Revision Date: October 19, 1996

COORDINATED ISSUE
CONSTRUCTION/REAL ESTATE INDUSTRY
ADVANCE PAYMENTS FROM CONSTRUCTION SERVICES CONTRACTS

ISSUE:

Whether an accrual basis taxpayer must report advance payments received from
construction services contracts in gross income in the year of receipt.

FACTS:

In the construction industry, there are two basic categories of contracts: construction
contracts and construction services contracts (design, engineering and construction
management). For financial purposes, revenue from both contracts is accounted for
under a percentage-of-completion method, or in very limited circumstances under the
completed-contract method.

For tax purposes, however, a taxpayer generally must use the accrual method of
accounting under section 446 for reporting gross income from construction services
contracts. On the other hand, a construction contractor that enters into a construction
contract that will not be completed before the end of the taxable year in which it is
entered, and whose average annual gross receipts for the 3 taxable years preceding
the year in which such contract is entered into exceed $10 million, generally must
report gross income from the contract under the percentage-of-completion method of
section 460.1

In this case, an accrual basis taxpayer (for federal income tax purposes) is engaged in
construction services contracts. These contracts are cost plus either a percentage or a
fixed fee. The terms of these contracts generally entitle the taxpayer to be
compensated for:

(1) certain defined costs incurred in performing the agreed services

(2) a fee for those services, based on either a percentage of the costs or a
set amount.

1
For an analysis of the distinctions between construction contracts and construction
services contracts, please refer to the Construction Management Coordinated Issue
Paper.
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All of the construction services contracts require the client to advance funds to the
taxpayer based on the amount of costs the taxpayer estimates it will incur in the next
subsequent period, usually, the next month. The contracts also provide that advanced
funds must be applied to the taxpayer’s costs incurred on the contract, and that any
excess determined at the time the contract is either completed or terminated must be
returned to the client. Similarly, excess fee payments, if any, must be returned to the
client.

With respect to the cost plus a percentage fee contracts, the taxpayer determines the
gross income for financial and federal income tax purposes at the end of each year by
taking into account an amount equal to the costs incurred during the year plus the
stated percentage of the costs. In the case of the fixed fee contracts, the taxpayer
determines gross income for financial and tax purposes at the end of each year by
taking into account an amount equal to the costs and the appropriate portion of the
fixed fee. The amount of gross income from the fixed fee is the portion of the total fee
equal to the ratio of all the man-hours worked by year-end to the total estimated
man-hours, or the costs incurred to date to total estimated costs, less amounts included
in previous years, for each contract.

DISCUSSION:

Both of these percentage-of-completion methods are permissible under generally

Federal income tax principles generally require accrual basis taxpayers to report gross
income in the taxable year when (1) the required performance takes place, (2) payment
is due, or (3) payment is made, whichever happens first. See Rev. Ruls. 79-292, 1979-
2 C.B. 287, and 84-31, 1984-1 C.B. 27. Thus, this principle requires an accrual basis
taxpayer to include advance payments received from construction services contracts in
gross income in the taxable year in which they are actually or constructively received,
rather than when earned at a later time under general accrual accounting principles.
See Treas. Reg. §§ 1.451-1(a), and 1.451-2(a).

Advance payments have traditionally been considered gross income in the year of
receipt. Rev. Rul. 60-85, 1960-1 C.B. 181 states:

The Service will continue its general policy of taxing prepaid income in the
year of receipt. This policy applies to income from contracts to furnish
services and to other types of prepaid income, . . . regardless of whether
the period of proration is definite or indefinite, unless a different treatment is
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specifically provided in the Internal Revenue Code . . . or the regulations

Moreover, the Supreme Court, pursuant to section 446(b), has consistently held that
the failure to report advance payments in the year of receipt does not clearly reflect
income, and that they should be included in income in the year received. Schlude v.
Commissioner, 372 U.S. 128, 137 (1963) (the "right to receive" income determines the
time for its inclusion in income); American Auto. Ass’n v. United States, 367 U.S. 687
(1961); Auto. Club of Mich. v. Commissioner, 353 U.S. 180 (1957). In each of these
cases, the taxpayers received prepaid income for services to be performed in the future
that they did not include in gross income in the year of receipt. The Supreme Court
held that the taxpayers’ method of accounting did not clearly reflect income because
deferring the advance payments would not match revenue and expenses more clearly
than including the payments in gross income when received.

The method of accounting used by the taxpayer discussed in this paper for construction
service contracts fails to clearly reflect income to the extent the taxpayer has not
included its advance payments received from construction services contracts in gross
income in the taxable year of receipt. See also, RCA Corp. v. United States, 664 F.2d
881 (2d Cir. 1981), cert. denied, 457 U.S. 1133 (1982), Simplified Tax Records, Inc. v.
Commissioner, 41 T.C. 75 (1963), and Popular Library, Inc. v. Commissioner, 39 T.C.
1092 (1963) (advance payments for services to be performed in future years and
received without restriction as to use are income in the year received).

It should be noted, however, that the Service recognizes a limited exception that allows
an accrual basis taxpayer to defer including some advance payments for services in
gross income for one taxable year under Rev. Proc. 71-21, 1971-2 C.B. 549. A
taxpayer may request a deferral of an advance payment for services from gross income
under Rev. Proc. 71-21 if the contract provides that all services must be performed by
the end of the taxable year immediately following the end of the taxable year in which
the advance payment is received. In addition, the amount of the deferral from or
inclusion in gross income for tax purposes must conform to the amount of income the
taxpayer defers or includes for book purposes. Rev. Proc. 71-21 is not available for
any contract where any portion of the services may be performed after the end of the
taxable year immediately following the year the advance payment is received; where
any part of the services are to be performed at an unspecified time, possibly after the
end of the taxable year immediately following the year the advance payment is
received; guaranty or warranty contracts; and contracts for prepaid rent or interest.

Taxpayers may also advance other theories to support the deferral of advance
payments from construction services contracts from gross income. See, e.g., Boise
Cascade Corp. v. United States, 530 F.2d 1367 (Ct. Cl.), cert. denied, 429 U.S. 867
(1976); Artnell Co. v. Commissioner, 400 F.2d 981 (7th Cir. 1968). In these cases, the
courts allowed the deferral of advance payments for services under a theory that the
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performance of services in the future was fixed and definite. However, the Service
does not agree with these cases. See Boise Cascade Corp., AOD CC-1986-014 (Feb.
19, 1986); Artnell Co., AOD-OM 17,542 (July 27, 1971); see also Hagen Advertising
Displays, Inc. v. Commissioner, 47 T.C. 139 (1966), aff’d, 407 F.2d 1105 (6th Cir.
1969). In addition, taxpayers may not defer including advance payments from
construction service contracts in income under Commissioner v. Indianapolis Power &
Light Co., 439 U.S. 203 (1990), because the advance payments are not deposits.

CONCLUSION:

Taxpayers must include advance payments from construction services contracts in