By Anna G. Duff, Tax Supervisor | Real Estate & Construction Team
Construction contractors are required to use a percentage-of-completion method in determining taxable income from any long-term contracts (Sec.460 (a)). However, in the case of home construction contracts, or any other construction contracts, entered into by a taxpayer who estimates that such contract will be completed within a two-year period, and whose average annual gross receipts for the three taxable years preceding the taxable year in which such contract is entered into, do not exceed $10 million, construction contractors are eligible to use a completed-contract method for regular income tax accounting (Sec.460 (e) (1)). The completed-contract method cannot be used to determine Alternative Minimum Taxable (AMT) income for any long-term contract, except for a home-construction contract.This could potentially result in AMT adjustment.
Definition of “Long-Term Contract” and “Home Construction Contract”
The term “long-term contract” is defined by the code as any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into (Sec.460 (f) (1)). The term “home construction contract” means any construction contract for which 80 percent or more of the estimated total contract cost (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to activities with respect to dwelling units and improvements to real property directly related to such dwelling units and located on the site of such dwelling units (Sec.460 (e) (6) (A)).
Contracts Subject to AMT
If the long-term contract is not a home-construction contract in progress at the year end, such contract is subject to the AMT even if the taxpayer uses the completed-contract method for regular income tax computation purposes. The taxpayer must report a positive AMT adjustment for the difference between regular taxable income and AMT income for the year the long-term contract work is in progress. This AMT adjustment will reverse in the year in which the long-term contract is completed as the cumulative income for regular income tax and AMT would be the same.
Additionally, the taxpayer might be required to pay an interest charge under the lookback method upon completion of a long-term contract. With respect to income from any long-term contract reported under the percentage of completion method, a taxpayer is required to pay or is entitled to receive interest under section 460(b) on the amount of tax liability that is deferred or accelerated as a result of overestimating or underestimating the total contract price or contract costs. Under this look-back method, taxpayers are required to pay interest for any deferral of tax liability resulting from the underestimation of the total contract price or the overestimation of total contract costs. Conversely, if the total contract price is overestimated or the total contract costs are underestimated, taxpayers are entitled to receive an interest refund for any resulting acceleration of tax liability.
The interest computed under the look-back method shall be determined by first allocating income under the contract among taxable years before the year in which the contract is completed on the basis of the actual contract price and costs instead of the estimated contract price and costs. Secondly, the taxpayer needs to determine the overpayment or underpayment of tax for each taxable year, and use the adjusted overpayment rate, compounded daily, on the overpayment or underpayment. Discounting of post-completion adjustments to the year of completion is required using the federal midterm rate (Sec.1274 (d)), unless an election not to discount is made (Regs.Sec.1.460-6 (c) (1) (ii) (C)). The election not to discount is to be made on a contract-by-contract basis and is binding with respect to all post-completion adjustments that arise with respect to a contract for which an election has been made.
The look-back method does not to apply to any contract with a gross price of which (as of the completion of the contract) does not exceed the lesser of $1 million, or 1 percent of the average annual gross receipts of the taxpayer for the 3 taxable years preceding the taxable year in which the contract was completed, and which is completed within 2 years of the contract commencement date. Also, the look-back method doesn’t apply to a long-term contract for a tax year in which the look-back method would otherwise apply if at the close of each “contract year” before that tax year, the cumulative taxable income (or loss) under the contract is within 10% of the cumulative “look-back income (or loss)” (Sec.460 (b) (6)).
Applying the Look-Back Method for Partnerships, S Corporations, or Trusts
A pass-through entity (partnership, S corporation, or trust) that is not closely held must apply the look-back method at the entity level to any contract for which at least 95% of the gross income is from U.S.sources. A pass-through entity is considered closely held if, at any time during any tax year for which there is income under the contract, 50% or more (by value) of the beneficial interests in the entity are held (directly or indirectly) by or for five or fewer persons. For this purpose, rules similar to the constructive ownership rules of Section 1563 (e) apply.
The amount of interest resulting from applying the lookback method is computed and reported on Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts, for the filing year.
Interest Expense for C Corporations, Individuals and Other Taxpayers
An interest expense can be deducted by a C Corporation. For individuals and other tax payers this interest is not deductible.
In the event of omission of the long-term contract AMT and the lookback interest adjustments, the taxpayer could become subject to the 20% accuracy-related penalty (Sec.6662 (a)).
Additional Resources for Accounting in the Construction Industry:
- High level look at disclosures required for revenue recognition
- Sales tax changes for sellers/installers of certain tangible property
- Access all of our construction related articles on our blog.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.