Indirect Cost Allocation: The Construction Tax Issue Hiding in Plain Sight

Key Takeaways

• Indirect Costs Must Be Allocated to Long-Term Contracts: Construction contractors are required under IRC Section 460 to allocate indirect costs to contracts in the same manner as direct costs.
• Percentage-of-Completion Is the Default Tax Method: Most long-term construction contracts should use the percentage-of-completion method (PCM) for tax reporting, unless the contractor qualifies for specific exemptions.
• Indirect Cost Allocation Can Defer or Accelerate Taxable Income: Allocating current and future indirect costs changes the timing of income recognition for tax purposes, creating opportunities for strategic tax planning.
• Certain Costs Are Excluded From Allocation Rules: Expenses related to research and development, unsuccessful bids, and marketing or advertising are specifically excluded from indirect cost allocation requirements under IRC Section 460.

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As a construction contractor, WIP schedules likely allocate direct costs, such as field salaries, equipment rent, overhead, etc. But some might be surprised to find out that IRC Section 460 requires indirect costs to be allocated to contracts in the same manner. These would include office salaries, employee benefits, office rent, etc. So, how are those costs allocated? Let’s find out!

What Is Considered a Long-Term Contract?

IRC Section 460 refers to a contract for the manufacture, building, installation, or construction of property that is not completed within the taxable year in which it is entered. So, if a taxpayer is a calendar-year filer and the contract starts in December and ends in January, they have a long-term contract.

It’s a Long-Term Contract. What Method Should Be Used for Income Recognition?

The default here is percentage-of-completion, or PCM. Exemptions would include the Small Contractor Exemption and home construction contracts, which open up more options such as Completed Contract Method.

How Are Costs Allocated?

Now the fun begins! For tax purposes, indirect costs are allocated in the same manner as direct costs and are capitalized to property under IRC 263A. This is essentially “UNICAP” for construction contractors, if one is familiar with the UNICAP rules for manufacturing companies. To allocate indirect costs, typically the taxpayer goes through all indirect costs and applies a percentage to each category of how much should be allocated to contracts. There is also an estimate of future indirect costs taken into account.

With those numbers, the percentage-of-completion is recalculated for tax purposes. When thinking about the future indirect costs, taking the position that 100% of indirect costs is often an aggressive tax strategy, but allocating 0% of future indirect costs is often too conservative. In practice, the allocation of future indirect costs generally falls in the 10-20% range but would of course depend on each individual business’ situation.

This allocation of indirect costs is a timing difference for tax purposes. Meaning, over the life of the contract, the same amount of income will be recognized for both book and tax purposes. However, throughout the life of the contract, income is either being accelerated or deferred for tax based on this indirect cost allocation.

Are Indirect Costs Required to Be Allocated?

If a taxpayer does not meet the small contractor exemption or the home builder exception, then yes!

Are Any Indirect Costs Excluded from Indirect Cost Allocation?

Yes – IRC Section 460 (c)(4) specifically excludes the following costs from the allocable-cost rules:

• Independent research and development costs
• Unsuccessful bid and proposal costs
• Marketing, selling, and advertising expenses

The allocation of indirect costs can sometimes be a hidden tax strategy for businesses. Not only is it generally required by the Internal Revenue Code, but taxpayers could be leaving money on the table by not taking advantage of deferring revenue, when applicable.

For more information about McKonly & Asbury’s Architecture, Engineering, and Construction (AEC) experience, visit the AEC Industry Page and don’t hesitate to contact a member of the AEC team.

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