Unearned / Deferred Revenue – Cash Basis

I’m reviewing taxes prepared by someone else. The company is a construction company, LLC taxed as a 1065 partnership on the cash basis. Schedule L shows no receivables or payables as would be expected on the cash basis. Annual revenue is a little over $9M. On the Schedule L, Other Current Liabilities, the detail shows Unearned Income of about $700K with nothing the year before. Is there a defensible position that would allow unearned / deferred revenue on the cash basis? This was not a relatively new construction job, it’s almost as if the job was cherry picked to report unearned revenue on a percentage of completion basis while all other jobs were left to the cash basis.

Maybe only this one job meets the definition of a long-term contract?

What did the taxpayer say when you asked them?

Maybe only this one job meets the definition of a long-term contract?

This was my thought as well.

There were several contracts that would easily be considered long-term, providing the definition is one that starts in one tax year and ends in a different tax year. Taxpayer said that the preparer was concerned that they'd have to pay too much tax on the revenue that was received and made the adjustment. Seems a bit questionable to me that there was no consistency of revenue recognition applied.

There were several contracts that would easily be considered long-term, providing the definition is one that starts in one tax year and ends in a different tax year.

That's the definition. Accounting methods have to be consistent among all items in that classification. Looks like this is an impermissable method of accounting for LT contracts.

Taxpayer said that the preparer was concerned that they'd have to pay too much tax on the revenue that was received and made the adjustment.

Lovely thought, but this act is something I do a lot of work in planning for. You can't just "adjust" income out of a tax year because the liability is large. There has to be an accounting method that allows for it (see first comment).

I've sold A LOT of contractors on in-depth planning engagements in November for this exact reason. It's a very valuable exercise, but until we've sat in Feb/Mar and I've told them "I wish I would have known about this in Nov" they usually don't want to pay me for doing that work.

So what now? Do you amend in this situation to do it right? How to proceed with no amendment? Just start doing it consistently going forward?

Thanks Captcook... I'm seeing a number of different issues with this preparers work. Ultimately, I'd like to see them on the accrual basis, in my opinion is a better matching of income and expenses and I'd be able to properly adjust billings in excess or cost in excess based on project WIP schedules. I wasn't sure if I'm missing something where a cash basis taxpayer can use percentage of completion on certain contracts to defer revenue and not on others. It looks really strange on the tax return to have such a large deferred revenue liability for a cash basis taxpayer.

Seems in order to change methods, a 3115 would have to be filed along with a substantial user fee for a non-automatic change.

I feel like I'm still missing something.

So what now? Do you amend in this situation to do it right? How to proceed with no amendment? Just start doing it consistently going forward?

Those are definitely questions that need to be answered. To amend a tax return and show an additional $700K pass through income to the partners, along with the associated interest and penalties would be expensive.

Ya think!!???

Assuming the contracts qualify, I've never seen a contractor that didn't inventory job costs and hold customer deposits until completion....

My first thought was somebody (the bookkeeper?) booked the PPP loan to a generic liability account and it was left there as the preparer was looking to get the 1065 out by the deadline.

If that is not the case, was the amount traceable to one specific invoice or cash receipt? Or did the prior accountant just make a journal entry to debit Revenue and credit the liability.

We did have a contractor year's ago receive funds from an insurance company because of a natural disaster. The contractor told the insurance company that they had not been engaged for any work and payment was made in error. Insurance company told them hold on the funds for now while they straitened it out. Funds were taken back after year end but I hated showing a large liability on the cash basis taxpayers books.

It seems pretty bold for an accountant to make a $700k adjustment just to lower the bottom line and even stranger that the client just went along with it.

Contractors who fail to adopt an accounting method for long term contracts are poorly advised.

This thread is a perfect example. The last time I looked at this issue, there is a specific rule that says if you got the cash, its income, save an accounting method such as completed contract or % of completion being in place. Contractors who get large deposits run afoul of this rule.

For the future, changing to accrual and adopting a method for LT contracts is an automatic approval. At least that was true 10 years ago when I did my last one going from cash to accrual and competed contract to % of completion.

Check the small business rule as well. Do qualify for anything other than % of completion?

A handful of questions (to figure if it is a LT contract or not), but is it a home construction contract (under IRC 460e1a)? Are these contracts expected to be completed within 2 years of the contract commencement date? As I could see a case where it was a one off contract (such as homebuilding contract, whereas they are normally a commercial construction company), that would fall outside of their normal type of contracts (and could be excluded from the LT contract treatment under IRC 460 and would default back to their elected method of accounting).

And in the cash method, it could come back to if they had constructive receipt of the payment (under 1.451-2). So, while there is a chance, I haven't seen anything quite like the pattern of facts the contractor would need to defer the 700k (other than if it was a misclassified loan).

I’ll try to answer a few more questions and I greatly appreciate the good advice that’s been given.

This was not related to PPP in any way. It’s also not traceable to a single cash receipt. I can’t actually trace the specific dollar amount just yet that was accrued. It was a reversing entry that was made on 12/31/2020 and subsequently reversed on 1/1/2021.

It is a commercial contract, not a home construction contract and will be completed within 2 years from the contract date.

The taxpayer went along with this because they trusted the advice of the tax preparer (CPA).
Unfortunately, every stone that I turn over, I seem to find something amiss during his tenure. I can’t even get fixed assets to reconcile with the Schedule L – something that should be elementary.

So, unless I’m really missing something, I see no defense on making a large deferred revenue adjustment on a cash basis taxpayer.