Construction Industry Audit Technique Guide

1 Publication 5522 (Rev. 4-2021) Catalog Number 35393M Department of the Treasury Internal Revenue Service Construction Industry Audit Technique Guide This document is not an official pronouncement of the law or the position of the Service and cannot be used, cited, or relied upon as such. This Guide is current through the revision date. Since changes may have occurred after the revision date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the revision date. The taxpayer names and addresses shown in this publication are hypothetical. Audit Technique Guide Revision Date 4/19/2021 2 Table of Contents I. Overview .. 10 A. Foreword .. 10 B. Participants in the Construction Industry .. 10 Contractors .. 10 General or Prime Contractors.

2 10 Construction Managers .. 10 Commercial Contractors .. 11 Commercial Project Owners .. 11 Residential Construction Developer .. 11 Subcontractors .. 12 Highway Contractors .. 12 Heavy Construction Contractors .. 12 Architects and Engineers .. 13 Material Suppliers .. 13 Construction Lenders .. 13 Surety Companies .. 14 Multiple Roles .. 14 C. The Contracting Process .. 14 Scheduling Subcontractors .. 15 D. Contract Income .. 16 E. Types of Contracts .. 16 Short-Term Contracts .. 16 Long-Term Contracts .. 16 Fixed Price or Lump Sum Contracts .. 16 Cost-Plus Contracts .. 17 Time and Material Contracts .. 17 Unit Price Contracts .. 17 Change Orders .. 17 F. Bonding .. 17 G. Building Permits .. 18 H. Notice of Completion .. 19 I. Law/Authority .. 19 Exhibit 1-1 Federal Tax Law and Guidance.

3 19 J. Relevant Terms .. 26 3 Exhibit 1-2 Definitions and Terminology .. 26 K. Resources .. 39 Exhibit 1-3 Construction Industry Resources .. 39 II. Long Term Contracts .. 44 A. Overview .. 44 B. Law/Authority related to Long-Term Contracts .. 45 C. Contracts Required to be Reported Using the PCM .. 45 D. Contracts Exempt from the PCM .. 46 Example of Small Construction Contract Exception: .. 46 E. Construction and Manufacturing Contracts .. 47 Long-term Contract .. 47 Construction Contract .. 47 Manufacturing Contract .. 47 Integral Components of Real Property .. 48 F. Contract Classifications .. 48 Hybrid Contracts .. 49 G. De Minimis Construction Activities .. 50 H. Non-Long-Term Contract Activities .. 50 I. Related Party Contract .. 51 J. Severing and Aggregating Contracts .. 53 III.

4 Small Construction Contractors .. 55 A. Overview .. 55 B. Exceptions to the PCM and Look-back Interest .. 55 $25 Million Gross Receipts Test ($10 million for tax years beginning prior to 1-1-2018) .. 56 Controlled Groups Explained .. 57 Attribution of Gross Receipts of Less than Controlling Interest .. 58 C. Proper Method of Accounting for Small Construction Contractors .. 58 D. General Rule for Accounting Methods .. 59 4 E. Methods of Accounting .. 60 F. Selecting an Accounting Method .. 60 G. Cash Method of Accounting .. 60 H. Accrual Method of Accounting .. 62 Advance Payments Accrual Method .. 62 Exception to Reporting Advance Payments in Year of Receipt Accrual Method (For tax years beginning before 1-1-2018) .. 63 Exception to Reporting Advance Payments in Year of Receipt Accrual Method (For tax years beginning after 12/31/2017).

5 63 Deducting Expenses under the Accrual Method of Accounting .. 64 Accrual Method and Retainages .. 64 I. Completed Contract Method (CCM) .. 65 Completion of a Long-Term Contract .. 65 Post Completion 66 Allocation of Indirect Costs .. 67 Issues to Consider for Completed Contract Method Taxpayers .. 69 Subcontracts and Completion .. 69 J. Exempt-contract percentage of completion method (EPCM) .. 70 Alternative Minimum Tax (AMT) .. 70 K. Small Construction Contractors Becoming Large Construction Contractors .. 70 IV. Large Construction Contractors .. 71 A. Overview .. 71 B. Methods of Accounting for Contracts Subject to IRC Section 460 PCM .. 72 C. Cost-to-Cost Method .. 72 Allocable Contract Costs .. 73 Direct Material Costs .. 75 Uninstalled Dedicated Materials .. 75 Direct Labor Costs.

6 76 Pre-Contract Costs .. 76 Indirect Costs Not Generally Allocable to a Contract .. 77 Nondeductible Costs .. 77 D. Impact of Cost Allocation on the Percentage of Completion Computation .. 78 5 E. Cost-Plus Contracts and Federal Long-Term Contracts .. 80 F. Simplified Cost-to-Cost Method .. 80 G. Percentage-of -Completion 10-Percent Method .. 81 H. Percentage-of -Completion/Capitalized-Cost Method (PCCM) .. 82 I. Total Estimated Contract Price and Claim Income .. 83 J. Additional Considerations for PCM .. 84 K. Reversal of Income on Terminated Contract .. 86 V. Mid-Contract Change in Taxpayer .. 87 A. Overview .. 87 B. Constructive Completion Transactions .. 88 Constructive Completion Transactions Tax Treatment by Old .. 88 Constructive Completion Transactions - Tax Treatment by New.

7 89 Examples of Constructive Completion .. 89 C. Step-in-The-Shoes Transactions .. 91 Step-in-the-Shoes Transactions - Tax Treatment by Old Taxpayer .. 91 Step-in-the-Shoes Transactions - Tax Treatment by New Taxpayer .. 92 Examples of Step-in-the-Shoes Transactions .. 92 Special Rules Related to Certain Partnership and Corporate Step-in-the Shoes Transactions .. 93 D. Look-Back Interest Rules for Taxpayer Mid-Contract Change . 94 E. Look-back Interest Constructive Completion Transaction .. 94 F. Look-back Interest Step-in-the-Shoes Transaction .. 94 VI. Financial Accounting Versus Tax Accounting .. 95 A. Overview .. 95 B. Financial Accounting .. 95 International Accounting Standards .. 96 Accounting Standards Codified Topic (ASC) 606 Revenue from Contracts with Customers .. 96 Balance Sheet Accounts.

8 97 Balance Sheet Reporting .. 99 C. Book and Tax Differences .. 99 6 Revenue Recognition .. 99 Contract Related Services .. 100 Determining Completion for Percentage of Completion Method .. 100 Loss Recognition .. 100 Uninstalled Dedicated Materials .. 100 ASC 606 Revenue from Contracts with Customers .. 101 D. Sample Financial Statements using Percentage of Completion Method .. 102 Exhibit 6-1 Balance 102 Exhibit 6-2 Statement of Income and Retained Earnings .. 103 Exhibit 6-3 Earnings from Contracts .. 104 Exhibit 6-4 Contracts Completed .. 104 Exhibit 6-5 Contracts in Progress .. 105 E. Exhibit 6-6 Tax Accounting Methods .. 105 VII. Homebuilders and Land Developers .. 108 A. Overview .. 108 B. Home Construction Contract Defined .. 108 Common Improvements .. 109 Mixed Use Buildings.

9 110 C. Recent Developments .. 110 Important Court Decisions Completed Contract Method .. 110 D. Taxation of Homebuilders .. 111 E. Speculative Homes (No Contract) .. 111 Income Recognition Spec Homes .. 112 Cost Recognition Spec Homes .. 112 Revenue Ruling 66-247 .. 112 Inventory vs. Real Estate .. 113 Speculative Homes Becoming Long-Term Contracts .. 114 F. Contractors Building Homes Under Contract .. 114 Long-Term Methods of Accounting .. 114 Completed Contract Method (CCM) .. 115 Percentage of Completion Method (PCM) .. 115 Exempt Contract Percentage of Completion Method (ECPM) .. 115 Other Permissible Accounting Methods .. 115 Large Homebuilders .. 116 Model Homes .. 116 7 Furnishings in Model Homes .. 116 G. Land Developer .. 117 Income Recognition Land Developer Without a Construction .

10 117 Cost Recognition Land Developer Without a Construction Contract 117 Allocating Costs to Each Parcel of Property .. 118 Common Improvements Allocable to the Cost of the Lots Developed by the Taxpayer .. 119 Alternative Cost Method of Accounting for Real Estate Developers Revenue Procedure 92-29 .. 123 VIII. Other Tax Issues in Construction .. 126 A. Overview .. 126 B. Accounting Method Issues .. 126 Improper Computation of the Average Annual Gross Receipts for Small Business Taxpayers under Internal Revenue Code 460 (After 12-31-2017).. 126 The taxpayer must aggregate all gross receipts from all trades or businesses whether or not they are under common control. For example:.. 127 Improper Computation of the $5 Million Average Annual Gross Receipts under IRC 448 (Before 1-1-2018).