Types of Contracts

Short-Term Contracts

ContractShort-term contracts are contracts started and completed within the taxpayer's taxable year. For short-term contracts, construction costs are treated as current period costs under all methods of accounting except the cash method. Under the cash method, construction costs are treated as current period costs for a short-term contract only if the expense is also paid during the year.

Long-Term Contracts

Long-term contracts are defined in IRC section 460(f)(1) as any contract for the manufacture, building, installation, or construction of property, if such contract is not completed within the taxable year in which such contract is entered.

Fixed Price or Lump Sum Contracts

A fixed price or lump sum contract states that the contractor will complete the project for an agreed price, despite unforeseen costs that might exist during the construction phase. Some fixed price contracts, in reality, provide for some variations for economic price adjustments, incentives, etc. If any modifications to the original contract occur, change orders are executed. These often increase or decrease the contract amount.

Cost-Plus Contracts

Cost-plus contracts stipulate that the contract amount will be the cost of the construction project plus a fee. The fee may be earned in various ways.

A fixed fee is generally earned evenly throughout the term of the contract. A percentage fee is frequently based on the amount of cost incurred. Most cost-plus contracts have a guaranteed maximum to protect the owner from cost overruns. Many cost-plus contracts allow the contractor to share in cost savings if the project is completed under budgeted cost. The contract will specify which costs are included in the contract amount. Generally, the contract will include a clause that allows the owner to review or audit those costs.

Time and Material Contracts

Time and material contracts are contracts that provide payments to the contractor based on direct labor hours at a fixed rate plus the cost of materials and other specified costs.

Unit Price Contracts

The unit price contract method is a variation of the lump-sum (or fixed price) contract method where the contractor bids a set price per unit item. The unit-price method is generally used in cases in which the number of units required has not been determined when the contract is bid.

Change Orders

The contractor or the owner can initiate change orders. A change order modifies the original contract, and either increases or deceases the contract costs and/or contract price.

IRS Construction Industry Audit Technique Guide (ATG) - Chapter 1, Publication Date - May 2009
The information on this page is taken from the IRS Website and it claims that this is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. It is current through the publication date noted above. In general, it is a good reference guide through the subjects discussed.