Accounting for construction contracts: IRS targets large land developers

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 that some developers are deferring profits that should be recognized — and taxed — earlier. Here’s what you need to know to protect yourself.

The issue

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:

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 the contract is entered into.

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.

Despite the TCJA liberalization, 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. (See “IRS compliance campaign terminology.”)

Preventive measures

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 liberalized 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.

Time for a change?

The IRS considers the timing of income recognition on long-term contracts a “method of accounting.” An examiner who determines that a developer isn’t permitted to use the CCM will initiate an “involuntary” change in accounting method.

But developers needn’t 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 that 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.

Act now

The LB&I campaign shows that the IRS takes the CCM issue seriously. A “wait-and-see” approach could make your company vulnerable to an audit that could be costly. Set up a meeting with your tax advisor as soon as possible to discuss whether you’re in compliance with the rules — and whether you might be one of the lucky contractors that are able to switch to the CCM method under the TCJA’s liberalized eligibility requirements.

IRS compliance campaign terminology

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 so-called “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.

We can help

The Elliott Davis Real Estate tax professionals would love to answer any questions. Call or email our team.