Construction contractors may use a hybrid accounting method

Plain-English summary

Chief Counsel considered how construction contractors should account for businesses that primarily provide services but also produce, purchase, or sell merchandise. The regulations require inventories when merchandise is an income-producing factor and generally require accrual accounting for the related purchases and sales. They also permit a taxpayer to use the cash method for other income and expense items if the combined methods clearly reflect income. The memorandum concluded that contractors may therefore use an accrual method for inventoriable items and the cash method for service activities. It also noted broader cash-method rules for qualifying smaller contractors under the section 448 gross-receipts test.

Ruling snapshot

• Question: May a construction contractor use accrual accounting for merchandise purchases and sales while using the cash method for its service activities?
• Outcome: advice given
• Key authorities: Treas. Reg. §§ 1.446-1(a)(4)(i), 1.446-1(c)(1)(iv), 1.446-1(c)(2)(i), and 1.471-1; IRC §§ 448 and 471(c)(1)(B)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           memorandum
           CC:ITA:B6:BEWESHNAK
           POSTU-127203-18
           Number: 202008007
           Release Date: 2/21/2020

 UILC:     446.00-00

  date:    January 15, 2020

     to:   William G. Bissell
           Associate Area Counsel (Houston, Group 2)
           (Large Business & International)

  from:    Roy A. Hirschhorn
           Branch Chief, Branch 6
           (Income Tax & Accounting)



subject:   Use of Hybrid Method by Construction Contractors

           Issue: May construction contractors (contractors) compute taxable income using the
           cash receipts and disbursements method except for purchases and sales when the
           contractors are providing substantial services while also producing, purchasing, or
           selling merchandise as an income producing factor in their businesses?

           Conclusion: Contractors may compute taxable income using the cash receipts and
           disbursements method except for purchases and sales when the contractors are
           providing substantial services while also producing, purchasing, or selling merchandise
           as an income producing factor in their businesses.

           Law: The regulations provide that a taxpayer is required to use inventories in every
           case in which the production, purchase, or sale of merchandise is an income producing
           factor. See §§ 1.446-1(a)(4)(i) and 1.471-1. Section 1.446-1(c)(2)(i) provides that in
           any case in which it is necessary to use an inventory, an accrual method of accounting
           must be used with regard to purchases and sales unless otherwise authorized.
           However, under § 1.446-1(c)(1)(iv) a taxpayer using an accrual method of accounting
           with respect to purchases and sales may use the cash receipts and disbursements
           method in computing all other items of income and expense.

           Discussion: Sections 1.446-1(c)(2)(i) and 1.446-1(c)(1)(iv) only require a taxpayer to
           use an accrual method with regard to purchases and sales. It is implicit that a taxpayer
POSTU-127203-18                                     2

that selects to do so may use another accounting method, such as the cash receipts
and disbursements method, for its other activities if the combination of methods clearly
reflects the taxpayer’s income. This combination of methods, referred to as a “hybrid
method”, is used by many contractors.

Contractors, such as plumbers and electricians, primarily provide services. While
providing services, contractors, at times, also provide inventoriable items.
Confusion has occurred when a contractor provides inventoriable items in connection
with services. In this situation, it could be argued that an overall accrual method must be
used by the contractor, because an inventory is needed.1 This argument fails to
recognize that the regulations only require that an accrual method of accounting be
used for purchases and sales and that the regulations specifically permit a taxpayer that
is using an accrual method for purchases and sales to use any other method, such as
the cash receipts and disbursements method, to compute all other items of income and
expense provided income is clearly reflected.

CC:ITA routinely grants requests by contractors to change their methods of accounting
so that they use the hybrid method set out in § 1.446-1(c)(1)(iv); an accrual method to
reflect income and expenses associated with inventoriable items with the cash receipts
and disbursements method to reflect the income and expenses associated with
services. Combining an accrual method for inventoriable items with the cash receipts
and disbursements method for services reflects both the contractors’ activities as well
as the regulations' requirements. This ruling position has not been applied to
contractors, except for tax shelters, with average annual gross receipts of $5 million or
less prior to 2018 ($25 million currently, adjusted for inflation) as they are allowed to use
the cash receipts and disbursements method for all their activities. 2




1 But see CC-2001-010, expired April 18, 2014, in which the Office of Chief Counsel announced that it

would no longer litigate the issue of whether contractors had inventoriable items or needed to use an
accrual method.
2 Tax Cuts & Job Act (TCJA) increased the § 448 gross receipts test to $25 million for taxable years after

2017, and also added an exception to the inventory requirements under § 471(c)(1)(B) for taxpayers
meeting the § 448 gross receipts test.