Long Term Contracts Tax Treatment – What You Need to Know

As a business owner, you may have entered into long term contracts with clients or vendors for the provision of goods or services. These contracts often involve a commitment of resources over an extended period, such as several months or years. While these contracts can offer stability and predictability for your business, they can also have tax implications that need to be carefully considered.

The Internal Revenue Service (IRS) has specific rules related to the tax treatment of long term contracts. These rules are designed to ensure that revenue and expenses related to the contract are recognized appropriately for tax purposes. Here are some key points to keep in mind when dealing with long term contracts:

1. Percentage of Completion Method

Under the percentage of completion method, revenue and expenses related to the contract are recognized in proportion to the work completed. This method is commonly used for long term contracts that span multiple years.

For example, if you enter into a three-year contract to provide consulting services, and you complete 25% of the work in the first year, you would recognize 25% of the contract revenue and expenses on your tax return for that year.

2. Completed Contract Method

Under the completed contract method, revenue and expenses related to the contract are not recognized until the contract is completed. This method is often used for contracts with a short duration or for contracts where it is difficult to estimate the total revenue and expenses.

For example, if you enter into a six-month contract to provide graphic design services, and the contract is completed in full within the six-month period, you would recognize all of the revenue and expenses related to the contract on your tax return for that year.

3. Exemptions

Small business taxpayers may be exempt from the percentage of completion method and may use the completed contract method for contracts with a duration of two years or less. Taxpayers with average annual gross receipts of $25 million or less in the prior three-year period may also be exempt from the percentage of completion method.

It is important to note that the exemption from the percentage of completion method does not apply to contracts with the federal government or any state or local government agency.

4. Change in Accounting Method

If you want to change your accounting method for long term contracts, you must obtain consent from the IRS. The IRS has specific procedures that must be followed in order to obtain consent for a change in accounting method.

In conclusion, long term contracts can have tax implications that need to be carefully considered. It is important to understand the IRS rules related to the tax treatment of long term contracts and to consult with a tax professional if you have any questions or concerns. By following these rules, you can ensure that your business stays compliant and avoids any potential tax issues in the future.