Pay-if-Paid Tax Deferral Opportunity for Contractors

Thoughtware Article Published: Feb 27, 2019
Construction male on site

Under Internal Revenue Code (IRC) Section 460, large contractors are required to use the percentage of completion method (PCM) to calculate their taxable income from any long-term contract, aside from home construction contracts. However, after the passage of the Tax Cuts and Jobs Act, contractors with average annual gross receipts of less than $25 million for the prior three years are exempt from reporting income from long-term contracts on the PCM for regular tax purposes (assuming the contractor estimates that such contract will be completed within the two-year period beginning on the contract commencement date of such contract)—see IRC §460(e)(1)(B). These contractors, however, generally would be required to report income from these contracts on the PCM for alternative minimum tax purposes—see Treasury Reg. §1.460-4(f)(1).

A long-term contract is any contract for the manufacture, building, installation or construction of property if such contract isn’t completed within the taxable year in which such contract is entered into, pursuant to §460(f). Note, there’s no de minimis contract amount exception for determining whether or not a contract is a long-term contract. If the contract commenced in one year and was completed in another, it’s a long-term contract for purposes of IRC §460.

Under §460(b)(1), the percentage of completion shall be determined by comparing costs allocated to the contract and incurred before the close of the taxable year with the estimated total contract costs. This fraction is illustrated as follows: (costs allocated to contract and incurred)/estimated total contract costs. Under this methodology, the higher the numerator is in the PCM fraction, the higher the amount of income that gets recognized in the current year on such contract (assuming the contractor expects, as of the end of the year, the contract will generate an overall profit). It’s important to note that the PCM fraction is to be calculated on the accrual basis under Treasury Reg. §1.460-1(b)(8).

An accrual basis taxpayer can’t accrue (or deduct) an expense the taxpayer has no legal obligation to pay (see Shepherd Construction Co. v. Commissioner, 51 T.C. 890). In essence, the “all-events test” isn’t met, as the obligation to make a payment isn’t fixed and certain unless there’s a legal obligation to make the payment. Therefore, in states where there’s no legal obligation to pay subcontractors, i.e., states that enforce “pay-if-paid” clauses in construction contracts, a contractor isn’t required to include payables to subcontractors in the PCM numerator.

If a contractor has historically included legally enforceable pay-if-paid clauses in its contracts, as well as amounts owed to subcontractors on these jobs in the numerator of its PCM fraction for jobs located in pay-if-paid states, the contractor would be required to file Form 3115, Application for Change in Accounting Method, by the end of the tax year in which the contractor wants to begin excluding these amounts from the numerator. A user fee would apply to this nonautomatic accounting method change (for 2019, the user fee is $10,800). Note, various states have different rules related to the legal enforceability of pay-if-paid clauses in construction contracts. So before contractors subject to PCM reporting for tax purposes pursue this potentially lucrative income tax deferral opportunity, it’s essential they consult with legal counsel to determine if legally enforceable pay-if-paid clauses already exist in, or could be written into, their construction contracts.

For more information, contact Jason or your trusted BKD advisor.

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