9056 / How does a taxpayer account for revenue and costs under a long-term contract?
Editor’s Note: The 2017 tax reform legislation expands the exception for small long-term construction contracts from the requirement to use the percentage-of-completion method. See heading in Q 9057.
If the contract is found to be a long-term contract (see Q 9055), the taxpayer will be required to use the percentage of completion method to account for revenue under that contract, unless an exception applies to allow use of the completed contract method. Generally, the completed contract method may only be used for certain home construction and other real estate construction contracts (see Q 9057), so the exception is very limited.1
The percentage of completion method requires the taxpayer to include the portion of the total contract price that corresponds to the percentage of the entire contract that has been completed during that tax year.2 The aim of this method is to include a portion of income during each year as the work under the contract progresses.
To determine the income that must be recognized under a long-term contract, a taxpayer uses the following steps:3
(1) The completion factor for the contract, which is the ratio of the cumulative allocable contract costs that the taxpayer has incurred through the end of the taxable year to the estimated total allocable contract costs that the taxpayer reasonably expects to incur under the contract, is computed;
(2) The amount of cumulative gross receipts from the contract is computed by multiplying the completion factor by the total contract price;
(3) The amount of current-year gross receipts is computed, which is the difference between the amount of cumulative gross receipts for the current taxable year and the amount of cumulative gross receipts for the immediately preceding taxable year (whether positive or negative); and
(4) Both the current-year gross receipts and the allocable contract costs incurred during the current year are taken into account in computing taxable income.
If this method does not result in the taxpayer including the total contract price in income by the time the contract is completed, the taxpayer must include any remaining amounts in income for the tax year following the year of completion.4
A de minimis rule allows a taxpayer to defer recognition of income under a long-term contract for any year in which less than 10 percent of the estimated contract costs have been incurred by the end of the year. This income and related costs must then be recognized in a later year in which at least 10 percent of the contract has been completed.5