Editor: Annette B. Smith, CPA
Contracts may include a provision that allows one party to withhold a certain percentage of the total payment called for under the contract until a project is substantially complete; the amount withheld is commonly referred to as a retainage. Retainages are intended to address concerns that a contractor will not finish a project if full payment already has been made. Retainages are frequently provided in construction and manufacturing contracts, as well as in contractual arrangements with the U.S. government. A retainage in a contract may cause uncertainty as to the timing of including payments in income for a contractor that receives some payments in one year and the retainage in a later year.
While Sec. 460 provides guidance on the treatment of long-term manufacturing and construction contracts, some contracts that include retainages do not fall within the definition of a long-term contract under Sec. 460(f). (Long-term contracts include any contract for the manufacture, building, installation, or construction of property if the contract is not completed within the tax year in which it is entered into.) For contracts that are not long-term contracts, such as service contracts entered into with the U.S. government, different rules may apply.
Regs. Secs. 1.446-1(c)(1)(ii)(A) and 1.451-1(a) provide that under an accrual method of accounting, income is to be included for the tax year when (1) all events have occurred that fix the right to receive such income and (2) the amount of the income can be determined with reasonable accuracy (the all-events test). Rev. Rul. 84-31 provides that, with respect to a service contract, all the events that fix the right to receive income under an accrual method of accounting occur when (1) the required performance occurs, (2) payment is due, or (3) payment is made, whichever happens first. Tax practitioners commonly refer to this standard as the earliest of when the amount is due, paid, or earned.
Retainage amounts might seem to be includible in the year in which the payment to which the retainage relates is accrued because that appears to be when all the events occur that fix the right to receive all amounts called for under the contract. However, when a taxpayer must still meet a condition for performance to be complete, the amount has not yet been earned (see the Dally case, discussed below). Further, because the taxpayer cannot yet bill for the retainage and has not been paid, the retainage is not due, paid, or earned in the earlier year.
IRS guidance agrees with this analysis. Rev. Rul. 69-314 provides that a taxpayer is not required to include in income the amount of a retainage until final acceptance of the project under the contract occurs. This ruling involves a contract with the U.S. government to build boats, under which a specified percentage of the amounts billed on each boat was retained by the government. The retainage amount was not payable in full until the taxpayer delivered all boats specified in the contract and the government accepted them. Citing two court decisions, the IRS concluded in the ruling that all events that fixed the right to receive the retainage did not occur until final acceptance of all boats specified in the contract.
In one of the cases cited, Dally, 20 T.C. 894 (1953), the taxpayer manufactured housing units as part of a contract with the U.S. government. Payments were to be made based on an estimated percentage of project completion, with 10% of these payments to be retained until final acceptance by the government contracting office. The Tax Court held the taxpayer should include in income the payments based on the estimated percentage of project completion, less the 10% retainage. The court stated, “[T]he petitioner’s right to the 10 per cent did not and could not ripen ‘until all of the construction and erection work of all the dwelling units has been finished and finally accepted by the contracting officer’” (Dally, 20 T.C. at 899).
Similarly, in the other case, Harmon, 205 F.2d 919 (10th Cir. 1953), the taxpayer engaged in a cost-plus-fixed-fee contract with the federal government. The contract provided for a 30% retainage, which the government would pay after it had audited the contractor’s books and determined the correct final production cost. The Tenth Circuit noted that
It is a well settled principle of law that where a taxpayer keeps his books and files his returns on the accrual basis, income is to be accounted for in the year in which it is realized, irrespective of when it is ultimately received. It is the right to receive and not the actual receipt of income that determines when income must be included. [Harmon, 205 F.2d at 920]
However, the court determined that the right to receive certain amounts of the retained fee had not yet become fixed and final until a final audit was complete. In fact, the taxpayer was not ultimately entitled to the full amount of the retainage, due to adjustments made during the audit.
Based on these authorities, when a taxpayer enters into a contract under which certain amounts are retained until some condition is met at a later date, the amount of the retainage generally is not includible in income until that condition has been met. As noted above, Rev. Rul. 69-314 and the cited case law do not apply directly to long-term contracts as defined under Sec. 460(f). For Sec. 460 purposes, retainages are included in the total contract price when determining the formula under the percentage-of-completion method in Sec. 460(b).
Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
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