Contracts may include a provision that allows one party to withhold a certain percentage of the total payment called for under the contract until a project is substantially complete; the amount withheld is commonly referred to as a retainage. Retainages are intended to address concerns that a contractor will not finish a project if full payment already has been made. Retainages are frequently provided in construction and manufacturing contracts, as well as in contractual arrangements with the U.S. government. A retainage in a contract may cause uncertainty as to the timing of including payments in income for a contractor that receives some payments in one year and the retainage in a later year.
While Sec. 460 provides guidance on the treatment of long-term manufacturing and construction contracts, some contracts that include retainages do not fall within the definition of a long-term contract under Sec. 460(f). (Long-term contracts include any contract for the manufacture, building, installation, or construction of property if the contract is not completed within the tax year in which it is entered into.) For contracts that are not long-term contracts, such as service contracts entered into with the U.S. government, different rules may apply.
Regs. Secs. 1.446-1(c)(1)(ii)(A) and 1.451-1(a) provide that under an accrual method of accounting, income is to be included for the tax year when (1) all events have occurred that fix the right to receive such income and (2) the amount of the income can be determined with reasonable accuracy (the all-events test). Rev. Rul. 84-31 provides that, with respect to a service contract, all the events that fix the right to receive income under an accrual method of accounting occur when (1) the required performance occurs, (2) payment is due, or (3) payment is made, whichever happens first. Tax practitioners commonly refer to this standard as the earliest of when the amount is due, paid, or earned.
Retainage amounts might seem to be includible in the year in which the payment to which the retainage relates is accrued because that appears to be when all the events occur that fix the right to receive all amounts called for under the contract. However, when a taxpayer must still meet a condition for performance to be complete, the amount has not yet been earned (see the Dally case, discussed below). Further, because the taxpayer cannot yet bill for the retainage and has not been paid, the retainage is not due...