Generally, an accounting method is chosen when establishing a business, and it does not change. If the method is changed, a Form 3115, Application for Change in Accounting Method, is often filed and must be approved by the IRS. However, there is a scenario wherein one does not have an option to choose a method. Instead, the accounting method must be changed by operation of law.
Sec. 446 allows a taxpayer to choose the method of accounting when establishing the business. The Code also states that the tax method must conform to the method used for book purposes. The law does state that the selected method must clearly reflect income, and, if it does not, the law further provides that the IRS has the power to select a method that does.
Another item affecting a business and its choice of accounting method is the existence of inventory. Sec. 471(a) allows the IRS to determine whether inventories are required to clearly reflect income. Regs. Sec. 1.471-1 requires the use of inventories whenever the "production, purchase, or sale of merchandise is an income-producing factor." Taxpayers often assume inventory is only merchandise held for sale to customers, but it also includes items that are substantial in the construction industry. In the construction industry, merchandise is commonly called materials. Materials are generally considered to be substantial when they are at least 10% to 15% of gross income for the year. This percentage is not a hard-and-fast rule but has been a guideline for some court cases. If an entity has inventory, its method of accounting cannot be on a cash basis.
It should be mentioned that Sec. 448 prohibits the use of the cash method of accounting by a C corporation, a partnership that has a C corporation as a partner, or a tax shelter.
The following example illustrates the limitations on the selection of accounting methods.
Example: A corporation performs installation services for customers in buildings for communication needs, installing telecommunication or data cabling. When it was started, the business elected to be taxed as an S corporation. The company chose to use the cash basis of accounting and the completed-contract method of accounting for its long-term contracts. Since it is an S corporation, it does not have any limitations as discussed above regarding Sec. 448 and the use of the cash method. However, the company has done well and now is achieving gross annual revenues that average greater than $10 million over the prior three years.
At first glance, one may determine that the corporation does not need to change its method of accounting. However, Regs. Sec. 1.446-1 mentions "construction merchandise," which reminds practitioners about contracts. Looking at long-term contracts and Sec. 460 leads to the conclusion that the method of accounting the next year will change to the use of the percentage-of-completion/accrual method for the company. How is this determination arrived at?
Sec. 460 states that in the case of any long-term contract, the taxable income from the contract shall be determined under the percentage-of-completion method.
Although the company's contracts are generally short-term, spanning a few months, they do overlap tax years. Thus, they are considered long-term contracts under Sec. 460(f). Sec. 460(f) states that "any contract for the building, installation, or construction of property, if such contract is not completed within the taxable year in which such contract is entered into" is considered a long-term contract (emphasis added). Although some types of service contracts are exempt from this provision, such as those for architectural, engineering, and construction management services, the corporation's services are not.
Further research reveals that, in Regs. Sec. 1.460-3, the key is whether the installation is deemed "an integral component to real property." Real property is defined in part as "inherently permanent structures" in Regs. Sec. 1.263A-8(c)(3). Regrettably, the taxpayer must overcome substantial hurdles to prove most installations are not an integral component of real property and inherently permanent, as discussed in Regs. Sec. 1.48-1, Regs. Sec. 1.897-1, Whiteco Industries, Inc., 65 T.C. 664 (1975), and Chief Counsel Advice 201211011.
Sec. 460(e)(1) provides an exception to the requirements of Sec. 460, stating in part:
(A) any home construction contract, or
(B) any other construction contract entered into by a taxpayer—
(i) who estimates . . . that such contract will be completed within the 2-year period beginning on the contract commencement date of such contract, and
(ii) whose average annual gross receipts for the 3 taxable years preceding the taxable year in which such contract is entered into do not exceed $10,000,000.
To conclude, although nothing new has been done and the corporation does not want to change its method of accounting, the Code requires that since the corporation is no longer exempt from the requirements of Sec. 460, it must now comply with it. Since the exemption no longer applies, there is no change in accounting method to elect; the taxpayer must make the change to the percentage-of-completion method, and the change is treated on a cutoff basis beginning in the year of change.
Michael Koppel is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.