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Taxpayers using PCM cautioned by IRS on delaying income recognition.

Due to the nature of their work and the uncertain environment in which they operate, contractors and real estate developers are more in tune with estimates of job costs than any other business segment. Cost estimates are extremely important to these businesses, as they determine the amount of taxable income that needs to be recognized in any tax year.

If a taxpayer is using the percentage of completion method (PCM) of accounting, contract taxable income for a given year is computed by multiplying the contract price by the ratio of contract costs incurred during the year to estimated total contract costs. Under the PCM as it existed prior to the Tax Reform Act of 1986, contractors used engineering or other estimates to determine each project's completion. Under Sec. 460, however, this subjective factor was removed, with a project's percentage of completion determined solely on costs incurred on the project. By postponing the recognition of costs incurred for the work of their subcontractors, contractors can postpone income under the PCM.

The IRS is concerned about certain taxpayers using the PCM who were deferring expenses in order to defer income. In a coordinated issue paper (ISP) effective Mar. 21,1997, the Service stated that contractors in the construction/real estate industry cannot postpone the recognition of costs incurred for the work of their subcontractors to postpone income under the PCM. The scenario illustrated in the ISP is one in which a taxpayer/contractor would treat its liability to its subcontractor as being incurred on receipt of the subcontractor's bill. Any bill received before the end of the year generated a deduction for that year and triggered inclusion of income.

The ISP went on to state that in this case the contractor modified its method of accounting in that it delayed the recognition of expenses until it actually paid the subcontractor. Under this modified method, any bills received before year-end and not paid until after year-end resulted in deferred expense and thus, deferred income recognition. The net result was that the taxpayer's profit was deferred until the year in which payment was made to the subcontractor.

The taxpayer in the ISP attempted to defend its new cost-deferral method by citing Regs. Sec. 1.461-4(d)(6)(iii), which allows a taxpayer to treat property as provided to the taxpayer when it is delivered or accepted or when title passes. The taxpayer claimed that it should not be treated as accepted until the customer accepts the subcontractor's work. The taxpayer also asserted that the customer does not accept the subcontractor's work until the subcontractor's work has been substantially completed.

In the ISP, the IRS found the following flaws and errors in the taxpayer's argument. First, the subcontractor's bills generally cannot be classified solely as bills for property. Construction contracts are usually for services, property (e.g., raw materials) and the use of property (e.g., rental of property), and governed by Regs. Sec. 1.4614(d)(6)(iv). Under that regulation, taxpayers are to differentiate between property and services provided to them by subcontractors and to recognize income and expenses accordingly. This requirement is relaxed only when the cost of property or services is incidental. Accordingly, the Service noted that it is unlikely that many taxpayers will be able to classify their subcontractor's work as entirely for the provision of property in order to postpone income as the taxpayer in the ISP was attempting to do.

Second, the acceptance of the property by the customer may be irrelevant, because the subcontractor typically works only for the contractor. If this is the case, acceptance by the contractor would trigger economic performance, causing the contractor to accrue a liability. Additionally, the IRS says that acceptance of the property generally is governed by a contract, usually occurring in stages, and usually is not dependent on the subcontractor's substantial completion of the work.

Third, for long-term contract expenses incurred after 1991, Regs. Sec. 1.461-4(d)(2)(ii) provides that economic performance occurs as the services or property is provided or, if earlier, as payment is made. Clearly in this situation, the subcontractor is providing its services during the course of the year. The payment of the subcontractor's invoice by the contractor is of secondary importance to the occurrence of economic performance.

The ISP also discusses the taxpayer's improper change in accounting method. The taxpayer was originally using the accrual basis of accounting. As a result of modifying his method for subcontractor costs, the taxpayer began using the cash method of accounting. Any method of accounting must be used consistency from year to year and cannot be changed without the Service's consent. In the ISP, the IRS rejected the taxpayer's assertion that Regs. Sec. 1.461-4(m)(2) authorizes a taxpayer to change its accounting method for subcontractor expenses. This regulation grants consent for contractors to change their methods of accounting for long-term contract liabilities for the purpose of complying with Sec. 461 and the regulations thereunder. The Service stated chat the taxpayer's change in methods was not in compliance with Sec. 461 and, therefore, the taxpayer had to request advance consent under the normal procedures.

The ISP has some very important cautionary aspects for contractors, real estate developers and even manufacturers who use the PCM. With the proper understanding of such concepts, taxpayers using the PCM can correctly implement this method and also avoid any IRS challenges on improper accounting method changes.

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Title Annotation:percentage of completion method
Author:Bliha, Richard F.
Publication:The Tax Adviser
Date:Sep 1, 1997
Previous Article:New rules for requesting accounting method changes.
Next Article:Annual exclusions allowed for contingent trust beneficiaries.

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