Whether the cash or accrual method is used, IRC Section 460 provides for special treatments for long term contracts (see GCA DIGEST Vol. 2, No. 1 for a discussion of financial accounting treatment of long term contracts).  The statute defines a long term contract as “any contract for the manufacture, building, installation or construction of property if such contract is not completed within the taxable year in which such contract is entered into.”  Note the definition is not that the contract must take over a year to complete but simply the contract must begin and end in different taxable years.  For manufacturing contracts there is one other requirement – either items produced must be unique and of a type not usually carried in the contractor’s finished goods inventory or they are items that are not normally completed in 12 months or less.  

Recent changes to the tax laws allow for the completed contract method only under very limited circumstances - general construction contracts estimated to be completed within two years from commencement as long as the annual gross receipts of the firm did not exceed $10 million over the three preceding tax years or home construction contracts if at least 80 percent of the total contract costs relate to buildings containing four or fewer dwellings.  Otherwise the percentage-of-completion method is used where income or loss on long-term contracts are based on annual evaluations of the cumulative progress made on the contracts.  Early recognition of income before actual completion of the contract is usually disadvantageous for tax purposes since it means the contractor must pay taxes on income sooner.  Of course, it can be advantageous if the income can be used to offset losses on other contracts or the calculated loss can offset income on other contracts.

The gross income to be recognized for tax purposes in any taxable year under the percentage-of-completion method equals the estimated percentage of completion of the contract times the gross contract price (unreduced for any retainages, holdbacks or payment considerations).  The percentage of completion of the contract is determined by comparing costs allocated to the contract that are incurred before the end of the tax year with the estimated total contract costs.  Taxes rule changes in 1989 allows taxpayers to elect non-recognition of any income in the first year on a long-term contract if less than 10 percent of the total contract costs have been incurred.

Though gross income is estimated and recognized over the life of the contract, expenses can be deducted only in the taxable year they are incurred under either the accrual or cash method.  In addition some expenses are disallowed such as material and supplies on hand at year’s end and deductive costs associated with guarantees, warranties and maintenance and service contracts.

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