Despite efforts to ensure communication is clear and contracts are effectively worded, contractors often face the possibility of disputes and claims. As a result, CFMs must be familiar with proper accounting for these issues.
This article examines how disputes and claims are handled for tax purposes under the percentage-of-completion method (PCM).
Generally, the Internal Revenue Code (IRC) and Treasury Regulations require contractors to report contingent compensation from disputes and claims as early as possible.
A contractor that is involved in a dispute or claim must include the potential revenue when it is reasonably assured of receiving the contingent amount.1 Moreover, the regulations covering contingent compensation for long-term contracts reflect as fundamental criteria for being reasonably able to predict that the contingent income will be earned when it is reported for financial statement purposes under GAAP.
IRC §460(b)(1) requires a contractor that uses the PCM to include all income not previously reported under the contract during the first taxable year after a contract is completed. Elsewhere, regulations also state that the contractor must include contingent amounts in the contract price as soon as it can reasonably predict that the disputed amount will be earned.
However, the regulations do not factor in when payment is received or when the dispute is resolved,4 giving rise to two main concerns:
- Estimated revenue must be included in income regardless of when the dispute is resolved and irrespective of when the revenue may be received; and
- The GAAP methodology for recognizing contingent compensation, such as revenue from claims or disputes, may influence when these amounts are reported for tax purposes.