In: Civil Engineering
5- Research about the Internal Revenue Service (IRS) Accounting for Construction Contracts and explain how IRS determines the accounting method that can be used in a project. Discuss concepts such as a Small or Large Contractor.
Internal Revenue Service(IRS) :
The Internal Revenue Service is the agency that collects tax revenue for the federal government. It has the entire force and power of the United States behind it, and mostly every citizen has to deal with it at least once a year in one way or another. It's the entity that's behind all those deductions in your salary and those quarterly estimated tax payments you have to make if you're self-employed.
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 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.
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.
Accounting Method
Every taxpayer (individuals, business entities, etc.) must figure taxable income for an annual accounting period called a tax year. The calendar year is the most common tax year. Other tax years include a fiscal year and a short tax year.Each taxpayer must use a consistent accounting method, which is a set of rules for determining when to report income and expenses. The most commonly used accounting methods are the cash method and the accrual method.Under the cash method, you generally report income in the tax year you receive it, and deduct expenses in the tax year in which you pay the expenses.Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received. You deduct expenses in the tax year you incur them, regardless of when payment is made.
Small Contractors:
IRC Section 460(e) provides two exceptions to the required use
of the percentage of completion accounting method and application
of the look-back interest rules applicable to certain construction
contracts. These exceptions do not apply to long-term manufacturing
contracts.
1. The home construction contract; and
2. The small contractor contract exception contained in IRC Section
460(e)(1)(B) requiresthe following conditions to be met:
A. At the time the contract was entered, it was
estimated that the contract would be completed within a 2-year
period beginning on the commencement date of the contract;
and
B. The contractor’s average annual gross receipts for
the 3 taxable years preceding the year in which the contract was
entered did not exceed $10 million.
Large Contractors
Large construction contractors are required to account for long-term contracts on the percentage of completion method. The amount of revenue reported each year under the contract using the percentage of completion method is determined by multiplying the total estimated contract price times the percentage of completion at the end of the taxable year (completion factor) less any gross receipts reported in the prior tax years of the contract.