Recent developments concerning the completed contract method of accounting.

• Author: Knight, Ray A.

Recent Developments Concerning the Completed Contract Method of Accounting

The completed contract method of accounting for income for long-term contracts is an exception to the annual accounting concept generally governing income recognition under the federal tax laws. Under this method, all costs properly allocable to a contract are accumulated until the contract is completed and accepted. At that point, the contractor includes the contract price in its gross income and deducts the related costs incurred in completing the contract. (1)

Two distinct advantages generally are associated with the completed contract method:

(1) it provides a precise matching of income and expenses and

(2) it permits the contractor to defer income, and thus taxes, until the year of contract completion.

The disadvantage, on the other hand, is that it tends to bunch income, especially where a taxpayer performs work on only a few contracts at a time.

The 1986 and 1987 tax acts severely limited, but did not prohibit, the use of the completed contract method. The two acts basically left the eligibility requirements of the method intact. In a recent case of first impression, Sierracin v. Commissioner, (2) the Tax Court restricted the method's use by its interpretation of two of the eligibility requirements: (1) that the manufactured or constructed item be "unique" and (2) that the contract be subject to a risk that makes the costs and benefits impossible to determine with a high degree of certainty. This article reviews the eligibility requirements of the completed contract method in light of the changes enacted by the two tax acts and the Sierracin decision. It then discusses the extent to which the benefits from the completed contract method still are realizable.

THE EFFECT OF THE 1986 AND

1987 TAX ACTS

Before the Tax Reform Act of 1986, contractors generally were free to select one of the long-term contract methods (percentage of completion or completed contract) or any other method (cash or accrual) that would clearly reflect income. The use of the method, however, was restricted. For example, section 446(a) required that the taxpayer's method of accounting for tax purposes be based upon its method of accounting for bookkeeping purposes. This requirement, interpreted liberally by both the courts and the Internal Revenue Service, required that the taxpayer maintain adequate books and records and reconcile any differences between book and taxable income.

Through the addition of section 460, the 1986 Act limited the contractor's freedom in selecting an accounting method by requiring a new hybrid method for all long-term contracts other than certain small real estate projects. Under this new method (termed the "percentage of completion-capitalized cost" method), 40 percent of income from long-term contracts had to be reported on the percentage of completion method, with the remaining 60 percent on the taxpayer's normal method of accounting. Thus, 60 percent of income still could be accounted for under the completed contract method, assuming this was the contractor's normal accounting method.

Certain contracts for construction or improvement of real property also were still eligible to use the completed contract method under the 1986 Act. The two primary requirements for such contracts were that they were (1) estimated to be completed within two years from the commencement date of the contract and (2) performed by a contractor with average annual gross receipts not in excess of $10 million for the three years preceding the taxable year the contract was executed. (3)

For long-termcontracts governed by new section 460, costs were to be allocated in accordance with the statutory and regulatory provisions applicable to extended period long-term contracts. (4) Allocation, however, was not required for independent research and development expenses, expenses for unsuccessful bids and proposals, and costs of marketing, selling, and advertising. (5) In addition, the contractor had to capitalize any costs which it identified as attributable to the contract, pursuant to a cost-plus contract or a contract for which costs were certified under federal statute of regulations. (6)

The Revenue Act of 1987 amended the percentages established by the 1986 Act for the percentage of completion-capitalized cost method. Under the 1987 Act, 70 percent of income from long-term contracts must be reported on the percentage of compaletion method, with the remaining 30 percent of the taxpayer's normal method of accounting. (7) The new percentages apply to contracts entered into after October 13, 1987. (8)

The 1986 and 1987 legislation obviously restricted the applicability of the completed contract method. The new laws, however, did not change the definition of a long-term contract. In fact, the Conference Committee Report on the 1987 Act expressly states:

It is anticipated that the criteria and methods used by the taxpayer, including those criteria and methods used to determine if an item is "unique," prior to February 28, 1986 [the effective date of the 1986 Act changes] in determining if a particular contract was a long-term contract will continue to be used by the taxpayer. (9)

Thus, statutory, regulatory, and case law governing the completed contract method still has relevance for (1) all contracts enterd into befor February 28, 1986, (2) 60 percent of ocntracts entered into from February 28, 1986, through October 13, 1987, (3) 30 percent of contracts entered into after October 13, 1987, and (4) all real property contracts meeting the requirements of section 460(e). For these contracts, the criteria for using the completed contract method (including those addressed by the Tax Court in Sierracin must be understood before the benefits of the method can be realized.

CRITERIA FOR COMPLETED

CONTRACT METHOD

ONly "long-term" contracts may be accounted for under the completed contract method. For this purpose, a manufacturing contract is long-term only if it involves the manufacture of (1) unique items of a type not normally carried in the finished goods inventoryt of the taxpayer or (2) items normally requiring more than 12 calendar months to complete, regardless of the duration of the actual contract. (10) In addition to these requirements, the courts have required that the contract be subject to unpredictable risks--that is, an inability to determine ultimate gain or loss until completion. (11) As previously noted, the uniqueness of the item manufactured and the unpredictability of the risks involved were two key issues addressed in Sierracin.

The completed contract method also applies to building, installation, or construction contracts. In Revenue Ruling 70-67, (12) the IRS explained its rationale for allowing the completed contract method on these contracts:

One of the reasons why permission on a completed contract basis is given in the case of building, installation and construction contracts, is the fact that there are changes in the price of articles to be used, losses and increased costs due to strikes, weather, etc., penalties for delay and unexpected difficulties in laying foundations which make it impossible for any construction contractor, no matter how carefully he may estimate, to tell with any certainty whether he has derived a gain or sustained a loss until a particular contract is completed.

The courts have prohibited taxpayers from using a long-term contract method with respect to contracts for the sale of property for delivery more than one year after the signing of the contract, (13) contracts calling for the sale of lumber, (14) oil brokerage contracts requiring delivery more than one year in the future, (15) and contracts for breeding animals where a refund must be made if a live birth does not occur. (16) Thus, it is clear that long-term contract reporting is not available for general merchandising contracts that do not call for building, installation, or construction. (17)

A corporation using the completed contract method must compute earnings and profits on the basis of the percentage of completion method--that is, recognize income each year according to the percentage of the contract completed during the year. (18) Since taxable dividends are determined on the basis of earnings and profits, this requirement diminishes the possibility of a company distributing progress payments to the shareholders tax-free or making capital gain distributions under section 301(c)(2) or (c)(3).

In applying the completed contract method, neither the contract price nor the costs are includable in the taxpayer's income tax return until the contract is "finally completed and accepted." (19) The decision of when this occurs has long been a source of considerable litigation and controversy.

The long-term contract regulations specifically provide that to clearly reflect income, it may be necessary to treat either (1) one contract as several contracts or (2) several contracts as one contract. (20) Although there is general agreement with the necessity of this provision, considerable criticism has been directed toward the regulatory rules governing the severance and aggregation of contracts.

MEANING OF "FINALLY

COMPLETED AND ACCEPTED"

Under prior regulations, the courts differed significantly in their interpretations of the phrase "finally completed and accepted." The Tax Court held that income was to be reported fo rthe taxable year in which the contract was substantially completed, even though some work remained to be done. (21) In contrast, several other courts held that the regulations were to be read literally: no income was to be reported until final completion and acceptance occurred. (22)

Regulations proposed in 1971 sought to require taxpayers to follow the Tax Court's approach of recognizing income based upon substantial completion. (23) Under these proposed regulations, a contract was considered complete when (1) the remaining costs required...