Accounting for Long-Term Contracts
DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Parts 1 and 602 [TD 8929] RIN 1545-
AQ30
TITLE: Accounting for Long-Term Contracts
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains final regulations describing how
income from a long-term contract must be accounted for under section
460 of the Internal Revenue Code, which was enacted by the Tax
Reform Act of 1986. A taxpayer manufacturing or constructing
property under a long-term contract will be affected by these
regulations.
DATES: Effective Date: These regulations are effective on January
11, 2001. Applicability Date: These regulations apply to any
contract entered into on or after January 11, 2001.
FOR FURTHER INFORMATION CONTACT: Leo F. Nolan II or John M. Aramburu
of the Office of Associate Chief Counsel (Income Tax and Accounting)
at (202) 622-4960 (not a toll-free number).
SUPPLEMENTARY INFORMATION: Paperwork Reduction Act The collection of
information contained in these final regulations has been reviewed
and approved by the Office of Management and Budget in accordance
with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under
control number 1545- 1650. Responses to this collection of
information are mandatory. An agency may not conduct or sponsor, and
a person is not required to respond to, a collection of information
unless it displays a valid control number assigned by the Office of
Management and Budget. The estimated annual burden per respondent
and/or recordkeeper is 15 minutes. Comments concerning the accuracy
of this burden estimate and suggestions for reducing this burden
should be sent to the Internal Revenue Service , Attn: IRS Reports
Clearance Officer, W:CAR:MP:FP:S:O, Washington, DC 20224, and to the
Office of Management and Budget , Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503. Books or records relating to a
collection of information must be retained as long as their contents
might become material in the administration of any internal revenue
law. Generally, tax returns and tax return information are
confidential, as required by 26 U.S.C. 6103.
Background
Section 460, which was enacted by section 804 of the Tax Reform Act
of 1986, Public Law 99-514 (100 Stat. 2085, 2358-2361), generally
requires a taxpayer to determine the taxable income from a long-term
contract using the percentage-of- completion method. Section 460 was
amended by section 10203 of the Omnibus Budget Reconciliation Act of
1987, Public Law 100-203 (101 Stat. 1330, 1330-394); by sections
1008(c) and 5041 of the Technical and Miscellaneous Revenue Act of
1988, Public Law 100-647 (102 Stat. 3342, 3438-3439 and 3673-3676);
by sections 7621 and 7811(e) of the Omnibus Budget Reconciliation
Act of 1989, Public Law 101-239 (103 Stat. 2106, 2375-2377 and
2408-2409); by section 11812 of the Omnibus Budget Reconciliation
Act of 1990, Public Law 101-508 (104 Stat. 1388, 1388-534 to 1388-
536); by sections 1702(h)(15) and 1704(t)(28) of the Small Business
Job Protection Act of 1996, Public Law 104-188 (110 Stat. 1755,
1874, 1888); and by section 1211 of the Taxpayer Relief Act of 1997,
Public Law 105-34 (111 Stat. 788, 998-1000).
Section 460(h) directs the Secretary to prescribe regulations to the
extent necessary or appropriate to carry out the purpose of section
460, including regulations to prevent a taxpayer from avoiding
section 460 by using related parties, pass-through entities,
intermediaries, options, and other similar arrangements.
On May 5, 1999, the IRS and Treasury Department published a notice
of proposed rulemaking (64 FR 24096 [REG-208156-91, 1999-22 I.R.B.
11]) relating to section 460. Comments responding to the notice were
received, and a public hearing was scheduled for September 14, 1999.
The IRS and Treasury Department received eleven comment letters
concerning the notice of proposed rulemaking. After considering the
comments contained in these letters, the IRS and Treasury Department
adopt the proposed regulations as revised by this Treasury decision.
The comments and revisions are discussed below.. Explanation of
Provisions
1. Overview
Section 460 generally requires the income from a long-term contract
to be determined using the percentage-of-completion method based on
a cost-to-cost comparison (PCM). However, the income from exempt
construction contracts still may be determined using the completed-
contract method (CCM), the exempt-contract percentage-of-completion
method (EPCM), or any other permissible method. Contracts that are
not long-term contracts must be accounted for using a permissible
method of accounting other than a long-term contract method (i.e., a
method other than the PCM, the CCM, or the EPCM). See section 446
and the regulations thereunder.
One commentator suggested that the exceptions to the mandatory use
of the PCM included in the proposed regulations be expanded to
include "any portion of the long-term manufacturing contract for
which no payment for the manufacture of the subject matter of the
contract is required to be made before the manufacture of the item
is completed." The exceptions contained in the proposed regulations
were specifically provided by the statute and the statute does not
include the suggestion made by the commentator. Thus, the IRS and
Treasury Department did not adopt this suggestion.
2. Definition of Long-Term Contract
Under section 460(f), "long-term contract" generally means any
contract for the building, installation, construction
(construction), or the manufacture, of property if the contract is
not completed within the taxable year the taxpayer enters into the
contract (contracting year). However, a manufacturing contract is
not a long-term contract. unless it involves the manufacture of (1)
a unique item of a type that is not normally included in the
finished goods inventory of the taxpayer or (2) an item normally
requiring more than 12 calendar months to complete, regardless of
the duration of the contract.
Continuing the policy established in Notice 89-15 (1989-1 C.B. 634),
the proposed regulations provide that it is not relevant whether the
customer has title to, control over, or risk of loss with respect to
the property. One commentator suggested that the final regulations
should not retain the rule that requires a contractor to ignore
title and risk-of-loss issues relative to the applicability of
section 460 because a contractor has little freedom to restructure a
contract to "construct" into a contract to "sell." The IRS and
Treasury Department did not adopt this suggestion because we believe
that a contract's classification should be based on the performance
required of the taxpayer under the contract regardless of whether
that contract otherwise would be classified as a sales contract or a
construction or manufacturing contract. Moreover, the IRS and
Treasury Department continue to believe that the rule in the
proposed regulations is necessary to prevent a taxpayer from
circumventing section 460 by structuring a construction contract to
resemble a sales contract without changing the taxpayer's
obligations under the contract. Another commentator asked whether a
contract is subject to section 460 if it requires the taxpayer to
manufacture or construct property in order to fulfill its
contractual obligation but the property is never delivered to the
customer (e.g., a research contract for test results). Again, the
IRS and Treasury Department believe that a contract's classification
should depend upon the performance required of the taxpayer under
the contract. Thus, the final regulations clarify that it is
irrelevant whether title in the property manufactured or constructed
under the contract is delivered to the customer.
The proposed regulations provide that a contract is not a
construction contract if it requires the taxpayer to provide land to
the customer and the estimated total allocable contract costs
attributable to the taxpayer's construction activities are less than
10 percent of the contract's total contract price. One commentator
asked for clarification concerning whether the estimated total
allocable contract costs attributable to the taxpayer's construction
activities includes the cost of the land provided under the
contract. The final regulations clarify that the cost of this land
is not an allocable contract cost when the taxpayer determines
whether the cost of its construction activities is less than 10
percent of the contract's total contract price.
3. Date Taxpayer Completes a Long-Term Contract
The proposed regulations provide that a long-term contract is
completed in the earlier taxable year (completion year) that: (1)
the customer uses the subject matter of the contract (other than for
testing) and at least 95 percent of the total allocable contract
costs attributable to the subject matter have been incurred by the
taxpayer; or (2) the subject matter of the contract is finally
completed and accepted. To the extent that the "customer-use" rule
requires a taxpayer to treat a contract as completed before final
completion and acceptance have occurred, the proposed regulations
explicitly adopt a rule different from that considered in Ball, Ball
and Brosamer, Inc. v. Commissioner, 964 F.2d 890 (9th Cir. 1992),
aff'g T.C. Memo. 1990-454..
Some commentators argued against having a rule that will declare a
contract completed earlier than under the finally-completed-and-
accepted standard illustrated in Ball. Some commentators also argued
that the customer-use rule is confusing to subcontractors because it
is unclear whether a subcontractor's "customer" is the general, or
"prime," contractor or the ultimate owner of the property. On the
other hand, one commentator asked for a bright-line standard for
completion and suggested, among other possibilities, that completion
occur when 95 percent of the estimated costs have been incurred.
The IRS and Treasury Department continue to believe that a contract
is complete for all practical purposes when the customer uses the
subject matter of that contract and the taxpayer has only five
percent or less of the total allocable contract costs remaining to
be incurred. Delaying a contract's completion beyond this point, as
the Tax Court permitted in Ball, does not reflect the substance of
the transaction and could encourage the use of formalities to delay
a contract's completion unreasonably. Thus, the final regulations do
not substantively change the customer-use rule contained in the
proposed regulations. However, the final regulations clarify that a
subcontractor's customer is the general contractor.
Several commentators expressed concern that the customer-use rule
contained in the proposed regulations will create additional
administrative burdens for taxpayers using the PCM because they
often will have to apply the look-back method two times, first upon
customer use and again upon final completion and acceptance. Though
the IRS and Treasury Department believe that the customer-use rule
results in an. appropriate determination of completion, we
understand these concerns. Thus, to simplify a taxpayer's reporting
requirements under the look-back method, the IRS and Treasury
Department have modified the look-back regulations to require a
taxpayer to delay the first application of the look-back method
until the taxable year in which a long-term contract is finally
completed and accepted.
4. Severing and Aggregating Contracts
The proposed regulations allow the Commissioner, and generally
require a taxpayer, to sever and aggregate contracts when necessary
to clearly reflect income. The proposed regulations provide the
following criteria for determining whether severance or aggregation
is required: independent versus interdependent pricing, separate
delivery or acceptance, and the reasonable businessperson standard.
However, under the proposed regulations, a taxpayer may not sever a
contract subject to the PCM. In addition, the proposed regulations
require a taxpayer to notify the Commissioner when severing a long-
term contract not accounted for using the PCM and provide agreement-
specific information, including the criteria for severing or
aggregating the agreement.
Some commentators criticized the "no severance" rule for long-term
contracts subject to the PCM. The "no severance" rule is provided in
the proposed regulations because the IRS and Treasury Department
believe that in most cases, a taxpayer's use of the PCM and look-
back method will clearly reflect the taxpayer's income from a long-
term contract. To date, the only identified reason to allow
severance of a contract subject to the PCM related to the
application of the 10-percent method as shown in §1.460-1(j)
Example 8 of the proposed income tax regulations. Conversely, the
IRS and Treasury Department believe that permitting a taxpayer to
sever a contract subject to the PCM could allow the taxpayer to
manipulate taxable income (e.g., by severing to create a loss
contract and accelerate the loss) or to avoid the application of
section 460 (e.g., by "completing" the contract during the
contracting year). Nonetheless, the IRS and Treasury Department
agree with the commentators' concerns that to the extent severance
is necessary to clearly reflect income from a long-term contract
(e.g., due to the application of the 10-percent method), it should
be permitted. Accordingly, the final regulations allow a taxpayer to
sever a long-term contract if necessary to clearly reflect income,
but only if the taxpayer has obtained the Commissioner's prior
written consent. Some commentators criticized the notification
requirement for severed and aggregated contracts as being unduly
burdensome. The IRS and Treasury Department continue to believe that
notification will help taxpayers and the IRS consistently apply the
severing and aggregating rules. In recognition of the potential
burden associated with the proposed notification requirement,
however, the final regulations simplify the notification by only
requiring that a taxpayer inform the IRS when it has severed or
aggregated agreements. Thus, the taxpayer is no longer required to
provide agreement-specific information.
One commentator suggested that the reasonable businessperson
standard be eliminated because it is merely a subset of independent
pricing and interdependent pricing (the pricing standards), which
should be the primary criteria for determining whether long-term
contracts must be severed or aggregated to clearly reflect income..
The IRS and Treasury Department agree that the pricing standards and
the reasonable businessperson standard overlap, but believe that the
pricing standard is a subset of the reasonable businessperson
standard. Besides requiring an analysis of pricing, the reasonable
businessperson standard requires an analysis of all the facts and
circumstances of the business arrangement between the taxpayer and
the customer. Thus, because the absence of the reasonable
businessperson standard might change the decision to sever or
aggregate in some cases, the final regulations retain this criterion
and clarify its distinction from the pricing standards.
5. Hybrid Contracts
Under the proposed regulations, a taxpayer generally must classify a
contract that requires the taxpayer to manufacture personal property
and to construct real property (hybrid contract) as separate
manufacturing and construction contracts. If at least 95 percent of
the estimated allocable contract costs are reasonably allocable to
manufacturing (or construction) activities, the taxpayer may
classify the contract as a manufacturing (or construction) contract.
One commentator suggested that the final regulations allow a
taxpayer to elect to use the PCM to account for a hybrid contract
instead of requiring the taxpayer to account for both parts
separately. The IRS and Treasury Department agree with the
commentator's request for simplification. Accordingly, the final
regulations allow a taxpayer to elect, on a contract-by-contract
basis, to classify a hybrid contract as a long-term manufacturing
contract subject to the PCM. In addition, because this election
effectively supersedes the 95-percent election that would have
applied to hybrid. contracts that are primarily manufacturing
contracts, the final regulations retain the 95- percent election as
a second election that applies only to hybrid contracts that are
primarily construction contracts.
6. Contracts of Related Parties
The proposed regulations provide that if a related party and its
customer enter into a long-term contract subject to the PCM, and a
taxpayer performs any activity that is incident to or necessary for
the related party's long-term contract, the taxpayer must account
for the gross receipts and costs attributable to the activity using
the PCM. However, the proposed regulations contain an inventory
exception for components and subassemblies produced by the taxpayer
if the taxpayer regularly carries these items in its finished goods
inventories and 80 percent or more of the gross receipts from the
sale of these items typically comes from unrelated parties.
One commentator suggested that the percentage threshold be lowered
from 80 percent to 50 percent and that the exception not be limited
to items regularly carried in the taxpayer's finished goods
inventories. The IRS and Treasury Department included the related
party rule, originally promulgated in Notice 89-15, in the proposed
regulations to prevent taxpayers from establishing special-purpose
subsidiaries to avoid the application of section 460. However, in
recognition that a related party that sells most units of a
manufactured item to unrelated parties was not established for the
purpose of avoiding section 460, the IRS and Treasury Department
added the inventory exception to the proposed regulations to reduce
the related party's accounting burden. The IRS and Treasury
Department agree, however, that the inventory exception is too
narrow. Accordingly, the final regulations lower the percentage
threshold from "80 percent or more" to "more than 50 percent" and
eliminate the requirement that the components or subassemblies be
carried in finished goods inventories.
7. Unique Items
Section 460 applies if a taxpayer manufactures a unique item of a
type that is not normally included in the finished goods inventory
of the taxpayer and if the contract is not completed by the close of
the contracting year. The proposed regulations provide that "unique"
means specifically designed for the needs of a customer. In
addition, the proposed regulations contain three safe harbors
concerning contracts to manufacture unique items. First, an item is
not unique if the taxpayer normally completes the item within 90
days. Second, an item is not unique if the total allocable contract
costs attributable to customizing activities that are incident to or
necessary for the production of the item do not exceed 5 percent of
the estimated total costs allocable to the item. Third, a unique
item ceases to be unique no later than when the taxpayer normally
includes similar items in its finished goods inventory. For an item
that does not satisfy one of these three safe harbors, the
determination of whether the item is unique is based on the facts
and circumstances.
Some commentators suggested that the final regulations contain
either a 140- day or a 180-day safe harbor instead of the 90-day
safe harbor. The IRS and Treasury Department did not adopt these
suggestions because we believe that a 90-day safe harbor
appropriately limits the meaning of "unique" in most cases. However,
the IRS. and Treasury Department have modified the 90-day safe
harbor to clarify that in the case of a contract to manufacture
multiple units of the same item, the 90-day safe harbor applies only
if each unit normally is completed within 90 days. Some commentators
suggested that the final regulations contain either a 10- percent,
15-percent, or 20-percent safe harbor instead of the 5-percent safe
harbor. In particular, these commentators stated that a 5-percent
safe harbor will not alleviate any controversy between taxpayers and
revenue agents because revenue agents generally do not raise the
issue of unique items if the taxpayer's customizing costs do not
exceed 5 percent. The IRS and Treasury Department agree that it is
reasonable to assume that an item is not unique if the taxpayer's
customizing costs do not exceed 10 percent. Thus, the customization
safe harbor in the final regulations has been increased to 10
percent.
One commentator suggested that the cost of a taxpayer's customizing
activities should not include the cost of any customized equipment
purchased by a taxpayer from an unrelated party under a "special
accommodation" arrangement with the customer that requires the
taxpayer to acquire and install that customized equipment. The IRS
and Treasury Department did not adopt this suggestion because such a
special accommodation rule could enable taxpayers to avoid section
460 by having some long-term contract activities performed by
outside parties.
Several commentators questioned the relevance of the "basic design"
concept included in §1.460-2(e) Example 1 of the proposed
regulations. To determine whether an item is unique, the relevant
analysis is whether an item is customized (or. manufactured
according to a customer's specifications) regardless of whether the
item is customized from a basic design. Accordingly, the final
regulations delete the reference to the taxpayer's basic design in
the example to eliminate any confusion. One commentator questioned
how the safe harbor applies in the case of a contract to manufacture
multiple units of the same item. The IRS and Treasury Department
believe that if significant customization is necessary to produce an
item for a customer under the contract, that item is specifically
designed for the needs of the customer, and thus is a unique item,
regardless of the number of units produced for the customer under
the contract. Thus, the final regulations clarify that for the
purposes of applying the 10-percent safe harbor to a contract to
manufacture multiple units of the same item, a taxpayer must
allocate all customization costs necessary to manufacture the first
unit manufactured under the contract to that first unit.
Some commentators suggested the addition of a fourth safe harbor
that would exclude "income on contracts for which progress payments
have not been received by year end." The IRS and Treasury Department
did not adopt this suggestion because we do not believe that such a
rule bears any relationship to a determination of the uniqueness of
an item and because such a rule is inconsistent with the statute.
8. 12-Month Completion Period
The proposed regulations provide that a manufactured item normally
requires more than 12 months to complete if its "production period,"
as defined in §1.263A-12, is reasonably expected to exceed 12
months, determined at the end of the contracting year. In general,
the production period for an item or unit begins when the taxpayer.
incurs at least 5 percent of the estimated total allocable contract
costs, including planning and design expenditures, allocable to the
item or unit, and the production period ends when the item or unit
is ready for shipment to the taxpayer's customer. Some commentators
suggested that the final regulations be clarified to provide that
"normal time to complete" includes only the time of physical
production activity and not the time of any research, development,
planning, or design activity. The IRS and Treasury Department did
not adopt this suggestion because we believe that the definition of
"production period" under §1.263A-12(c)(3), which includes the
time required for planning and design activity, is consistent with
the allocation of costs to extended-period long-term contracts under
§1.451-3(d)(6) and with section 460(c)(1), which requires that
costs be allocated under the rules applicable to extended-period
long-term contracts. In addition, if an item manufactured under a
long-term contract requires a significant amount of design time to
produce, it is appropriate to include the time needed to perform
these activities when determining that item's "normal time to
complete" because these activities are directly attributable to that
contract and are necessary to manufacture the subject matter of the
contract. However, the final regulations clarify that a taxpayer is
not required to consider activities related to costs that are not
allocable contract costs under section 460 (e.g., independent
research and development expenses, marketing expenses) when
determining the item's normal time to complete.
Some commentators asked how the 12-month rule applies in the case of
a contract to manufacture multiple units of the same item. The final
regulations clarify, that for the purposes of applying the 12-month
rule to this type of contract, the time required to design and
manufacture the first unit generally does not reflect the item's
"normal time to complete." For example, the time required to design
the first unit of an item should not be considered as time required
to manufacture subsequent identical units. The final regulations
also include an example illustrating the determination of normal
time to complete an item in the case of a contract to manufacture
multiple units of the same item.
9. Percentage-of-Completion Method
The proposed regulations provide that, under the PCM, a taxpayer
generally includes a portion of the total contract price in income
for each taxable year that the taxpayer incurs contract costs
allocable to the long-term contract. Under the proposed regulations,
total contract price included all bonuses, awards, and incentive
payments if it is reasonably estimated that they will be received,
even if the all events test has not yet been met. If, by the end of
the completion year, a taxpayer cannot reasonably estimate whether a
contingency will be satisfied, the bonus, award, or incentive
payment is not includible in total contract price.
Some commentators argued that a taxpayer should not have to include
contingent compensation in "total contract price" until the all
events test for the item has been satisfied. The IRS and Treasury
Department did not adopt this suggestion because the all events test
is a judicially created test applying to taxpayers using an accrual
method. U.S. v. Anderson, 269 U.S. 422 (1926). Conversely, section
460 is a self-contained, statutorily created accounting method that
requires taxpayers to use. estimated amounts when computing taxable
income under the PCM and to use actual amounts when applying the
look-back method. In addition, using the most accurate estimate of
total contract price and total contract costs will produce the most
accurate annual reporting of income and costs and will minimize
discrepancies that could necessitate paying look-back interest. See
Tutor-Saliba Corp. v. Commissioner, 115 T.C. No. 1 (July 17, 2000).
However, in response to comments and questions concerning the
contingent income rule, the final regulations provide that
contingent income is includible in total contract price not later
than when it is included in income for financial reporting purposes
under generally accepted accounting principles. One commentator
suggested that the final regulations incorporate the rule under
§1.451-3(a)(1) that allows a taxpayer to account for long-term
contracts of less-than- substantial duration using a method of
accounting other than a long-term contract method of accounting. The
IRS and Treasury Department did not adopt this suggestion because
such a rule would be inconsistent with the statutory definition of
"long-term contract."
One commentator asked how a contractor should account for the
subject matter of a long-term contract when the customer breaches
that contract before the contractor has transferred title to the
customer but after the contractor has reported taxable income from
that contract under the PCM (e.g., unfinished condominium unit). In
response to this comment, the final regulations include new
§1.460-4(b)(7), which provides that if a long-term contract is
terminated before completion and, as a result, the taxpayer retains
ownership of the property that is the subject matter of that
contract,. the taxpayer must reverse the previously reported gross
income (loss) from the transaction in the taxable year of
termination. As a result of reversing its previously reported gross
income under this rule, a taxpayer generally will have an adjusted
basis in the retained property equal to its previously deducted
allocable contract costs. The look-back method does not apply to any
terminated contract to the extent it is subject to this rule. The
IRS and Treasury Department request suggestions for rules that will
apply when the customer acquires ownership of some, but not all, of
the property that is the subject matter of the contract.
10. Cost Allocation Rules
The proposed and final regulations provide that a taxpayer generally
must allocate costs to a contract subject to section 460(a) in the
same manner as direct and indirect costs are capitalized to property
produced by a taxpayer under section 263A. The regulations provide
exceptions, however, that reflect the differences in the cost
allocation rules of sections 263A and 460.
One commentator argued that the final regulations should contain a
single standard for determining when the cost of a direct material
is allocable to a long-term contract. In response to this comment,
the final regulations contain a single standard linked to the
uniform capitalization (UNICAP) rules of section 263A. The final
regulations also clarify that, among other methods, a taxpayer
dedicates direct materials by associating them with a specific
contract (e.g., by purchase order, entry on books and records,
shipping instructions).
One commentator suggested that the final regulations clarify that
taxpayers should not treat software development and software
implementation costs as customization costs for the purposes of the
proposed 5-percent safe harbor. The IRS and Treasury Department did
not adopt this suggestion because we believe that software costs are
allocable contract costs (and thus customization costs) to the
extent they are incident to or necessary for the manufacture of the
subject matter of the contract.
This commentator also suggested that the final regulations clarify
that taxpayers should not treat guarantee, warranty, and maintenance
costs as customization costs for the purposes of the proposed 5-
percent safe harbor. The IRS and Treasury Department modified
§1.460-1(d)(2) to clarify that these types of costs are not
allocable contract costs.
11. Simplified Cost-To-Cost Method
The proposed regulations generally permit a taxpayer to elect to
allocate contract costs using the simplified cost-to-cost method.
Under the simplified cost-to-cost method, a taxpayer must determine
a contract's completion factor based upon only direct material
costs; direct labor costs; and depreciation, amortization, and cost
recovery allowances on equipment and facilities directly used to
manufacture or construct property under the contract.
One commentator suggested that the final regulations clarify whether
a taxpayer using the simplified cost-to-cost method is allowed or
required to include subcontracted costs in a contract's completion
factor. In response to this comment, the final regulations clarify
that subcontracted costs represent either direct material or direct
labor costs and thus must be allocated to a contract under the
simplified cost-to-cost method when incurred under § 1.461-4(d)
(2)(ii). In addition, a taxpayer must allocate subcontracted costs
for all section 460 purposes (e.g., applying the 10-percent safe
harbor under §1.460-2(b)(2)(ii)).
12. Statute of Limitations and Compound Interest on Look-Back
Interest
One commentator requested guidance concerning the statute of
limitations applicable to payments of, and claims for, look-back
interest. The final regulations amend §1.460-6(f)(1) and (2) to
clarify the reporting requirements and add new §1.460- 6(f)(3).
New §1.460-6(f)(3) provides guidance on the statute of
limitations applicable to the assessment and collection of look-back
interest owed by a taxpayer. In addition, new §1.460-6(f)(3)
provides that a taxpayer's claim for credit or refund of look-back
interest previously paid by or collected from the taxpayer is a
claim for credit or refund of an overpayment of tax for federal
income tax purposes, which is subject to the section 6511 statute of
limitations. In contrast, new §1.460-6(f)(3) provides that a
taxpayer's claim for look-back interest (or interest payable on
look-back interest) that is not attributable to an amount previously
paid by or collected from the taxpayer is a general claim against
the federal government, which is subject to the statutes of
limitations found in 28 U.S.C. sections 2401 and 2501.
13. Effective Date
These final regulations apply to any contract entered into on or
after January 11, 2001.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations. Pursuant
to section 7805(f) of the Internal Revenue Code, this Treasury
decision was submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business. It is hereby certified that the collection of information
in this Treasury decision will not have a significant economic
impact on a substantial number of small entities. The regulations
require a taxpayer to attach a statement to its original federal
income tax return if the taxpayer severs or aggregates a long-term
contract. The statement is needed so the Commissioner can determine
whether the taxpayer properly severed or aggregated the contract. It
is uncommon for a taxpayer that has a long-term contract to sever or
aggregate that contract. In addition, if a contract is severed or
aggregated and a statement is required, it is estimated that it
will, on average, require only 15 minutes to complete.
Drafting Information
The principal author of these regulations is Leo F. Nolan II, Office
of Associate Chief Counsel (Income Tax and Accounting). However,
other personnel from the IRS and Treasury Department participated in
their development.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations Accordingly, 26 CFR parts
1 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation is amended by removing the entry
for "Section 1.451-3 and 1.451-5", revising the entry for "Section
1.460-4", and adding the following entries in numerical order to
read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.451-5 also issued under 96 Stat. 324, 493.***
Section 1.460-1 also issued under 26 U.S.C. 460(h).
Section 1.460-2 also issued under 26 U.S.C. 460(h).
Section 1.460-3 also issued under 26 U.S.C. 460(h).
Section 1.460-4 also issued under 26 U.S.C. 460(h) and 1502.
Section 1.460-5 also issued under 26 U.S.C. 460(h). * * *
§1.446-1 [Amended ]
Par. 2. Section 1.446-1 is amended as follows:
1. In the second sentence of paragraph (c)(1)(iii), the language
"451" is removed and "460" is added in its place.
2. In the fourth sentence of paragraph (e)(2)(ii)(a), the language
"§1.451-3" is removed and "§1.460-4" is added in its
place.
§1.451-3 [Removed ] Par. 3. Section 1.451-3 is removed.
§1.451-5 [Amended ] Par. 4. Section 1.451-5 is amended by
removing the language "§1.451-3" and adding
"§1.460-4" in its place in the first sentence of paragraph (b)
(3). Par. 5. Section 1.460-0 is amended by:
1. Revising the introductory text.
2. Revising the entries for §§1.460-1 through 1.460-3,
1.460-4(a) through (i), and 1.460-5.
3. Adding an entry for §1.460-4(k).
4. Removing the entry for §1.460-6(c)(4)(iv).
5. Adding an entry for §1.460-6(f)(3).
6. Removing the entries for §§1.460-7 and 1.460-8. The
revisions and addition read as follows:
§1.460-0 Outline of regulations under section 460. This section
lists the paragraphs contained in §1.460-1 through
§1.460-6.
§1.460-1 Long-term contracts.
(a) Overview.
(1) In general.
(2) Exceptions to required use of PCM.
(i) Exempt construction contract.
(ii) Qualified ship or residential construction contract.
(b) Terms.
(1) Long-term contract.
(2) Contract for the manufacture, building, installation, or
construction of property.
(i) In general.
(ii) De minimis construction activities.
(3) Allocable contract costs.
(4) Related party.
(5) Contracting year.
(6) Completion year.
(7) Contract commencement date.
(8) Incurred.
(9) Independent research and development expenses.
(10) Long-term contract methods of accounting.
(c) Entering into and completing long-term contracts.
(1) In general.
(2) Date contract entered into.
(i) In general.
(ii) Options and change orders.
(3) Date contract completed.
(i) In general.
(ii) Secondary items.
(iii) Subcontracts.
(iv) Final completion and acceptance.
(a) In general.
(b) Contingent compensation.
(c) Assembly or installation.
(d) Disputes.
(d) Allocation among activities.
(1) In general.
(2) Non-long-term contract activity.
(e) Severing and aggregating contracts.
(1) In general.
(2) Facts and circumstances.
(i) Pricing.
(ii) Separate delivery or acceptance.
(iii) Reasonable businessperson.
(3) Exceptions.
(i) Severance for PCM.
(ii) Options and change orders.
(4) Statement with return.
(f) Classifying contracts.
(1) In general.
(2) Hybrid contracts.
(i) In general.
(ii) Elections.
(3) Method of accounting.
(4) Use of estimates.
(i) Estimating length of contract.
(ii) Estimating allocable contract costs.
(g) Special rules for activities benefitting long-term contracts of
a related party.
(1) Related party use of PCM.
(i) In general.
(ii) Exception for components and subassemblies.
(2) Total contract price.
(3) Completion factor.
(h) Effective date.
(1) In general.
(2) Change in method of accounting.
(i) [Reserved]
(j) Examples. §1.460-2 Long-term manufacturing contracts.
(a) In general.
(b) Unique.
(1) In general.
(2) Safe harbors.
(i) Short production period.
(ii) Customized item.
(iii) Inventoried item.
(c) Normal time to complete.
(1) In general.
(2) Production by related parties.
(d) Qualified ship contracts.
(e) Examples. §1.460-3 Long-term construction contracts.
(a) In general.
(b) Exempt construction contracts.
(1) In general.
(2) Home construction contract.
(i) In general.
(ii) Townhouses and rowhouses.
(iii) Common improvements.
(iv) Mixed use costs.
(3) $10,000,000 gross receipts test.
(i) In general.
(ii) Single employer.
(iii) Attribution of gross receipts.
(c) Residential construction contracts. §1.460-4 Methods of
accounting for long-term contracts.
(a) Overview.
(b) Percentage-of-completion method.
(1) In general.
(2) Computations.
(3) Post-completion-year income.
(4) Total contract price.
(i) In general.
(a) Definition.
(b) Contingent compensation.
(c) Non-long-term contract activities.
(ii) Estimating total contract price.
(5) Completion factor.
(i) Allocable contract costs.
(ii) Cumulative allocable contract costs.
(iii) Estimating total allocable contract costs.
(iv) Pre-contracting-year costs.
(v) Post-completion-year costs.
(6) 10-percent method.
(i) In general.
(ii) Election.
(7) Terminated contract.
(i) Reversal of income.
(ii) Adjusted basis.
(iii) Look-back method.
(c) Exempt contract methods.
(1) In general.
(2) Exempt-contract percentage-of-completion method.
(i) In general.
(ii) Determination of work performed.
(d) Completed-contract method.
(1) In general.
(2) Post-completion-year income and costs.
(3) Gross contract price.
(4) Contracts with disputed claims.
(i) In general.
(ii) Taxpayer assured of profit or loss.
(iii) Taxpayer unable to determine profit or loss.
(iv) Dispute resolved.
(e) Percentage-of-completion/capitalized-cost method.
(f) Alternative minimum taxable income.
(1) In general.
(2) Election to use regular completion factors.
(g) Method of accounting. (h) Examples.
(i) [Reserved].
* * * * *
(k) Mid-contract change in taxpayer [Reserved]. §1.460-5 Cost
allocation rules.
(a) Overview.
(b) Cost allocation method for contracts subject to PCM.
(1) In general.
(2) Special rules.
(i) Direct material costs.
(ii) Components and subassemblies.
(iii) Simplified production methods.
(iv) Costs identified under cost-plus long-term contracts and
federal long-term contracts.
(v) Interest.
(a) In general.
(b) Production period.
(c) Application of section 263A(f).
(vi) Research and experimental expenses.
(vii) Service costs.
(a) Simplified service cost method.
(1) In general.
(2) Example.
(b) Jobsite costs.
(c) Limitation on other reasonable cost allocation methods.
(c) Simplified cost-to-cost method for contracts subject to the PCM.
(1) In general.
(2) Election.
(d) Cost allocation rules for exempt construction contracts reported
using CCM.
(1) In general.
(2) Indirect costs.
(i) Indirect costs allocable to exempt construction contracts.
(ii) Indirect costs not allocable to exempt construction contracts.
(3) Large homebuilders.
(e) Cost allocation rules for contracts subject to the PCCM.
(f) Special rules applicable to costs allocated under this section.
(1) Nondeductible costs.
(2) Costs incurred for non-long-term contract activities.
(g) Method of accounting. §1.460-6 Look-back method.
* * * * *
(f) * * *
(3) Statutes of limitations and compounding of interest on look-back
interest.
* * * * *
Par. 6. Sections 1.460-1 through 1.460-3 are revised to read as
follows: §1.460-1 Long-term contracts.
(a) Overview--
(1) In general. This section provides rules for determining whether
a contract for the manufacture, building, installation, or
construction of property is a long-term contract under section 460
and what activities must be accounted for as a single long-term
contract. Specific rules for long-term manufacturing and
construction contracts are provided in §§1.460-2 and
1.460-3, respectively. A taxpayer generally must determine the
income from a long-term contract using the percentage-of- completion
method described in §1.460-4(b) (PCM) and the cost allocation
rules described in §1.460-5(b) or (c). In addition, after a
contract subject to the PCM is completed, a taxpayer generally must
apply the look-back method described in §1.460- 6 to determine
the amount of interest owed on any hypothetical underpayment of tax,
or earned on any hypothetical overpayment of tax, attributable to
accounting for the long-term contract under the PCM.
(2) Exceptions to required use of PCM--
(i) Exempt construction contract. The requirement to use the PCM
does not apply to any exempt construction contract described in
§1.460-3(b). Thus, a taxpayer may determine the income from an
exempt construction contract using any accounting method permitted
by §1.460-4(c) and, for contracts accounted for using the
completed-contract method (CCM), any cost allocation method
permitted by §1.460-5(d). Exempt construction contracts that
are not subject to the PCM or CCM are not subject to the cost
allocation rules of §1.460-5 except for the production-period
interest rules of §1.460-5(b)(2)(v). Exempt construction
contractors that are large homebuilders described in
§1.460-5(d)(3) must capitalize costs under section 263A. All
other exempt construction contractors must account for the cost of
construction using the appropriate rules contained in other sections
of the Internal Revenue Code or regulations.
(ii) Qualified ship or residential construction contract. The
requirement to use the PCM applies only to a portion of a qualified
ship contract described in §1.460-2(d) or residential
construction contract described in §1.460-3(c). A taxpayer
generally may determine the income from a qualified ship contract or
residential construction contract using the percentage-of-
completion/capitalized-cost method (PCCM) described in
§1.460-4(e), but must use a cost allocation method described in
§1.460-5(b) for the entire contract.
(b) Terms--(1) Long-term contract. A long-term contract generally is
any contract for the manufacture, building, installation, or
construction of property if the contract is not completed within the
contracting year, as defined in paragraph (b)(5) of this section.
However, a contract for the manufacture of property is a long-term
contract only if it also satisfies either the unique item or 12-
month requirements described in §1.460-2. A contract for the
manufacture of personal property is a manufacturing contract. In
contrast, a contract for the building, installation, or construction
of real property is a construction contract.
(2) Contract for the manufacture, building, installation, or
construction of property--
(i) In general. A contract is a contract for the manufacture,
building, installation, or construction of property if the
manufacture, building, installation, or construction of property is
necessary for the taxpayer's contractual obligations to be fulfilled
and if the manufacture, building, installation, or construction of
that property has not been completed when the parties enter into the
contract. If a taxpayer has to manufacture or construct an item to
fulfill its obligations under the contract, the fact that the
taxpayer is not required to deliver that item to the customer is not
relevant. Whether the customer has title to, control over, or bears
the risk of loss from, the property manufactured or constructed by
the taxpayer also is not relevant. Furthermore, how the parties
characterize their agreement (e.g., as a contract for the sale of
property) is not relevant.
(ii) De minimis construction activities. Notwithstanding paragraph
(b)(2)(i) of this section, a contract is not a construction contract
under section 460 if the contract includes the provision of land by
the taxpayer and the estimated total allocable contract costs, as
defined in paragraph (b)(3) of this section, attributable to the
taxpayer's construction activities are less than 10 percent of the
contract's total contract price, as defined in §1.460-4(b)(4)
(i). For the purposes of this paragraph (b)(2)(ii), the allocable
contract costs attributable to the taxpayer's construction
activities do not include the cost of the land provided to the
customer. In addition, a contract's estimated total allocable
contract costs include a proportionate share of the estimated cost
of any common improvement that benefits the subject matter of the
contract if the taxpayer is contractually obligated, or required by
law, to construct the common improvement.
(3) Allocable contract costs. Allocable contract costs are costs
that are allocable to a long-term contract under §1.460-5.
(4) Related party. A related party is a person whose relationship to
a taxpayer is described in section 707(b) or 267(b), determined
without regard to section 267(f)(1)(A) and determined by replacing
"at least 80 percent" with "more than 50 percent" for the purposes
of determining the ownership of the stock of a corporation in
sections 267(b)(2), (8), (10)(A), and (12).
(5) Contracting year. The contracting year is the taxable year in
which a taxpayer enters into a contract as described in paragraph
(c)(2) of this section.
(6) Completion year. The completion year is the taxable year in
which a taxpayer completes a contract as described in paragraph (c)
(3) of this section.
(7) Contract commencement date. The contract commencement date is
the date that a taxpayer or related party first incurs any allocable
contract costs, such as design and engineering costs, other than
expenses attributable to bidding and negotiating activities.
Generally, the contract commencement date is relevant in applying
§1.460- 6(b)(3) (concerning the de minimis exception to the
look-back method under section 460(b)(3)(B)); §1.460-5(b)(2)(v)
(B)(1)(i) (concerning the production period subject to interest
allocation); §1.460-2(d) (concerning qualified ship contracts);
and §1.460- 3(b)(1)(ii) (concerning the construction period for
exempt construction contracts). (8) Incurred. Incurred has the
meaning given in §1.461-1(a)(2) (concerning the taxable year a
liability is incurred under the accrual method of accounting),
regardless of a taxpayer's overall method of accounting. See
§1.461-4(d)(2)(ii) for economic performance rules concerning
the PCM.
(9) Independent research and development expenses. Independent
research and development expenses are any expenses incurred in the
performance of research or development, except that this term does
not include any expenses that are directly attributable to a
particular long-term contract in existence when the expenses are
incurred and this term does not include any expenses under an
agreement to perform research or development.
(10) Long-term contract methods of accounting. Long-term contract
methods of accounting, which include the PCM, the CCM, the PCCM, and
the exempt-contract percentage-of-completion method (EPCM), are
methods of accounting that may be used only for long-term contracts.
(c) Entering into and completing long-term contracts--
(1) In general. To determine when a contract is entered into under
paragraph (c)(2) of this section and completed under paragraph (c)
(3) of this section, a taxpayer must consider all relevant allocable
contract costs incurred and activities performed by itself, by
related parties on its behalf, and by the customer, that are
incident to or necessary for the long-term contract. In addition, to
determine whether a contract is completed in the contracting year,
the taxpayer may not consider when it expects to complete the
contract.
(2) Date contract entered into--
(i) In general. A taxpayer enters into a contract on the date that
the contract binds both the taxpayer and the customer under
applicable law, even if the contract is subject to unsatisfied
conditions not within the taxpayer's control (such as obtaining
financing). If a taxpayer delays entering into a contract for a
principal purpose of avoiding section 460, however, the taxpayer
will be treated as having entered into a contract not later than the
contract commencement date.
(ii) Options and change orders. A taxpayer enters into a new
contract on the date that the customer exercises an option or
similar provision in a contract if that option or similar provision
must be severed from the contract under paragraph (e) of this
section. Similarly, a taxpayer enters into a new contract on the
date that it accepts a change order or other similar agreement if
the change order or other similar agreement must be severed from the
contract under paragraph (e) of this section.
(3) Date contract completed--
(i) In general. A taxpayer's contract is completed upon the earlier
of--
(A) Use of the subject matter of the contract by the customer for
its intended purpose (other than for testing) and at least 95
percent of the total allocable contract costs attributable to the
subject matter have been incurred by the taxpayer; or
(B) Final completion and acceptance of the subject matter of the
contract.
(ii) Secondary items. The date a contract accounted for using the
CCM is completed is determined without regard to whether one or more
secondary items have been used or finally completed and accepted. If
any secondary items are incomplete at the end of the taxable year in
which the primary subject matter of a contract is completed, the
taxpayer must separate the portion of the gross contract price and
the allocable contract costs attributable to the incomplete
secondary item(s) from the completed contract and account for them
using a permissible method of accounting. A permissible method of
accounting includes a long-term contract method of accounting only
if a separate contract for the secondary item(s) would be a long-
term contract, as defined in paragraph (b)(1) of this section.
(iii) Subcontracts. In the case of a subcontract, a subcontractor's
customer is the general contractor. Thus, the subject matter of the
subcontract is the relevant subject matter under paragraph (c)(3)(i)
of this section.
(iv) Final completion and acceptance--(A) In general. Except as
otherwise provided in this paragraph (c)(3)(iv), to determine
whether final completion and acceptance of the subject matter of a
contract have occurred, a taxpayer must consider all relevant facts
and circumstances. Nevertheless, a taxpayer may not delay the
completion of a contract for the principal purpose of deferring
federal income tax.
(b) Contingent compensation. Final completion and acceptance is
determined without regard to any contractual term that provides for
additional compensation that is contingent on the successful
performance of the subject matter of the contract. A taxpayer must
account for all contingent compensation that is not includible in
total contract price under §1.460-4(b)(4)(i), or in gross
contract price under §1.460-4(d)(3), using a permissible method
of accounting. For application of the look-back method for contracts
accounted for using the PCM, see §1.460-6(c)(1)(ii) and (2)
(vi).
(C) Assembly or installation. Final completion and acceptance is
determined without regard to whether the taxpayer has an obligation
to assist or supervise assembly or installation of the subject
matter of the contract where the assembly or installation is not
performed by the taxpayer or a related party. A taxpayer must
account for the gross receipts and costs attributable to such an
obligation using a permissible method of accounting, other than a
long-term contract method.
(d) Disputes. Final completion and acceptance is determined without
regard to whether a dispute exists at the time the taxpayer tenders
the subject matter of the contract to the customer. For contracts
accounted for using the CCM, see §1.460- 4(d)(4). For
application of the look-back method for contracts accounted for
using the PCM, see §1.460-6(c)(1)(ii) and (2)(vi).
(d) Allocation among activities--
(1) In general. Long-term contract methods of accounting apply only
to the gross receipts and costs attributable to long-term contract
activities. Gross receipts and costs attributable to long-term
contract activities means amounts included in total contract price
or gross contract price, whichever is applicable, as determined
under §1.460-4, and costs allocable to the contract, as
determined under §1.460-5. Gross receipts and costs
attributable to non-long-term contract activities (as defined in
paragraph (d)(2) of this section) generally must be taken into
account using a permissible method of accounting other than a long-
term contract method. See section 446(c) and §1.446-1(c).
However, if the performance of a non-long- term contract activity is
incident to or necessary for the manufacture, building,
installation, or construction of the subject matter of one or more
of the taxpayer's long- term contracts, the gross receipts and costs
attributable to that activity must be allocated to the long-term
contract(s) benefitted as provided in §§1.460-4(b)(4)(i)
and 1.460-5(f)(2), respectively. Similarly, if a single long-term
contract requires a taxpayer to perform a non-long-term contract
activity that is not incident to or necessary for the manufacture,
building, installation, or construction of the subject matter of the
long-term contract, the gross receipts and costs attributable to
that non-long-term contract activity must be separated from the
contract and accounted for using a permissible method of accounting
other than a long-term contract method. But see paragraph (g) of
this section for related party rules.
(2) Non-long-term contract activity. Non-long-term contract activity
means the performance of an activity other than manufacturing,
building, installation, or construction, such as the provision of
architectural, design, engineering, and construction management
services, and the development or implementation of computer
software. In addition, performance under a guaranty, warranty, or
maintenance agreement is a non-long-term contract activity that is
never incident to or necessary for the manufacture or construction
of property under a long-term contract.
(e) Severing and aggregating contracts--
(1) In general. After application of the allocation rules of
paragraph (d) of this section, the severing and aggregating rules of
this paragraph (e) may be applied by the Commissioner or the
taxpayer as necessary to clearly reflect income (e.g., to prevent
the unreasonable deferral (or acceleration) of income or the
premature recognition (or deferral) of loss). Under the severing and
aggregating rules, one agreement may be treated as two or more
contracts, and two or more agreements may be treated as one
contract. Except as provided in paragraph (e)(3)(ii) of this
section, a taxpayer must determine whether to sever an agreement or
to aggregate two or more agreements based on the facts and
circumstances known at the end of the contracting year.
(2) Facts and circumstances. Whether an agreement should be severed,
or two or more agreements should be aggregated, depends on the
following factors:
(i) Pricing. Independent pricing of items in an agreement is
necessary for the agreement to be severed into two or more
contracts. In the case of an agreement for similar items, if the
price to be paid for the items is determined under different terms
or formulas (e.g., if some items are priced under a cost-plus
incentive fee arrangement and later items are to be priced under a
fixed-price arrangement), then the difference in the pricing terms
or formulas indicates that the items are independently priced.
Similarly, interdependent pricing of items in separate agreements is
necessary for two or more agreements to be aggregated into one
contract. A single price negotiation for similar items ordered under
one or more agreements indicates that the items are interdependently
priced.
(ii) Separate delivery or acceptance. An agreement may not be
severed into two or more contracts unless it provides for separate
delivery or separate acceptance of items that are the subject matter
of the agreement. However, the separate delivery or separate
acceptance of items by itself does not necessarily require an
agreement to be severed.
(iii) Reasonable businessperson. Two or more agreements to perform
manufacturing or construction activities may not be aggregated into
one contract unless a reasonable businessperson would not have
entered into one of the agreements for the terms agreed upon without
also entering into the other agreement(s). Similarly, an agreement
to perform manufacturing or construction activities may not be
severed into two or more contracts if a reasonable businessperson
would not have entered into separate agreements containing terms
allocable to each severed contract. Analyzing the reasonable
businessperson standard requires an analysis of all the facts and
circumstances of the business arrangement between the taxpayer and
the customer. For purposes of this paragraph (e)(2)(iii), a
taxpayer's expectation that the parties would enter into another
agreement, when agreeing to the terms contained in the first
agreement, is not relevant.
(3) Exceptions--
(i) Severance for PCM. A taxpayer may not sever under this paragraph
(e) a long-term contract that would be subject to the PCM without
obtaining the Commissioner's prior written consent.
(ii) Options and change orders. Except as provided in paragraph (e)
(3)(i) of this section, a taxpayer must sever an agreement that
increases the number of units to be supplied to the customer, such
as through the exercise of an option or the acceptance of a change
order, if the agreement provides for separate delivery or separate
acceptance of the additional units.
(4) Statement with return. If a taxpayer severs an agreement or
aggregates two or more agreements under this paragraph (e) during
the taxable year, the taxpayer must attach a statement to its
original federal income tax return for that year. This statement
must contain the following information--
(i) The legend NOTIFICATION OF SEVERANCE OR AGGREGATION UNDER SEC.
1.460-1(e);
(ii) The taxpayer's name; and
(iii) The taxpayer's employer identification number or social
security number.
(f) Classifying contracts--
(1) In general. After applying the severing and aggregating rules of
paragraph (e) of this section, a taxpayer must determine the
classification of a contract (e.g., as a long-term manufacturing
contract, long-term construction contract, non-long-term contract)
based on all the facts and circumstances known no later than the end
of the contracting year. Classification is determined on a contract-
by-contract basis. Consequently, a requirement to manufacture a
single unique item under a long-term contract will subject all other
items in that contract to section 460.
(2) Hybrid contracts--
(i) In general. A long-term contract that requires a taxpayer to
perform both manufacturing and construction activities (hybrid
contract) generally must be classified as two contracts, a
manufacturing contract and a construction contract. A taxpayer may
elect, on a contract-by-contract basis, to classify a hybrid
contract as a long-term construction contract if at least 95 percent
of the estimated total allocable contract costs are reasonably
allocable to construction activities. In addition, a taxpayer may
elect, on a contract-by-contract basis, to classify a hybrid
contract as a long-term manufacturing contract subject to the PCM.
(ii) Elections. A taxpayer makes an election under this paragraph
(f)(2) by using its method of accounting for similar construction
contracts or for manufacturing contracts, whichever is applicable,
to account for a hybrid contract entered into during the taxable
year of the election on its original federal income tax return for
the election year. If an electing taxpayer's method is the PCM, the
taxpayer also must use the PCM to apply the look-back method under
§1.460-6 and to determine alternative minimum taxable income
under §1.460-4(f).
(3) Method of accounting. Except as provided in paragraph (f)(2)(ii)
of this section, a taxpayer's method of classifying contracts is a
method of accounting under section 446 and, thus, may not be changed
without the Commissioner's consent. If a taxpayer's method of
classifying contracts is unreasonable, that classification method is
an impermissible accounting method.
(4) Use of estimates--
(i) Estimating length of contract. A taxpayer must use a reasonable
estimate of the time required to complete a contract when necessary
to classify the contract (e.g., to determine whether the five-year
completion rule for qualified ship contracts under §1.460-2(d),
or the two-year completion rule for exempt construction contracts
under §1.460-3(b), is satisfied, but not to determine whether a
contract is completed within the contracting year under paragraph
(b)(1) of this section). To be considered reasonable, an estimate of
the time required to complete the contract must include anticipated
time for delay, rework, change orders, technology or design
problems, or other problems that reasonably can be anticipated
considering the nature of the contract and prior experience. A
contract term that specifies an expected completion or delivery date
may be considered evidence that the taxpayer reasonably expects to
complete or deliver the subject matter of the contract on or about
the date specified, especially if the contract provides bona fide
penalties for failing to meet the specified date. If a taxpayer
classifies a contract based on a reasonable estimate of completion
time, the contract will not be reclassified based on the actual (or
another reasonable estimate of) completion time. A taxpayer's
estimate of completion time will not be considered unreasonable if a
contract is not completed within the estimated time primarily
because of unforeseeable factors not within the taxpayer's control,
such as third-party litigation, extreme weather conditions, strikes,
or delays in securing permits or licenses.
(ii) Estimating allocable contract costs. A taxpayer must use a
reasonable estimate of total allocable contract costs when necessary
to classify the contract (e.g., to determine whether a contract is a
home construction contract under §1.460- (3)(b)(2)). If a
taxpayer classifies a contract based on a reasonable estimate of
total allocable contract costs, the contract will not be
reclassified based on the actual (or another reasonable estimate of)
total allocable contract costs.
(g) Special rules for activities benefitting long-term contracts of
a related party--
(1) Related party use of PCM--
(i) In general. Except as provided in paragraph (g)(1)(ii) of this
section, if a related party and its customer enter into a long-term
contract subject to the PCM, and a taxpayer performs any activity
that is incident to or necessary for the related party's long-term
contract, the taxpayer must account for the gross receipts and costs
attributable to this activity using the PCM, even if this activity
is not otherwise subject to section 460(a). This type of activity
may include, for example, the performance of engineering and design
services, and the production of components and subassemblies that
are reasonably expected to be used in the production of the subject
matter of the related party's contract.
(ii) Exception for components and subassemblies. A taxpayer is not
required to use the PCM under this paragraph (g) to account for a
component or subassembly that benefits a related party's long-term
contract if more than 50 percent of the average annual gross
receipts attributable to the sale of this item for the 3-taxable-
year-period ending with the contracting year comes from unrelated
parties.
(2) Total contract price. If a taxpayer is required to use the PCM
under paragraph (g)(1)(i) of this section, the total contract price
(as defined in §1.460- 4(b)(4)(i)) is the fair market value of
the taxpayer's activity that is incident to or necessary for the
performance of the related party's long-term contract. The related
party also must use the fair market value of the taxpayer's activity
as the cost it incurs for the activity. The fair market value of the
taxpayer's activity may or may not be the same as the amount the
related party pays the taxpayer for that activity.
(3) Completion factor. To compute a contract's completion factor (as
described in §1.460-4(b)(5)), the related party must take into
account the fair market value of the taxpayer's activity that is
incident to or necessary for the performance of the related party's
long-term contract when the related party incurs the liability to
the taxpayer for the activity, rather than when the taxpayer incurs
the costs to perform the activity. (h) Effective date--
(1) In general. Except as otherwise provided, this section and
§§1.460-2 through 1.460-5 are applicable for contracts
entered into on or after January 11, 2001.
(2) Change in method of accounting. Any change in a taxpayer's
method of accounting necessary to comply with this section and
§§1.460-2 through 1.460-5 is a change in method of
accounting to which the provisions of section 446 and the
regulations thereunder apply. For the first taxable year that
includes January 11, 2001, a taxpayer is granted the consent of the
Commissioner to change its method of accounting to comply with the
provisions of this section and §§1.460-2 through 1.460-5
for long-term contracts entered into on or after January 11, 2001. A
taxpayer that wants to change its method of accounting under this
paragraph (h)(2) must follow the automatic consent procedures in
Rev. Proc. 99-49 (1999-52 I.R.B. 725) (see §601.601(d)(2) of
this chapter), except that the scope limitations in section 4.02 of
Rev. Proc. 99-49 do not apply. Because a change under this paragraph
(h)(2) is made on a cut-off basis, a section 481(a) adjustment is
not permitted or required. Moreover, the taxpayer does not receive
audit protection under section 7 of Rev. Proc. 99-49 for a change in
method of accounting under this paragraph (h)(2). A taxpayer that
wants to change its exempt-contract method of accounting is not
granted the consent of the Commissioner under this paragraph (h)(2)
and must file a Form 3115, "Application for Change in Accounting
Method," to obtain consent. See Rev. Proc. 97-27 (1997-1 C.B. 680)
(see §601.601(d)(2) of this chapter).
(i) [Reserved].-44-
(j) Examples. The following examples illustrate the rules of this
section: Example 1. Contract for manufacture of property. B notifies
C, an aircraft manufacturer, that it wants to purchase an aircraft
of a particular type. At the time C receives the order, C has on
hand several partially completed aircraft of this type; however, C
does not have any completed aircraft of this type on hand. C and B
agree that B will purchase one of these aircraft after it has been
completed. C retains title to and risk of loss with respect to the
aircraft until the sale takes place. The agreement between C and B
is a contract for the manufacture of property under paragraph (b)(2)
(i) of this section, even if labeled as a contract for the sale of
property, because the manufacture of the aircraft is necessary for
C's obligations under the agreement to be fulfilled and the
manufacturing was not complete when B and C entered into the
agreement.
Example 2. De minimis construction activity. C, a master developer
whose taxable year ends December 31, owns 5,000 acres of undeveloped
land with a cost basis of $5,000,000 and a fair market value of
$50,000,000. To obtain permission from the local county government
to improve this land, a service road must be constructed on this
land to benefit all 5,000 acres. In 2001, C enters into a contract
to sell a 1,000- acre parcel of undeveloped land to B, a residential
developer, for its fair market value, $10,000,000. In this contract,
C agrees to construct a service road running through the land that C
is selling to B and through the 4,000 adjacent acres of undeveloped
land that C has sold or will sell to other residential developers
for its fair market value, $40,000,000. C reasonably estimates that
it will incur allocable contract costs of $50,000 (excluding the
cost of the land) to construct this service road, which will be
owned and maintained by the county. C must reasonably allocate the
cost of the service road among the benefitted parcels. The portion
of the estimated total allocable contract costs that C allocates to
the 1,000-acre parcel being sold to B (based upon its fair market
value) is $10,000 ($50,000 x ($10,000,000 ÷ $50,000,000)).
Construction of the service road is finished in 2002. Because the
estimated total allocable contract costs attributable to C's
construction activities, $10,000, are less than 10 percent of the
contract's total contract price, $10,000,000, C's contract with B is
not a construction contract under paragraph (b)(2)(ii) of this
section. Thus, C's contract with B is not a long-term contract under
paragraph (b)(2)(i) of this section, notwithstanding that
construction of the service road is not completed in 2001.
Example 3. Completion--customer use. In 2002, C, whose taxable year
ends December 31, enters into a contract to construct a building for
B. In November of 2003, the building is completed in every respect
necessary for its intended use, and B occupies the building. In
early December of 2003, B notifies C of some minor deficiencies that
need to be corrected, and C agrees to correct them in January 2004.
C reasonably estimates that the cost of correcting these
deficiencies will be less than five percent of the total allocable
contract costs. C's contract is complete under paragraph (c)(3)(i)
(A) of this section in 2003 because in that year, B used the
building and C had incurred at least 95 percent of the total
allocable contract costs attributable to the building. C must use a
permissible method of accounting for any deficiency-related costs
incurred after 2003.
Example 4. Completion--customer use. In 2001, C, whose taxable year
ends December 31, agrees to construct a shopping center, which
includes an adjoining parking lot, for B. By October 2002, C has
finished constructing the retail portion of the shopping center. By
December 2002, C has graded the entire parking lot, but has paved
only one-fourth of it because inclement weather conditions prevented
C from laying asphalt on the remaining three-fourths. In December
2002, B opens the retail portion of the shopping center and the
paved portion of the parking lot to the general public. C reasonably
estimates that the cost of paving the remaining three-fourths of the
parking lot when weather permits will exceed five percent of C's
total allocable contract costs. Even though B is using the subject
matter of the contract, C's contract is not completed in December
2002 under paragraph (c)(3)(i)(A) of this section because C has not
incurred at least 95 percent of the total allocable contract costs
attributable to the subject matter.
Example 5. Completion--customer use. In 2001, C, whose taxable year
ends December 31, agrees to manufacture 100 machines for B. By
December 31, 2002, C has delivered 99 of the machines to B. C
reasonably estimates that the cost of finishing the related work on
the contract will be less than five percent of the total allocable
contract costs. C's contract is not complete under paragraph (c)(3)
(i)(A) of this section in 2002 because in that year, B is not using
the subject matter of the contract (all 100 machines) for its
intended purpose.
Example 6. Non-long-term contract activity. On January 1, 2001, C,
whose taxable year ends December 31, enters into a single long-term
contract to design and manufacture a satellite and to develop
computer software enabling B to operate the satellite. At the end of
2001, C has not finished manufacturing the satellite. Designing the
satellite and developing the computer software are non-long-term
contract activities that are incident to and necessary for the
taxpayer's manufacturing of the subject matter of a long-term
contract because the satellite could not be manufactured without the
design and would not operate without the software. Thus, under
paragraph (d)(1) of this section, C must allocate these non-long-
term contract activities to the long-term contract and account for
the gross receipts and costs attributable to designing the satellite
and developing computer software using the PCM.
Example 7. Non-long-term contract activity. C agrees to manufacture
equipment for B under a long-term contract. In a separate contract,
C agrees to design the equipment being manufactured for B under the
long-term contract. Under paragraph (d)(1) of this section, C must
allocate the gross receipts and costs related to the design to the
long-term contract because designing the equipment is a non-long-
term contract activity that is incident to and necessary for the
manufacture of the subject matter of the long-term contract.
Example 8. Severance. On January 1, 2001, C, a construction
contractor, and B, a real estate investor, enter into an agreement
requiring C to build two office buildings in different areas of a
large city. The agreement provides that the two office buildings
will be completed by C and accepted by B in 2002 and 2003,
respectively, and that C will be paid $1,000,000 and $1,500,000 for
the two office buildings, respectively. The agreement will provide C
with a reasonable profit from the construction of each building.
Unless C is required to use the PCM to account for the contract, C
is required to sever this contract under paragraph (e)(2) of this
section because the buildings are independently priced, the
agreement provides for separate delivery and acceptance of the
buildings, and, as each building will generate a reasonable profit,
a reasonable businessperson would have entered into separate
agreements for the terms agreed upon for each building.
Example 9. Severance. C, a large construction contractor whose
taxable year ends December 31, accounts for its construction
contracts using the PCM and has elected to use the 10-percent method
described in §1.460-4(b)(6). In September 2001, C enters into
an agreement to construct four buildings in four different cities.
The buildings are independently priced and the contract provides a
reasonable profit for each of the buildings. In addition, the
agreement requires C to complete one building per year in 2002,
2003, 2004, and 2005. As of December 31, 2001, C has incurred 25
percent of the estimated total allocable contract costs attributable
to one of the buildings, but only five percent of the estimated
total allocable contract costs attributable to all four buildings
included in the agreement. C does not request the Commissioner's
consent to sever this contract. Using the 10-percent method, C does
not take into account any portion of the total contract price or any
incurred allocable contract costs attributable to this agreement in
2001. Upon examination of C's 2001 tax return, the Commissioner
determines that C entered into one agreement for four buildings
rather than four separate agreements each for one building solely to
take advantage of the deferral obtained under the 10-percent method.
Consequently, to clearly reflect the taxpayer's income, the
Commissioner may require C to sever the agreement into four separate
contracts under paragraph (e)(2) of this section because the
buildings are independently priced, the agreement provides for
separate delivery and acceptance of the buildings, and a reasonable
businessperson would have entered into separate agreements for these
buildings.
Example 10. Aggregation. In 2001, C, a shipbuilder, enters into two
agreements with the Department of the Navy as the result of a single
negotiation. Each agreement obligates C to manufacture a submarine.
Because the submarines are of the same class, their specifications
are similar. Because C has never manufactured submarines of this
class, however, C anticipates that it will incur substantially
higher costs to manufacture the first submarine, to be delivered in
2007, than to manufacture the second submarine, to be delivered in
2010. If the agreements are treated as separate contracts, the first
contract probably will produce a substantial loss, while the second
contract probably will produce substantial profit. Based upon these
facts, aggregation is required under paragraph (e)(2) of this
section because the submarines are interdependently priced and a
reasonable businessperson would not have entered the first agreement
without also entering into the second.
Example 11. Aggregation. In 2001, C, a manufacturer of aircraft and
related equipment, agrees to manufacture 10 military aircraft for
foreign government B and to deliver the aircraft by the end of 2003.
When entering into the agreement, C anticipates that it might
receive production orders from B over the next 20 years for as many
as 300 more of these aircraft. The negotiated contract price
reflects C's and B's consideration of the expected total cost of
manufacturing the 10 aircraft, the risks and opportunities
associated with the agreement, and the additional factors the
parties considered relevant. The negotiated price provides a profit
on the sale of the 10 aircraft even if C does not receive any
additional production orders from B. It is unlikely, however, that C
actually would have wanted to manufacture the 10 aircraft but for
the expectation that it would receive additional production orders
from B. In 2003, B accepts delivery of the 10 aircraft. At that
time, B orders an additional 20 aircraft of the same type for
delivery in 2007. When negotiating the price for the additional 20
aircraft, C and B consider the fact that the expected unit cost for
this production run of 20 aircraft will be lower than the unit cost
of the 10 aircraft completed and accepted in 2003, but substantially
higher than the expected unit cost of future production runs. Based
upon these facts, aggregation is not permitted under paragraph (e)
(2) of this section. Because the parties negotiated the prices of
both agreements considering only the expected production costs and
risks for each agreement standing alone, the terms and conditions
agreed upon for the first agreement are independent of the terms and
conditions agreed upon for the second agreement. The fact that the
agreement to manufacture 10 aircraft provides a profit for C
indicates that a reasonable businessperson would have entered into
that agreement without entering into the agreement to manufacture
the additional 20 aircraft.
Example 12. Classification and completion. In 2001, C, whose taxable
year ends December 31, agrees to manufacture and install an
industrial machine for B. C elects under paragraph (f) of this
section to classify the agreement as a long-term manufacturing
contract and to account for it using the PCM. The agreement requires
C to deliver the machine in August 2003 and to install and test the
machine in B's factory. In addition, the agreement requires B to
accept the machine when the tests prove that the machine's
performance will satisfy the environmental standards set by the
Environmental Protection Agency (EPA), even if B has not obtained
the required operating permit. Because of technical difficulties, C
cannot deliver the machine until December 2003, when B conditionally
accepts delivery. C installs the machine in December 2003 and then
tests it through February 2004. B accepts the machine in February
2004, but does not obtain the operating permit from the EPA until
January 2005. Under paragraph (c)(3)(i)(B) of this section, C's
contract is finally completed and accepted in February 2004, even
though B does not obtain the operating permit until January 2005,
because C completed all its obligations under the contract and B
accepted the machine in February 2004. §1.460-2 Long-term
manufacturing contracts.
(a) In general. Section 460 generally requires a taxpayer to
determine the income from a long-term manufacturing contract using
the percentage-of-completion method described in §1.460-4(b)
(PCM). A contract not completed in the contracting year is a long-
term manufacturing contract if it involves the manufacture of
personal property that is--
(1) A unique item of a type that is not normally carried in the
finished goods inventory of the taxpayer; or
(2) An item that normally requires more than 12 calendar months to
complete (regardless of the duration of the contract or the time to
complete a deliverable quantity of the item).
(b) Unique--
(1) In general. Unique means designed for the needs of a specific
customer. To determine whether an item is designed for the needs of
a specific customer, a taxpayer must consider the extent to which
research, development, design, engineering, retooling, and similar
activities (customizing activities) are required to manufacture the
item and whether the item could be sold to other customers with
little or no modification. A contract may require the taxpayer to
manufacture more than one unit of a unique item. If a contract
requires a taxpayer to manufacture more than one unit of the same
item, the taxpayer must determine whether that item is unique by
considering the customizing activities that would be needed to
produce only the first unit. For the purposes of this paragraph (b),
a taxpayer must consider the activities performed on its behalf by a
subcontractor.
(2) Safe harbors. Notwithstanding paragraph (b)(1) of this section,
an item is not unique if it satisfies one or more of the safe
harbors in this paragraph (b)(2). If an item does not satisfy one or
more safe harbors, the determination of uniqueness will depend on
the facts and circumstances. The safe harbors are:
(i) Short production period. An item is not unique if it normally
requires 90 days or less to complete. In the case of a contract for
multiple units of an item, the item is not unique only if it
normally requires 90 days or less to complete each unit of the item
in the contract.
(ii) Customized item. An item is not unique if the total allocable
contract costs attributable to customizing activities that are
incident to or necessary for the manufacture of the item do not
exceed 10 percent of the estimated total allocable contract costs
allocable to the item. In the case of a contract for multiple units
of an item, this comparison must be performed on the first unit of
the item and the total allocable contract costs attributable to
customizing activities that are incident to or necessary for the
manufacture of the first unit of the item must be allocated to that
first unit.
(iii) Inventoried item. A unique item ceases to be unique no later
than when the taxpayer normally includes similar items in its
finished goods inventory.
(c) Normal time to complete--
(1) In general. The amount of time normally required to complete an
item is the item's reasonably expected production period, as
described in §1.263A-12, determined at the end of the
contracting year. Thus, in general, the expected production period
for an item begins when a taxpayer incurs at least five percent of
the costs that would be allocable to the item under §1.460-5
and ends when the item is ready to be held for sale and all
reasonably expected production activities are complete. In the case
of components that are assembled or reassembled into an item or unit
at the customer's facility by the taxpayer's employees or agents,
the production period ends when the components are assembled or
reassembled into an operable item or unit. To the extent that
several distinct activities related to the production of the item
are expected to occur simultaneously, the period during which these
distinct activities occur is not counted more than once.
Furthermore, when determining the normal time to complete an item, a
taxpayer is not required to consider activities performed or costs
incurred that would not be allocable contract costs under section
460 (e.g., independent research and development expenses (as defined
in §1.460-1(b)(9)) and marketing expenses). Moreover, the time
normally required to design and manufacture the first unit of an
item for which the taxpayer intends to produce multiple units
generally does not indicate the normal time to complete the item.
(2) Production by related parties. To determine the time normally
required to complete an item, a taxpayer must consider all relevant
production activities performed and costs incurred by itself and by
related parties, as defined in §1.460-1(b)(4). For example, if
a taxpayer's item requires a component or subassembly manufactured
by a related party, the taxpayer must consider the time the related
party takes to complete the component or subassembly and, for
purposes of determining the beginning of an item's production
period, the costs incurred by the related party that are allocable
to the component or subassembly. However, if both requirements of
the exception for components and subassemblies under
§1.460-1(g)(1)(ii) are satisfied, a taxpayer does not consider
the activities performed or the costs incurred by a related party
when determining the normal time to complete an item.
(d) Qualified ship contracts. A taxpayer may determine the income
from a long-term manufacturing contract that is a qualified ship
contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in
§1.460-4(e). A qualified ship contract is any contract entered
into after February 28, 1986, to manufacture in the United States
not more than 5 seagoing vessels if the vessels will not be
manufactured directly or indirectly for the United States Government
and if the taxpayer reasonably expects to complete the contract
within 5 years of the contract commencement date. Under
§1.460-1(e)(3)(i), a contract to produce more than 5 vessels
for which the PCM would be required cannot be severed in order to be
classified as a qualified ship contract.
(e) Examples. The following examples illustrate the rules of this
section: Example 1. Unique item and classification. In December
2001, C enters into a contract with B to design and manufacture a
new type of industrial equipment. C reasonably expects the normal
production period for this type of equipment to be eight months.
Because the new type of industrial equipment requires a substantial
amount of research, design, and engineering to produce, C determines
that the equipment is a unique item and its contract with B is a
long-term contract. After delivering the equipment to B in September
2002, C contracts with B to produce five additional units of that
industrial equipment with certain different specifications. These
additional units, which also are expected to take eight months to
produce, will be delivered to B in 2003. C determines that the
research, design, engineering, retooling, and similar customizing
costs necessary to produce the five additional units of equipment
does not exceed 10 percent of the first unit's share of estimated
total allocable contract costs. Consequently, the additional units
of equipment satisfy the safe harbor in paragraph (b)(2)(ii) of this
section and are not unique items. Although C's contract with B to
produce the five additional units is not completed within the
contracting year, the contract is not a long-term contract since the
additional units of equipment are not unique items and do not
normally require more than 12 months to produce. C must classify its
second contract with B as a non-long term contract, notwithstanding
that it classified the previous contract with B for a similar item
as a long-term contract, because the determination of whether a
contract is a long-term contract is made on a contract-by-contract
basis. A change in classification is not a change in method of
accounting because the change in classification results from a
change in underlying facts.
Example 2. 12-month rule--related party. C manufactures cranes. C
purchases one of the crane's components from R, a related party
under §1.460-1(b)(4). Less than 50 percent of R's gross
receipts attributable to the sale of this component comes from sales
to unrelated parties; thus, the exception for components and
subassemblies under §1.460-1(g)(1)(ii) is not satisfied.
Consequently, C must consider the activities of R as R incurs costs
and performs the activities rather than as C incurs a liability to
R. The normal time period between the time that both C and R incur
five percent of the costs allocable to the crane and the time that R
completes the component is five months. C normally requires an
additional eight months to complete production of the crane after
receiving the integral component from R. C's crane is an item of a
type that normally requires more than 12 months to complete under
paragraph (c) of this section because the production period from the
time that both C and R incur five percent of the costs allocable to
the crane until the time that production of the crane is complete is
normally 13 months.
Example 3. 12-month rule--duration of contract. The facts are the
same as in Example 2, except that C enters into a sales contract
with B on December 31, 2001 (the last day of C's taxable year), and
delivers a completed crane to B on February 1, 2002. C's contract
with B is a long-term contract under paragraph (a)(2) of this
section because the contract is not completed in the contracting
year, 2001, and the crane is an item that normally requires more
than 12 calendar months to complete (regardless of the duration of
the contract).
Example 4. 12-month rule--normal time to complete. The facts are the
same as in Example 2, except that C (and R) actually complete B's
crane in only 10 calendar months. The contract is a long-term
contract because the normal time to complete a crane, not the actual
time to complete a crane, is the relevant criterion for determining
whether an item is subject to paragraph (a)(2) of this section.
Example 5. Normal time to complete. C enters into a multi-unit
contract to produce four units of an item. C does not anticipate
producing any additional units of the item. C expects to perform the
research, design, and development that are directly allocable to the
particular item and to produce the first unit in the first 24
months. C reasonably expects the production period for each of the
three remaining units will be 3 months. This contract is not a
contract that involves the manufacture of an item that normally
requires more than 12 months to complete because the normal time to
complete the item is 3 months. However, the contract does not
satisfy the 90-day safe harbor for unique items because the normal
time to complete the first unit of this item exceeds 90 days. Thus,
the contract might involve the manufacture of a unique item
depending on the facts and circumstances. §1.460-3 Long-term
construction contracts.
(a) In general. Section 460 generally requires a taxpayer to
determine the income from a long-term construction contract using
the percentage-of-completion method described in §1.460-4(b)
(PCM). A contract not completed in the contracting year is a long-
term construction contract if it involves the building,
construction, reconstruction, or rehabilitation of real property;
the installation of an integral component to real property; or the
improvement of real property (collectively referred to as
construction). Real property means land, buildings, and inherently
permanent structures, as defined in §1.263A-8(c)(3), such as
roadways, dams, and bridges. Real property does not include vessels,
offshore drilling platforms, or unsevered natural products of land.
An integral component to real property includes property not
produced at the site of the real property but intended to be
permanently affixed to the real property, such as elevators and
central heating and cooling systems. Thus, for example, a contract
to install an elevator in a building is a construction contract
because a building is real property, but a contract to install an
elevator in a ship is not a construction contract because a ship is
not real property.
(b) Exempt construction contracts--
(1) In general. The general requirement to use the PCM and the cost
allocation rules described in §1.460-5(b) or (c) does not apply
to any long-term construction contract described in this paragraph
(b) (exempt construction contract). Exempt construction contract
means any--
(i) Home construction contract; and
(ii) Other construction contract that a taxpayer estimates (when
entering into the contract) will be completed within 2 years of the
contract commencement date, provided the taxpayer satisfies the
$10,000,000 gross receipts test described in paragraph (b)(3) of
this section.
(2) Home construction contract--
(i) In general. A long-term construction contract is a home
construction contract if a taxpayer (including a subcontractor
working for a general contractor) reasonably expects to attribute 80
percent or more of the estimated total allocable contract costs
(including the cost of land, materials, and services), determined as
of the close of the contracting year, to the construction of--
(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I),
contained in buildings containing 4 or fewer dwelling units
(including buildings with 4 or fewer dwelling units that also have
commercial units); and
(B) Improvements to real property directly related to, and located
at the site of, the dwelling units.
(ii) Townhouses and rowhouses. Each townhouse or rowhouse is a
separate building.
(iii) Common improvements. A taxpayer includes in the cost of the
dwelling units their allocable share of the cost that the taxpayer
reasonably expects to incur for any common improvements (e.g.,
sewers, roads, clubhouses) that benefit the dwelling units and that
the taxpayer is contractually obligated, or required by law, to
construct within the tract or tracts of land that contain the
dwelling units.
(iv) Mixed use costs. If a contract involves the construction of
both commercial units and dwelling units within the same building, a
taxpayer must allocate the costs among the commercial units and
dwelling units using a reasonable method or combination of
reasonable methods, such as specific identification, square footage,
or fair market value.
(3) $10,000,000 gross receipts test--
(i) In general. Except as otherwise provided in paragraphs (b)(3)
(ii) and (iii) of this section, the $10,000,000 gross receipts test
is satisfied if a taxpayer's (or predecessor's) average annual gross
receipts for the 3 taxable years preceding the contracting year do
not exceed $10,000,000, as determined using the principles of the
gross receipts test for small resellers under §1.263A-3(b).
(ii) Single employer. To apply the gross receipts test, a taxpayer
is not required to aggregate the gross receipts of persons treated
as a single employer solely under section 414(m) and any regulations
prescribed under section 414. (iii) Attribution of gross receipts. A
taxpayer must aggregate a proportionate share of the construction-
related gross receipts of any person that has a five percent or
greater interest in the taxpayer. In addition, a taxpayer must
aggregate a proportionate share of the construction-related gross
receipts of any person in which the taxpayer has a five percent or
greater interest. For this purpose, a taxpayer must determine
ownership interests as of the first day of the taxpayer's
contracting year and must include indirect interests in any
corporation, partnership, estate, trust, or sole proprietorship
according to principles similar to the constructive ownership rules
under sections 1563(e), (f)(2), and (f)(3)(A). However, a taxpayer
is not required to aggregate under this paragraph (b)(3)(iii) any
construction-related gross receipts required to be aggregated under
paragraph (b)(3)(i) of this section.
(c) Residential construction contracts. A taxpayer may determine the
income from a long-term construction contract that is a residential
construction contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in
§1.460-4(e). A residential construction contract is a home
construction contract, as defined in paragraph (b)(2) of this
section, except that the building or buildings being constructed
contain more than 4 dwelling units. Par. 7. Section 1.460-4 is
amended by adding paragraphs (a) through (i) to read as follows:
§1.460-4 Methods of accounting for long-term contracts.
(a) Overview. This section prescribes permissible methods of
accounting for long-term contracts. Paragraph (b) of this section
describes the percentage-of- completion method under section 460(b)
(PCM) that a taxpayer generally must use to determine the income
from a long-term contract. Paragraph (c) of this section lists
permissible methods of accounting for exempt construction contracts
described in §1.460-3(b)(1) and describes the exempt-contract
percentage-of-completion method (EPCM). Paragraph (d) of this
section describes the completed-contract method (CCM), which is one
of the permissible methods of accounting for exempt construction
contracts. Paragraph (e) of this section describes the percentage-
of-completion/ capitalized-cost method (PCCM), which is a
permissible method of accounting for qualified ship contracts
described in §1.460-2(d) and residential construction contracts
described in §1.460-3(c). Paragraph (f) of this section
provides rules for determining the alternative minimum taxable
income (AMTI) from long-term contracts that are not exempted under
section 56. Paragraph (g) of this section provides rules concerning
consistency in methods of accounting for long-term contracts.
Paragraph (h) of this section provides examples illustrating the
principles of this section. Paragraph (j) of this section provides
rules for taxpayers that file consolidated tax returns.
(b) Percentage-of-completion method--
(1) In general. Under the PCM, a taxpayer generally must include in
income the portion of the total contract price, as defined in
paragraph (b)(4)(i) of this section, that corresponds to the
percentage of the entire contract that the taxpayer has completed
during the taxable year. The percentage of completion must be
determined by comparing allocable contract costs incurred with
estimated total allocable contract costs. Thus, the taxpayer
includes a portion of the total contract price in gross income as
the taxpayer incurs allocable contract costs.
(2) Computations. To determine the income from a long-term contract,
a taxpayer--
(i) Computes the completion factor for the contract, which is the
ratio of the cumulative allocable contract costs that the taxpayer
has incurred through the end of the taxable year to the estimated
total allocable contract costs that the taxpayer reasonably expects
to incur under the contract;
(ii) Computes the amount of cumulative gross receipts from the
contract by multiplying the completion factor by the total contract
price;
(iii) Computes the amount of current-year gross receipts, which is
the difference between the amount of cumulative gross receipts for
the current taxable year and the amount of cumulative gross receipts
for the immediately preceding taxable year (the difference can be a
positive or negative number); and
(iv) Takes both the current-year gross receipts and the allocable
contract costs incurred during the current year into account in
computing taxable income.
(3) Post-completion-year income. If a taxpayer has not included the
total contract price in gross income by the completion year, as
defined in §1.460-1(b)(6), the taxpayer must include the
remaining portion of the total contract price in gross income for
the taxable year following the completion year. For the treatment of
post-completion- year costs, see paragraph (b)(5)(v) of this
section. See §1.460-6(c)(1)(ii) for application of the look-
back method as a result of adjustments to total contract price.
(4) Total contract price--
(i) In general--(A) Definition. Total contract price means the
amount that a taxpayer reasonably expects to receive under a long-
term contract, including holdbacks, retainages, and cost
reimbursements. See §1.460-6(c)(1)(ii) and (2)(vi) for
application of the look-back method as a result of changes in total
contract price.
(b) Contingent compensation. Any amount related to a contingent
right under a contract, such as a bonus, award, incentive payment,
and amount in dispute, is included in total contract price as soon
as the taxpayer can reasonably predict that the amount will be
earned, even if the all events test has not yet been met. For
example, if a bonus is payable to a taxpayer for meeting an early
completion date, the bonus is includible in total contract price at
the time and to the extent that the taxpayer can reasonably predict
the achievement of the corresponding objective. Similarly, a portion
of the contract price that is in dispute is includible in total
contract price at the time and to the extent that the taxpayer can
reasonably predict that the dispute will be resolved in the
taxpayer's favor (regardless of when the taxpayer actually receives
payment or when the dispute is finally resolved). Total contract
price does not include compensation that might be earned under any
other agreement that the taxpayer expects to obtain from the same
customer (e.g., exercised option or follow-on contract) if that
other agreement is not aggregated under §1.460-1(e). For the
purposes of this paragraph (b)(4)(i)(B), a taxpayer can reasonably
predict that an amount of contingent income will be earned not later
than when the taxpayer includes that amount in income for financial
reporting purposes under generally accepted accounting principles.
If a taxpayer has not included an amount of contingent compensation
in total contract price under this paragraph (b)(4)(i) by the
taxable year following the completion year, the taxpayer must
account for that amount of contingent compensation using a
permissible method of accounting. If it is determined after the
taxable year following the completion year that an amount included
in total contract price will not be earned, the taxpayer should
deduct that amount in the year of the determination.
(c) Non-long-term contract activities. Total contract price includes
an allocable share of the gross receipts attributable to a non-long-
term contract activity, as defined in §1.460-1(d)(2), if the
activity is incident to or necessary for the manufacture, building,
installation, or construction of the subject matter of the long-term
contract. Total contract price also includes amounts reimbursed for
independent research and development expenses (as defined in
§1.460-1(b)(9)), or for bidding and proposal costs, under a
federal or cost-plus long-term contract (as defined in section
460(d)), regardless of whether the research and development, or
bidding and proposal, activities are incident to or necessary for
the performance of that long-term contract.
(ii) Estimating total contract price. A taxpayer must estimate the
total contract price based upon all the facts and circumstances
known as of the last day of the taxable year. For this purpose, an
event that occurs after the end of the taxable year must be taken
into account if its occurrence was reasonably predictable and its
income was subject to reasonable estimation as of the last day of
that taxable year.
(5) Completion factor--
(i) Allocable contract costs. A taxpayer must use a cost allocation
method permitted under either §1.460-5(b) or (c) to determine
the amount of cumulative allocable contract costs and estimated
total allocable contract costs that are used to determine a
contract's completion factor. Allocable contract costs include a
reimbursable cost that is allocable to the contract.
(ii) Cumulative allocable contract costs. To determine a contract's
completion factor for a taxable year, a taxpayer must take into
account the cumulative allocable contract costs that have been
incurred, as defined in §1.460-1(b)(8), through the end of the
taxable year.
(iii) Estimating total allocable contract costs. A taxpayer must
estimate total allocable contract costs for each long-term contract
based upon all the facts and circumstances known as of the last day
of the taxable year. For this purpose, an event that occurs after
the end of the taxable year must be taken into account if its
occurrence was reasonably predictable and its cost was subject to
reasonable estimation as of the last day of that taxable year. To be
considered reasonable, an estimate of total allocable contract costs
must include costs attributable to delay, rework, change orders,
technology or design problems, or other problems that reasonably can
be predicted considering the nature of the contract and prior
experience. However, estimated total allocable contract costs do not
include any contingency allowance for costs that, as of the end of
the taxable year, are not reasonably predicted to be incurred in the
performance of the contract. For example, estimated total allocable
contract costs do not include any costs attributable to factors not
reasonably predictable at the end of the taxable year, such as
third-party litigation, extreme weather conditions, strikes, and
delays in securing required permits and licenses. In addition, the
estimated costs of performing other agreements that are not
aggregated with the contract under §1.460-1(e) that the
taxpayer expects to incur with the same customer (e.g., follow-on
contracts) are not included in estimated total allocable contract
costs for the initial contract.
(iv) Pre-contracting-year costs. If a taxpayer reasonably expects to
enter into a long-term contract in a future taxable year, the
taxpayer must capitalize all costs incurred prior to entering into
the contract that will be allocable to that contract (e.g., bidding
and proposal costs). A taxpayer is not required to compute a
completion factor, or to include in gross income any amount, related
to allocable contract costs for any taxable year ending before the
contracting year or, if applicable, the 10-percent year defined in
paragraph (b)(6)(i) of this section. In that year, the taxpayer is
required to compute a completion factor that includes all allocable
contract costs that have been incurred as of the end of that taxable
year (whether previously capitalized or deducted) and to take into
account in computing taxable income the related gross receipts and
the previously capitalized allocable contract costs. If, however, a
taxpayer determines in a subsequent year that it will not enter into
the long-term contract, the taxpayer must account for these pre-
contracting-year costs in that year (e.g., as a deduction or an
inventoriable cost) using the appropriate rules contained in other
sections of the Code or regulations.
(v) Post-completion-year costs. If a taxpayer incurs an allocable
contract cost after the completion year, the taxpayer must account
for that cost using a permissible method of accounting. See
§1.460-6(c)(1)(ii) for application of the look-back method as a
result of adjustments to allocable contract costs.
(6) 10-percent method--
(i) In general. Instead of determining the income from a long-term
contract beginning with the contracting year, a taxpayer may elect
to use the 10-percent method under section 460(b)(5). Under the 10-
percent method, a taxpayer does not include in gross income any
amount related to allocable contract costs until the taxable year in
which the taxpayer has incurred at least 10 percent of the estimated
total allocable contract costs (10-percent year). A taxpayer must
treat costs incurred before the 10-percent year as pre-contracting-
year costs described in paragraph (b)(5)(iv) of this section.
(ii) Election. A taxpayer makes an election under this paragraph (b)
(6) by using the 10-percent method for all long-term contracts
entered into during the taxable year of the election on its original
federal income tax return for the election year. This election is a
method of accounting and, thus, applies to all long-term contracts
entered into during and after the taxable year of the election. An
electing taxpayer must use the 10-percent method to apply the look-
back method under §1.460-6 and to determine alternative minimum
taxable income under paragraph (f) of this section. This election is
not available if a taxpayer uses the simplified cost-to-cost method
described in §1.460- 5(c) to compute the completion factor of a
long-term contract.
(7) Terminated contract--
(i) Reversal of income. If a long-term contract is terminated before
completion and, as a result, the taxpayer retains ownership of the
property that is the subject matter of that contract, the taxpayer
must reverse the transaction in the taxable year of termination. To
reverse the transaction, the taxpayer reports a loss (or gain) equal
to the cumulative allocable contract costs reported under the
contract in all prior taxable years less the cumulative gross
receipts reported under the contract in all prior taxable years.
(ii) Adjusted basis. As a result of reversing the transaction under
paragraph (b)(7)(i) of this section, a taxpayer will have an
adjusted basis in the retained property equal to the cumulative
allocable contract costs reported under the contract in all prior
taxable years. However, if the taxpayer received and retains any
consideration or compensation from the customer, the taxpayer must
reduce the adjusted basis in the retained property (but not below
zero) by the fair market value of that consideration or
compensation. To the extent that the amount of the consideration or
compensation described in the preceding sentence exceeds the
adjusted basis in the retained property, the taxpayer must include
the excess in gross income for the taxable year of termination.
(iii) Look-back method. The look-back method does not apply to a
terminated contract that is subject to this paragraph (b)(7).
(c) Exempt contract methods--
(1) In general. An exempt contract method means the method of
accounting that a taxpayer must use to account for all its long-term
contracts (and any portion of a long-term contract) that are exempt
from the requirements of section 460(a). Thus, an exempt contract
method applies to exempt construction contracts, as defined in
§1.460-3(b); the non-PCM portion of a qualified ship contract,
as defined in §1.460-2(d); and the non-PCM portion of a
residential construction contract, as defined in §1.460-3(c).
Permissible exempt contract methods include the PCM, the EPCM
described in paragraph (c)(2) of this section, the CCM described in
paragraph (d) of this section, or any other permissible method. See
section 446.
(2) Exempt-contract percentage-of-completion method--
(i) In general. Similar to the PCM described in paragraph (b) of
this section, a taxpayer using the EPCM generally must include in
income the portion of the total contract price, as described in
paragraph (b)(4) of this section, that corresponds to the percentage
of the entire contract that the taxpayer has completed during the
taxable year. However, under the EPCM, the percentage of completion
may be determined as of the end of the taxable year by using any
method of cost comparison (such as comparing direct labor costs
incurred to date to estimated total direct labor costs) or by
comparing the work performed on the contract with the estimated
total work to be performed, rather than by using the cost-to-cost
comparison required by paragraphs (b)(2)(i) and (5) of this section,
provided such method is used consistently and clearly reflects
income. In addition, paragraph (b)(3) of this section (regarding
post-completion-year income), paragraph (b)(6) of this section
(regarding the 10-percent method) and §1.460-6 (regarding the
look-back method) do not apply to the EPCM.
(ii) Determination of work performed. For purposes of the EPCM, the
criteria used to compare the work performed on a contract as of the
end of the taxable year with the estimated total work to be
performed must clearly reflect the earning of income with respect to
the contract. For example, in the case of a roadbuilder, a standard
of completion solely based on miles of roadway completed in a case
where the terrain is substantially different may not clearly reflect
the earning of income with respect to the contract.
(d) Completed-contract method--
(1) In general. Except as otherwise provided in paragraph (d)(4) of
this section, a taxpayer using the CCM to account for a long-term
contract must take into account in the contract's completion year,
as defined in §1.460-1(b)(6), the gross contract price and all
allocable contract costs incurred by the completion year. A taxpayer
may not treat the cost of any materials and supplies that are
allocated to a contract, but actually remain on hand when the
contract is completed, as an allocable contract cost.
(2) Post-completion-year income and costs. If a taxpayer has not
included an item of contingent compensation (i.e., amounts for which
the all events test has not been satisfied) in gross contract price
under paragraph (d)(3) of this section by the completion year, the
taxpayer must account for this item of contingent compensation using
a permissible method of accounting. If a taxpayer incurs an
allocable contract cost after the completion year, the taxpayer must
account for that cost using a permissible method of accounting.
(3) Gross contract price. Gross contract price includes all amounts
(including holdbacks, retainages, and reimbursements) that a
taxpayer is entitled by law or contract to receive, whether or not
the amounts are due or have been paid. In addition, gross contract
price includes all bonuses, awards, and incentive payments, such as
a bonus for meeting an early completion date, to the extent the all
events test is satisfied. If a taxpayer performs a non-long-term
contract activity, as defined in §1.460-1(d)(2), that is
incident to or necessary for the manufacture, building,
installation, or construction of the subject matter of one or more
of the taxpayer's long-term contracts, the taxpayer must include an
allocable share of the gross receipts attributable to that activity
in the gross contract price of the contract(s) benefitted by that
activity. Gross contract price also includes amounts reimbursed for
independent research and development expenses (as defined in
§1.460-1(b)(9)), or bidding and proposal costs, under a federal
or cost-plus long-term contract (as defined in section 460(d)),
regardless of whether the research and development, or bidding and
proposal, activities are incident to or necessary for the
performance of that long-term contract.
(4) Contracts with disputed claims--
(i) In general. The special rules in this paragraph (d)(4) apply to
a long-term contract accounted for using the CCM with a dispute
caused by a customer's requesting a reduction of the gross contract
price or the performance of additional work under the contract or by
a taxpayer's requesting an increase in gross contract price, or
both, on or after the date a taxpayer has tendered the subject
matter of the contract to the customer.
(ii) Taxpayer assured of profit or loss. If the disputed amount
relates to a customer's claim for either a reduction in price or
additional work and the taxpayer is assured of either a profit or a
loss on a long-term contract regardless of the outcome of the
dispute, the gross contract price, reduced (but not below zero) by
the amount reasonably in dispute, must be taken into account in the
completion year. If the disputed amount relates to a taxpayer's
claim for an increase in price and the taxpayer is assured of either
a profit or a loss on a long-term contract regardless of the outcome
of the dispute, the gross contract price must be taken into account
in the completion year. If the taxpayer is assured a profit on the
contract, all allocable contract costs incurred by the end of the
completion year are taken into account in that year. If the taxpayer
is assured a loss on the contract, all allocable contract costs
incurred by the end of the completion year, reduced by the amount
reasonably in dispute, are taken into account in the completion
year.
(iii) Taxpayer unable to determine profit or loss. If the amount
reasonably in dispute affects so much of the gross contract price or
allocable contract costs that a taxpayer cannot determine whether a
profit or loss ultimately will be realized from a long-term
contract, the taxpayer may not take any of the gross contract price
or allocable contract costs into account in the completion year.
(iv) Dispute resolved. Any part of the gross contract price and any
allocable contract costs that have not been taken into account
because of the principles described in paragraph (d)(4)(i), (ii), or
(iii) of this section must be taken into account in the taxable year
in which the dispute is resolved. If a taxpayer performs additional
work under the contract because of the dispute, the term taxable
year in which the dispute is resolved means the taxable year the
additional work is completed, rather than the taxable year in which
the outcome of the dispute is determined by agreement, decision, or
otherwise.
(e) Percentage-of-completion/capitalized-cost method. Under the
PCCM, a taxpayer must determine the income from a long-term contract
using the PCM for the applicable percentage of the contract and its
exempt contract method, as defined in paragraph (c) of this section,
for the remaining percentage of the contract. For residential
construction contracts described in §1.460-3(c), the applicable
percentage is 70 percent, and the remaining percentage is 30
percent. For qualified ship contracts described in §1.460-2(d),
the applicable percentage is 40 percent, and the remaining
percentage is 60 percent.
(f) Alternative minimum taxable income--
(1) In general. Under section 56(a)(3), a taxpayer (not exempt from
the AMT under section 55(e)) must use the PCM to determine its AMTI
from any long-term contract entered into on or after March 1, 1986,
that is not a home construction contract, as defined in
§1.460-3(b)(2). For AMTI purposes, the PCM must include any
election under paragraph (b)(6) of this section (concerning the 10-
percent method) or under §1.460-5(c) (concerning the simplified
cost-to-cost method) that the taxpayer has made for regular tax
purposes. For exempt construction contracts described in
§1.460-3(b)(1)(ii), a taxpayer must use the simplified cost-to-
cost method to determine the completion factor for AMTI purposes.
Except as provided in paragraph (f)(2) of this section, a taxpayer
must use AMTI costs and AMTI methods, such as the depreciation
method described in section 56(a)(1), to determine the completion
factor of a long-term contract (except a home construction contract)
for AMTI purposes.
(2) Election to use regular completion factors. Under this paragraph
(f)(2), a taxpayer may elect for AMTI purposes to determine the
completion factors of all of its long-term contracts using the
methods of accounting and allocable contract costs used for regular
federal income tax purposes. A taxpayer makes this election by using
regular methods and regular costs to compute the completion factors
of all long-term contracts entered into during the taxable year of
the election for AMTI purposes on its original federal income tax
return for the election year. This election is a method of
accounting and, thus, applies to all long-term contracts entered
into during and after the taxable year of the election. Although a
taxpayer may elect to compute the completion factor of its long-term
contracts using regular methods and regular costs, an election under
this paragraph (f)(2) does not eliminate a taxpayer's obligation to
comply with the requirements of section 55 when computing AMTI. For
example, although a taxpayer may elect to use the depreciation
methods used for regular tax purposes to compute the completion
factor of its long-term contracts for AMTI purposes, the taxpayer
must use the depreciation methods permitted by section 56 to compute
AMTI.
(g) Method of accounting. A taxpayer that uses the PCM, EPCM, CCM,
or PCCM, or elects the 10-percent method or special AMTI method (or
changes to another method of accounting with the Commissioner's
consent) must apply the method(s) consistently for all similarly
classified long-term contracts, until the taxpayer obtains the
Commissioner's consent under section 446(e) to change to another
method of accounting. A taxpayer-initiated change in method of
accounting will be permitted only on a cut-off basis (i.e., for
contracts entered into on or after the year of change), and thus, a
section 481(a) adjustment will not be permitted or required.
(h) Examples. The following examples illustrate the rules of this
section: Example 1. PCM--estimating total contract price. C, whose
taxable year ends December 31, determines the income from long-term
contracts using the PCM. On January 1, 2001, C enters into a
contract to design and manufacture a satellite (a unique item). The
contract provides that C will be paid $10,000,000 for delivering the
completed satellite by December 1, 2002. The contract also provides
that C will receive a $3,000,000 bonus for delivering the satellite
by July 1, 2002, and an additional $4,000,000 bonus if the satellite
successfully performs its mission for five years. C is unable to
reasonably predict if the satellite will successfully perform its
mission for five years. If on December 31, 2001, C should reasonably
expect to deliver the satellite by July 1, 2002, the estimated total
contract price is $13,000,000 ($10,000,000 unit price + $3,000,000
production-related bonus). Otherwise, the estimated total contract
price is $10,000,000. In either event, the $4,000,000 bonus is not
includible in the estimated total contract price as of December 31,
2001, because C is unable to reasonably predict that the satellite
will successfully perform its mission for five years.
Example 2. PCM--computing income.
(i) C, whose taxable year ends December 31, determines the income
from long-term contracts using the PCM. During 2001, C agrees to
manufacture for the customer, B, a unique item for a total contract
price of $1,000,000. Under C's contract, B is entitled to retain 10
percent of the total contract price until it accepts the item. By
the end of 2001, C has incurred $200,000 of allocable contract costs
and estimates that the total allocable contract costs will be
$800,000. By the end of 2002, C has incurred $600,000 of allocable
contract costs and estimates that the total allocable contract costs
will be $900,000. In 2003, after completing the contract, C
determines that the actual cost to manufacture the item was
$750,000.
(ii) For each of the taxable years, C's income from the contract is
computed as follows:
Taxable Year
2001 2002 2003
(A) Cumulative incurred costs $200,000 $600,000 $750,000
(B) Estimated total costs 800,000 900,000 750,000
(C) Completion facto (A)÷(B) 25.00% 66.67% 100.00%
(D) Total contract price 1,000,000 1,000,000 1,000,000
(E) Cumulative gross receipts: 250,000 666,667 1,000,000
(C) x (D)
(F) Cumulative gross receipts
(prior year): (0) (250,000) (666,667)
(G) Current-year gross receipts 250,000 416,667 333,333
(H) Cumulative incurred costs 200,000 600,000 750,000
(I) Cumulative incurred costs
(prior year): (0) (200,000) (600,000)
(J) Current-year costs 200,000 400,000 150,000
(K) Gross income: (G) - (J) $50,000 $16,667 $183,333
Example 3. PCM--computing income with cost sharing.
(i) C, whose taxable year ends December 31, determines the income
from long-term contracts using the PCM. During 2001, C enters into a
contract to manufacture a unique item. The contract specifies a
target price of $1,000,000, a target cost of $600,000, and a target
profit of $400,000. C and B will share the savings of any cost
underrun (actual total incurred cost is less than target cost) and
the additional cost of any cost overrun (actual total incurred cost
is greater than target cost) as follows: 30 percent to C and 70
percent to B. By the end of 2001, C has incurred $200,000 of
allocable contract costs and estimates that the total allocable
contract costs will be $600,000. By the end of 2002, C has incurred
$300,000 of allocable contract costs and estimates that the total
allocable contract costs will be $400,000. In 2003, after completing
the contract, C determines that the actual cost to manufacture the
item was $700,000.
(ii) For each of the taxable years, C's income from the contract is
computed as follows (note that the sharing of any cost underrun or
cost overrun is reflected as an adjustment to C's target price under
paragraph (b)(4)(i) of this section): Taxable Year
2001 2002 2003
(A) Cumulative incurred costs $200,000 $300,000 $700,000
(B) Estimated total costs 600,000 400,000 700,000
(C) Completion factor: (B) 33.33% 75.00% 100.00%
(A)÷
(D) Target price $1,000,000 $1,000,000 $1,000,000
(E) Estimated total costs 600,000 400,000 700,000
(F) Target costs 600,000 600,000 600,000
(G) Cost (underrun)/overrun:
(E) - (F) 0 (200,000) 100,000
(H) Adjustment rate 70% 70% 70%
(I) Target price adjustment 0 (140,000) 70,000
(J) Total contract price: $1,000,000 $860,000 $1,070,000
(D)+(I)
(K) Cumulative gross receipts:
(C) x (J) $ 333,333 $645,000 $1,070,000
(L) Cumulative gross receipts
(prior year): (0) (333,333) (645,000)
(M) Current-year gross receipt 333,333 311,667 425,000
(N) Cumulative incurred costs 200,000 300,000 700,000
(O) Cumulative incurred costs
(prior year): (0) (200,000) (300,000)
(P) Current-year costs 200,000 100,000 400,000
(Q) Gross income: (M)-(P) $133,333 $211,667 $25,000
Example 4. PCM--10 percent method.
(i) C, whose taxable year ends
December 31, determines the income from long-term contracts using
the PCM. In November 2001, C agrees to manufacture a unique item for
$1,000,000. C reasonably estimates that the total allocable contract
costs will be $600,000. By December 31, 2001, C has received $50,000
in progress payments and incurred $40,000 of costs. C elects to use
the 10 percent method effective for 2001 and all subsequent taxable
years. During 2002, C receives $500,000 in progress payments and
incurs $260,000 of costs. In 2003, C incurs an additional $300,000
of costs, C finishes manufacturing the item, and receives the final
$450,000 payment.
(ii) For each of the taxable years, C's income from the contract is
computed as follows:
Taxable Year
2001 2002 2003
(A) Cumulative incurred costs $40,000 $ 300,000 $600,000
(B) Estimated total costs 600,000 600,000 600,000
(C) Completion factor (B) 6.67% 50.00% 100.00%
(A)÷
(D) Total contract price 1,000,000 1,000,000 1,000,000
(E) Cumulative gross receipts: 0 500,000 1,000,000
(C)x(D) *
(F) Cumulative gross receipts
(prior year): (0) (0) (500,000)
(G) Current-year gross receipts 0 500,000 500,000
(H) Cumulative incurred costs 0 300,000 600,000
(I) Cumulative incurred costs
(prior year): (0) (0) (300,000)
(J) Current-year costs 0 300,000 300,000
(K) Gross income: (G) - (J) $0 $200,000 $200,000
* Unless (C) < 10 percent.
Example 5. PCM-contract terminated. C, whose taxable year ends
December 31, determines the income from long-term contracts using
the PCM. During 2001, C buys land and begins constructing a building
that will contain 50 condominium units on that land. C enters into a
contract to sell one unit in this condominium to B for $240,000. B
gives C a $5,000 deposit toward the purchase price. By the end of
2001, C has incurred $50,000 of allocable contract costs on B's unit
and estimates that the total allocable contract costs on B's unit
will be $150,000. Thus, for 2001, C reports gross receipts of
$80,000 ($50,000 ÷ $150,000 x $240,000), current-year costs
of $50,000, and gross income of $30,000 ($80,000 - $50,000). In
2002, after C has incurred an additional $25,000 of allocable
contract costs on B's unit, B files for bankruptcy protection and
defaults on the contract with C, who is permitted to keep B's $5,000
deposit as liquidated damages. In 2002, C reverses the transaction
with B under paragraph (b)(7) of this section and reports a loss of
$30,000 ($50,000 -$ 80,000). In addition, C obtains an adjusted
basis in the unit sold to B of $70,000 ($50,000 (current-year costs
deducted in 2001) - $5,000 (B's forfeited deposit) + $25,000
(current-year costs incurred in 2002). C may not apply the look-back
method to this contract in 2002.
Example 6. CCM-contracts with disputes from customer claims. In
2001, C, whose taxable year ends December 31, uses the CCM to
account for exempt construction contracts. C enters into a contract
to construct a bridge for B. The terms of the contract provide for a
$1,000,000 gross contract price. C finishes the bridge in 2002 at a
cost of $950,000. When B examines the bridge, B insists that C
either repaint several girders or reduce the contract price. The
amount reasonably in dispute is $10,000. In 2003, C and B resolve
their dispute, C repaints the girders at a cost of $6,000, and C and
B agree that the contract price is not to be reduced. Because C is
assured a profit of $40,000 ($1,000,000 - $10,000 - $950,000) in
2002 even if the dispute is resolved in B's favor, C must take this
$40,000 into account in 2002. In 2003, C will earn an additional
$4,000 profit ($1,000,000 - $956,000 - $40,000) from the contract
with B. Thus, C must take into account an additional $10,000 of
gross contract price and $6,000 of additional contract costs in
2003.
Example 7. CCM-contracts with disputes from taxpayer claims. In
2003, C, whose taxable year ends December 31, uses the CCM to
account for exempt construction contracts. C enters into a contract
to construct a building for B. The terms of the contract provide for
a $1,000,000 gross contract price. C finishes the building in 2004
at a cost of $1,005,000. B examines the building in 2004 and agrees
that it meets the contract's specifications; however, at the end of
2004, C and B are unable to agree on the merits of C's claim for an
additional $10,000 for items that C alleges are changes in contract
specifications and B alleges are within the scope of the contract's
original specifications. In 2005, B agrees to pay C an additional
$2,000 to satisfy C's claims under the contract. Because the amount
in dispute affects so much of the gross contract price that C cannot
determine in 2004 whether a profit or loss will ultimately be
realized, C may not taken any of the gross contract price or
allocable contract costs into account in 2004. C must take into
account $1,002,000 of gross contract price and $1,005,000 of
allocable contract costs in 2005.
Example 8. CCM-contracts with disputes from taxpayer and customer
claims. C, whose taxable year ends December 31, uses the CCM to
account for exempt construction contracts. C constructs a factory
for B pursuant to a long-term contract. Under the terms of the
contract, B agrees to pay C a total of $1,000,000 for construction
of the factory. C finishes construction of the factory in 2002 at a
cost of $1,020,000. When B takes possession of the factory and
begins operations in December 2002, B is dissatisfied with the
location and workmanship of certain heating ducts. As of the end of
2002, C contends that the heating ducts are constructed in
accordance with contract specifications. The amount of the gross
contract price reasonably in dispute with respect to the heating
ducts is $6,000. As of this time, C is claiming $14,000 in addition
to the original contract price for certain changes in contract
specifications which C alleges have increased his costs. B denies
that these changes have increased C's costs. In 2003, the disputes
between C and B are resolved by performance of additional work by C
at a cost of $1,000 and by an agreement that the contract price
would be revised downward to $996,000. Under these circumstances, C
must include in his gross income for 2002, $994,000 (the gross
contract price less the amount reasonably in dispute because of B's
claim, or $1,000,000 - $6,000). In 2002, C must also take into
account $1,000,000 of allocable contract costs (costs incurred less
the amounts in dispute attributable to both B's and C's claims, or
$1,020,000 -$6,000 - $14,000). In 2003, C must take into account an
additional $2,000 of gross contract price ($996,000 - $994,000) and
$21,000 of allocable contract costs ($1,021,000 - $1,000,000).
(i) [Reserved]
* * * * *
(k) Mid-contract change in taxpayer. [Reserved]
Par. 8. Section 1.460-5 is added to read as follows: §1.460-5
Cost allocation rules.
(a) Overview. This section prescribes methods of allocating costs to
long-term contracts accounted for using the percentage-of-completion
method described in §1.460-4(b) (PCM), the completed-contract
method described in §1.460-4(d) (CCM), or the percentage-of-
completion/capitalized-cost method described in §1.460-4(e)
(PCCM). Exempt construction contracts described in §1.460-3(b)
accounted for using a method other than the PCM or CCM are not
subject to the cost allocation rules of this section (other than the
requirement to allocate production-period interest under paragraph
(b)(2)(v) of this section). Paragraph (b) of this section describes
the regular cost allocation methods for contracts subject to the
PCM. Paragraph (c) of this section describes an elective simplified
cost allocation method for contracts subject to the PCM. Paragraph
(d) of this section describes the cost allocation methods for exempt
construction contracts reported using the CCM. Paragraph (e) of this
section describes the cost allocation rules for contracts subject to
the PCCM. Paragraph (f) of this section describes additional rules
applicable to the cost allocation methods described in this section.
Paragraph (g) of this section provides rules concerning consistency
in method of allocating costs to long-term contracts.
(b) Cost allocation method for contracts subject to PCM--
(1) In general. Except as otherwise provided in paragraph (b)(2) of
this section, a taxpayer must allocate costs to each long-term
contract subject to the PCM in the same manner that direct and
indirect costs are capitalized to property produced by a taxpayer
under §1.263A-1(e) through (h). Thus, a taxpayer must allocate
to each long-term contract subject to the PCM all direct costs and
certain indirect costs properly allocable to the long-term contract
(i.e., all costs that directly benefit or are incurred by reason of
the performance of the long-term contract). However, see paragraph
(c) of this section concerning an election to allocate contract
costs using the simplified cost-to-cost method. As in section 263A,
the use of the practical capacity concept is not permitted. See
§1.263A-2( a)(4).
(2) Special rules--
(i) Direct material costs. The costs of direct materials must be
allocated to a long-term contract when dedicated to the contract
under principles similar to those in §1.263A-11(b)(2). Thus, a
taxpayer dedicates direct materials by associating them with a
specific contract, including by purchase order, entry on books and
records, or shipping instructions. A taxpayer maintaining
inventories under §1.471-1 must determine allocable contract
costs attributable to direct materials using its method of
accounting for those inventories (e.g., FIFO, LIFO, specific
identification). (ii) Components and subassemblies. The costs of a
component or subassembly (component) produced by the taxpayer must
be allocated to a long-term contract as the taxpayer incurs costs to
produce the component if the taxpayer reasonably expects to
incorporate the component into the subject matter of the contract.
Similarly, the cost of a purchased component (including a component
purchased from a related party) must be allocated to a long-term
contract as the taxpayer incurs the cost to purchase the component
if the taxpayer reasonably expects to incorporate the component into
the subject matter of the contract. In all other cases, the cost of
a component must be allocated to a long-term contract when the
component is dedicated, under principles similar to those in
§1.263A-11(b)(2). A taxpayer maintaining inventories under
§1.471- 1 must determine allocable contract costs attributable
to components using its method of accounting for those inventories
(e.g., FIFO, LIFO, specific identification).
(iii) Simplified production methods. A taxpayer may not determine
allocable contract costs using the simplified production methods
described in §1.263A-2(b) and (c).
(iv) Costs identified under cost-plus long-term contracts and
federal long-term contracts. To the extent not otherwise allocated
to the contract under this paragraph (b), a taxpayer must allocate
any identified costs to a cost-plus long-term contract or federal
long-term contract (as defined in section 460(d)). Identified cost
means any cost, including a charge representing the time-value of
money, identified by the taxpayer or related person as being
attributable to the taxpayer's cost-plus long-term contract or
federal long-term contract under the terms of the contract itself or
under federal, state, or local law or regulation.
(v) Interest--(A) In general. If property produced under a long-term
contract is designated property, as defined in §1.263A-8(b)
(without regard to the exclusion for long-term contracts under
§1.263A-8(d)(2)(v)), a taxpayer must allocate interest incurred
during the production period to the long-term contract in the same
manner as interest is allocated to property produced by a taxpayer
under section 263A(f). See §§1.263A-8 to 1.263A-12
generally.
(b) Production period. Notwithstanding §1.263A-12(c) and (d),
for purposes of this paragraph (b)(2)(v), the production period of a
long-term contract--
(1) Begins on the later of--
(i) The contract commencement date, as defined in §1.460-1(b)
(7); or
(ii) For a taxpayer using the accrual method of accounting for long-
term contracts, the date by which 5 percent or more of the total
estimated costs, including design and planning costs, under the
contract have been incurred; and
(2) Ends on the date that the contract is completed, as defined in
§1.460-1(c)(3).
(c) Application of section 263A(f). For purposes of this paragraph
(b)(2)(v), section 263A(f)(1)(B)(iii) (regarding an estimated
production period exceeding 1 year and a cost exceeding $1,000,000)
must be applied on a contract-by-contract basis; except that, in the
case of a taxpayer using an accrual method of accounting, that
section must be applied on a property-by-property basis. (vi)
Research and experimental expenses. Notwithstanding §1.263A-1(
e)(3)(ii)(P) and (iii)(B), a taxpayer must allocate research and
experimental expenses, other than independent research and
development expenses (as defined in §1.460- 1(b)(9)), to its
long-term contracts.
(vii) Service costs--(A) Simplified service cost method--
(1) In general. To use the simplified service cost method under
§1.263A-1(h), a taxpayer must allocate the otherwise
capitalizable mixed service costs among its long-term contracts
using a reasonable method. For example, otherwise capitalizable
mixed service costs may be allocated to each long-term contract
based on labor hours or contract costs allocable to the contract. To
be considered reasonable, an allocation method must be applied
consistently and must not disproportionately allocate service costs
to contracts expected to be completed in the near future.
(2) Example. The following example illustrates the rule of this
paragraph (b)(2)(vii)(A):
Example. Simplified service cost method. During 2001, C, whose
taxable year ends December 31, produces electronic equipment for
inventory and enters into long-term contracts to manufacture
specialized electronic equipment. C's method of allocating mixed
service costs to the property it produces is the labor-based,
simplified service cost method described in §1.263A-1(h)(4).
For 2001, C's total mixed service costs are $100,000, C's section
263A labor costs are $500,000, C's section 460 labor costs (i.e.,
labor costs allocable to C's long-term contracts) are $250,000, and
C's total labor costs are $1,000,000. To determine the amount of
mixed service costs capitalizable under section 263A for 2001, C
multiplies its total mixed service costs by its section 263A
allocation ratio (section 263A labor costs ÷ total labor
costs). Thus, C's capitalizable mixed service costs for 2001 are
$50,000 ($100,000 x $500,000 ÷ $1,000,000). Thereafter, C
allocates its capitalizable mixed service costs to produced property
remaining in ending inventory using its 263A allocation method
(e.g., burden rate, simplified production). Similarly, to determine
the amount of mixed service costs that are allocable to C's long-
term contracts for 2001, C multiplies its total mixed service costs
by its section 460 allocation ratio (section 460 labor ÷
total labor costs). Thus, C's allocable mixed service contract costs
for 2001 are $25,000 ($100,000 x $250,000 ÷ $1,000,000).
Thereafter, C allocates its allocable mixed service costs to its
long-term contracts proportionately based on its section 460 labor
costs allocable to each long-term contract.
(b) Jobsite costs. If an administrative, service, or support
function is performed solely at the jobsite for a specific long-term
contract, the taxpayer may allocate all the direct and indirect
costs of that administrative, service, or support function to that
long-term contract. Similarly, if an administrative, service, or
support function is performed at the jobsite solely for the
taxpayer's long-term contract activities, the taxpayer may allocate
all the direct and indirect costs of that administrative, service,
or support function among all the long-term contracts performed at
that jobsite. For this purpose, jobsite means a production plant or
a construction site.
(c) Limitation on other reasonable cost allocation methods. A
taxpayer may use any other reasonable method of allocating service
costs, as provided in §1.263A-1( f)(4), if, for the taxpayer's
long-term contracts considered as a whole, the--
(1) Total amount of service costs allocated to the contracts does
not differ significantly from the total amount of service costs that
would have been allocated to the contracts under §1.263A-1(f)
(2) or (3);
(2) Service costs are not allocated disproportionately to contracts
expected to be completed in the near future because of the
taxpayer's cost allocation method; and
(3) Taxpayer's cost allocation method is applied consistently.
(c) Simplified cost-to-cost method for contracts subject to the
PCM--(1) In general. Instead of using the cost allocation method
prescribed in paragraph (b) of this section, a taxpayer may elect to
use the simplified cost-to-cost method, which is authorized under
section 460(b)(3)(A), to allocate costs to a long-term contract
subject to the PCM. Under the simplified cost-to-cost method, a
taxpayer determines a contract's completion factor based upon only
direct material costs; direct labor costs; and depreciation,
amortization, and cost recovery allowances on equipment and
facilities directly used to manufacture or construct the subject
matter of the contract. For this purpose, the costs associated with
any manufacturing or construction activities performed by a
subcontractor are considered either direct material or direct labor
costs, as appropriate, and therefore must be allocated to the
contract under the simplified cost-to-cost method. An electing
taxpayer must use the simplified cost-to-cost method to apply the
look-back method under §1.460-6 and to determine alternative
minimum taxable income under §1.460-4(f).
(2) Election. A taxpayer makes an election under this paragraph (c)
by using the simplified cost-to-cost method for all long-term
contracts entered into during the taxable year of the election on
its original federal income tax return for the election year. This
election is a method of accounting and, thus, applies to all long-
term contracts entered into during and after the taxable year of the
election. This election is not available if a taxpayer does not use
the PCM to account for all long-term contracts or if a taxpayer
elects to use the 10-percent method described in §1.460-4(b)
(6).
(d) Cost allocation rules for exempt construction contracts reported
using the CCM--
(1) In general. For exempt construction contracts reported using the
CCM, other than contracts described in paragraph (d)(3) of this
section (concerning contracts of homebuilders that do not satisfy
the $10,000,000 gross receipts test described in §1.460-3(b)(3)
or will not be completed within two years of the contract
commencement date), a taxpayer must annually allocate the cost of
any activity that is incident to or necessary for the taxpayer's
performance under a long-term contract. A taxpayer must allocate to
each exempt construction contract all direct costs as defined in
§1.263A-1( e)(2)(i) and all indirect costs either as provided
in §1.263A-1(e)(3) or as provided in paragraph (d)(2) of this
section.
(2) Indirect costs--
(i) Indirect costs allocable to exempt construction contracts. A
taxpayer allocating costs under this paragraph (d)(2) must allocate
the following costs to an exempt construction contract, other than a
contract described in paragraph (d)(3) of this section, to the
extent incurred in the performance of that contract--
(A) Repair of equipment or facilities;
(B) Maintenance of equipment or facilities;
(C) Utilities, such as heat, light, and power, allocable to
equipment or facilities;
(D) Rent of equipment or facilities;
(E) Indirect labor and contract supervisory wages, including basic
compensation, overtime pay, vacation and holiday pay, sick leave pay
(other than payments pursuant to a wage continuation plan under
section 105(d) as it existed prior to its repeal in 1983), shift
differential, payroll taxes, and contributions to a supplemental
unemployment benefits plan;
(F) Indirect materials and supplies;
(G) Noncapitalized tools and equipment;
(H) Quality control and inspection;
(I) Taxes otherwise allowable as a deduction under section 164,
other than state, local, and foreign income taxes, to the extent
attributable to labor, materials, supplies, equipment, or
facilities;
(J) Depreciation, amortization, and cost-recovery allowances
reported for the taxable year for financial purposes on equipment
and facilities to the extent allowable as deductions under chapter 1
of the Internal Revenue Code;
(K) Cost depletion;
(L) Administrative costs other than the cost of selling or any
return on capital;
(M) Compensation paid to officers other than for incidental or
occasional services;
(N) Insurance, such as liability insurance on machinery and
equipment; and
(O) Interest, as required under paragraph (b)(2)(v) of this section.
(ii) Indirect costs not allocable to exempt construction contracts.
A taxpayer allocating costs under this paragraph (d)(2) is not
required to allocate the following costs to an exempt construction
contract reported using the CCM--
(A) Marketing and selling expenses, including bidding expenses;
(B) Advertising expenses;
(C) Other distribution expenses;
(D) General and administrative expenses attributable to the
performance of services that benefit the taxpayer's activities as a
whole (e.g., payroll expenses, legal and accounting expenses);
(E) Research and experimental expenses (described in section 174 and
the regulations thereunder);
(F) Losses under section 165 and the regulations thereunder;
(G) Percentage of depletion in excess of cost depletion;
(H) Depreciation, amortization, and cost recovery allowances on
equipment and facilities that have been placed in service but are
temporarily idle (for this purpose, an asset is not considered to be
temporarily idle on non-working days, and an asset used in
construction is considered to be idle when it is neither en route to
nor located at a job-site), and depreciation, amortization and cost
recovery allowances under chapter 1 of the Internal Revenue Code in
excess of depreciation, amortization, and cost recovery allowances
reported by the taxpayer in the taxpayer's financial reports;
(I) Income taxes attributable to income received from long-term
contracts;
(J) Contributions paid to or under a stock bonus, pension, profit-
sharing, or annuity plan or other plan deferring the receipt of
compensation whether or not the plan qualifies under section 401(a),
and other employee benefit expenses paid or accrued on behalf of
labor, to the extent the contributions or expenses are otherwise
allowable as deductions under chapter 1 of the Internal Revenue
Code. Other employee benefit expenses include (but are not limited
to): worker's compensation; amounts deductible or for whose payment
reduction in earnings and profits is allowed under section 404A and
the regulations thereunder; payments pursuant to a wage continuation
plan under section 105(d) as it existed prior to its repeal in 1983;
amounts includible in the gross income of employees under a method
or arrangement of employer contributions or compensation which has
the effect of a stock bonus, pension, profit-sharing, or annuity
plan, or other plan deferring the receipt of compensation or
providing deferred benefits; premiums on life and health insurance;
and miscellaneous benefits provided for employees such as safety,
medical treatment, recreational and eating facilities, membership
dues, etc.;
(K) Cost attributable to strikes, rework labor, scrap and spoilage;
and
(L) Compensation paid to officers attributable to the performance of
services that benefit the taxpayer's activities as a whole.
(3) Large homebuilders. A taxpayer must capitalize the costs of home
construction contracts under section 263A and the regulations
thereunder, unless the contract will be completed within two years
of the contract commencement date and the taxpayer satisfies the
$10,000,000 gross receipts test described in §1.460-3(b)(3).
(e) Cost allocation rules for contracts subject to the PCCM. A
taxpayer must use the cost allocation rules described in paragraph
(b) of this section to determine the costs allocable to the entire
qualified ship contract or residential construction contract
accounted for using the PCCM and may not use the simplified cost-to-
cost method described in paragraph (c) of this section.
(f) Special rules applicable to costs allocated under this
section--(1) Nondeductible costs. A taxpayer may not allocate any
otherwise allocable contract cost to a long-term contract if any
section of the Internal Revenue Code disallows a deduction for that
type of payment or expenditure (e.g., an illegal bribe described in
section 162(c)).
(2) Costs incurred for non-long-term contract activities. If a
taxpayer performs a non-long-term contract activity, as defined in
§1.460-1(d)(2), that is incident to or necessary for the
manufacture, building, installation, or construction of the subject
matter of one or more of the taxpayer's long-term contracts, the
taxpayer must allocate the costs attributable to that activity to
such contract(s).
(g) Method of accounting. A taxpayer that adopts or elects a cost
allocation method of accounting (or changes to another cost
allocation method of accounting with the Commissioner's consent)
must apply that method consistently for all similarly classified
contracts, until the taxpayer obtains the Commissioner's consent
under section 446(e) to change to another cost allocation method. A
taxpayer-initiated change in cost allocation method will be
permitted only on a cut-off basis (i.e., for contracts entered into
on or after the year of change, and thus, a section 481(a)
adjustment will not be permitted or required.
Par. 9. Section 1.460-6 is amended as follows:
1. A sentence is added to the end of paragraph (a)(2).
2. The third sentence of paragraph (b)(1) is removed.
3. In the fourth sentence of paragraph (b)(1), "Therefore, to the
extent that the percentage of completion method is required to be
used" is removed and "To the extent that the percentage of
completion method is required to be used under § 1.460-1(g)" is
added in its place.
4. The first sentence of paragraph (c)(1)(ii)(A) is revised.
5. In the first sentence of paragraph (c)(1)(ii)(B), the language
"no later than the year" is removed and "in the year" is added in
its place and "§1.451-3(b)(2)" is removed and "§1.460-1(c)
(3)" is added in its place.
6. The last two sentences of paragraph (c)(1)(ii)(B) are removed.
7. In the last sentence of paragraph (c)(1)(ii)(C)(2), the language
"§5h.6" is removed and "§301.9100-8 of this chapter" is
added in its place.
8. In the fourth sentence of paragraph (c)(2)(v)(A), the language
"similarly" is removed.
9. The first, second, fifth, and sixth sentences of paragraph (c)(2)
(v)(A) are removed.
10. In the first sentence of paragraph (c)(2)(vi)(B), the language
"§1.451- 3(b)(2)(ii), (iii), (iv), and §1.451-3(d)(2),
(3), and (4)" is removed and "§1.460-4(b)(4)(i)" is added in
its place.
11. In the second sentence of paragraph (c)(2)(vi)(B), the language
"the percentage of completion method and" is removed.
12. In the third sentence of paragraph (c)(2)(vi)(B), the language
", for purposes of both the percentage of completion method and the
look-back method" is removed.
13. In the fourth sentence of paragraph (c)(2)(vi)(B), the language
"Similarly, a" is removed and "A" is added in its place.
14. In the first sentence of paragraph (c)(2)(vi)(C), the language
"§1.451-3(e)" is removed and "§1.460-1(e)" is added in its
place.
15. Paragraph (c)(4)(iv) is removed.
16. In the first sentence of paragraph (d)(4)(ii)(C), the language "
within the meaning of section 1504(a)" is removed and ", as defined
in § 1.1502-1(h)" is added in its place.
17. In the fourth sentence of paragraph (e)(2), the language "within
the meaning of section 1504(a)" is removed and ", as defined in
§1.1502-1(h)" is added in its place.
18. In the first sentence of paragraph (f)(1), the language "or to
be refunded" is removed and "from, or payable to, a taxpayer" is
added in its place.
19. In the first sentence of paragraph (f)(1), the language "and
reported" is removed.
20. In the second sentence of paragraph (f)(1), the language "and
Form 8697 is filed by" is removed.
21. In the second sentence of paragraph (f)(2)(i), the language
"fails to file Form 8697 with respect to interest required to be
paid or that" is removed.
22. In the second sentence of paragraph (f)(2)(i), the language "a
penalty for failing to file Form 8697" is removed and "an
underpayment penalty under section 6651, and the taxpayer also is
liable for underpayment interest under section 6601" is added in its
place.
23. In the third sentence of paragraph (f)(2)(i), the language
"penalty" is removed and "subtitle F" is added in its place.
24. In the fourth sentence of paragraph (f)(2)(i), the language "or
a tax refund" is added after "liability".
25. In the first sentence of paragraph (f)(2)(ii), the language
"refunded" is removed and "payable" is added in its place.
26. Paragraph (f)(3) is added. The revisions and additions read as
follows: §1.460-6 Look-back method.
(a) * * *
(2) * * * Paragraph (j) of this section provides guidance concerning
the election not to apply the look-back method in de minimis cases.
* * * * *
(c) * * *(1) * * *
(ii) * * *(A) In general. Except as otherwise provided in section
460(b)(6) (see §1.460-6(j) for method of electing) or
§1.460-6(e), a taxpayer must apply the look-back method to a
long-term contract in the completion year and in any post-completion
year for which the taxpayer must adjust total contract price or
total allocable contract costs, or both, under the PCM. * * *
* * * * *
(f) * * *
(3) Statute of limitations and compounding of interest on look-back
interest. For guidance on the statute of limitations applicable to
the assessment and collection of look-back interest owed by a
taxpayer, see sections 6501 and 6502. A taxpayer's claim for credit
or refund of look-back interest previously paid by or collected from
a taxpayer is a claim for credit or refund of an overpayment of tax
and is subject to the statute of limitations provided in section
6511. A taxpayer's claim for look-back interest (or interest payable
on look-back interest) that is not attributable to an amount
previously paid by or collected from a taxpayer is a general, non-
tax claim against the federal government. For guidance on the
statute of limitations that applies to general, non-tax claims
against the federal government, see 28 U.S.C. sections 2401 and
2501. For guidance applicable to the compounding of interest when
the look-back interest is not paid, see sections 6601 to 6622.
* * * * *
§§1.460-7 and 1.460-8 [Removed ]
Par. 10. Sections 1.460-7 and 1.460-8 are removed.
§1.471-10 [Amended ]
Par. 11. Section 1.471-10 is amended by removing the language
"§1.451-3" and adding "§1.460-2" in its place.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 12. The authority citation for part 602 continues to read as
follows: Authority: 26 U.S.C. 7805.
Par. 14. In §602.101, paragraph (b) is amended by:
1. Removing the entry for "1.451-3"..2. The following entries are
added in numerical order to the table to read as follows:
§602.101 OMB Control numbers.
* * * * *
(b) * * *
CFR part or section where Current OMB identified and described
control No.
* * * * *
1.460-1............................................1545-1650
* * * * *
Deputy Commissioner of Internal Revenue
Approved:
Acting Assistant Secretary of the Treasury
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