Accounting methods: What government contractors should know
INSIGHT ARTICLE |
Recent tax legislation passed in 2017 (commonly referred to as the Tax Cuts and Jobs Act, or TCJA) created a number of changes for government contractors in how they can recognize revenue and expenses. In addition to the broad TCJA changes affecting all taxpayers, government contractors have industry-specific considerations. Government contracts typically involve long or complex contracts that require special methods of accounting, and the Federal Acquisition Register (FAR) places certain requirements on contracts that dictate the timing of income and expense recognition. Additionally, there are new considerations for revenue recognition with new standards for financial accounting under ASC 606. The new guidance was effective as of Jan. 1, 2018 for public entities with calendar year ends. For all nonpublic entities with calendar year ends, the new guidance is effective in the year ending Dec. 31, 2019. This paper discusses opportunities and risks that government contractors should be aware of in the face of the new laws and standards.
Where to start – section 451 or sec. 460?
Many of the opportunities and concerns break down differently whether a contract is an ordinary contract governed by section 451, or a long-term contract governed by section 460.
In general, section 451 governs most contracts for services and the sale of goods. Contracts for the provision of services, if they do not involve building, installation, or construction of property, generally fall into section 451 rather than section 460. These changes can often be made using automatic procedures and may allow a section 481(a) adjustment instead of a cutoff.
Section 460, on the other hand, covers long-term contracts, which include contracts for construction, installation, building, or manufacturing of property. Section 460 contracts must begin in one tax year and be completed in a later tax year. These contracts are typically accounted for on the percentage of completion method. Method changes relating to long-term contracts usually require non-automatic procedures and are effected on a cut-off method. A non-automatic method change requires an IRS user fee (currently $10,800) to have the change reviewed and the change cannot be implemented until the IRS accepts the change. A method change under the automatic method change procedures does not require a user fee to have the change reviewed by the IRS. The List of Automatic Changes can be found in Rev. Proc. 2018-31 (or its successor). Method changes are made on either a cut-off basis or apply a historical section 481(a) adjustment. If the method change is on a cut-off basis only the treatment of current-year and future-year expenditures is changed (there is no historical adjustment), while other method changes are available to make a historical section 481(a) adjustment.
Standard contracts – section 451
Section 451 covers the general rules for determining when items of income should be included in the taxpayer’s gross income. The basic rule for revenue recognition is the ‘all events test’ – a taxpayer should recognize revenue when all the events have occurred which fix the right to receive income and the amount of such income can be determined with reasonable accuracy. In addition to an item of income being ‘fixed’ and ‘determinable,’ TCJA added another prong to the all events test by adding section 451(b). With this new rule, the all events test is treated as met no later than when revenues are recognized in the taxpayer’s applicable financial statement (AFS). This rule does not apply to special methods of accounting, which includes long-term contracts under section 460.
For many taxpayers section 451(b) will accelerate revenue, but the addition of a new automatic method change number 239 via Rev. Proc. 2018-60 offers a new opportunity to make broader changes to permissible revenue recognition methods. Such changes have traditionally required costly non-automatic procedures. The operative rule set forth in section 451(b)(1)(A) includes the requirement of the all events test under section 451(b)(1)(C). Thus, to satisfy section 451(b)(1)(A), a taxpayer must also comply with the all events test as defined in section 451(b)(1)(C). Accordingly, taxpayers can use Rev. Proc. 2018-60 to fix the timing of revenue recognition even if the change is not related to the timing of recognition under the taxpayer’s AFS.
Different FAR contract types, different results
The new 451(b) provisions may accelerate recognition of unbilled receivables and retainages for many taxpayers. It is important to understand the relationship between FAR contract provisions and the all events test. The FAR has traditionally required government approval before certain payments may be considered due or earned for purposes of the all events test, but 451(b) complicates the analysis.
Payment becomes ‘due’ for purposes of the first prong of the all-events test as soon as invoicing is allowed under the contract or the Federal Acquisition Regulation (FAR), and remaining minor or ministerial duties (e.g., submitting the invoice) do not delay accrual. In most contracts, FAR provisions dictate a particular interval that the taxpayer is allowed to bill, making it easy to determine when a payment is ‘due.’ Even if the taxpayer does not bill immediately, the FAR allows invoicing on most contracts either monthly or every two weeks. This is the latest date that revenue can be recognized in such contracts.
Under the FAR, any cost-type contract (i.e. a contract that reimburses the cost of performance in addition to a fee) requires government approval before performance is complete and billing of a particular amount is permitted. Similar language is included in all contracts requiring approval of rate adjustments and additional costs. In these cases where performance includes non-severable portions or approval is required before billing is allowed (as opposed to before payment is allowed), approval is a condition precedent to the right to receive becoming fixed. Therefore, the right to receive income does not become fixed until the contracting officer exercises that approval and the applicant gets the right to bill. However, section 451(b)(1)(A) provides that income shall not be treated as met any later than when such item is taken into account as revenue in an AFS of the taxpayer, or such other financial statement. Accordingly, if the taxpayer’s AFS recognizes these amounts before performance is complete or the FAR allows billing, revenue must still be recognized for tax under section 451(b)(1)(A).
Taxpayers earn revenues for services on severable contracts as each severable portion of the contract is performed, and a taxpayer's right to receive income from those services becomes fixed under section 451 no later than such performance, regardless of whether the taxpayer has the right to bill at that time.
It is important to examine each contract for the earliest moment that the all events test is met, and even when the FAR would delay that moment, the AFS may accelerate it. The silver-lining taxpayers may find is that the new automatic changes make the process of getting on a good method much less painful. Similarly, changes relating to expense recognition for contracts governed by section 451 will generally be automatic and relatively simple.
451(c) – a limited deferral option
While tax reform got rid of some deferral options, section 451(c) codified a portion of the provisions of Rev. Proc. 2004-34. Section 451(c) provides a one-year deferral option for certain advance payments. For certain payments, an accrual basis taxpayer can recognize advance payments in the year received only to the extent the taxpayer recognizes such payments in its AFS, and then defer the remaining portion into the following taxable year. Not all advance payments qualify, but this is a useful provision and the IRS has stated that taxpayers without an AFS may continue relying on Rev. Proc. 2004-34 until further guidance says otherwise.
Section 460 opportunities for government contractors
Many government contracts are governed under section 460 as they have long periods of performance or require construction and manufacturing.
The default rule under section 460(a) requires the percentage of completion method (PCM) for these types of contracts. Unlike section 451, long-term contract accounting under section 460 disregards advance payments, instead recognizing revenue as the taxpayer incurs costs. Note that the PCM method for tax rules might not precisely follow the PCM method used for financial accounting. These differences should become more evident as government contractors adopt the new standards for financial accounting.
Method changes for section 460 contracts are more costly, as virtually all changes – whether for income or expense – are non-automatic. IRS has taken the view that section 460 governs the timing of both income and expense on long-term contracts. Certain expenses may be characterized as outside of the long-term contract method, which is an area of opportunity to identify automatic changes. Additionally, qualified small business taxpayers may file automatic changes to go on or off the PCM beginning in 2018.
Special methods of accounting are exempt from the book acceleration rule of section 451(b), and long‑term contract methods qualify as exempt special methods. Section 460 offers the opportunity to defer unbilled receivables and retainages later than financials. Note also there are several different methods of accounting for different types of long-term contracts or based on taxpayer attributes.
Deferring subcontractor payables
Subcontractor payables offer a rare opportunity to defer revenue under PCM. The service will respect valid ‘pay-if-paid’ clauses (i.e. clauses stipulating that a contractor will not pay a subcontractor until the customer pays the contractor) if the clauses stand in the jurisdiction of the contract. These subcontractor payables may be eligible for deferral, which means the associated revenue is also deferrable under PCM.
Deferring Retainage Income
Retainages provide several opportunities to defer income, but as with most methods issues in the GovCon space, the efficacy varies by section 460 vs non-460 contracts.
For contracts subject to section 460, method changes related to retainage income are likely non‑automatic. Retainages must be included in the gross contract price. This means the retainages simply factor in over the course of accounting under PCM. There is generally no way to fit retainages into an automatic method change on section 460 contracts.
For non-section 460 contracts, automatic change number 130 offers an effective way to defer income. Accrual basis taxpayers can defer retainage income until after the contingency giving rise to the retainage is satisfied, subject to certain restrictions. This method is not available for contracts using the PCM, CCM, or exempt PCM methods. This method allows a section 481(a) adjustment. Certain long-term contracts can qualify to defer retainage income via automatic change number 217; however, for long-term exempt construction contracts, these changes must be made on a cut-off basis without a section 481(a) adjustment.
Simplified methods for small business taxpayers
TCJA greatly increased the number of business that may be qualified small business taxpayers (QSBTs) by raising the ceiling from $5,000,000 to $25,000,000 in gross receipts. Taxpayers with less than $25,000,000 in average annual gross receipts qualify for simplified methods and less burdensome automatic method change procedures. Some of the benefits include exemption from the requirement to capitalize inventory costs under section 263A (UNICAP), exemption from the requirement to account for inventories under section 471; qualifying to use the overall cash method of accounting; and exemption from the requirement to account for certain long-term contracts under section 460 or to capitalize costs under section 263A for certain home construction contracts.
Note that the gross receipts test may require aggregation of entities with common ownership or other relationships. Tax shelters, as defined in section 448(d)(3), are also prohibited from using the overall cash method of accounting. However, the reward for qualifying is great as these simplified procedures can accelerate expense recognition, defer revenue, and significantly reduce the cost of tax compliance.
Major changes to the tax code coinciding with major changes to financial accounting standards have created a constantly-shifting legal landscape for government contractors. There are a number of compliance pitfalls, particularly as revenue recognition standards change and require more taxpayers to accelerate income on traditionally simple FAR-governed contracts. However, there are an equal number of planning opportunities to take advantage of the new laws, and the time is ripe for examining accounting methods.
 Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (Topic 606), as amended (“ASC 606”)
 See generally section 460.
 Section 460(a).
 See section 451(b)(3) (describing the types of statements and records that constitute an “applicable financial statement.”)
 See Rev. Proc. 2018-60.
 CCA 201852019 (Allowing changes under Rev. Proc. 2019-60 to fix the timing of revenue recognition).
 See, e.g., Kuehner v. Commissioner, 214 F.2d 437, 440 (1st Cir. 1954) (taxpayer recognized income when amounts went into escrow fund because payment from fund by trustee to taxpayer was “ministerial”); Georgia School-Book Depository v. Commissioner , 1 T.C. 463 (1943) (collecting from state and transmitting payment to publisher are “the least of [taxpayer's] duties“; right to income still accrues); Rev. Rul. 74-372, 1974-2 C.B. 147 (broker accrues commission income on trade date; recording transaction, physically exchanging securities, and collecting payment are “ministerial”).
 See, e.g., FAR 52.216-7 (making payment subject to approval and permitting a contracting officer to adjudge costs and withhold fees on cost-plus contracts).
 See, e.g. T.A.M. 200903079 (“acceptance by the Government is not only a condition precedent to payment, but it also is a condition precedent to Taxpayer’s right to bill. In such contracts, Taxpayer’s right to bill under the FAR does not occur until the Government accepts the completed milestone”).
 Rev. Rul. 79-195.
 Schlude, 372 U.S. 128; Rev. Rul. 2004-52; Rev. Rul. 2003-10; Rev. Rul. 84-31.
 IRS removed the former automatic change number 41 in 2016. Compare Rev. Proc. 2016-29 with 2015-14, section 18.01.
 E.g., the election to use the 10-percent method under section 460(b)(5) (taxpayers on PCM can elect not to recognize any revenue until a contract is 10% complete); the look-back method under section 460(b)(2) (for interest paid and received, comparing the percentage of gross profit recognized in prior years to the actual gross profit percentage once the job has been completed); the completed contract method in Treas. Reg. § 1.460-1(b)(6) (for certain home construction contracts or small taxpayer contracts, where a contract is reasonably expected to be completed within two years, recognizing all income and expense in the year the contract is completed); the percentage-of-completion/capitalized-cost method (PCCM ( the PCM for a portion of long-term contract income, and exempt contract method to report remaining contract income, for residential constructions contracts, qualified ship contracts, and qualified naval ship contracts). Note that each type of contract and method is subject to specific rules.
 See Rev. Proc. 2018-31 at section 16.09.
 Id. at section 16.09(1)(b).
 Id. at section 16.09(2)(a).
 Id. at section 16.09(2)(b).
 Section 448(c) provides a test that averages the taxpayer’s gross receipts in the prior three tax years.
 Section 12.16 of Rev. Proc. 2018-31 as modified by Rev. Proc. 2018-40.
 Id. at section 22.19.
 Id. at section 15.18.
 Id. at section 19.01.
 See section 448(c)(2) (requiring aggregation for persons treated as a single employer under sections 52, 414(m), or 414(o).
 Section 448(a)(3).