Applying the percentage of completion method in M&A transactions

Executive summary: Tax treatment of PCM contracts in an M&A Transaction

Taxpayers (buyer or seller) investigating an mergers and acquisitions (M&A) transaction where the business being acquired accounts for long-term contracts using the percentage of completion method (PCM) need to be aware of the special rules that apply in the year of the transaction. Failure to do so could provide unexpected tax results to both the purchaser and seller. Similar to issues that arise with deferred revenue in the year of an M&A transaction, the PCM accounting for tax purposes can differ from generally accepted accounting principles (GAAP), and transactions which appear similar may have varying consequences.  

The basics of the percentage of completion method

Introduction

Generally, in a fully taxable asset transaction, the seller is treated as completing the contract on the date of the transaction and the buyer is treated as entering into a new contract.¹ In a non-taxable transaction where a new taxpayer will complete the contract, the seller’s responsibility to account for the contract terminates and the buyer is treated as “stepping into the shoes” of the seller.²  More complex issues arise in a partially taxable transaction, where a company may be treated as selling a portion of its assets and rolling over a portion, as commonly seen in the private equity context.

The analysis below provides a general discussion of the PCM and then takes a deeper dive into mid-contract changes in the taxpayer completing a contract under taxable asset transactions and certain tax-deferred transactions.

Defining long-term contracts

With certain exceptions and special rules beyond the scope of our discussion, section 460(f)(1) defines a long-term contract as “any contract for the manufacture, building, installation, or construction of property if such contract is not completed within the taxable year in which such contract is entered into.”³

Computing income under PCM

The rules for computing income under the PCM are found in  Reg. section  1.460-4(b)(2), and consist of the following steps:

1. Compute the completion factor. The completion factor is the ratio of the cumulative allocable contract costs incurred through the end of the taxable year over the estimated total allocable contract costs that the taxpayer reasonably expects to incur under the contract.
2.  Compute the amount of cumulative gross receipts. This amount is determined by multiplying the completion factor by the total contract price.
3.  Compute the amount of current-year gross receipts. This amount (which may be positive or negative) is equal to the amount of cumulative gross receipts for the current taxable year less the amount of cumulative gross receipts from the immediately preceding taxable year. 
4. Compute taxable income. This amount is equal to current-year gross receipts less the allocable contract costs incurred during the current taxable year. 

A taxpayer generally may make an election to postpone reporting income and costs until the tax year in which at least 10% of allocable contract costs have been incurred.⁴ The following two examples will be utilized throughout the discussion below, and it is assumed that there is no difference between the book and tax treatment under the PCM.

Example 1

Facts: In Year 1, Seller enters into a long-term contract for $100 with expected costs of $75 that is expected to complete in Year 3. At the end of Year 1, Seller has completed 80 percent of the contract (i.e., has incurred $60 of total expected costs). However, Seller has only billed $50 on the contract. In this case, for Year 1 Seller recognizes $80 of revenue under the contract, $60 of costs, and as of the end of Year 1 has a debit balance/asset account for “costs in excess of billings” of $30.

Example 2

Facts: In Year 1, Seller enters into a long-term contract for $100 with expected costs of $75 that is expected to complete in Year 3. At the end of Year 1, Seller has completed 60 percent of the contract (i.e., has incurred $40 of total expected costs), but has billed $80 on the contract. In this case, for Year 1, Seller recognizes $60 of revenue under the contract, $40 of costs, and as of the end of Year 1 has a credit balance/liability account for “billings in excess of costs” of $20.

Tax consequences for a “Mid-Contract” transfer

As discussed above, an M&A transaction or reorganization may involve a transfer of a long-term contract prior to its completion. Commonly referred to as a “mid-contract” transfer, the transaction involves a transfer of a contract by a taxpayer (“Transferor” or “Seller”), who reported income under the PCM, to a new taxpayer (“Transferee” or “Buyer”), who is now responsible for completing the contract. When a mid-contract transfer occurs as a result of an M&A transaction, Seller and Buyer’s tax consequences depend on whether such transaction was a fully taxable asset transaction or non-taxable/ deferred tax transaction.

Fully taxable asset transactions

A fully taxable asset transaction, such as a sale under section 1001 or a section 338 deemed asset sale, is governed by the constructive completion rules.⁵ Under these rules, on the date of the mid-contract transfer, Seller is treated as if it has completed the contract and Buyer is treated as entering into a new contract. As such, Seller’s obligations under the contract are terminated and income or expense is recognized on the contract.

First, Seller must determine the total contract price. The total contract price is any amount the Seller received in the transaction that is allocated to the contract plus any amounts the Seller has received or reasonably expects to receive under the contract. That amount is then reduced by any amount Seller paid to Buyer, and by any transaction costs, that are allocable to the contract. Once the total contract price is determined Seller is able to determine whether they have a profit or a loss on the contract. To the extent the parties agree to a payment from Buyer to Seller in a transaction covered by sections 1060 or 338, the payment is treated as made to the contract as opposed to assets in the seven-asset class allocation.⁶

Example 1

Facts: In Year 1, Seller enters into a long-term contract for $100 with expected costs of $75 that is expected to complete in Year 3. As of the end of Year 1, Seller has completed 80 percent of the contract (i.e., has incurred $60 of cost) and for federal income tax purposes recognizes $80 of revenue and $60 of costs. However, Seller has only billed $50 under the contract. In Year 2, before incurring any additional costs on the contract, Seller enters into a fully taxable asset transaction with Buyer. If the parties do not agree on a payment to Seller allocable to the contract, the Seller would realize a loss of $10 on the contract ($50 received minus $60 costs incurred). As part of the transaction, assume Seller negotiates with Buyer for an additional $30 payment for the contract.

Seller’s consequences under the constructive completion rules

Seller has previously picked up $80 of income from the contract and the total contract price under the constructive completion rules also equals $80, so there is no additional income recognized on the contract as of the transaction date. Seller calculates a total contract price of $80 and has incurred $60 of costs at the time of the transaction. Thus, the total profit from the contract equals $20, all of which was recognized prior to the transaction date.

Buyer’s consequences under the constructive completion rules

Buyer is treated as entering into a new contract on the date of the transaction and as such must determine whether the new contract should be treated as a long-term contract under section 460. Because the contract is expected to complete in Year 3, Buyer determines that it is a long-term contract under section 460 for which the PCM is required. Next, Buyer must determine the new contract’s total contract price. Buyer’s total contract price is any amount they reasonably expect to receive under the contract. This amount is then reduced by any of consideration the Buyer paid as a result of the transaction and increased by any amount Buyer received in the transaction that is allocable to the contract.

Buyer expects to receive $50 from the contract since only $50 was billed by Seller. Additionally, the total contract price is reduced by the $30 Buyer paid Seller. This results in a total contract price of $20. The Buyer will report net income or loss based on the difference between the total contract price and the costs Buyer incurs in completing the contract. Without the payment from Buyer to Seller, Buyer would have picked up an additional $30 in ordinary income over the remainder of the contract.

Example 2

Facts: The same as Example 1 except that as of the end of Year 1, Seller has billed $80 and only incurred $40 of costs (i.e., 60% of the contract is complete); thus, Seller recognizes $60 of revenue and $40 of costs. As part of the negotiations, Seller agrees to pay Buyer $30 for the contract. The M&A agreement calls for a payment from Seller to Buyer of $30. 

Seller’s consequences under the constructive completion rules

So, the contract price is $50 and costs incurred are $40, with a total profit on the contract of $10. Previously Seller recognized $60 of income and $40 of expense related to the contract. If Seller had not made the payment to Buyer, then Seller would recognize $20 of additional revenue on the contract in the transaction year for a total contract price of $80 and costs of $40, for a total of $40 profit on the contract. Instead, the total profit on the contract is reduced to $10 (i.e., $50 contract price less $40 of costs), so the payment to Buyer reduced the ordinary income recognized by Seller on the contract by $30.

Buyer’s consequences under the constructive completion rules

In this case Buyer will recognize $50 of revenue under the contract and is expected to incur $35 of additional costs, projecting a $15 profit, where it would have expected to recognize a $15 loss without the payment.

Non-Taxable transactions or partially taxable transactions

Many M&A transactions, particularly those involving private equity, are structured as partially tax deferred. Mid-contract transfers resulting from a tax deferred transaction are generally subject to subject to the “step-in-the-shoes” rules.⁷  There are several tax deferred transactions,⁸  but for purposes of this analysis, our focus is on sections 721 and 351 transfers. In the discussion below, the term Seller/Transferor and Buyer/Transferee are used interchangeably.  

Under the step-in the shoes rules, on the date of the transaction, Seller’s responsibility to account for the contract terminates and the contract is assumed by the Buyer. As a result, under the PCM, Seller is required to recognize income from the contract based on the total contract costs incurred as of the date of the transaction. Buyer “steps-in-the-shoes” of Seller and must assume Seller’s method of accounting for the contract, (unlike a Buyer in a fully taxable asset transaction that must evaluate the applicability of section 460 as if the contract is a new contract entered into by Buyer on the date of the transaction). 

Assuming the same facts in Example 1 above but that the transfer is in a non-taxable transaction, Transferee (Buyer in the example) will receive $50 in cash ($100 contract price minus $50 previously received by Transferor), yet will only recognize $20 of taxable income as the contract is completed and will recognize the remaining costs, estimated at $15.  In Example 2 on the other hand, Transferee will only receive $20 in payments ($100 contract price minus $80 previously received by Seller) but will recognize $50 in taxable income and must incur $35 to complete the contract. In a non-taxable transfer, the concept of a payment between transferor and transferee related to the contracts does not appear to exist.

To make things more complicated, many M&A transactions, particularly those involving private equity, are structured as partially tax deferred. In these situations, understanding the tax consequences associated with a mid-contract transfer is important, as a contract could be subject to both the constructive completion and step-in-the-shoes rules. For example, assume that a transaction occurs that is addressed in situation 1 of Revenue Ruling 99-5, where Buyer acquires interests in a disregarded LLC (LLC) owned by Seller.  The transaction is treated as Buyer acquiring a proportionate interest in the assets of LLC from Seller, and then both Buyer and Seller contribute the assets to a newly created partnership entity. 

Assume for example that Buyer acquired 50% of LLC from Seller. In that case, 50% of each contract accounted for under PCM is accounted for under the constructive completion rules, while the other 50 percent of each contract is subject to the step-in-the-shoes rules. Making sure that these contracts are appropriately accounted for by Buyer, Seller, and LLC is no small task.

Balance sheet items and the purchase price allocation

As stated above the PCM allows companies to recognize income at the time the work is performed, rather than when the entire contract is completed. As we have discussed above, two items on the balance sheet are used to account for the difference between the PCM and the billings: (1) costs in excess of billings (debt/asset account); and (2) billings in excess of costs (credit/liability account). As such, at the time of the mid-contract transfer resulting from a taxable purchase of assets, a question often arises as to how these two items are treated in determining and allocating the adjusted grossed up basis⁹  (AGUB) and aggregate deemed selling price¹⁰  (ADSP).¹¹  

Billings in excess of costs as a liability

In determining both AGUB and ADSP the parties include liabilities assumed in the transaction. How is the credit balance for billings in excess of costs treated in the determination of AGUB and ADSP? The correct answer is that it is likely ignored. This is not a true liability for tax purposes. This reflects an amount similar to deferred revenue, where billings have occurred in excess of the revenue recognized. Including this liability in AGUB or ADSP would result in over recognition of basis and gain in the transaction. This credit balance, as discussed above, will result in income recognition upon the constructive completion rule, so including it in a liability assumed would result in a double inclusion.

Could this credit balance be included in Seller ADSP and provide Seller a payment to Buyer on the contract, thereby reducing ordinary income to Seller in the year of the transaction? In the context of deferred revenue there is an approach, referred to as the Pierce approach, based upon James M. Pierce Corporation v. Commissioner.¹²   Under this theory, Seller would treat the credit balance (or some other amount) as a payment to Buyer on the contracts, followed by Buyer taking those proceeds and paying them to Seller, increasing gain on the transaction, which is offset by a reduction in contract price. It seems reasonable for such an agreement; however, it is unclear whether this approach has been specifically addressed by the IRS in the PCM context, and agreement to such treatment by both Buyer and Seller should occur.

Costs in excess of billings as an asset

Like the credit side discussed above, costs in excess of billings does not look like an actual asset, but rather represents revenues recognized by the Seller that exceed the actual billings on a contract. Further, due to the constructive completion treatment, the debit balance is eliminated as a result of the transaction and should not be a debit balance on the balance sheet at closing. With that said, the PCM regulations do address payments made by the Buyer to Seller and attributed to a contract. Specifically, under regulation section 1.460-4(k)(2)(ii), ADSP and AGUB are allocated to the contracts under the seven-asset class residual method of reg. section 1.338-6 and 1.338-7. But what are those amounts? Allocations are allocated equal to the fair market value of each asset in a particular class starting at Class I going to Class VI, with any residual to goodwill in Class VII. What is the fair market value of the contracts? As with any asset under the allocation system, Buyer and Seller may decide to agree to a specific allocation of purchase price to an asset. If agreed upon, Buyer and Seller, but not the IRS, are bound by the allocation.

What happens then if the purchase agreement simply says purchase price is allocated based upon the Seller closing book balances? Does that mean that the parties have agreed to allocate the debit balance in the costs in excess of billings account on the balance sheet? That does not appear to represent a fair market value of all of the contracts, but rather simply income recognized in excess of billings to a customer. It is unclear how the IRS would look at this issue, but buyers and sellers should make sure the purchase agreement truly reflects their intention with respect to the contracts.

Summary    

Buyers and Sellers who are considering an acquisition or disposition of a business need to be aware of the consequences of a mid-contract transfer of any contracts required to be accounted for under the PCM for federal income tax purposes. Attention should be given to whether the transaction engaged in by Buyer and Seller is a fully taxable asset acquisition, non-taxable transaction, or partially both. The type of transaction will affect how the contract is treated post-acquisition, as well as the tax considerations for both Buyer and Seller. 

Prior to the agreeing on a purchase price allocation of the business assets, a taxpayer should carefully examine the position of all PCM contracts. This detail may fuel negotiations for additional payments with regards to contracts from Buyer or Seller and vice versa. Understanding how these additional payments affect the contract price, AGUB and ADSP, and ordinary income in the year of the transaction is vital. 

Since an M&A transaction only adds to the complexity of the rules and considerations surrounding contracts using the PCM, taxpayers should consult with a tax professional to assist in tax planning strategies and ensure proper analysis of a mid-contract transfer. 

^{1. Reg. section 1.460-4(k)(2).} 

^{2. Reg. section 1.460-4(k)(3).}

^{3. Section 460(f)(2) provides special rules for manufacturing contracts and  Reg. section  1.460-3(b)(1)-(2) provides exemptions for certain construction contracts, both are outside the scope of this analysis.} 

^{4. Section 460(b)(5). If elected, the 10% method applies to all long-term contracts entered into during and after the year of election. Reg. section  1.460-4(b)(6).}

^{5. Reg. section  1.460-4(k)(2).}

^{6. Reg. section  1.1060-1(c); Reg.  section 1.338-6 and 1.338-7.} 

^{7. Reg. section  1.460-4(k)(3)(i).}

^{8. The complete list of transaction under Reg. section  1.460-4(k)(3)(i) includes: (i) transfers to a corporation in an A, C, or F reorganization; (ii) transfers to a controlled corporation in connection with a D or G reorganization; (iii) liquidating distributions to which section 332 applies, provided that the contract is transferred to an 80 percent distributee; (iv) transfers described in section 351; (v) conversions to or from an S corporation; (vi) sales and other transfers of S corporation stock; (vii) members joining or leaving a consolidated group; (viii) contributions of long-term contracts to which section 721(a) applies; (ix) contributions of property to a partnership that holds a long-term contract; (x) transfers of partnership interest, other than transfer caused by a partnership termination under section 708(b)(1)(A); (xi) distributions to which section 731 applies; and (xii) any other transaction so designated by the IRS.} 

^{9. Reg. section 1.338-5.}

^{10. Reg. section 1.338-4.}

^{11 Reg. section 1.1060-1(c)(2); Reg. section 1.338-6(b).} 

^{12. James M. Pierce Corporation v. Commissioner, 326 F.2d 67 (8th Cir. 1964).}