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It is not a matter of if the IRS is going to audit your construction company, but when. While the audit rates have been declining in recent years, according to IRS' published statistics, that trend may soon change.
Only a few months ago the IRS issued the Market Segment Specialization Program Audit Technique Guide (ATG) for the construction industry, a training document to be used by agents prior to conducting an audit of a construction company. That is a solid indication that the audit frequency for contractors may increase.
In addition, within the last year the Large and Midsize Business Division of the IRS issued a memorandum to its directors and managers advising of noncompliance in the industry with regard to the look-back interest under Internal Revenue Code (IRC) section 460. That section requires the complex reporting and computation of interest, on form 8697, for certain long-term contracts using the percentage of completion method (PCM) in the completion year and some applicable post-completion years. The memorandum points out several specific problems of noncompliance and has designated this as an "Emerging Issue." Additional audits will certainly result as the IRS develops this issue on the admittedly complex Look-back method application to PCM contracts.
This is your scouting report for the future confrontation. The ATG is the opposing side's playbook and is a must read for every contractor.
The ATG is a summary of many of the issues and tax rules controlling the construction industry. It begins with a basic explanation of some of the players in the industry, and also discusses bonding, estimating, the various types of contracts and basic terms such as change orders. It basically provides the uninformed IRS agent with more comfort on the first day of the examination.
It then discusses the basic rules of IRC 460, with the definition of long-term contracts, exempt contracts, exempt contractors, the types of contracts, and the rules of severing and aggregating contracts for tax-reporting purposes and the different allowable methods of reporting long-term contracts, such as the cash method, accrual methods, and the completed contract method.
The manual instructs the agents in differentiating the contracts that are required to be on the PCM and those that are exempt from those rules, as well as the applicability of the Alternative Minimum Tax, the look-back method and joint ventures. It differentiates the rule of contractors, homebuilders, and developers.
Since the agents may not be experienced in the construction industry, the ATG is supposed to train them in the tax rules for the industry. That same instruction is a must read for the construction financial executive who may not be informed of all the intricacies and complex rules of the applicable laws, regulations and cases.
There are some great clarifications of rules, which have caused conflicts previously between agents and contractors. For example, the ATG acknowledges that retainage payable is not included in the numerator of the percentage of completion calculation until the all-events test has been met per IRC 461.
The ATG also acknowledges that contracts are not complete until "completed and accepted" but might be competed under the "95 percent rule" in some circumstances and instructs the agents that jobs that are 95 percent or more complete as of the end of the year will "require further investigation...." Expect those jobs to have additional audit scrutiny.
Another issue the ATG emphasizes is the mechanics of the PCM. In some prior audits agents would find additional contract costs that should have been charged to the contracts in progress and would make adjustments based on the inclusion of those costs in the numerator of the PCM without a corresponding consideration in the enominator. The ATG instructs the agents in the proper methodology of that adjustment, which often then results in no audit adjustment at all. This should help many future audits progress more smoothly on that issue with the better informed agents.
In addition to the discussion of the rules, the most important aspects of the ATG are the dozens of specific instructions to the agents for audit procedures and items to examine for possible non-compliance with the law. The construction CFO and controller will be well advised to know exactly the more than sixty specific audit steps that the agents are instructed to perform, the preconceptions, and in some cases, the misconceptions that the agents may have. The audit steps are sprinkled throughout the ATG rather than being in a concise punchlist, which makes it more difficult for the construction CFO to precisely pinpoint the agent's game plan.
One provision of tax law for contractors that has not been in a previously published construction case, and thus may not have been closely audited in the past, is the provision for built-in gains tax for C corporations that switch to S corporation status that were using a deferral method for tax accounting. The Guide instructs the agents to compute the PCM at the date of S conversion and compare it to the reported income on jobs in progress under the completed contract method, or other deferral method, and compute the built-in gains tax on the deferred income.
The agents are instructed to look for unreported income, and may conduct the examination with some unreasonable expectations. For example, they are instructed to perform income probes by comparing reported income in comparison to contract costs, with reference to "industry standards from websites such as Bizstats.com..." If the contractor is out of line with those lineal, non-scalable figures of that site, which statistically most contractors will be, then the agent may be predisposed to suspect misreporting for even the most squeaky clean tax return.
In conclusion, since future examining agents will have extensive training in the complex laws of construction taxation, and the number of audits may be increasing, it is imperative that every contractor know the rules, the hot audit issues that will come under scrutiny, and be completely familiar with the agent's play book before the game begins.
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