Taxation of Income On Long Term Contracts

In our modern world businesses often enter contracts that take several years to complete, and the question arises on when a taxpayer should recognize the income from a long term contract. The general rule is that a taxpayer earning income on a contract for the manufacture, building installation, or construction of property that will not be completed in the tax year in which is starts must report income on each annual tax return using the percentage of completion method.

In the percentage of completion method the business first calculates the cost of the project for the tax year and then determines what percentage this amount is to the total costs that will be incurred on the contract. The second step is to apply this percentage to the total gross receipts that will be received under the contract, and by subtracting the years cost from this calculated percentage of gross receipts one determines the income or loss for the tax year. Exceptions to the requirement to use the percentage of completion method include home construction, other real property construction expected to be completed within two years by a taxpayer with less than $10,000,000 of annual gross receipts, and manufactured items that are not unique and normally take less than twelve months to complete.

Of course to apply the percentage of completion method one has to estimate the total costs and the total receipts one is going to incur during the entire contract term, and as any bankruptcy attorney can tell you contracts do not always finish within budget. The law however includes a look back rule, which requires the taxpayer to recompute at the completion of the project what the profit would have been each year, if they had known the actual total costs and receipts at the time, and pay or receive interest on the difference between the tax paid and what the tax should have been. There are exceptions to the look back rule for certain small contracts and for home and other real estate contracts that are not subject to the percentage of completion method.