Taxpayers using PCM cautioned by IRS on delaying income recognition.

• Author: Bliha, Richard F.
• Position: Percentage of completion method

Due to the nature of their work and the uncertain environment in which they operate, contractors and real estate developers are more in tune with estimates of job costs than any other business segment. Cost estimates are extremely important to these businesses, as they determine the amount of taxable income that needs to be recognized in any tax year.

If a taxpayer is using the percentage of completion method (PCM) of accounting, contract taxable income for a given year is computed by multiplying the contract price by the ratio of contract costs incurred during the year to estimated total contract costs. Under the PCM as it existed prior to the Tax Reform Act of 1986, contractors used engineering or other estimates to determine each project's completion. Under Sec. 460, however, this subjective factor was removed, with a project's percentage of completion determined solely on costs incurred on the project. By postponing the recognition of costs incurred for the work of their subcontractors, contractors can postpone income under the PCM.

The IRS is concerned about certain taxpayers using the PCM who were deferring expenses in order to defer income. In a coordinated issue paper (ISP) effective Mar. 21,1997, the Service stated that contractors in the construction/real estate industry cannot postpone the recognition of costs incurred for the work of their subcontractors to postpone income under the PCM. The scenario illustrated in the ISP is one in which a taxpayer/contractor would treat its liability to its subcontractor as being incurred on receipt of the subcontractor's bill. Any bill received before the end of the year generated a deduction for that year and triggered inclusion of income.

The ISP went on to state that in this case the contractor modified its method of accounting in that it delayed the recognition of expenses until it actually paid the subcontractor. Under this modified method, any bills received before year-end and not paid until after year-end resulted in deferred expense and thus, deferred income recognition. The net result was that the taxpayer's profit was deferred until the year in which payment was made to the subcontractor.

The taxpayer in the ISP attempted to defend its new cost-deferral method by citing Regs. Sec. 1.461-4(d)(6)(iii), which allows a taxpayer to treat property as provided to the taxpayer when it is delivered or accepted or when title passes. The taxpayer claimed that it should not be treated as...