When Is Income Recognized Under Cost-Plus Contracts?

By Cathy Fitzpatrick, CPA, MST, Washington, DC

Editor: Mary Van Leuven, J.D., LL.M.

Generally, tax law delays recognition of income until the all-events test is satisfied. The IRS recently issued taxpayer-favorable guidance, ruling that an accrual-method taxpayer recognizes income from the reimbursement of allowable costs under cost-plus contracts when the amounts are billed and due, not when the taxpayer incurs the reimbursable costs. This item recaps the IRS guidance and considers what it may mean for other taxpayers.

On January 18, 2008, the IRS released Technical Advice Memorandum (TAM) 200803017. The TAM addresses the treatment of income earned by an accrual-method taxpayer for services it provided to the U.S. government under cost-plus contracts. The taxpayer was a contractor that performed technical services, including research and design, information technology, engineering and consulting, training, and operational services for the U.S. government. Under cost-plus contracts, the government reimburses a contractor for its costs and separately negotiates and pays the contractor a profit for work related to the contracts.

The Federal Acquisition Regulations (FAR) generally provide the rules for government cost-plus contracts. The FAR provide the terms for each contract, including timing payments and bills and establishing a ceiling for total costs incurred by the contractor (allowable costs). In the case of cost-plus contracts for services, a contractor may submit interim bills for allowable costs incurred, subject to the government’s right to inspect and test all contract services. If the services do not conform to the contract requirements, the government may require the contractor to repeat the services for no additional fee. When the contractor cannot correct the defects by reperformance or fails to promptly reperform the services, the government has additional remedies available, such as reducing the fee payable or terminating the contract for default. Finally, in some cases, the government may terminate a cost-plus contract for convenience. This usually occurs when the government believes that the project is no longer viable or that the funds should be spent on other projects. If a contract is terminated for convenience, the contractor may be reimbursed for its allowable costs and paid an appropriate percentage of its contract fee.

Timing of Income Recognition

At issue in the TAM was whether the taxpayer was required to recognize service income for reimbursable allowable costs when it incurred the costs or when the amounts were due (billable). Under the accrual method of accounting, under Sec. 451 and Regs. Sec. 1.451-1(a), income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount of income can be determined with reasonable accuracy (the all-events test).

As interpreted by the courts and the IRS, in the absence of a contingency affecting the taxpayer’s right to income, the all-events test is satisfied on the earliest of when either (1) the income is received, (2) the income is due, or (3) the required performance or events have occurred. See, e.g., Schlude, 372 US 128 (1963); Rev. Rul. 2004-52; Rev. Rul. 2003-10; and Rev. Rul. 84-31. The Tax Court held in Decision, Inc., 47 TC 58 (1966), acq. 1967-2 CB 2, that the terms of an agreement can be relevant in determining when the all-events test is met.

During an examination of the taxpayer, the IRS’s examining agent concluded that the taxpayer should have recognized income as reimbursable allowable costs were incurred, even though not yet billed or received. The agent argued that the all-events test was satisfied and the required performance occurred as the taxpayer incurred costs in performing under its cost-plus contracts because the taxpayer would, in all circumstances under the contracts’ terms, receive income representing the amount of the costs. Disagreeing with the agent’s conclusion, the IRS National Office determined in the TAM that the taxpayer did not have to recognize income for the costs until the amounts were due.

The National Office found that the taxpayer’s cost-plus contracts were similar to the service agreements in the 1966 Decision case. The defendant in Decision derived income from the sale of advertising space in a job directory. Advertisers who purchased space in the directory signed a contract that allowed the advertisers to immediately use the defendant’s résumé service. Directory advertising orders were due by November 1963, invoices were sent in January 1964, and the directory was published the next month. In holding that the defendant did not have a fixed right to receive income until the billing date, the Tax Court rejected the IRS’s argument that the defendant’s right to receive income was fixed by performance of a portion of the services required under the contract (the résumé services). In so concluding, the court stated that the IRS “has referred us to no cases holding that income accrues upon part performance of a contract prior to an agreed billing or payment date.”

Based on the factual similarities of the taxpayer’s situation to that in Decision, the National Office commented that the examining agent’s position depended on the cost portion of the cost-plus contract being divisible from the rest of the contract and cited Rev. Rul. 79-195. In that ruling, the IRS concluded that a divisible portion of service income was earned before all contract services were completed. The ruling involved a correspondence school that received federally guaranteed promissory notes as payment for home study courses. Each course consisted of several lessons to be completed by a student over a 36-month period. The tuition contracts and promissory notes conditioned payment on the school’s rendering of the instruction and the student’s completion, on a lesson-by-lesson basis, of the courses. No amounts were due or paid until nine months after the student graduated or ceased to carry a certain academic workload. The ruling concluded that the school recognized tuition income when a student completed each lesson.

The National Office distinguished the taxpayer’s cost-plus service income from the tuition income in Rev. Rul. 79-195 and noted that in the ruling, the income accrued represented all income attributable to the portion of the services completed during the tax year of the accrual. To the contrary, performance under the cost-plus contracts entitled the taxpayer to both cost reimbursement income and possible fee income attributable to the same performance. Therefore, by contending that only the cost reimbursement income is includible in gross income, the examining agent attempted to divide the required performance under a contract based on divisible components of the amounts to be billed under the contract, as opposed to dividing the required performance into divisible services. The National Office stated,

We are not aware of any authorities that permit divisibility based on components of the billable amounts for federal income tax purposes. Consequently, we do not think the required performance for the accrual of the cost portion of the billable amount differs from the required performance for the fee portion of the billable amount. For both amounts, the required performance has not occurred prior to the time the amounts under the contract are due.

Therefore, according to the National Office, the taxpayer does not have a fixed right to receive income under the cost-plus contracts until the amounts become due.

Practical Implications

Although in TAM 200803017 the National Office specifically addressed income earned for the provision of research, information technology, engineering, consulting, and similar services under a cost-plus contract, its analysis may be applicable to a service provider that enters into contracts with customers under which billing and payment are deferred and the required services are not divisible into separate components, even where fees are not determined on a cost-plus basis. Based on the TAM, a taxpayer who has these types of contracts and is reporting income as the services are partially performed, rather than when the services are complete, may be able to start deferring the income until the date of completion or the date of billing or collection, if earlier. (However, it should be noted that a holding in a TAM applies only to the taxpayer for whom the advice was requested.)

A taxpayer’s timing of recognizing income from services is an accounting method within the meaning of Sec. 446. Thus, any change in the treatment of such income by a taxpayer is a change in the method of accounting within the meaning of Sec. 446(e), which requires the taxpayer to secure the IRS’s consent before implementing such a change. A method change from recognizing income as services are partially performed (but when the income is not yet received, due, or earned) to recognizing income when services are complete is subject to the nonautomatic provisions of Rev. Proc. 97-27 (as modified by Rev. Proc. 2002-19). Therefore, taxpayers who, after consultation with their tax advisers, wish to request this change must file Form 3115, Application for Change in Accounting Method, by the last day of the year of change.


Mary Van Leuven ia a Senior Manager at Washington National Tax KPMG LLP in Washington, DC

The information contained in this Tax Clinic is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions expressed are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.

© 2008 KPMG LLP, a U.S. limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.



If you would like additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or mvanleuven@kpmg.com.

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