Directly speaking, indirect costs directly affect construction contractors

How indirect costs are handled for accounting and tax purposes by construction contractors is a trail of dots that connect 43 years into the past, and lead to Idaho.

Idaho Power, which serves eastern Oregon and Southern Ohio, had used its own equipment and employees on construction projects to build or improve its facilities. For accounting purposes, the company capitalized the equipment’s depreciation. On the tax side, Idaho Power deducted the depreciation, based on a 10-year schedule, on the equipment used in the capital construction.

The IRS said no, you can’t do that, and squelched the deduction, capitalized the construction equipment used on the capital assets, and allowed depreciation on a 30-year schedule.

What followed was a case of dueling IRS code sections. A tax court agreed with the IRS decision, but the 9th Circuit, citing IRS Code Section 263 on capital expenditures. The 9th Circuit overturned the tax court’s decision, pointing to Section 167, which sets depreciation rules.

The U.S. Supreme Court in June 1974 reversed the 9th Circuit’s decision and came down on the side of Section 263: depreciation of equipment used in constructing capital assets had to be capitalized, in part to keep the balance relatively stable between taxpayers using their own equipment and employees on capital projects as opposed to those who contracted out the work to construction companies.

A Dec. 2008 memorandum from the IRS chief counsel’s office addressed indirect costs, again pointing to Section 263. The case situation: “Whether the following indirect costs are properly allocable to property produced as a result of Taxpayer’s construction and remodeling activities: salaries, pensions and other related costs, and employee benefit expenses of (company) employees.”

The conclusion: “Yes. The indirect costs at issue directly benefit or are incurred by reason of Taxpayer’s performance of production activities  See§ 1.263A-1(e)(3)(i) of the Income Tax Regulations. Accordingly, these indirect costs are properly allocable to property produced. Moreover, the indirect costs previously described are specifically identified in § 1.263A-1(e)(3)(ii) as examples of indirect costs that must be capitalized under §263A of the Internal Revenue Code to the extent they are properly allocable to property produced.” 

Section 263 resulted in Uniform Capitalization Rules (UNICAP) that set out whether costs are expensed or capitalized. The TCJA made life a little easier for small businesses with less than $25 million in gross income in that under the law certain UNICAP costs are not capitalized to a company’s inventory.

The Construction Industry Institute, of the University of Texas at Austin, researched indirect construction costs and in its publication “Managing Indirect Costs,” concluded there are four main areas: construction equipment, project supervision, temporary construction, and temporary facilities. Within each component there are multiple sub-groups of specific items.

On any project, a contractor is best protected – financially and legally, for tax purposes -if there is a clear delineation and explanation for how indirect costs are treated, either as fixed company expenses or assigned to specific projects. Incorrect, overzealous, or stretching-the-boundaries use of indirect costs is a potential tripwire to invite IRS scrutiny.

Accurate classification of indirect costs has a direct impact on a contractor’s bottom line. Therefore, it’s vital for the profitability of a contractor to either know the complex rules – which is unlikely, given project demands - or have someone working with them who knows their business, how it operates, the nature of its projects, and how allocating indirect costs best serves the company’s needs.

Find that person and you may well find money you didn’t know you weren’t making.


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Tagged Construction