Examining IRS Code Section 460: What You Don’t Know Can Hurt You

by Megan Hiles
A construction worker or foreman at a construction site

This article was first published in the November 2017 issue of Properties Magazine

With construction accounting, there are a number of allowable choices to consider when determining the correct and most beneficial tax method to use.

Under Internal Revenue Code § 460 (460), the percentage-of-completion method (PCM) of accounting is required for large contractors with contracts meeting the definition of “long-term”. LTC are defined as contracts that are not completed within the same taxable year in which it is entered into. Additionally the contract has to be classified as a building, installation, construction, or manufacturing contract.

Exemptions and Elections

This code section can be complicated with many exemptions and elections involved. For example, service contracts are exempt from the provisions of 460, including but limited to architects, engineers, construction managers and commercial painters.

  • Home Construction Contracts
    • Contracts with 80% or more of the estimated total contract costs expected to be attributed to a home construction contract are exempt from 460. These projects must be related to the construction of dwelling units containing four or fewer units.
  • Small Contractor Exemption
    • You are exempt from following 460 when accounting for your LTC, meaning no PCM. A small contractor is a contractor who’s average annual gross receipts for the three taxable years preceding did not exceed $10 million.  One word or caution, make sure you know if you are part of a controlled group, or will become part of a controlled group.

If a small contractor is exempt from 460, for the most part allowable tax methods include:

  • Cash: Income is recognized when received and expenses are recognized in the year paid.
  • Accrual: Revenue is recognized when it’s earned or received and expenses are deducted when the expense occurs, not when the cash is paid.
  • Accrual Electing to Exclude Retainage: Accrual basis contractor can exclude retainages receivable/payable.
  • Completed Contract: Revenue and costs incurred on a contract are not recognized until the contract is completed and accepted.

Large Contractors

Large contractors must comply with 460 and are required to use the PCM for their LTC, recognizing revenue on the percentage of contract completion determined by the total costs incurred to date over the total estimated costs. Generally as stated above, PCM is required to be used by large contractors, except for the exceptions below:

  • Home Construction Contracts
    • See above, same rules apply for large contractors. You may be surprised what gets classified as a home construction contract!
  • Residential Construction Contracts
    • 70% of the contract is reported on the percentage of completion method and 30% of the contract is reported on the completed contract method. A residential contract is defined as containing more than four dwelling units.
  • PCM Excluding Retainage Payables
    • This method excludes retainages payable from the contract costs to date until the retention is payable as defined within the contract. This can reduce the overall percentage complete of the project, which in turn reduces the income to be recognized.
  • 10% Deferral Method
    • Contracts that are less than 10% complete at year end can be accounted for on the completed contract method until the % complete exceeds 10%.

The techniques noted above may require a change in accounting method and approval by the IRS. Use of some of the exceptions and methods may also have different Alternative Minimum Tax (AMT) applications, which may result in taxes higher than when computing taxes on a regular tax base.

All contractors need to ask themselves the following questions in preparation for the year-end.

  • Am I a small contractor or large contractor?
  • What is my tax method: overall method and LTC method?
  • If I am a general contractor, we need to look at PCM excluding retainages payable?
  • Do we have any of the following contracts on our year-end contracts in progress schedule:
    • Home construction
    • Residential construction
    • 10% or Less Complete
  • Have I taken AMT into account for our allowable methods?
  • Do I need IRS approval for any elected changes, if so do we need to file Form 3115 prior to year-end and pay a user fee?