Choosing The Wrong Accounting Method for Home Construction Contracts is a Costly Mistake

Often you learn the most from your mistakes.  If a contractor chooses the wrong accounting method, during the first two years of operations, the contractor will either not be eligible to defer the maximum amount of income on home construction contracts, or will have to pay the Internal Revenue Service (IRS) a user fee ($10,800 in 2020) to request permission to change its accounting method (for contacts not subject to the percentage of completion method of accounting). That’s an expensive lesson.

General Requirement to use the Percentage of Completion Accounting Method

Internal Revenue Code (IRC) Section 460(a) states that in the case of any long-term contract, taxable income shall be determined under the percentage of completion method of accounting. Easy enough, right? Well, get ready for some definitions courtesy of the IRC.

IRS Section 460(f) defines the term “long-term contract” as any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which the contract is entered into. For example, if a calendar year taxpayer begins a contract on December 30 and completes the contract on January 5 of the subsequent year, the contract is considered a long-term contract. As a result, a contractor may be required to account for this 7-day contract under the percentage of completion method of accounting.

Exception to the Percentage of Completion Requirement

For every good tax rule, there’s usually a good exception. IRC Section 460(e) contains an exception to the general rule requiring the use of the percentage of completion method. The following contracts and taxpayers are exempt from the general percentage of completion requirement:

• Home construction contracts
• Any other construction contract if the estimated completion time is within two years beginning on the contract commencement date and for which the taxpayer’s average annual gross receipts for the preceding three taxable years does not exceed $26 million. (the “small contractor exception”)

What is a Home Construction Contract?

Internal Revenue Code Section 460(e)(5) defines a home construction as a contract where 80% of more of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to:

• Dwelling units contained in buildings containing four or fewer dwelling units and
• Improvements to real property directly related to such dwelling units and located on the site of such dwelling unit

When dealing with townhouses, for purposes of IRC Section 460, each townhouse or rowhouse is treated as a separate building. However, a condominium building containing more than four units would not be eligible for the home construction contract exception.

Tax Benefits of Home Construction Contracts

From a tax perspective, classifying a contract as a home construction contract is a significant benefit because these contracts are exempt from:

• Percentage of Completion method of accounting
• Look-back interest
• Alternative minimum tax adjustments

What Accounting Method Does a Taxpayer Use When it has Contracts that are Subject to Percentage of Completion and Contracts that are Exempt from Percentage of Completion (Home Construction Contracts or “Small Contractors”)?

IRC Section 460(e)(1) permits the use of different methods of accounting for exempt contracts and nonexempt contracts within the same trade or business. As a result, a taxpayer may use a method of accounting, such as the completed contract method, for exempt contracts (home construction contracts) even though it must use the percentage of completion method for nonexempt contracts.

However, a taxpayer may have only one long-term contract method of accounting for all exempt contracts within the same trade or business. In accordance with the consent requirements of IRC Regulation Section 1.446-1(e), once a taxpayer adopts a method of accounting for long-term contracts that are not subject to the percentage of completion method of accounting, the taxpayer must continue that method of accounting until the taxpayer obtains the consent of the Commissioner to change its method of accounting. 

In certain circumstances, changing a taxpayer’s accounting method is not automatic and actually requires the IRS’ consent. For example, a request to change from the accrual method of accounting to the completed contract method of accounting is not an automatic method change. As a result, a taxpayer would have to pay a user fee ($10,800 in 2020) to make this method change. The user fee, in addition to the professional fees required to prepare the change in accounting method application, makes this a costly decision that could have been avoided if the proper method of accounting was elected when the contractor started doing business.

If you have any questions, or would like to discuss the most advantageous method of accounting for your construction company, do not hesitate to contact a member of the Schneider Downs Construction Industry Group.