Tax Savings Opportunities for Taxable Contract Acquisitions

Editor: Frank J. O’Connell, Jr., CPA, Esq.

Taxpayers using percentage-of-completion accounting have an opportunity for gross profit deferral following a mid-contract change in ownership. Taxpayers that acquire contracts in taxable transactions may wish to consider opportunities to defer gross profit resulting from the deemed constructive-completion rules that apply to taxable contract sales. In addition, an exception may exist that provides a current deduction for interest that must typically be allocated to the contract.

Percentage-of-Completion Overview

The percentage-of-completion method of accounting (PCM) is prescribed by Sec. 460 for building, installation, construction, or manufacturing contracts not completed in the tax year in which they are entered. Further, to qualify for long-term-contract treatment, manufacturing contracts must either be unique in nature or relate to the manufacture of items routinely requiring more than 12 months to complete (Sec. 460(f)(2)).

Under the PCM, a taxpayer recognizes revenue over the life of the contract. Taxpayers include in income a portion of the total contract price based on costs incurred and allocable to the long-term contract. As such, the taxpayer computes a completion factor, which is the ratio of costs incurred to estimated total allocable contract costs. Next, the taxpayer computes cumulative gross receipts from the contract by multiplying the completion factor by the total contract price. The taxpayer then subtracts its gross receipts recognized through the end of the prior year from its cumulative gross receipts at year end. Regs. Sec. 1.460-4(b)(2) provides that current-year costs incurred on the contracts are then deducted from the year’s gross receipts to arrive at gross profit.

Constructive Completion

The constructive completion rules described in Regs. Sec. 1.460-4(k)(2) apply to taxable contract sales, including deemed-asset sales under Sec. 338, of contracts accounted for using the PCM. In a constructive completion transaction, the selling taxpayer is treated as having completed the contract as of the day of the transaction and thus must recognize income from the contract. The purchasing taxpayer is treated as having entered into a new contract on the date of the transaction. If Sec. 460 applies, the total contract price is the amount that the new taxpayer expects to receive under the contract reduced by the allocable consideration paid to acquire the contracts. The new taxpayer’s contract costs do not include any amounts paid to the old taxpayer or any costs incurred by the old taxpayer as a result of the transactions that are allocable to the contract.

Example 1: In 2006, S Company begins a $1,500,000 long-term contract that is accounted for under the PCM. The estimated cost of completing the contract is $1,000,000. During 2006, S incurs costs totaling $250,000, or 25% of the total anticipated costs. S will report gross receipts of $375,000 (25% of $1,500,000) offset by $250,000 of costs, resulting in gross profit of $125,000 (see Exhibit 1).

In 2007, S incurs additional costs of $100,000. Late in the year, S sells the contract in a taxable transaction to B for $150,000. At the time of the sale, S has received progress payments of $500,000. As such, S’s contract price is adjusted from $1,500,000 to $650,000 ($500,000 progress payments + $150,000 sales consideration). The total contract costs are $350,000 ($250,000 from 2006 + $100,000 incurred during 2007). S is deemed to be 100% complete with respect to the contract and in 2007 will recognize gross receipts of $275,000 ($650,000 total contract price – $375,000 recognized in 2006) and will deduct the $100,000 costs incurred during the year (see Exhibit 2).

B is treated as having entered into a new contract at the time of the purchase in late 2007. In B’s hands, the contract price is $850,000 ($1,500,000 original contract price – $500,000 progress payments made – $150,000 consideration paid for contract). B anticipates that its total cost to complete the contract will be $600,000. Through the end of 2007, B incurs costs totaling $25,000 (or approximately 4% of its anticipated costs under the “new” contract). Barring any elections, B will recognize gross receipts of $35,000 and gross profit of $10,000 in 2007 (see Exhibit 3).

Deferral Opportunity with 10% Election

A taxpayer may make an election under Sec. 460(b)(5) to exclude from gross income any amount related to jobs where the taxpayer has incurred less than 10% of the estimated total allocable contract costs. If the election is made, a taxpayer must treat costs incurred before the 10% year as pre-contracting costs, as described in Regs. Sec. 1.460-4(b)(5)(iv). Pre-contracting costs may not be deducted in the current year; rather, one must capitalize the costs into the related contract or job. The 10% method may not be used by a taxpayer that determines percentage of completion under the simplified method prescribed in Regs.Sec.1.460-5(c)(1). A taxpayer makes the election to use the 10% method by using the method on its return for all contracts entered into during the election year. The election is an accounting method and must be applied consistently in future years.

Example 2: The facts are the same as in Example 1, although a significant portion ($375,000) of the total costs associated with the overall contract have been incurred by B and S, collectively; in B’s hands only 4% of the “new” contract’s total costs were incurred prior to year end. If B elects to use the 10% method, it will not include the gross receipts from the purchased contract in its gross profit because less than 10% of its estimated costs were incurred prior to year end. After capitalizing the $25,000 of 2007 costs, B will defer $10,000 of gross profit ($35,000 otherwise recognizable gross receipts – $25,000 capitalized costs). The deferred profit will be recognized in the following tax year, assuming the contract is then greater than 10% complete (see Exhibit 4).

Capitalization of Interest

Taxpayers should also be mindful of the rules for interest capitalization for jobs that are less than 5% complete. Taxpayers must allocate interest expense to long-term contracts to the extent the property produced is designated property. Under Regs. Sec. 1.263A-8, “designated property” is defined to include (among other categories):

1. Tangible personal property with an estimated production period exceeding two years, or
2. Property with an estimated production period exceeding one year and estimated production expenses exceeding $1 million.

Regs. Sec. 1.460-5(b)(2)(v)(A) provides that interest “incurred during the production period to the long-term contract [must be allocated] in the same manner as interest is allocated to property produced by a taxpayer under section 263A(f).” For purposes of applying this provision, Regs. Sec. 1.460-5(b)(2)(v)(B) provides that the production period begins on the later of (1) the contract commencement date or (2) the date by which more than 5% of the total estimated costs have been incurred.

Therefore, if less than 5% of total estimated costs have been incurred, taxpayers are not required to capitalize interest related to the designated property into the cost of the contract. Note that if the taxpayer has made the 10% election described above, such interest would have been a pre-contracting cost that must be capitalized in the current year.

Example 3: The facts are the same as in Examples 1 and 2, and B has historically applied the 5% method of accounting for interest capitalization. B funded the contract’s purchase from S with debt resulting in $10,000 of interest being allocated to the contract in 2007. Typically, the interest expense incurred during the production period must be allocated to the contract cost and would not be currently deductible. However, because the contract is less than 5% complete, Regs. Sec. 1.460-5(b)(v)(B) provides that the production period has not begun, allowing B to deduct the $10,000 interest expense currently.

In summary, following a taxable mid-contract purchase, taxpayers may wish to consider making the 10% election, which may provide significant gross profit deferral. Further, to the extent that less than 5% of the new contract’s costs have been incurred, associated interest is not required to be allocated to the job and may be deducted currently, resulting in additional reductions to taxable income.

EditorsNotes

Frank J. O’Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.

Unless otherwise noted, contributors are independent members of Crowe Chizek.

If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or foconnell@crowechizek.com.