Engineering Company Fails Two-year Test for Exception to Percentage of Completion Accounting Method

(Parker Tax Publishing February 2017)

The Tax Court held that an engineering company couldn't use the completed contract method of accounting to report income from contracts to move, refurbish, and reassemble refineries in Bulgaria and Pakistan. The company was required to use the percentage of completion method because the construction contract exception to the percentage of completion method didn't apply because the company could not have estimated that the contracts would be completed within two years. Basic Engineering Inc. v. Comm'r, T.C. Memo. 2017-26.

Background

Basic Engineering (Basic) designed, refurbished, and delivered crude oil processing and refining systems to customers around the world. Upon auditing the company, the IRS was concerned with the proper accounting treatment for two of Basic's contracts that were ongoing in 2009 and 2010: (1) a contract to reconstruct an oil refinery in Bulgaria (the Petromaxx contract); and (2) a contract to transport, refurbish, and reassemble an oil refinery in Pakistan (the Amber contract). Since its incorporation in 2004, and during the tax years at issue, Basic accounted for its long-term contracts using the completed contract method of accounting.

General Long-term Contract Rules

Under Reg. Sec. 1.446-1(c)(1), taxpayers can compute taxable income under the (1) cash method, (2) accrual method, (3) other permissible special method, or (4) any combination of these methods. The long-term contract method fits within categories (3) and (4) because it is a permissible special method explicitly referenced in Reg. Sec. 1.446-1(c)(1)(iii), but only applies to the taxpayer's long-term contracts and so is used in tandem with the taxpayer's overall method (cash or accrual) of accounting for other, non-long-term contract items of income or expense.

Code Sec. 460(f)(1) defines a long-term contract as a contract for the manufacture, building, installation, or construction of property that is not completed within the tax year it is entered into. The general rule under Code Sec. 460(a) is that taxable income from long-term contracts must be recognized over the life of the contract using the percentage of completion method of accounting. The percentage of completion method requires taxpayers to recognize income and expenses over the life of the contract based on the percentage of the contract that is completed each year. However, certain contracts are excluded from the requirement of reporting income under the percentage of completion method. Code Sec. 460(f)(2) excludes certain manufacturing contracts, and Code Sec. 460(e)(1)(B) excludes certain construction contracts, from being reported under the percentage of completion method.

Exception for Manufacturing Contracts

Manufacturing contracts generally are not treated as long-term contracts. But if a contract involves the manufacture of an item that normally requires more than 12 calendar months to complete, the contract is subject to Code Sec. 460. The two contracts in this caseeach for the disassembly, transportation, refurbishing, and reassembly of an oil refinerywould normally require more than 12 calendar months to complete.

Exception for Construction Contracts

In some cases, construction contracts can be accounted for under a method other than the percentage of completion method, including the completed contract method. The construction contract exception applies in pertinent part when the taxpayer can estimate, when the contract is entered into, that it will be completed within the two-year period beginning on the contract commencement date. The "contract commencement date" is defined by Reg. Sec. 1.460-1(b)(7) as the first date that costs allocable to the contract (other than costs incurred in bidding for and/or negotiating the contract) are first incurred.

Contract Completion within Two Years from Commencement Date

For Basic to be eligible for the construction contract exception, it must have reasonably estimated, when each contract was entered into, that the project would be completed within two years from its commencement date. According to Reg. Sec. 1.460-1(f)(4)(i), to be reasonable "an estimate of the time required to complete the contract must include anticipated time for delay, rework, change orders, technology or design problems, or other problems that reasonably can be anticipated . . . . A contract term that specifies an expected completion or delivery date may be considered evidence that the taxpayer reasonably expects to complete or deliver the subject matter of the contract on or about the date specified, especially if the contract provides bona fide penalties for failing to meet the specified date."

Taxpayer's and the IRS's Positions

From 2005 through 2010, Basic accounted for the Petromaxx and Amber contracts using the completed contract method of accounting. As a result, its policy was to recognize all income and expenses associated with the contracts in the year of the contract's completion. Because Basic contended that the contracts were not yet completed, it did not report income or expenses from either contract for 2009 or 2010, the two tax years at issue (or any earlier year either).

In its notice of deficiency, the IRS determined that Basic must account for both contracts using the percentage of completion method because it could not have estimated that either contract would be completed within two years of the contract commencement date. The IRS adjusted Basic's gross receipts and cost of goods sold for the percentage of the contracts completed in 2009 and 2010. The IRS determined that Basic completed 84.23 percent of the Petromaxx contract and 34.33 percent of the Amber contract in 2009, and 84.39 percent of the Petromaxx contract and 34.36 percent of the Amber contract in 2010.

The IRS multiplied those percentages by the estimated total contract price to arrive at the amounts Basic should have recognized as income had it accounted for the contracts using the percentage of completion method.

Tax Court's Decision

The Tax Court held that Basic was required to use the percentage of completion method to report income from the Petromaxx and Amber contracts.

As an initial matter, the Tax Court concluded that both contracts met the definition of "long-term contracts" and thus were governed by Code Sec. 460. The court then had to determine the reasonableness of Basic's estimate of the time it would take to complete each contract. The Tax Court was not required to make this determination based on the contract alone. Where, as here, the parties disagree on whether the two-year rule was met, the Tax Court can look back to the time the contract was entered into and consider all the facts and circumstances in deciding whether the estimate was reasonable. The court noted the following about the different contracts.

Petromaxx Contract: Although Basic and Petromaxx executed the contract on October 28, 2006, the first date that Basic incurred costs allocable to the contract was March 22, 2006, when Basic purchased the refinery. The contract did not contain a project schedule but did require Basic to "use its best efforts" to deliver the last unit to its facility in Houston by April 30, 2007. If Basic failed to do so, there were no penalties. But if Basic failed to deliver the last unit on or before September 12, 2007, it would default under the terms of the contract. At some point during the course of the project, Petromaxx lost its financing and was unable to pay Basic. At the time of trial, the dismantled units from the refinery were still in Basic's construction yard in Texas. The parties disagreed on whether Basic reasonably estimated that the Petromaxx contract could be completed within two years from the March 22, 2006, commencement date. The IRS relied on the terms of the contract and expert testimony that three years was an optimistic estimate of the time required to complete a project like this one. Basic countered that 3-D laser scanning and a parallel processing system allowed it to reasonably estimate that the project would be completed within two years.

The Tax Court concluded that even if the April 30, 2007, best efforts date, and not the September 12, 2007, default date, was the relevant delivery date, the Petromaxx project could not have been completed within two years from March 22, 2006. The time between the commencement and best efforts dates was 13 months, and once the units were delivered, it would take six months to ship them from Texas to Bulgaria. Upon receipt of all of the units, it would take Petromaxx 12 months to assemble the refinery; and once the refinery was assembled, it would take approximately 2months to commission and conduct performance tests. In total, a project similar to the Petromaxx refinery project would take over 33 months to complete using traditional industry practices.

Importantly, Basic did not produce any witnesses, other than its president, or provide documentary evidence that "reflect a meeting of the minds between the parties to use a parallel processing system, or even explain how much time parallel processing would save."

Amber Contract: While Basic and Amber executed the contract on July 17, 2008, the first date that Basic incurred costs allocable to the contract was July 24, 2008, when Basic purchased the desired refinery. The contract did not contain a project schedule but did require Basic to deliver the last unit no later than November 15, 2010. Basic was entitled to bonus payments if the delivery date for the units occurred before November 15, 2010, and subject to penalties if the delivery date occurred after November 15, 2010. On January 18, 2010, the parties agreed to cancel the deal. At the time of trial, the fluid catalytic cracker unit was in Basic's construction yard in Texas, and the refinery units were still in Northern Cyprus.The parties again disagreed on whether Basic reasonably estimated that the Amber contract could be completed within two years from the July 24, 2008, commencement date. The IRS pointed to its expert's testimony that 4years was an optimistic estimate of the time required to complete such a project. Basic countered that 3-D laser scanning and a parallel processing system allowed it to reasonably estimate that the contract would be completed within two years.

The Tax Court noted that the Amber contract clearly stated that Basic was required to deliver the last unit by November 15, 2010, which was approximately 28 months after the July 24, 2008, commencement date. Basic was subject to penalties if it failed to meet this deadline, and was entitled to a bonus if it met this deadline. While the court considered the president's testimony on the benefits of a parallel processing system, there was no evidence of an intent to use a parallel processing system, or how much time that parallel processing would save.

The Tax Court concluded that Basic did not prove that it reasonably expected, at the time it entered into either contract, that it would complete the contract within two years from its commencement date. Therefore, it was not eligible for the construction contract exception to the percentage of completion method of accounting.

Section 6662(a) Accuracy-Related Penalties

Basic argued that it was not liable for the Code Sec. 6662 accuracy-related penalty because, "in view of the complexity of [Code Sec.] 460 and the accompanying regulations, it made a good-faith effort to comply." Under Code Sec. 6664(c), the penalty does not apply to any portion of an underpayment if there was reasonable cause and the taxpayer acted in good faith. One way that reasonable cause can be shown is by establishing reliance on professional advice. However, there was no evidence that Basic requested or received any advice from its CPA concerning the application of the long-term contract exception under Code Sec. 460(e) to either project.

Although other circumstances can establish reasonable cause and good faithsuch as an honest misunderstanding of the facts or law that is reasonable based on the experience, knowledge, and education of the taxpayerBasic's president did not did not provide concrete examples of previous projects he had worked on to support his claim that the Petromaxx and Amber contracts could be completed within two years. In fact, he agreed with the IRS expert's estimates of each project's duration to the extent they were based on traditional (non-parallel processing) industry practices.

The Tax Court concluded that Basic did not act with reasonable cause and in good faith when it accounted for the two contracts using the completed contract method of accounting. Accordingly, the court sustained the IRS's imposition of the accuracy-related penalties for 2009 and 2010.

For further discussion of the long-term contract method of accounting, see Parker Tax ¶245,600.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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