The IRS percentage of completion method (PCM) is mandatory for specific long-term contracts, notably in the construction and manufacturing industries. This method allows closes and expenses to be recognized as work is performed, preventing companies from postponing revenue recognition for the entirety of the project.
When the IRS Percentage of Completion Method is Required
Based on Implementing Internal Revenue Code Section 460, for the IRS, the long-term PCM contracts are the contracts for a year. The PCM applies when:
- The contract is for the construction or manufacture of property.
- The taxpayer average annual gross receipts are above $25 million for the last 3 years.
- Contracts are NOT exempt from the small contractor or home construction rules.
Small contractors, or those with receipts under the $25M threshold, are permitted by CCM, to defer revenue and expense acknowledgment on a completed project. However, large contractors, or those with many ongoing projects, are required by PCM for tax purposes.
How the IRS Defines the Method
Under the IRS’s rules, the percentage of completion method calculates taxable income each year based on the portion of the project completed to date. This is typically determined using one of the following measures:
- Cost-to-cost method: Percentage = (Costs incurred to date ÷ Total estimated costs) × 100
- Efforts-expended method: Based on labor hours, machine hours, or other measurable efforts.
Once the completion percentage is determined, the same ratio is applied to the total contract revenue to recognize income for that year.
Why the IRS Uses PCM
The IRS enforces this method to promote accurate and consistent revenue recognition for long-term projects. By spreading income recognition across multiple tax years, PCM prevents income manipulation and aligns reported profits with the actual progress of work performed.
Conclusion
In summary, the IRS does require the percentage of completion method for many long-term construction contracts, especially for larger businesses. Smaller contractors, however, may qualify for exemptions and can use alternative methods like the completed contract method. If you are unsure how to apply such methods, reach out to us. Dimov Tax presents expert assistance.