With the recent Internal Revenue Service (IRS) Large Business and International (LB&I) division’s announcement of “13 campaigns,” specific industries are being impacted. Land developers are under close scrutiny and are proactively trying to gauge exactly what the implications will be under IRC Section 460.
IRC Section 460 generally requires taxable income to be reported under the percentage of completion method (PoC) of accounting. This requires recognition of revenue on the percentage of the contract completed, which is determined by the total contract cost to date over the total estimated cost.
Certain taxpayers can also use the completed contract method (CCM) of accounting for long-term housing development contracts that go beyond a single tax year. Under CCM, taxpayers do not recognize revenue until the contract is completed and accepted by the customer. This method usually results in the greatest deferral of income, and thus deferral of taxes. For large developers, this could equate to millions of dollars of deferred tax payments. However, some land developers have been incorrectly using CCM accounting; thus, the reason for the IRS targeted campaign. For example, some developers are improperly deferring all gains until all developments — not just home construction projects — are completed.
The goal of the IRS campaign is to ensure that large land developers constructing in residential communities are properly using CCM. The IRS is providing specialized training for revenue agents assigned to enforce the use of this method. In addition, the IRS plans to issue soft letters (or warnings), and audit as needed. Not having a thought-out strategy, if selected for audit, could prove to be very costly. According to the Financial Executives Research Foundation (FERF), audit fees paid by 6,490 unique company filers for their 2015 audits hovered around $1.8 million, with a median of $522,205.
To avoid an audit as a land developer, your best defense is a stellar offense. First, make sure your company meets the CCM criteria outlined by the IRS. Second, model out all tax implications with and without the use of CCM. This type of sophisticated analysis requires advanced software that performs “what-if” analysis over multiple years and compares tax strategies against past, current, and future guidance. Bloomberg Tax offers several integrated software solutions:
- Fixed Assets does the heavy lifting on GAAP and tax methods for construction-in-progress situations. An open timeline supports multiyear analysis.
- Fixed assets data then feeds into Corporate Tax Analyzer™ for enhanced decision making and development of informed, proactive strategies surrounding federal tax impacts and audit controversy.
- State Tax Analyzer™ provides the multistate, multiyear strategic analysis for any downstream state tax implications from federal accounting/tax method changes, including full net operating loss (NOL) tracking that takes 382/SRLY adjustments into effect.
With this valuable strategic analysis, land developers that correctly used CCM can rest assured; those that used it incorrectly can take corrective action; and those that could have legitimately benefited from using CCM can file amended returns. After careful review, if you find that you need to change your accounting method, follow these guidelines:
- If a taxpayer incorrectly used the CCM method on their first tax return, but have not yet filed their second tax return, the IRS will allow them to file an amended return. This is valid since the CCM method for the taxpayer has not yet been established across years.
- If tax returns have been incorrectly filed for two or more years, taxpayers will need to apply for a change in accounting method using Form 3115.
Software solutions from Bloomberg Tax offer “what-if” scenario planning, instrumental in determining the best future tax strategies, such as CCM. By working with the latest IRS guidance available, you can proactively put a comprehensive tax strategy into place that enables your company to quickly resolve any IRS inquiry — potentially saving hundreds of thousands of dollars, and a time-consuming IRS audit.