IRS Audit Focus: Are You at Risk?
As the IRS increases audit scrutiny of large land developers, best practice companies reduce risk by modeling accounting method options.
An Internal Revenue Service audit can be a terrifying, expensive proposition. For large land developers, an IRS campaign is examining the completed contract method of accounting for compliance risks.
This IRS campaign is designed to ensure that land developers are complying with Internal Revenue Code Section 460, which states that they generally are required to report taxable income under the percentage of completion method.
Dueling Accounting Methods
Land developers for long-term housing development contracts sometimes use the completed contract method of accounting instead of the percentage of completion method. Under PoC, taxable income is recognized based on a contract's cost to date when compared to the total estimated cost of the contract.
Unlike PoC, CCM does not recognize revenue until the client completes and accepts the contract. CCM allows for a higher deferral of income, which results in deferral of taxes compared to PoC. This could result in tax deferrals of millions of dollars for large land developers.
Prompting the current campaign, the IRS believes that some developers, particularly residential developers, have been using CCM incorrectly. For example, developers who gross $10 million annually can use CCM only under a home construction contract that extends beyond a single year. However, some developers are deferring all gains until the entire development is completed, not just the home construction projects.
The overall objective of the IRS LB&I Land Developer CCM campaign is to ensure compliance with CCM accounting standards. The IRS is taking a three-pronged approach to enforcing compliance:
- Giving specialized training to revenue agents assigned to work on the issue;
- Issuing warning letters to those deemed noncompliant; and
- Following up on audits, when necessary.
Given the IRS attention and approach to the issue, land developers must take proactive action to protect themselves. A wait-and-see approach is not a viable option; it could open the possibility of a costly audit. The Financial Executives Research Foundation, for example, estimates the median audit fee in 2015 at $522,205.
CCM still is a valuable and accepted accounting tool. Since land developers and CCM accounting are receiving attention, it is critical to address strategy and proper application of the rules.
Commercial real estate professionals can best protect their businesses in the following four ways.
First, make sure the company meets CCM criteria as outlined by the IRS. Many nuances surround the use of CCM. It's possible to unintentionally use it incorrectly. Stay within the guidelines for best protection against audits.
Second, to better understand the tax liabilities in various situations, create models for tax implications with and without CCM. Sophisticated tax analysis is easier with specialized tax and accounting software, which allows companies to see the outcomes of different tax scenarios over multiple years.
Third, analyze past data and take corrective action. Strategic analysis of past CCM accounting usage can help land developers identify areas of concern. Sometimes companies can file amended returns, if they have not used CCM over multiple years. However, if incorrect returns have been filed for more than two years, commercial real estate professionals will need to file Form 3115 to apply for a change in accounting method.
Finally, continue to evaluate tax strategies. Regularly create models for what-if scenarios and follow the latest IRS guidelines to help dictate future tax strategies and ensure compliance with current rules and regulations.
A proactive approach to accounting and compliance will position a company for success and minimize its audit risk. If an IRS inquiry occurs, these preventive measures will allow the company to respond quickly, potentially save money, and reduce the countless hours of work needed to comply with an IRS audit.