Construction Industry Audit Technique Guide (ATG)

1 Construction Industry Audit Techniques Guide (ATG) NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This Guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date. Publication Date 5/2009 1 Table of Contents CHAPTER 1: INTRODUCTION TO THE Construction INTENDED PARTICIPANTS IN THE Construction THE CONTRACTING CONTRACT TYPES OF BUILDING NOTICE OF CHAPTER 2: LONG TERM LONG TERM CONTRACT CONTRACTS SUBJECT TO IRC SECTION CONTRACTS EXEMPT FROM IRC SECTION Construction AND MANUFACTURING INTEGRAL COMPONENTS OF REAL CONTRACT HYBRID DE MINIMIS Construction NON LONG-TERM CONTRACT RELATED PARTY SEVERING AND AGGREGATING CHAPTER 3: SMALL Construction EXCEPTIONS TO THE PERCENTAGE OF COMPLETION ACCOUNTING METHOD AND LOOK-BACK PRODUCTION PERIOD $10 MILLION GROSS RECEIPTS PROPER METHOD OF ACCOUNTING FOR SMALL GENERAL RULE FOR ACCOUNTING METHODS OF SELECTING AN ACCOUNTING CASH METHOD OF ACCRUAL METHOD OF COMPLETED CONTRACT METHOD (CCM).

2 33 COMPLETION OF A LONG-TERM SUBCONTRACTS AND EXEMPT-CONTRACT PERCENTAGE-OF-COMPLETION METHOD (EPCM)..37 ALTERNATIVE MINIMUM TAX (AMT)..38 SMALL CONTRACTORS BECOMING LARGE PROS AND CONS OF LONG-TERM ACCOUNTING CHAPTER 4: LARGE Construction METHODS OF ACCOUNTING FOR CONTRACTS SUBJECT TO IRC SECTION 460 PERCENTAGE OF COMPLETION METHOD (PCM)..42 COST-TO-COST ALLOCABLE CONTRACT IMPACT OF COST ALLOCATION ON THE PERCENTAGE OF COMPLETION 2 COST-PLUS CONTRACTS AND FEDERAL LONG-TERM SIMPLIFIED COST-TO-COST PERCENTAGE-OF-COMPLETION (10 PERCENT METHOD)..48 PERCENTAGE-OF-COMPLETION OR CAPITALIZED-COST METHOD (PCCM)..49 TOTAL ESTIMATED CONTRACT PRICE AND CLAIM ADDITIONAL CONSIDERATIONS FOR REVERSAL OF INCOME ON TERMINATED CHAPTER 5: LOOK-BACK LOOK-BACK IS SCOPE OF LOOK-BACK EXCEPTIONS FROM THE APPLICATION OF ELECTION NOT TO APPLY COMPUTATION OF STEP 1: REAPPLY THE PCM TO ALL LONG-TERM STEP 2: COMPUTATION OF OVERPAYMENT OR UNDERPAYMENT OF STEP 3: CALCULATION OF INTEREST ON UNDERPAYMENT OR OVERPAYMENT OF SIMPLIFIED MARGINAL IMPACT METHOD (SMIM).

3 65 POST-COMPLETION REVENUE AND REVENUE ACCELERATION REPORTING LOOK-BACK - FORM MID-CONTRACT CHANGE IN TAXPAYER AND LOOK-BACK COMMON CHAPTER 6: FINANCIAL ACCOUNTING VERSUS TAX FINANCIAL BALANCE SHEET SAMPLE FINANCIAL STATEMENTS USING PERCENTAGE OF COMPLETION Exhibit 6A XYZ Corporation Balance Sheet December 31, Exhibit 6B XYZ Corporation Statement of Income and Retained Earnings December 31, Exhibit 6C XYZ Corporation Schedule 1 Earnings from Contracts Year Ended December 31, Exhibit 6D XYZ Corporation Schedule 2 Contracts Completed Year Ended December 31, Exhibit 6E XYZ Corporation Schedule 3 Contracts in Process Year Ended December 31, CHAPTER 7: HOMEBUILDERS AND HOME Construction CONTRACT TAXATION OF HOMES BUILT FOR SPECULATION (NO CONTRACT)..82 INVENTORY VS. REAL CONTRACTORS BUILDING HOMES UNDER LAND ALLOCATING COSTS TO EACH PARCEL OF CHAPTER 8: OTHER TAX ISSUES IN 3 ACCOUNTING METHOD INCOME TAX CHAPTER 9: INCOME UNDERSTANDING THE ACCOUNTING MINIMUM INCOME INTERNAL USE OF INDIRECT MISCELLANEOUS INCOME CHAPTER 10: Construction JOINT TYPES OF JOINT JOINT VENTURE POTENTIAL JOINT VENTURE CHAPTER 11: CONTRACTOR SQUARE FOOT DIVISION 1 SITE DIVISION 2 - DIVISION 3 - DIVISION 4 - EXTERIOR DIVISION 5 - DIVISION 6 - DIVISION 7 - DIVISION 8 - DIVISION 9 - DIVISION 10 - INSTALLING CONTRACTOR'S OVERHEAD & Audit ISSUES AND EXAMINATION APPENDIX 1 FEDERAL TAX LAW AND APPENDIX 2 TAX ACCOUNTING APPENDIX 3 Construction Industry APPENDIX 4 COST APPENDIX 5 DEFINITIONS AND APPENDIX 6 Construction Industry INTERVIEW Chapter 1.

4 Introduction to the Construction Industry Intended Audience This Industry Guide is intended for examiners conducting audits in the Construction Industry and as information for taxpayers and practitioners associated with the Construction Industry . Review of this Guide is recommended prior to initiating an Audit . Users of this Guide may need to augment these guidelines by researching specific tax issues and new tax law. 4 Participants in the Construction Industry Numerous participants in the Construction Industry play a distinct role in the process. The key participants are discussed below. Contractors Contractors perform the Construction work in accordance with the plans and specifications provided by the owner and are required to be licensed by state law. General or Prime Contractors A general contractor's principal business is the performance of the Construction work in accordance with the plans and specifications of the owner.

5 A general contractor takes full responsibility for the completion of the project. The general contractor will normally subcontract out a substantial part of the work, while maintaining overall control through project managers and onsite supervision. The general contractor may utilize specialty subcontractors, but can perform any portion of the work. Generally contractors are licensed. If the contractor is a corporation or partnership, an officer or partner, the contractor must be licensed. Construction Managers Generally, the Construction manager does not perform Construction work on projects, but is an agent for the owner. The Construction manager may be engaged in lieu of or in addition to a general contractor. As an agent, the Construction manager coordinates the Construction project, but has no contractual relationship with the subcontractors. Generally, Construction managers only provide services.

6 Construction managers do not perform any Construction work. Construction managers are not liable for defects in the Construction . However, the Construction manager may be liable for design defects. Commercial Contractors Commercial contractors specialize in commercial Construction projects. These projects may include the Construction of a single building or any number of buildings. Commercial projects include: 1. Retail project like shopping centers, restaurants, and grocery stores; 2. Rental facilities like office buildings, industrial parks, and apartments; 3. Business locations like company headquarters, manufacturing plants, and insurance companies; 4. Municipal buildings like city halls, prisons, schools, and hospitals; or 5. Special projects like amusement parks, racetracks, coliseums, and churches. A commercial contractor constructs nonresidential buildings, such as office buildings, warehouses, and shopping centers.

7 Commercial Project Owners The owner of a Construction project may be an individual, corporation, partnership, or government body. The owner evaluates whether a project is feasible and will provide the future benefits desired. The owner then engages an architect or engineer to design the plans and specifications of the project. Normally, the owner secures the necessary financing for the project for both the 5construction period and permanent financing upon completion. The owner will retain title to the project throughout the Construction phase, subject to liens from Construction loans and mechanics liens. The general contractor may or may not have an ownership interest in the project. The contractor may own a percentage interest in one of the following ways: 1. Owning stock in the corporation that owns the project; 2. Being a partner in a development partnership; or 3.

8 Owning the property or an interest in a joint venture as an individual. Residential Construction Developer The examination of residential developers is different than the examination of a contractor who builds in accordance with a contract for an owner. The developer is generally the owner and the builder of the residential development. The developer acquires land, obtains approval, secures Construction financing, and begins Construction of the residential development in stages or phases of Construction . The initial phase is sold, and the Construction process begins on the next phase. This process requires the builder allocate a per-unit cost to each unit sold. The cost of each unit (on-site costs, such as direct materials and labor, and an allocated portion of off-site costs such as streets and amenities) must be matched with the sales price of each unit sold. The sales price is often based on what the market will bear under the current economic environment.

9 Subcontractors The largest number of taxpayers in the Construction Industry is a specialty subcontractor. They can range from one-man operations to nationwide, publicly traded corporations, or divisions of larger corporations. Subcontractors are distinguished from the general contractor by the limited scope of their work, which usually involves a special skill, knowledge, or ability. Subcontractors include specialists, such as plumbers, electricians, framers, and concrete workers. They generally enter into contracts with the general contractors, and may provide the raw materials used in their specialty areas. The general contractor, not the owner of the property, will usually pay the subcontractors. Materials purchased by the subcontractors are generally delivered directly to the job site. The subcontractors' work may be completed in stages, or it may be continuous. Highway Contractors Highway and street contractors require specialized equipment and techniques.

10 The equipment includes bulldozers, graders, dump trucks, and rollers. Examples of highway Construction include city streets, freeways, country roads, highway bridges, and tunnels. Heavy Construction Contractors Heavy Construction contractors require large and complex mechanized equipment, such as cranes, bulldozers, pile drivers, dredges, and pipe-laying devices. Some examples of projects in this category include dams, large bridges, refineries, petrochemical plants, nuclear and fossil fuel power plants, pipelines, and offshore platforms. Most industrial plants are classified in this category because of the complexity of the work. The largest engineering and Construction firms are included in the heavy Construction classification. 6 Architects and Engineers The architect or engineer designs the plans to be used by the Construction contractors. The plans provide the necessary detail (dimensions, materials to be used, location of fixtures, etc.)