This document provides an overview of Section 460 of the Internal Revenue Code, which regulates the tax treatment of long-term contracts. It discusses the small contractor exception for contractors with average annual gross receipts under $10 million. It also covers available accounting methods for long-term contracts, including percentage-of-completion for large contractors. The document concludes with a discussion of look-back provisions that recalculate taxes owed based on final contract costs.

1. MITIGATING TAXES FOR
CONTRACTORS
SECTION 460 APPLICATION
LISA M. WHITE, CPA
CHRIS T. CARE

2. FRAUD ENGAGEMENT
FROM A TO Z
SAMUEL BOWERCRAFT, MSIS, CISA
&
DAVID HAMMARBERG,
CPA, CFE, CISSP, MCSE, WXYZ

3. 11
/
/ 20
13

4. MITIGATING TAXES FOR
CONTRACTORS
SECTION 460 APPLICATION
LISA M. WHITE, CPA
CHRIS T. CARE

5. INTRODUCTIONS
Lisa White
• Tax Senior Manager
• Real Estate and Construction Focus

6. INTRODUCTIONS
Chris Care
• Staff Tax Accountant
• Real Estate and Construction Focus

7. ABOUT MCKONLY & ASBURY, LLP
• Audit, Tax and Risk Management Firm
• Regional presence in Pennsylvania
• Variety of clients ranging from construction to manufacturing and other
clients
• Special capabilities real estate and construction industries
• Best Places to Work and Best Accounting Firm

8. AGENDA
• A definition of Section 460
• Small Contractor Application
• Large Contractor Application
• Look-Back

9. IRC SECTION 460
The section of the Internal Revenue Code that regulates long-term contracts.
• Long-term contract is defined as…
• Non long-term contract activities
• Exemptions:
• Small Construction Contracts
• Home Construction Contracts

10. SMALL CONTRACTOR CONTRACT EXCEPTION
Average annual gross receipts for 3 prior tax years
are less than $10 Million
AND
The contract is expected to be completed within a
2-year period

11. SMALL CONTRACTOR CONTRACT EXCEPTION
$10 Million Test
• All trades or businesses under common control
• All members of any controlled group of corporations of which
taxpayer is a member
• Attribution Rules!
• Less than 50% ownership, but more than 5%

12. SMALL CONTRACTOR CONTRACT EXCEPTION
Example
• Adam owns the following:
• 100% of Build-It Corporation
• Average annual gross receipts of $5 Million
• 15% of Crafty Corporation
• Average annual gross receipts of $50 Million
• For the $10 Million Test, Build-It Corporation shows average annual gross
receipts (due to attribution rules) of $12,500,000

13. SMALL CONTRACTOR CONTRACT EXCEPTION
$10 Million Test
• Does not include:
• Returns and allowances
• Interest, dividends, rents, royalties, or annuities, not derived in the
ordinary course of a trade or business
• Receipts from the sale or exchange of capital assets

14. AVAILABLE METHODS
Exempt-contact Methods
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Cash
Accrual
Hybrid
Accrual with Deferred
Retainages
• Completed Contract
Method (CCM)
• Exempt-Contract Percentage of
Completion (EPCM)
• Percentage of Completion (PCM)
• PCM – Simplified Cost Method
• PCM – 10% Method
• PCM Capitalized Cost Method (PCCCM)

15. AVAILABLE METHODS (CONT.)
Methods of accounting
• Overall and short-term contracts
• Long-term contracts – Home Construction
• Long-term contracts – Residential Construction
• Long-term contracts – General Construction estimated to be completed
within two years
• Long-term contracts – General Construction estimated to be completed in
two or more years

16. LARGE CONTRACTORS
Required to use percentage of completion
• Cost to Cost Method
• Simplified Cost to Cost Method
• Reduces the number of costs that must be used
• 10 Percent Method
• Defers recognition on job until greater than 10% complete
• Can only choose one!!

17. INDIRECT COSTS
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Indirect labor costs
Officers’ compensation
Pension and other related costs
Employee benefit expenses
Indirect material costs
Purchasing costs
Handling costs
Storage costs
Cost recovery (depreciation)
Depletion
Rent
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Taxes
Insurance
Utilities
Repairs and maintenance
Engineering and design costs
Spoilage
Tools and equipment
Quality control
Bidding costs
Licensing and franchise costs
Interest
Capitalized service costs

18. IMPACT OF INDIRECT COSTS
Example:
• Estimated Total Contract
• Revenue: $500,000
• Costs: $400,000
• Gross Profit: $100,000
• Year 1:
• Contract Costs Incurred to Date: $300,000
• Percentage Complete: 75%
• $300,000/$400,000
• Gross Profit Recognized: $75,000

19. IMPACT OF INDIRECT COSTS (CONT.)
Determine indirect costs to be allocated to the contract, but do not adjust
Total Estimated Contract Costs:
• Allocated indirect costs: $80,000
• Percentage Complete: 95%
• $300,000 + $80,000/$400,000
• Gross Profit Recognized: $95,000
• (Increase of $20,000)

20. IMPACT OF INDIRECT COSTS (CONT.)
Determine indirect costs to be allocated to the contract, but only adjust
Total Estimated Contract Costs for the same amount:
• Allocated indirect costs: $80,000
• Percentage Complete: 79.17%
• $300,000 + $80,000/$400,000 + $80,000
• Gross Profit Recognized: $79,167
• (Increase of $4,167)

21. IMPACT OF INDIRECT COSTS (CONT.)
Determine indirect costs to be allocated to the contract, and adjust Total Estimated
Contract Costs for an estimated amount to be incurred over the life of the
contract:
• Allocated indirect costs: $80,000
• Estimated indirect costs to be incurred: 30%
• Percentage Complete: 74.50%
• $300,000 + $80,000/$400,000 + $80,000 + $30,000
• Gross Profit Recognized: $74,500
• (Decrease of $500)

22. HOME CONTRACT EXCEPTION
80% of the estimated total contract costs are attributable to:
• Buildings containing 4 or fewer dwelling units or
• Real property directly related to those dwelling units
• Dwelling units cannot be used transient basis.

23. HOME CONTRACTS (CONT.)
“Spec” Homes
• No construction contract exists
Custom Homes Built on Builder’s Land
• Large Contractor – follow Spec Home Rules
• Small Contractor – must use CCM
Custom Homes Built on Buyer’s Land
• Large Contractor – Accrual, PCM, or CCM
• Small Contractor – Accrual, Exempt PCM, PCM, or CCM

24. RESIDENTIAL CONTRACTS
Buildings containing more than 4 dwelling units.
Use either PCM or PCCCM
• 70% - PCM
• 30% - Exempt contract method (Usually CCM)

25. LOOK-BACK
Hypothetical calculation
Uses final contract costs to recalculate percentage of completion and
revenue that should have been recognized in each year
• 10% deferral year
Payment or refund of interest for tax paid during those years
• Not a change in tax!

26. LOOK-BACK
Only applicable to long-term contracts required to use POC
• i.e. not home contracts, not small contractors
De minimis:
• Contract completed within two years of commencement date; and,
• Lesser of:
• $1,000,000 or
• 1% of annual gross receipts of taxpayer for the previous three years

27. LOOK-BACK
Regular Method
• Considers all aspects of taxable income calculations
• AMT
• Itemized Deductions (AGI Limitations)
Simplified Marginal Impact Method (SMIM)
• Uses assumed marginal tax rate
• Highest in effect for the prior year
• Required for domestic contracts for non-closely held partnerships and S-Corps (others may elect this method)
• Applied at the entity level
• Calculated as hypothetical change in contract gross profit times highest marginal tax rate
• No consideration for other limitations on the returns (i.e. itemized deductions)

28. LOOK-BACK
For corporations, look-back interest due can be deducted as interest
expense.
For individuals, look-back interest due is considered nondeductible
personal interest.
For all taxpayers, look-back interest received is considered interest
income.

29. RECAP
• A definition of Section 460
• Small Contractor Application
• Large Contractor Application
• Look-Back

30. THANK YOU
If you have questions, please contact us:
Lisa White
• lwhite@macpas.com
Chris Care
• ccare@macpas.com

31. 11
/
/ 20
13

32. 11
/
/ 20
13

33. FRAUD ENGAGEMENT
FROM A TO Z
SAMUEL BOWERCRAFT, MSIS, CISA
&
DAVID HAMMARBERG,
CPA, CFE, CISSP, MCSE, WXYZ