An income deferral strategy was rejected in a road project.

Koch Industries signed a contract with New Mexico to expand State Highway 44 using a new polymer-modified asphalt that was supposed to last much longer than normal asphalt and to save the state money in the long run on road maintenance even though the state had to spend more at the start of construction. Koch offered customers a 15-year warranty on the product in order to help with sales.

The State Highway 44 project was divided into two phases. Phase one was the initial construction work that Koch did on expanding the road. Phase two was a rehabilitation phase that required Koch to maintain the road for 21.5 years under a contract called a “Pavement Warranty” and to maintain bridges, drainage ditches and other structures for 11.5 years under another contract called a “Structure Warranty.” Both contracts had baselines against which normal deterioration was measured. Although some work was virtually certain to have to be done during the rehabilitation phase, it was only required once the condition of the pavement or structures fell below the performance baselines.

Koch received $62 million in advance for its work under the two contracts. It took the position that it could spread the taxable income over the contract terms under a special rule for long-term contracts for the “manufacture, building, installation, or construction of property” that allows payments received under such contracts to be reported as income over time based on the percentage of the job that is completed each year during the contract term.

A federal appeals court said in late April that the full $62 million in income had to be reported upon receipt.

The court said the “manufacture, building, installation, or construction of property” had to be “necessary for the taxpayer’s contractual obligations to be fulfilled” to qualify for long-term contract accounting. That was not true in this case because neither contract required Koch to do anything unless the pavement and structures failed to meet performance standards. In other words, they were warranties rather than construction contracts.

The case is Koch Industries v. United States.

Keith Martin