Current Federal Tax Developments

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Contract, Whether a Construction or Manufacturing Contract, was Required to be Reported on Percentage of Completion Basis

While most practitioners likely think of the tax percentage of completion method of accounting as something only affecting construction contractors, in fact such provisions can impact other types of contracts under certain conditions. In the case of Basic Engineering, Inc. v. Commissioner, TC Memo 2017-26 the key issue was whether the contract the taxpayer had was really not a construction contract and, if not, whether it would still be required to be accounted for under the percentage of completion method of accounting for tax purposes.

The case involved two contracts where the taxpayer was hired to assist in constructing refineries. In each case the taxpayer was hired to help in removing and refurbishing equipment in a refinery in the United States, transporting the equipment to a distant location (Bulgaria in one case, Pakistan in another), installing the equipment in new refinery and, finally, testing the equipment to get it certified to be used in production.

The Internal Revenue Code taxes long-term contracts pursuant to IRC §460 and normally requires the use of the percentage of completion method of accounting to record income over the term of the contract. A long-term contract is defined as one where work begins in one tax year but ends in a later tax year.

There are two potentially applicable exceptions to the requirement to use the percentage of completion method of accounting.

  • Manufacturing contracts are exempt unless the contract involves the manufacture of:
    • Any unique item of a type not normally included in the finished goods inventory of the taxpayer or
    • Any item which normally requires more than 12 months to complete
  • Certain construction contracts are exempted if:
    • The taxpayer estimates, at the time the contract is entered into, that the contract will take less than 2 years to complete and
    • The taxpayer’s average annual gross receipts for the three years before the contract is entered into do not exceed $10 million

The taxpayer argued initially that this was a manufacturing contract rather than a construction contract—they had primarily been engage to refurbish the refinery equipment which the taxpayer argued was a manufacturing activity.

The Tax Court, however, found that if the contract was viewed as a manufacturing contract it would fail the 12 month test, noting:

At issue are two contracts -- each for the disassembly, transportation, refurbishing, assembly, and certification of a new oil refinery. Petitioner introduced sufficient evidence, corroborated by the testimony of Mr. Balke, showing that the processes involved normally require more than 12 calendar months to complete. Respondent's expert, Mr. Harris, agreed, stating that the assembly process alone “could hardly be expected in less than one year.” Assuming without finding that these contracts are for the manufacture of two oil refineries, each would fall under the section 460(f)(2)(B) requirement that it be treated as a long-term contract under section 460 and thus generally accounted for using the percentage of completion method of accounting.

Since the taxpayer’s average annual gross receipts were less than $10 million for the three prior years the Court did consider whether, if they were construction contracts, they could qualify for the exception for those contracts. That would require that the taxpayer could show that it reasonably estimated the contracts would be completed within 24 months from the date the contract was entered into.

The Court found that the evidence indicated that the taxpayers could not show that reasonable estimate. The Court, taking the testimony the experts, found that the projects could not be completed within that time frame. While it is possible the equipment could be refurbished within that time frame, the Court noted that the taxpayer’s obligations did not end at that time.

Once the refurbishment was completed, the equipment had to be transported to Bulgaria in one case and Pakistan in the other. The simple shipping of the equipment to the new refinery location would take many months, along with the assembly process and then an extended testing/certification period. The Court found that the math simply didn’t work to make it feasible to have assumed these projects could have been completed within 2 years.

The Court also imposed the 20% accuracy related penalty for substantial understatement of tax on the taxpayer in this case, declining to agree with the taxpayer that it had reasonable cause for its reporting. The taxpayer noted that this was a complex area of tax law—a statement that certainly appears reasonable.

The taxpayer argued that it had relied upon the CPA who had prepared the returns for the year in question. But the taxpayer could not show that it had relied on the CPA’s advice with regard to the use of a proper method for reporting such contracts.

As the opinion notes:

Petitioner used the services of the same CPA from at least 2005 through 2010. However, the only evidence of petitioner's reliance upon professional advice rendered by its CPA is the fact that its Federal income tax returns were filed. Nothing in the record indicates that petitioner either requested of or received from its CPA advice regarding the application of the long-term contract exception under section 460(e) to the Petromaxx or Amber SPAs. Based on the absence of evidence indicating that petitioner even addressed this issue with its CPA, the Court cannot find that it exercised ordinary business care and prudence here.