Tax accounting is not the most exciting topic, even to tax geeks.  But it can be important. This is certainly the case for how federal tax law treats income due to construction contracts. Among other proposals in a recent Senate Finance Committee legislative draft is a change that would, if enacted, affect how and when home builders pay taxes for home construction. NAHB has argued in testimony to protect present law and will submit comments on the proposal described in this post.

First – present law. One of the changes made by the Tax Reform Act of 1986 required more business taxpayers to pay a portion of expected income taxes prior to completion of a contracted project.

Such long-term contracts (which includes a building construction contract not completed within the tax year in which it is entered into) must use the percentage-of-completion (PCM) method of tax accounting, in lieu of the completed contract method (CCM). Under the PCM method, taxpayers must report expected income from the contract proportional to the tax years in which construction costs are incurred, regardless of when revenue is received. The net result is that under the PCM method, home builders would be required to pay a portion of income tax prior to completion of construction and sale when home construction spans multiple tax years. This could require having to finance a portion of expected income taxes among other development costs.

Targeted at multiyear, large manufacturing and defense contracts, the 1986 change was originally intended to exempt home building. Builders considered their agreements with customers sales contracts, not construction contracts, and thus not subject to the rule. Among other differences with construction contracts, home building agreements do not typically involve progress payments, and while buyers place downpayments, such funds are generally held in an escrow account and cannot be used to cover construction or tax costs. However, in 1988 the IRS published guidance that NAHB recognized would include home building in the construction contract definition.

Recognizing the harm that IRS implementation of 1986 rule could cause to the home building sector, NAHB succeeded in having Congress enact exceptions to the long-term contact rules. The most important was the home construction contract exception, which provides an exemption from the PCM requirement for any contract for which 80 percent or more of estimated total costs are expected to be attributable to 1-4 unit home building and site improvement for such homes. Such contracts can use the CCM under which net income from the contract may be reported in the year in which the contract is completed and accepted.

A further partial exception is available for construction of 5+ unit housing, under which the taxpayer may use a 70/30 split: 70% PCM and 30% exempt from PCM. A final exception is available under the heading of “small construction contracts.” Under this rule, contracts expected to be completed within two years and performed by a taxpayer whose average annual gross receipts for three prior tax years is no more than $10 million may use the completed contracted method.

Under the Senate Finance Committee Chair draft proposal, the home construction contract exceptions noted above would be repealed. The small construction contract exception (the $10 million rule) would be retained, and it would be indexed for inflation. The result of these changes would be to add complexity and financial burdens on many home builders, particularly in high cost areas.

In the final analysis, the proposal repeals a fix made to the 1986 Act that was widely recognized as placing an accounting burden on small businesses. Given that many builders will fall into the definition of a “long-term contract” because construction can span across two tax years (even if taking less than 12 months in total), the proposal is clearly anti-growth and investment. While imposing financing challenges on builders, it is also only a revenue gainer for the government in the sense that it is a timing change. For these reasons, NAHB will oppose any changes to the home construction contract rules in the tax code.

Tags: accounting, economics, home building, tax