Taxpayer ineligible to use the completed contract method, court rules

Taxpayer ineligible to use the completed contract method, court rulesIn Basic Engineering v. Commissioner, T.C Memo 2017-26 (Feb. 1, 2017), the Tax Court ruled that an engineering company was ineligible to use the completed contract method and was liable for an accuracy-related penalty. The taxpayer in that case entered into two contracts each of which required the taxpayer to disassemble, transport, refurbish, assemble and supervise the commissioning of an oil refinery. The taxpayer accounted for the contracts using the completed contract method.

The IRS asserted that the taxpayer must use either the general rules under the accrual method of accounting for revenue and expenses or alternatively the percentage of completion method.

The Tax Court concluded that the contracts were long-term contracts requiring the percentage of completion method under Section 460 because the contracts were not complete by the end of the year. The court analyzed various exceptions from applying the percentage of completion method, but held that the taxpayer did not meet any of them.

For example, the contracts did not meet the exception under Section 460(f)(2) for a contract that does not involves the manufacture of (a) any unique item not normally included in the finished goods inventory of the taxpayer, or (b) any item which normally requires more than 12 calendar months to complete. Additionally, the court considered whether the exception of Section 460(e)(1)(B) applied. That exception requires, in part, that the taxpayer estimates, at the time a construction contract is entered into, that it will be completed within the two-year period beginning on the contract commencement date (the two-year rule).

The court concluded that it was not reasonable for the taxpayer to estimate that the length of the contracts would allow either exception to apply (regardless of whether the contracts were manufacturing contracts subject to Section 460(f)(2) or construction contracts potentially subject to Section 460(e)(1)(B)). As a result, the taxpayer was required to use the percentage of completion method of accounting.

Finally, the court also sustained the accuracy related penalties under Section 6662(b)(2) for a substantial understatement of income tax, holding that the taxpayer did not act with reasonable cause and in good faith when using the completing contract method of accounting. Even though the taxpayer’s returns were prepared and signed by a CPA, the court said there was no evidence of reliance by the taxpayer on the CPA with regard to advice on the application of the long-term contract exception under Section 460(e), and, therefore, the taxpayer did not exercise ordinary business care and prudence, as required under the regulations and case law.

Contact Sharon Kay
Partner, Washington National Tax Office
+1 202 861 4140

Ellen Martin
Partner, Washington National Tax Office
+1 202 521 1558

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