Extended Maintenance Work on Paving Job Not Eligible for Tax Percentage of Completion Treatment

The issue of whether a taxpayer that entered into contract with the state of New Mexico to build a highway and then insure that highway met minimum standards for years in the future could use the percentage of completion method for the entire term was the question before the Tenth Circuit Court of Appeals in the case of Koch Industries v. United States.

Koch Industries had developed a high quality road paving system that was more expensive to build, but which had significantly lower maintenance cost over an extended period.  However it turns out that it took 12 years, based on the company’s calculations, for the state to see that benefit.  So to sell their paving system to the state of New Mexico for a contract to pave a state highway, the firm agreed to a guarantee that the road would meet certain minimum standards defined in the contract for 14 years.

The contract specified amounts of the price that were for the initial paving, and a separate amount for the long term maintenance.  The contract provided that the contractor was under no obligation to perform any maintenance to earn the maintenance fee unless the road failed to meet the defined standards.  It was, however, almost certain the contractor would end up having to perform some services over the term of the maintenance portion of the contract.

The firm used the percentage of completion method for the contract, and counted the warranty work and costs expected to be incurred during the maintenance period as part of its percentage of completion calculation.  The IRS argued that, under the regulations, this was warranty work that was not allowed to be counted under the percentage of completion method.  The District Court held for the taxpayer.

However, the Court of Appeals reversed the District Court’s decision, holding that the work was warranty work which could not, under the regulations, be included as part of the paving contract since under the regulations warranty work can never be treated as a cost incident to or necessary for the construction of the property.

The maintenance portion itself was not properly treated as a separate job for construction since, the court noted, the contract explicitly held that there was nothing the company was required to construct–and the mere fact it was likely that work would be performed was not enough to make this a long term construction contract.

The use of the percentage of completion method for income tax purposes is one of the topics I’ll be discussing on June 4 in an eight hour course at the ASCPA offices in Phoenix.  Registration for course, Construction Contractors: Special Tax and Accounting Considerations, is now open on the ASCPA website.

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