Certain construction contractors may be eligible to use the cash or completed-contract method of accounting for regular income tax. However, these taxpayers may also be liable for alternative minimum tax (AMT), in which case they may be required to make an adjustment for the percentage-of-completion method that may be overlooked, as well as pay an interest charge under the lookback method upon completion of a long-term contract. This column describes the adjustment and interest charge and when they apply.
Taxable income from a long-term contract is determined under the percentage-of-completion method (Sec. 460(a)). However, any home-construction contract or any construction contract entered into by a taxpayer that estimates that the contract will be completed within two years and whose average annual gross receipts for the three previous years do not exceed $10 million is exempt from the percentage-of-completion method in determining regular taxable income (Sec. 460(e)(1)).
THE AMT ADJUSTMENT
Rev. Proc. 2002-28 allows construction contractors that are otherwise required to use an accrual method under Sec. 446 because they are required to account for inventories under Sec. 471 to use the cash method for regular income tax, unless prohibited under Sec. 448, if their average annual gross receipts, as defined under Section 5 of Rev. Proc. 2002-28, do not exceed $10 million for the three previous tax years. Additionally, construction contractors qualified under Sec. 460(e)(1) may use the completed-contract method, as outlined in Regs. Sec. 1.460-4(d), to account for exempt contracts. The cash method or the completed-contract method, however, cannot be used to determine AMT income (AMTI) for a long-term contract, except for a home-construction contract (Sec. 56(a)(3)).
Sec. 460(f)(1) defines a "long-term contract" as any contract for the manufacture, building, installation, or construction of property that is not completed within the tax year in which the contract is entered into. For example, if a contract is entered into on Dec. 29 of year 1 and completed on Jan. 5 of year 2, the contract is deemed to be a long-term contract. Under Regs. Sec. 1.460-4(f)(1), a taxpayer must use the percentage-of-completion method to determine AMTI from any long-term contract entered into by the taxpayer on or after March 1, 1986, that is not a home-construction contract, as defined in Regs. Sec. 1.460-3(b)(2). Accordingly, any long-term contract that is not a home-construction contract in progress at year end is deemed to be a long-term contract subject to the AMT, even if the taxpayer uses the cash or completed-contract method to report income for regular income tax. Small C corporations are exempt from the AMT (Sec. 55(e)).
The AMT adjustment is illustrated in the following example:
Example: Z, a construction contractor, elected to use the cash method to report regular taxable income. Z had one contract totaling $1 million, with projected costs totaling $800,000 and estimated profit totaling $200,000. During year 1, Z incurred $400,000 in construction costs (50% completion, based on total projected costs) and recognized $500,000 (50% of the contract price) in revenue using the percentage-of-completion method. Z billed its client $500,000 and received $400,000 at the end of year 1. Z paid off $400,000 in construction costs by the end of year 1. Accordingly, Z had zero regular taxable income for year 1 (collection totaling $400,000, less disbursements totaling $400,000).
However, Z must make a positive AMT adjustment for the difference between its regular taxable income, which is zero, and AMTI based on the percentage-of-completion method, which is $100,000 ($500,000 minus $400,000) for the long-term contract. The contract was completed in year 2, and Z billed the remaining $500,000 on the contract, collected $600,000 (including accounts receivable totaling $100,000 at the end of year 1), and paid off the other $400,000 in contract costs incurred in year 2.
Therefore, Z's regular taxable income totaled $200,000 ($600,000 less $400,000) for year 2. Z must make a negative AMT adjustment totaling $100,000 in year 2 to bring the AMTI to $100,000, which is the percentage-of-completion profit for year 2. Because the $200,000 regular tax profit in year 2 included the $100,000 profit already recognized in year 1 for AMT, there must be a negative adjustment from regular tax for AMT in year 2 for the $100,000; otherwise, Z would have reported $300,000 in cumulative AMTI on a job that only had $200,000 profit. The AMT adjustment is for work in progress at the end of the prior year, plus the adjustment for work in progress at the end of the current year. Since Z had no jobs in progress at the end of year 2, there is no AMT adjustment for work in progress for the end of year 2. When the job is completed at the end of year 2, final receivables are collected, and job costs have been paid, the cumulative income for regular income tax and AMT are the same, which is as it should be.
THE LOOKBACK METHOD
Generally, long-term contracts are subject to the interest computation under the lookback method under Sec. 460(b)(2). The lookback method applies to AMTI from a long-term contract, except for home-construction contracts (Regs. Sec. 1.460-6(b)). Under the lookback method, a taxpayer is required to pay or is entitled to receive interest on the amount of tax liability that is deferred or accelerated as a result of overestimating or underestimating total contract price or contract costs (Regs. Sec. 1.460-6(a)). The interest is calculated on the difference of the actual tax for the carryback year to the total hypothetical tax, including AMT, for that year, using the actual contract price and contract costs in the year of completion as well as in a post-completion year in which the contract price or costs were adjusted (Regs. Sec. 1.460-6(c)(1)(ii)(A)). Discounting of post-completion adjustments to the year of completion is required using the federal midterm rate under Sec. 1274(d), unless an election not to discount is made (Regs. Sec. 1.460-6(c)(1)(ii)(C)).
Under Regs. Sec. 1.460-6(b)(2), the lookback method does not apply to regular income tax for any home-construction contract or a small contractor, as defined under Secs. 460(e)(1)(A) and (B), respectively. Also excepted is any long-term contract that is completed within two years of commencement and has a gross contract price not exceeding the lower of $1 million or 1% of the average annual gross receipts of the taxpayer for the three tax years preceding the tax year in which the contract is completed (Sec. 460(b)(3)(B)). This de minimis exception is mandatory and also applies for the AMT (Regs. Secs. 1.460-6(b)(3) and (4)). A taxpayer can elect to have the lookback method not apply where the lookback income (loss) under the contract is within 10% of the cumulative income (loss) as of the close of the prior contract year (Sec. 460(b)(6)).
The amount of interest due from, or payable to, a taxpayer as a result of applying the lookback method is computed and reported on Form 8697, Interest Computation Under the Look-Back Method for Completed Long-Term Contracts, for the filing year. The lookback method generally spans more than one year, and the interest owed (or to be received) is netted for the filing year. The net interest owed is included on the taxpayer's return for that year, with Form 8697 attached to the return. Corporations (other than S corporations) may deduct this amount as interest expense. For individuals and other taxpayers, this interest is not deductible. Net interest to be received is filed on Form 8697 separately from the return of the filing year.
In reviewing prospective construction clients' income tax returns over the years, I have noticed a glaring and consistent omission of the long-term contract adjustment for AMT from cash-basis taxpayers. The punishment can be the application of the 20% accuracy-related penalty under Sec. 6662(a) in the year of omission. Additionally, lookback interest is not subject to the estimated-tax penalty, but the 20% accuracy-related penalty does apply (Sec. 460(b)(1)).
Wayne Swilley (firstname.lastname@example.org) is principal of S. Wayne Swilley, CPA, in Conyers, Ga.
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