What Is Revenue Procedure 2006-45 for Contractors?
Understand the framework of Revenue Procedure 2006-45, an IRS safe harbor offering a simplified approach to income recognition for eligible contractors.
Revenue Procedure 2006-45 is a safe harbor from the Internal Revenue Service (IRS) that provides a simplified accounting method for small business taxpayers with long-term construction projects. This procedure was established to reduce the complexity and administrative load of more stringent accounting rules. By following this guidance, eligible contractors can use an accounting method for recognizing income that better aligns with their operational scale.
Taxpayer and Contract Eligibility
To use the accounting method in Revenue Procedure 2006-45, both the taxpayer and the contract must meet eligibility criteria. The primary requirement is that the taxpayer qualifies as a “small taxpayer” based on an average annual gross receipts test. A taxpayer meets this test if their average annual gross receipts for the three preceding tax years do not exceed a specific inflation-adjusted dollar threshold.
The second requirement is that the contract must be a “long-term construction contract,” which is any contract for building, installation, or construction of property not completed in the same taxable year it is entered into.
Applying the EPCM Accounting Method
The Exempt-Contract Percentage-of-Completion Method (EPCM) is the accounting method authorized by the revenue procedure for contracts still in progress at year-end. The calculation begins with determining the completion factor for each eligible contract. This factor is a ratio calculated by dividing the total costs incurred for the contract to date by the total estimated costs for the entire contract. The taxpayer multiplies this completion factor by the total contract price and then subtracts any gross income from that contract recognized in previous tax years.
For example, consider a contractor with a $500,000 contract. By the end of the first year, the contractor has incurred $150,000 in costs out of a total estimated cost of $300,000, making the completion factor 50% ($150,000 / $300,000). The income to recognize for that year would be $250,000 (50% of $500,000). If in year two, cumulative costs reach $240,000, the new completion factor is 80%, and the cumulative income to recognize is $400,000 (80% of $500,000), so the contractor reports $150,000 of income in year two ($400,000 cumulative minus the $250,000 from year one). A feature of the EPCM method is that the look-back method, which can require re-computation of tax liability, does not apply.
Information and Documentation for Method Change
Adopting the EPCM method requires a formal change in accounting method using Form 3115, Application for Change in Accounting Method. On this form, taxpayers request permission from the IRS to switch from their current accounting method to EPCM. Completing Form 3115 requires a detailed description of both the present and proposed accounting methods, explaining how income and expenses are treated under each.
A component of this process is the calculation of the net Section 481(a) adjustment. This adjustment represents the cumulative difference in income that would have been recognized in prior years if the EPCM method had always been in use. This calculation prevents the duplication or omission of income or deductions due to the change.
Submitting the Application for Change
The submission process for Form 3115 follows an automatic consent procedure, so the taxpayer does not need to wait for an approval letter from the IRS before implementing the change. The original, signed Form 3115 must be attached to the taxpayer’s timely filed federal income tax return for the year the change takes effect. For example, a change for the 2024 tax year requires the form to be filed with the 2024 tax return in 2025.
In addition to attaching the form to the tax return, a duplicate copy of the completed Form 3115 must be filed with the IRS national office. This dual-filing requirement is part of the automatic consent process. If the taxpayer is eligible and has correctly filed Form 3115 in both locations, the IRS’s consent to the change in accounting method is considered automatically granted.