February 2002

Construction Claims: The Next Big Audit Area

BY JAMES S. ANCHIN, CPA

The IRS is sending a message to contractors about reporting income derived from disputed construction claims. In the past, contractors with disputed claims would recognize large amounts of income from these claims on their financial statements. However, they would exclude them for tax purposes because the claims did not meet the "all events" test.

Under the "all-events" test, a contractor is generally required to include in income the face amount of a claim receivable in the tax year in which: all of the events have occurred that determine the fact of the receivable; and the amount of the receivable can be determined with reasonable accuracy. Contractors claimed that the all events test was not met until a disputed claim was settled. Today, contractors will find it more difficult to avoid deferring taxes on construction claims.

In fact, there will be an IRS audit focus on the construction industry and how proceeds from construction claims are reported for tax purposes. After years of legal wrangling with Tutor-Saliba, one of the country's largest public works contractors, the Tax Court has upheld the IRS's stance on taxing construction claims pertaining to long-term contracts. As a result, contractors should prepare for situations where they may have to pay taxes on construction claims before they have those dollars in hand.

The Tutor-Saliba controversy revolved around how estimated contract price should be defined for contractors using the percentage of completion method to recognize income on long-term contracts.

(For tax purposes, long-term contracts are contracts that start in one fiscal year and are completed in a subsequent year, regardless of how long the job actually runs. As an example, a job starting Dec. 26, 2001 and completed Jan. 3, 2002 would be considered long-term for a contractor whose fiscal year ends Dec. 31.)

The IRS contended that disputed claims should be included in the estimated contract price, and thus, included in income on a percentage of completion basis as soon as it was reasonably estimated that they would be received, even if the dispute had not yet been resolved. But Tutor-Saliba saw things differently. They contended that claim income should be deferred until the all events test was met, namely when the dispute was settled or resolved. In addition, Tutor-Saliba claimed it was difficult to determine when there is a reasonable chance of collecting on a disputed claim.

The Tax Court sided with the IRS, ruling that the tax code that governs the recognition of income on long-term contracts does not require the all events test to be met before including claim income in contract price. While it may be difficult to accurately foresee how much a contractor will receive with regard to a claim, that does not preclude the contractor from making an estimate once it is reasonably certain that some income will be received.

The IRS viewed the Tutor-Saliba issue as a test case to determine its latitude in taxing construction claims income. Based on the court's decision, the agency will now be taking a hard look to make sure that proper taxes are being collected on all claimsÑand the IRS will have the benefit of hindsight, when it looks over the books many years after tax returns have been filed. Contractors should be aware that any footnote describing the amount of a construction claim in their financial statements will be a red flag to the IRS. The IRS may contend that this is a reasonable estimate and should be added to the contract price. In the past, a popular practice among contractors was to record a portion of the claim for financial reporting purposes, but omit it for tax purposes. Now the IRS will look to make the necessary adjustments.

Many tax experts are convinced the IRS will be off to the races on this issue. They will waive the results of the Tudor-Saliba audit as a banner in its pursuit of other contractors that do large public sector work. In view of today's complex construction contractsÑand the recent Tax Court rulingÑit is more important than ever to have expert assistance in tracking claims and to double-check the accuracy of income reported under the percentage of completion method. Be prepared to withstand IRS scrutiny.

It's important to remember though that the tax court ruling applies only to long-term contracts that are subject to percentage of completion tax treatment. Short-term contracts (contracts started and completed within the same fiscal year) and long-term contracts not subject to percentage of completion (generally for small contractors and certain home construction contracts) are not subject to these rules. The all events test for these accrual basis taxpayers would apply.

Consult with your accountant to make sure that you are using the most beneficial tax method permissible for reporting your construction claim income. Claim amounts are frequently substantial, so it's best to plan for and document how to properly defer this income to protect you and your company from surprises.

About the author: Mr. Anchin is managing partner of Anchin, Block & Anchin, LLP, a New York City certified public accounting firm that specializes in meeting the needs of contractors in the tri-state area.