The ratio of (costs incurred through year end/estimated total contract costs)_________________________________________________________          

= The actual costs incurred to date on the contract as well as any gross profit recognized in prior years

 All contractors must use the PCM for reporting income unless the contractor meets the small construction contractor or home construction exemptions. To qualify for the small construction contract exception, the contract has to be completed within two years from the contract commencement date and the taxpayer's average annual gross receipts for the three years preceding the year in which the contract is entered cannot exceed $10 million. To qualify for the home construction contract exemption, 80 percent or more of the estimated total contract costs must be attributable to residential construction and related land improvements. The contract must involve buildings containing four or fewer dwelling units and can also include improvements to real property directly related to dwelling units.

 In August 2008, the IRS issued proposed regulations expanding the types of construction contracts eligible for the home construction contract exemption. Pursuant to the proposed regulations, a land developer selling individual lots could effectively have long-term construction contracts that qualify for the home construction contract exemption.

Completed Contract Method

If a contractor qualifies for either the small construction contract exception or the home construction contract exemption, they are eligible to use the Completed Contract Method (CCM) for long-term contracts. Under this method, all contract revenue is deferred and all expenditures are capitalized until the contract is completed. The contract is deemed complete for a particular tax year if either of the following occurs:

  • At least 95 percent of the total allocable contract costs attributable to the contract have been incurred

           or

  • Final acceptance has been given to the contract

Although the CCM allows contractors to defer recognition of income on long-term contracts until completed, this method could result in a contractor recognizing substantial income during a particular tax year if multiple contracts are completed during that period.

Look-Back Rule

The look-back rule applies to long-term construction contracts that are required to be reported under the PCM.  At the completion of each contract, the contractor must complete a hypothetical calculation to look-back at the prior tax years when the contract was in progress and re-compute the gross profit/loss based upon the actual, rather than the estimated, total contract cost.

  • For all contracts completed during the year, recalculate the percentage-age of completion income to be recognized in each year of the contract using the actual contract price and costs as of the end of the year of completion.
  • Compare the tax liability on the originally reported income (based upon estimated total contract cost) with the recomputed tax liability calculated on actual total contract cost.
  • If the look-back calculation reveals that a prior year's tax liability was understated, then the contractor owes interest to the IRS. Conversely, the contractor is owed a refund from the IRS if the look-back calculation indicates the prior year's tax liability was overstated.

Example Applying the PCM with the "Look-Back" Rule:

A contractor (C) enters into a long-term contract during 2009. At December 31, 2009, the estimated contract income is $20 million and C has incurred $4 million of contract costs. Total estimated contract costs are $16 million.

  • As of December 31, 2009, C is estimating that the contract is 25 percent complete ($4 million/$16 million).
  • Since the long-term contract is 25 percent complete, C pays tax on 25 percent of estimated contract revenues, less any contract costs incurred. Therefore, C pays tax on $1 million computed as $5 million (25 percent of $20 million) less the $4 million contract costs incurred.

 Since the $16 million of total contract costs is an estimate, it's possible that C will be under or overpaid to the