Trusted Accounting Services
Businesses in the construction industry deal with unique issues and have unique tax planning opportunities.
On the accounting side, tracking job profitability is necessary if you want to understand your company's financial performance.
Cash management is paramount to keeping the organization healthy.
Construction Contracts: Long-Term Contracts
The term "construction" is liberally construed. Almost any activity that adds to the value of real property may be treated as construction.
Long-term contracts are contracts for the manufacture, building, installation, or construction of property, where the contract is not completed within the tax year in which it is entered into. To be a long-term contract, the contract must involve the manufacture of a unique item that is not normally included in finished goods inventory, or of an item that normally requires more than 12 months to produce. The percentage of completion method is required for most long-term contracts. The completed contract method may be used in some instances.
Percentage of Completion Method (PCM); Completed Contract Method (CCM)
A taxpayer using the PCM includes an amount in income based on the percentage of the contract completed as of the end of the year, and deducts all costs incurred during the year. The PCM is determined by comparing costs allocable to the contract and incurred as of the end of the year with estimated total contract costs. The taxpayer includes a portion of the projected income from the contract in income for that year, based on this percentage. However, a taxpayer can elect not to recognize any income until 10 percent of the contract has been completed.
Under the CCM, the gross contract price is included in income when the contract is completed and accepted; expenses are deducted at that time. The use of either of these methods supersedes the use of the cash method, which would otherwise be available for construction contracts that do not have inventories.
Long-Term Contracts: Allocation of Costs
Long-term contract accounting methods apply only to costs allocable to a long-term contract. Allocable costs include direct costs and indirect costs. Direct costs, such as research and development costs, directly benefit, or are incurred by reason of, a long-term contract. Indirect costs are costs other than direct material and labor costs that are incidental to and necessary for the performance of the long-term contract. Taxpayers are required to use separate accounts for each long-term contract. Any change in the method of determining the costs allocable to a long-term contract is considered a change of accounting method that requires the IRS's consent.
Economic Debt and Losses
Taxpayers may only take deductions for bona fide "bad" debts. A bona fide debt is a debt arising from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money. Taxpayers may use the specific charge-off method to account for bad debts. Taxpayers may deduct business bad debts that become either wholly or partially worthless during the tax year. Taxpayers deduct business debts that are worthless as ordinary losses. The worthlessness of the debt must be established by an identifiable event.
A loss must be distinguished from a bad debt. A creditor’s loss from the compromise of a debt owed by a solvent debtor is a loss, not a bad debt. The settlement extinguishes the debt and leaves no balance that may be regarded as a bad debt. A loss on the compromise of a debt of an insolvent debtor is a bad debt. A taxpayer that loans property, other than money, that is not returned sustains a loss, not a bad debt.
The construction area relies heavily on leasing and financing in conjunction with construction projects. It is important the leases and leasing issues be considered when determining the tax consequences of construction activity.
Revenue recognition relates back to the accounting method used for the construction contract. The requirement of economic performance will affect when the taxpayer is entitled to deduct expenses from income, including deductions from income under a long-term contract. The all-events test that generally applies to deductions is not met until the taxpayer satisfies the economic performance test. This occurs when the activities that the taxpayer is obligated to perform, to satisfy the liability, are actually performed.
A contractor with multiple relationships, economic ties and transactions may agree to terms and conditions that would not satisfy an arm's-length or market standard. It is important contractors be aware of related party rules. For example, loans between shareholders and their corporations, or between affiliated corporations, may be closely scrutinized to determine whether the loan is a true debt. Sale-leaseback transactions may be disregarded, and deductions denied for rental payments, if the transaction is not bona fide. Gain on a sale or exchange of depreciable property between related persons may be ordinary income and may not be reportable under the installment method. Losses from sales or exchanges between related parties may also be denied or deferred.
The energy credit is a separate element of the investment tax credit, equal to 30 percent of the taxpayer's basis in fuel cell, solar, wind or other energy property. The property must meet IRS and Department of Energy standards. A taxpayer may elect to apply the credit percentage of progress expenditures incurred during the year, such as construction expenditures for energy property with a normal construction period of two years or more.
Qualified homebuilders can claim a credit of $2,000 for each qualified new energy efficient home they build and sell for use as a residence. The home must meet federal standards and must be sold by December 31, 2013. Construction also includes substantial reconstruction and rehabilitation.
We have highlighted only some of the many federal tax laws that impact construction companies. Every business is unique and has particular tax considerations. Please contact our office so that we can set a time to discuss your business in more detail.
Long-term contracts for tax law recognition-of-income purposes are contracts for manufacturing, building, installing or constructing property that are not completed in tax year in which they are entered into. A contract is considered to be for building, installation or construction of property if it provides for the erection of a structure, such as a building, oil well or other improvements, bridge, railroad or highway, or large industrial machine.
Taxable income from long-term contracts generally must be determined using the percentage of completion method. Under the percentage-of-completion method, gross income is reported annually according to the percentage of the contract completed in that year. The completion percentage must be determined by comparing costs allocated and incurred before the end of the tax year with the estimated total contract costs (cost-to-cost method or simplified cost-to-cost method). A taxpayer who has entered into a small construction contract or home construction contract, however, may use an exempt contract method of accounting.
Income and expenses attributable to engineering or architectural services are accounted for as part of the long-term contract if they enable the taxpayer to construct or manufacture the qualifying subject matter of the long-term contract. Other income and expense items, such as investment income, expenses not attributable to such contracts, and costs incurred with respect to any guarantee, warranty, maintenance or other service agreement relating to the subject matter of such contracts, including engineering activity performed after the delivery and acceptance of the subject matter of the contract, must be accounted under the taxpayer's normal accounting method.
Construction Management Contracts
One type of construction contract that primarily involves the performance of services is a construction management contract. In a typical construction management contract, the construction manager coordinates the construction project for the owner. The construction management firm does not have a contractual relationship with the contractors or subcontractors and is not at risk for defects in the materials or for mistakes in the construction. The construction management firm will oversee and coordinate the construction activity, may provide engineering and design services, may negotiate with contractors, subcontractors or suppliers on the owner's behalf, and may perform some construction services.
The IRS has inferred in a number of private rulings that a taxpayer may be able to carve out a portion of the income from a construction management contract and report such portion using the percentage of completion method in limited circumstances. The taxpayer would need to show that the separate construction activities qualify as long-term contract activities, that a reasonable amount of revenue has been allocated to the construction portion of the contract as opposed to the construction management portion, and that the proper costing techniques have been utilized in determining the annual percentage of completion for the construction portion of the contract.
Real Property Construction Contracts
The requirement that income be computed using the percentage of completion method or the percentage of completion-capitalized cost method and the requirements concerning the allocation of costs to long-term contracts do not apply to construction contracts entered into by a taxpayer:
who estimates, at the time the contract is entered into, that the contract will be completed within the two-year period beginning on the contract commencement date, and
whose average annual gross receipts for the three tax years preceding the tax year the contract is entered into do not exceed $10 million.
However, the rules for allocation of production period interest to long-term contracts apply to the long-term construction contracts. A construction contract for this purpose is any contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property.
Home Construction Contracts
Proposed IRS regulations provide that a contract for the construction of common improvements is considered a contract for the construction of improvements to real property directly related to and located on the site of the dwelling units, even if the contract is not for dwelling unit construction. For example, a land developer that sells individual lots (and its contractors and subcontractors) might have long-term construction contracts that qualify for the home construction contract exemption. These regulations also permit an individual condominium unit to be considered a "townhouse" or "rowhouse" under the exemption, so that each condominium unit can be treated as a separate building in determining whether the underlying contract qualifies.
If you have any questions about the tax rules related to long-term construction contracts or their application to your business, please do not hesitate to contact this office.
DOMESTIC PRODUCTION DEDUCTION (PRE-2018)
Code Sec. 199: Benefits and Burdens
The Code Sec. 199 domestic production activities deduction (DPAD) can be particularly beneficial. The deduction equals nine percent of income from the manufacture or production of qualified property. Qualified property generally is tangible personal property.
The taxpayer must own the property while it is being produced. While ownership is not an issue in many cases, it is important for taxpayers that enter into a contract manufacturing arrangement. In a contract manufacturing arrangements, one party contracts with another, unrelated party to produce the property for which the deduction is claimed.
Ownership depends on who the benefits and burdens for the property, at the time that the property is manufactured or produced. Determining benefits and burdens depends on all the facts and circumstances. Recent developments have spotlighted the issue of benefits and burdens under Code Sec. 199. These include a Tax Court decision, ADVO, Inc., 141 TC No. 9 (2013), and an IRS Large Business & International Division directive, LB&I-04-1013-008 (2013).
The courts have developed at least eight factors for determining benefits and burdens. The Tax Court in ADVO applied evaluated these factors and determined that the contract manufacturer, not the taxpayer who ultimately sold the product, had the benefits and burdens of ownership at the time the property was produced. The court noted that the contract manufacturer held legal title to the property; was required to manufacture the property; had possession; enjoyed the economic gain or had the risk of loss from the sale of the property; controlled the details of the production process without supervision or management by the taxpayer; and was the party intended to manufacture the property. Therefore, the contract manufacturer was entitled to the Code Sec. 199 deduction, not the taxpayer who ultimately sold the product to customers and clients. This decision was a solid win for the IRS.
IRS examiners have historically used a four-factor test to determine benefits and burdens, gleaned from court cases, regulations, and internal IRS guidance (directives): who controls the details of the manufacturing process; who bears the risk of loss or damage during the manufacturing; who has the economic risk of loss from the sale of the property; and who has legal title to the property during the manufacturing process.
Only party can claim the Code Sec. 199 deduction. The IRS has noted that in a contract manufacturing arrangement, both parties may have some indicia of ownership. It may not be clear which party is entitled to the deduction. The IRS does not want to be whipsawed, where both parties claim the deduction for the same product at the same time.
Certification By Taxpayers Under Audit
To address this problem during an IRS audit, the Large Business & International Division has developed a procedure that allows the parties to the contract manufacturing arrangement to decide between themselves who will claim the deduction. The IRS believes this will save resources for both the taxpayers and for the government.
To claim the deduction, the taxpayer must submit a statement explaining the basis for its claim of benefits and burdens and must certify that it can and will claim the deduction. The other party to the contract manufacturing arrangement must certify that it will not claim the deduction. If the taxpayer follows this procedure, LB&I directs it examiners not to challenge the ownership claim. If the directive does not apply, the examiner (and the taxpayer) must apply all the facts and circumstances to determine who owns the property.
As you can see, the benefits and burdens issue can be particularly complex. Determining whether you have ownership of property for claiming the Code Sec. 199 deduction can be challenging. This firm stands ready to help you understand this question, interpret the factors used to determine benefits and burdens, and assist you with any ownership claims. Please contact our firm so that we can help you with this issue.
QUALIFIED BUSINESS INCOME DEDUCTION (2018 - 2025)