Generally speaking, in determining taxable income from long-term contracts, the percentage-of-completion method is required unless a home construction contract is involved. However, there’s an exception to this requirement provided for certain “small construction contracts.”
If the taxpayer qualifies to treat its long-term contracts as “small construction contracts,” the taxpayer may use its exempt method, such as the completed contract method, when calculating taxable income. Using the taxpayer’s exempt method typically results in a deferral of taxable income compared to the percentage-of-completion method.
Under pre-Tax Cuts and Jobs Act (TCJA) law, to qualify for the exception, two requirements must have been met: The contract must be entered into by a taxpayer (1) who, at the time the contract was entered into, estimated that the contract would be completed within two years of the contract’s inception and (2) whose average annual gross receipts for the prior three tax years didn’t exceed $10 million.
After the TCJA’s passage, there’s no change to the two-year contract estimate requirement to qualify for the exception. However, the TCJA increased the gross receipts requirement from $10 million to $25 million of gross receipts for any contract entered into after December 31, 2017. As a result, significantly more contractors can take advantage of the small construction contract exception under the TCJA. While greatly increasing the dollar amount of the gross receipts requirement, the new law also has expanded the definition of “gross receipts” for this calculation. To verify they meet the gross receipts threshold, taxpayers must determine whether or not receipts from certain related businesses are required to be aggregated. Below is a summary of these requirements before and after the TCJA.
Under the old law, the gross receipts test was determined as follows:
- Gross receipts meant the total amount of receipts (reduced by returns and allowances), as determined under the taxpayer’s method of accounting, received from all trades or businesses carried on by the taxpayer.
- Gross receipts specifically excluded, among other items, interest, dividends, rents, royalties or annuities not derived in the ordinary course of a trade or business and receipts from the sale or exchange of capital assets.
- In general, gross receipts from related entities and commonly controlled entities also were required to be aggregated and included in the gross receipts calculation. In addition, if there was less than 50 percent ownership in the entity, only a proportionate share of the construction-related receipts was required to be included in the calculation.
Under the new tax law, the gross receipts test is slightly more complex. After the TCJA, Internal Revenue Code (IRC) Section 460 now refers to IRC §448(c) for purposes of determining how to calculate gross receipts.
1. Similar to the pre-TCJA gross receipts test, gross receipts means the total amount of receipts (reduced by returns and allowances), as determined under the taxpayer’s method of accounting, received from all trades or businesses carried on by the taxpayer.
2. However, as a result of the TCJA’s passage, until and unless further guidance is issued, gross receipts now also include interest (including tax-exempt interest), dividends, rents, royalties and the amount realized from the sale of a capital or depreciable asset reduced by the taxpayer’s adjusted basis in the asset.
3. TCJA also affected which entities are required to be aggregated when calculating gross receipts. As a result, there’s potentially a larger number of entities and receipts that will need to be aggregated in determining if the $25 million gross receipts test is exceeded.
Note that a complete analysis of these aggregation rules under pre- and post-TCJA law is beyond the scope of this article. As the TCJA has provided significant changes to the rules related to the gross receipts calculation under IRC §460, taxpayers are advised to re-examine their gross receipts calculations to determine if they may take advantage of the small construction contract exception to percentage-of-completion method reporting for long-term contracts under the TCJA. To the extent taxpayers qualify to apply their exempt method of accounting to long-term contracts, they’ll also want to consider how using their exempt method will affect their alternative minimum tax and state income tax liabilities to help ensure there are no unintended surprises.
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