I Have to Do What?! A Look at Allocation of Costs for Long-Term Contracts

Internal Revenue Code § 460 is the regulatory authority that addresses long-term contract accounting for tax purposes. This code section is long and complicated, and the compliance rules can sometimes seem unreasonable. In this article, we'll take a look at one of the more ignored compliance issues: Allocation of G&A.

Under IRC § 460, percentage-of-completion method of accounting is required for any large construction contractor with contracts meeting the definition of "long-term". Specifically, this is determined by considering 1) if a contractor has average annual gross receipts for the past three years exceeding $10 million, and 2) if the contract will span over two or more tax periods. If both of these tests are met, and you don't meet the homebuilder exception, you have long-term contracts subject to percentage-of-completion.

The Rules of Cost Allocation

There are in fact one general rule and seven "special" rules for cost allocation under Treasury Regulation § 1.460-5. We aren't going to delve into each of these, instead opting to focus on the first one listed: the general rule. This requires that both direct and indirect costs be allocated to long-term contracts "in the same manner that direct and indirect costs are capitalized to property produced by a taxpayer under § 1.263A-1 (e) through (h)". In other words, both direct and certain indirect costs should be allocated to long-term contracts, as long as the expense is being incurred because of the contracts.

Completely clear, right? 

Let's try it again. Direct costs are (obviously) incurred because of contracts. These are 100% allocable to job expense. Indirect costs are not as clearly linked to job costs. There are indirect costs that would exist even if you had no contracts. However, these costs might increase as you take on jobs. Theoretically, that increase should be allocated to long-term contracts and included as job costs.

Now, unless you have only one job that you are tracking, and you've been in existence for at least a year prior to starting that job, there is no reasonable way to determine the allocable amount detailed above. Thankfully, the code does not require that. As long as the allocation is reasonable and is applied systematically, it will be allowed.

What Costs Have to be Allocated?

We just covered the rule requiring the allocation of indirect costs. Now, let's see exactly which ones have to be allocated. Note, something for those of you who say, "I've already included a provision for G&A Allocation in my job costs": unless you're specifically listing the items below and showing those allocations, you aren't technically in compliance with the tax law.

Below is a table that summarizes the (extensive) list of expenses required to be allocated under IRC § 460(c):

Cost allocation method and location of authorization	Regular cost allocation required by Code § 460(c)
Under what revenue recognition method is the cost allocation method appropriate?	Appropriate for large contractors not exempt under § 460(e) that must use the PC method
Direct materials	Yes
Direct labor (including subcontractors)	Yes
Indirect costs:
- Repairs	Yes
- Maintenance	Yes
- Utilities	Yes
- Rent	Yes
- Certain indirect labor	Yes
- Materials and supplies	Yes
- Small tools and equipment	Yes
- QC and inspection	Yes
- Taxes other than income taxes	Yes
- Financial statement depreciation	No
- Tax return depreciation	Yes
- Cost depletion	Yes
- Percentage depletion in excess of cost	Yes
- Contract administrative expense	Yes
- Contract related officer salaries	Yes
- Insurance (including bonds)	Yes
- Adm. support departments	Yes
- Pension, profit sharing, etc., except for    past service costs	Yes
- Past service costs	Yes
- Direct R and D	Yes
- Rework, scrap, and spoilage	Yes
- Successful bidding expense	Yes
- Engineering and design	Yes
- Transportation costs	Yes
- Storage, handling, purchasing, and     related costs	Yes
- Production period interest	Yes
- Any additional costs under cost plus or    certain governmental contracts	Yes
Deductible period costs:
- Marketing, selling, advertising, and    distribution	No
- Unsuccessful bidding expense	No
- Noncontract related G and A	No
- R and D not related to contracts	No
- Losses under Code Section 165, e.g.,    obsolescence of material, decline in    value of assets, casualty losses, etc.	No
- Section 179 expense	No
- Depreciation on idle equipment	No
- Income taxes	No
- Costs attributable to strikes	No
- Repairs not associated with production    equipment	No
© 2010 Thomson Reuters/PPC

Simplified Cost Election

An alternative to analyzing the costs listed above is to make an election called the "Simplified Cost Election". Once made, this election allows you to allocate only three items: direct costs, direct labor, and tax return depreciation. However, it's important to note that if you make this election, the 10% Election (that allows you to defer recognition of gross profit on a job until the job is 10% complete) cannot be made.

Some may say, "That's a trade-off I'm willing to take!" But hold on, and let's look at the math first.

The Math and the Aftermath

Percentage-of-completion is calculated by considering costs incurred to date divided by total estimated costs for the contract. Seems simple enough. But now we've thrown in these allocated costs listed above. How does this affect your percentage-of-completion percentage?

The IRS has a helpful document called the "Construction Industry Audit Technique Guide". This guide offers three scenarios where Allocated G&A has been 1) included in the numerator only, 2) included for the same amount in the numerator and the denominator, and 3) included in the numerator with an estimated pro rata amount included in the denominator.

Simple algebra tells us that when looking at ratios if you increase your numerator without increasing your denominator, your percentage is going to increase. Similarly, if you increase your numerator and denominator by exactly the same amount, your percentage is going to also increase. However, if you increase your denominator proportionately to your numerator, there is a good chance your percentage will actually decrease.

This last scenario is not one you will find in the "Guide". That scenario assumes that the indirect cost is incurred statically over the life of the contract - meaning the same amount of indirect cost is recognized each year. This works well for examples since the numbers come out even, but in reality, those indirect costs fluctuate year to year. This is why determining just how much to include in your denominator for estimated future allocable indirect costs is so important.

Decreasing your percentage complete for tax purposes only when dealing with percentage-of-completion is reason enough to consider first allocating those indirect costs before automatically making the "Simplified Cost Election".

If you have any questions regarding the contents of this article or would like more information, please contact the construction professionals at McKonly and Asbury, LLP.