Long Term Construction Contracts
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OVERVIEW ————
Taxpayers generally must account for income, deductions, and other items arising from long-term contracts under the percentage of completion method. A "long-term contract" is any building, installation, construction, or manufacturing contract that is not completed in the same taxable year as the contract was entered into. Thus, contracts for, e.g., services, are not "long-term contracts" regardless of how long the services are to be provided.
The percentage of completion method measures annual revenue based on a fraction: the numerator is the percentage of costs incurred through the end of the taxable year and the denominator is the total costs the taxpayer expects to incur during the life of the contract. This fraction is multiplied by the total revenue to be received over the life of the contract. The result is then decreased by the total contract revenue required to be recognized in previous taxable years. Contract costs, under the percentage of completion method, are taken into account in the taxable year that they are incurred, regardless of the taxpayer's overall method of accounting.
When a long-term contract is completed, a "look-back" rule requires the taxpayer to recompute the amount of tax that would have been payable during each year of the contract, based on the actual total contract revenue and costs. If the actual liability would have been greater, the taxpayer must pay interest based on the deemed underpayment. Conversely, if the actual liability would have been less, the taxpayer is entitled to interest from the government on the deemed overpayment.
Exceptions to the above rules are available for "home construction contracts," certain contracts of "small contractors" (generally, contractors having average annual gross receipts of $10 million or less for the 3 preceding taxable years), and contracts entered into before certain dates. These exceptions, and the rules governing them, are also discussed in this paragraph.
———— EXPLANATION ————
¶3610.01
General Principles
¶3610.01.A. Qualifying Contracts
In general, a long-term contract is a building, installation, construction, or manufacturing contract that is not completed in the same taxable year in which it is entered into. 1 Thus, a contract which is commenced by a calendar year taxpayer in October of one year and is finished in March of the following year is a long-term contract, if it is a building, installation, construction, or manufacturing contract.
/Footnote/ 1 §460(f)(1). See Regs. §1.451-3(b).
There is considerable authority with respect to what constitutes a building, installation or construction contract. Generally, the taxpayer is required to actually construct or build something. 2 Thus, the following types of contracts do not qualify as building, installation or construction contracts:
• contracts for architectural, engineering or construction management services; 3
• contracts for the sale of land, minerals or timber; 4
• contracts of a painting contractor for painting services; 5
• contracts for animal breeding; 6
• contracts including "installation" of computer software systems. 7
/Footnote/ 2 See generally Regs. §1.451-3(b)(3)(ii), which discusses the meaning of "construction contract."
/Footnote/ 3 Rev. Rul. 70-67, 1970-1 C.B. 117; Rev. Rul. 80-18, 1980-1 C.B. 103; Rev. Rul. 82-134, 1982-2 C.B. 88.
/Footnote/ 4 Wood v. Comr., 245 F.2d 888 (5th Cir. 1957); Ayrton Metal Co. v. Comr., 34 T.C. 464 (1960); Lakeside Petroleum Co. v. U.S., 1 F. Supp. 31 (D.C. Ill. 1932); Deer Island Logging Co. v. Comr., 14 B.T.A. 1027 (1929); C.H. Swift & Sons v. Comr., 13 B.T.A. 138 (1928).
/Footnote/ 5 Rev. Rul. 84-32, 1984-1 C.B. 129.
/Footnote/ 6 B.F. Whitaker Estate v. Comr., 259 F.2d 379 (5th Cir. 1958).
/Footnote/ 7 PLR 8545007.
Manufacturing contracts eligible for long-term contract accounting treatment must pass additional tests. A manufacturing contract that is not completed in the same taxable year it is commenced will qualify only if it meets one of two criteria:
(1) It is for the manufacture of "unique" items of a type not usually carried in the taxpayer's finished goods inventory; or,
(2) The items being manufactured "normally" require more than 12 calendar months to complete. 8
Thus, a contract that commences in one taxable year and is completed in a following taxable year for manufacture of custom-designed equipment will meet the "unique item" test and qualify as a long-term contract regardless of whether the time required to manufacture the equipment is more or less than 12 months. 9 Similarly, a contract that commences in one taxable year and is completed in a following taxable year for manufacture of equipment and that actually takes less than 12 months to construct will qualify as a long-term contract if it normally takes more than 12 months to construct, regardless of whether the equipment is unique. On the other hand, a contract involving the manufacture of numerous common items that require only a short period of time to construct (for example, 15,000 folding chairs that can be manufactured in three days each) is not a long-term contract regardless of the fact that the entire contract may require more than one year to complete. 10
/Footnote/ 8 Regs. §1.451-3(b)(1)(ii).
/Footnote/ 9 In Sierracin Corp. v. Comr., 90 T.C. 341 (1988), the Tax Court held that the degree to which products are custom designed is of special importance in determining whether they are unique. The category is not limited to unusual, notable or one-of-a-kind items. In its recommendation for acquiescence to Sierracin (AOD 1990-16), the Chief Counsel's Office stated that no single characteristic is determinative in analyzing whether an item is unique and noted several characteristics of unique items.
/Footnote/ 10 See Regs. §1.451-3(b)(1)(ii).
Note: The IRS has attempted to advance a theory that specific contractual obligations that would not qualify for long-term contract treatment standing by themselves can be "carved-out" of otherwise qualifying contracts. 11 The rationale is that where non-qualifying activities are only functionally related to (as opposed to incident to or interrelated with) the qualifying work under the long-term contract, the non-qualifying work can be separated. Whether this theory can withstand challenge is uncertain.
/Footnote/ 11 PLR 8623001; PLR 8546002. In both rulings the contracts related to construction contracts that included architectural and engineering services, and the IRS relied heavily on Rev. Rul. 70-67, Rev. Rul. 80-18 and Rev. Rul. 82-134, supra fn. 3.
¶3610.01.B. Completion
Determination of when a contract is completed is important regardless of which method of accounting the taxpayer chooses, because completion of a long-term contract terminates the taxpayer's ability to use a long-term contract accounting method for any follow-on costs or work unless the follow-on cost or work qualifies on its own as a long-term contract. 12
/Footnote/ 12 See Regs. §1.451-3(b)(1)(ii).
A contract is completed only upon "final completion and acceptance." However, a taxpayer will not be allowed to delay completion of a contract for the principal purpose of deferring Federal income tax. 13 Final completion and acceptance is not necessarily a clearly marked event, and often must be determined based on an analysis of all relevant facts and circumstances, including:
• the manner in which the parties deal with each other and the subject matter of the contract;
• the physical condition and state of readiness of the subject matter of the contract;
• the nature of any costs to be incurred or work remaining to be performed on the contract; and
• any use of the subject matter of the contract by the purchaser, other than for testing purposes that produces no cost savings, gross revenue or other substantial benefits. 14
The last of these factors is particularly important. When the customer actually occupies a building built by the taxpayer or puts a piece of machinery to commercial use, the contract is likely to be found complete notwithstanding that there are outstanding minor deficiencies on a punchlist, or governmental or other certifications that have not yet been obtained. 15 On the other hand, when the contract specifies a period of testing to prove that the subject matter of the contract meets contract specifications, the contract is not likely to be considered complete until the testing period is finished. 16 This should not be confused with warranty periods or situations in which a portion of the taxpayer's compensation is dependent on successful performance of the subject matter for a period of time. 17
/Footnote/ 13 Regs. §1.451-3(b)(2)(i)(A).
/Footnote/ 14 Regs. §1.451-3(b)(2)(i)(B).
/Footnote/ 15 See Regs. §1.451-3(b)(2)(i), Examples (1) and (4).
/Footnote/ 16 See Regs. §1.451-3(b)(2)(i), Example (3).
/Footnote/ 17 Regs. §1.451-3(b)(2)(iii). This type of provision was common to certain types of satellite contracts.
Note: The key to distinguishing these situations is often the use of the machine by the customer. A true testing period will not likely involve the customer actually relying on the subject matter for its business. On the other hand, where the subject matter is regularly available for the customer's operations, the contract is most likely complete.
¶3610.01.C. Primary Subject Matter
In many long-term manufacturing contracts, the contractor will not only provide the equipment ordered under the contract, but will also provide additional items or services, such as spare parts, training manuals or training services. If these relatively low-cost items or services were taken into account in determining final completion and acceptance, the taxpayer might have the opportunity to extend the contract completion date (and, therefore, the recognition of income on the entire contract) for an extended period of time. Accordingly, the long-term contract regulations provide that final completion and acceptance is based on the "primary subject matter" of the contract, and not on other items that are not the primary subject matter of the contract. 18
/Footnote/ 18 Regs. §1.451-3(b)(2)(ii)(A).
Note: The determination of what constitutes the primary subject matter of a contract will always be a factual analysis and it is important to consider all of the facts and circumstances.
Example—Time of Completion
The taxpayer enters into a qualifying long-term contract in year one to manufacture a machine plus spare parts. Because of production schedules and the purchaser's needs, the machine will be manufactured first, will be delivered and operational in year two. The spare parts will be manufactured in year two, but delivered in year three. Assuming that the machine is the primary subject matter of the contract, the contract is completed in year two upon final completion and acceptance of the machine. Note, however, that if the machine were delivered in year three, there would only be one contract.
When a contract is deemed complete under the primary subject matter rule, work remaining after the end of the year of completion must be accounted for under a "proper method of accounting." 19 In order to do this, costs incurred prior to completion on the non-primary items and a portion of the gross contract price reasonably allocable to the items are separated from the long-term contract and accounted for as if they were part of a separate contract. If this deemed separate contract would itself qualify as a long-term contract, then a long-term contract method may be used. If however, it would not qualify, the taxpayer would have to use another method. 20
/Footnote/ 19 Id.
/Footnote/ 20 Id.
Example—Separate Contract Treatment
Assume in the example above that the contract is deemed complete in year two. The provision of spare parts is thus deemed a separate contract and a portion of the gross contract price plus the costs allocable to the spares will be removed from the contract price and costs of the machine contract. Whether the spares contract can be a qualifying long-term contract will depend on whether the spares qualify as unique or normally require more than twelve months each to complete (the multi-year requirement is satisfied in this example by the fact that work on the spares begins in year two and is completed in year three). If the taxpayer were providing training services in year two and three rather than manufacturing spare parts, the deemed separate contract for the training services would not qualify as a long-term contract because there is no manufacturing in this separate contract.
¶3610.02
Rules for Contracts Entered Into After February 28, 1986
¶3610.02.A. Introduction
Taxpayers generally must compute income from long-term contracts entered into after February 28, 1986, and before July 11, 1989 (unless entered into pursuant to a written, irrevocable bid or proposal submitted by such date), under either: (1) the "percentage of completion-capitalized cost" method; or (2) the percentage of completion method. 21 The percentage of completion-capitalized cost method is repealed, however, relative to long-term contracts entered into after July 10, 1989. 22 Subsequently, taxpayers are required to compute income from such contracts under the percentage of completion method. The exceptions for certain construction contracts of small contractors, qualified ship contracts, home construction contracts and residential construction contracts are retained. 23
/Footnote/ 21 See §460(a) added by §804(a) of TRA 1986. Extensive IRS guidance on this provision is contained in Notice 89-15, 89-1 C.B. 634, in question-and-answer format, reproduced in the Practice Aids, infra.
/Footnote/ 22 §460(a) as amended by §7621 of the Revenue Reconciliation Act of 1989 (the 1989 Act). This amendment does not apply to contracts entered into pursuant to a written bid or proposal submitted before July 11, 1989, if the bid or proposal could not have been revoked or amended by the taxpayer. In Notice 90-6, 1990-3 I.R.B. 5, the IRS provides that the following conditions do not prevent a contract from qualifying as a binding contract: (1) the contract is subject to a condition outside the control of the parties; (2) insubstantial contractual terms remain to be negotiated; or (3) the contract is subject to approval by the board of directors of a corporate party where the directors have approved, or are apprised of, the negotiations and promptly approve the contract after its execution.
/Footnote/ 23 §7621(c)(5) and §7621(d)(3) of the 1989 Act. For a discussion of these exceptions, see ¶3610.02.C, infra.
Under the percentage of completion-capitalized cost method, a certain percentage of income from a long-term contract must be reported on the percentage of completion method. The remaining percentage must be reported on the taxpayer's "normal" method of accounting (e.g., the completed contract method). This general rule does not apply, however, to certain small construction and home construction contracts, see ¶3610.02.C, infra. In addition, for long-term contracts entered into after July 10, 1989 (unless entered into pursuant to a written, irrevocable bid or proposal submitted before July 11, 1989), taxpayers may elect to use the 10% method. 24 For a discussion of the 10% method, see ¶3610.02.E, infra.
/Footnote/ 24 §460(b)(5) as added by §7621(b) of the 1989 Act. Note: The Statement of Managers report for the 1989 Act (p. 137) contradicts the 1989 Act by stating that the 10% method election applies only to contracts entered into after 1989.
1. Percentage of Completion-Capitalized Cost Method
Under the percentage of completion-capitalized cost method of accounting, a certain percentage of each item of revenue and each item of cost is taken into account at the time that such item would be taken into account using the percentage of completion method, 25 and the remaining percentage is taken into account at the time that such item would be taken into accounting using the taxpayer's "normal" method of accounting for the contract. 26 The percentage of each item to be taken into account under each of these two methods of accounting depends on the date that the contract was entered into. For contracts entered into after February 28, 1986, but before October 14, 1987, 40% of each item of revenue or cost is taken into account under the percentage of completion method and the remaining 60 percent is taken into account under the taxpayer's normal method of accounting (the "40/60 split"). In general, for contracts entered into after October 13, 1987, but before June 21, 1988, 70% of each item of revenue or cost is taken into account under the percentage of completion method and the remaining 30% is taken into account under the taxpayer's normal method of accounting (the "70/30 split"). In general, for contracts entered into on or after June 21, 1988, 90% of each item of revenue or cost is taken into account under the percentage of completion method and the remaining 10% is taken into account under the taxpayer's normal method of accounting (the "90/10 split"). 27
/Footnote/ 25 See ¶3610.03.A.
/Footnote/ 26 §460(a).
/Footnote/ 27 See TRA 1986 §804(a), TRA 1986 §804(d); 1987 Act §10203(a), 1987 Act §10203(b) and TAMRA §5041(a), TAMRA §5041(e); Notice 89-15, 89-1 C.B. 634, Q & A-15.
In applying the percentage of completion-capitalized cost method of accounting, a taxpayer is not permitted to reduce the amount of contract revenue required to be taken into account in a particular year under the taxpayer's normal method of accounting by the amount of contract revenue taken into account under the percentage of completion method in that year and previous years. 28 In other words, the two computations are made independently of each other.
/Footnote/ 28 See Notice 89-15, 89-1 C.B. 634, Q & A-16.
Example—70/30 Split
After Oct. 12, 1987, but before June 21, 1988, X enters into a long-term contract that is accounted for under the percentage of completion-capitalized cost method using the 70/30 method. X's normal method of accounting is an accrual method. Assume that if X were using the percentage of completion method for the contract, X would be required to take into account $500,000 of contract revenue in 1988. Assume that if X were using the accrual method, X would be required to take into account $200,000 of contract revenue in 1988. Under the percentage of completion-capitalized cost method, X is required to take into account the following amounts of contract revenue in 1988: (1) 70% of $500,000 or $350,000; plus (2) 30% of $200,000, or $60,000 for a total of $410,000.
A taxpayer's "normal" method of accounting is the method of accounting that the taxpayer used immediately prior to February 28, 1986, to account for its long-term contracts within a particular trade or business. If that method was the percentage of completion method, the taxpayer may not use the percentage of completion-capitalization cost method. If the normal method was other than the percentage of completion method, the taxpayer must use the percentage of completion-capitalization cost method. 29 If the taxpayer has been required by law or has obtained the consent of the Commissioner to change from its normal method to a new method of accounting, then the new method is treated as the taxpayer's normal method of accounting. 30
/Footnote/ 29 Id., Q & A-14 and 18.
/Footnote/ 30 Id., Q & A-18.
2. Percentage of Completion Method
The general rule for the percentage of completion method is framed in terms of contract revenue. Computation is a two-step process. First, the taxpayer multiplies: (1) the total amount of revenue that the taxpayer expects to receive with respect to the contract; by (2) the cumulative percentage of the contract that has been completed as of the end of the taxable year. Second, the taxpayer subtracts from this result the cumulative amount of contract revenue required to be included in gross income in all preceding taxable years. 31 The total estimated contract revenues may differ during the term of a contract. 32
/Footnote/ 31 Id., Q & A-19.
/Footnote/ 32 Id.
Unless the taxpayer uses the "simplified method," described at ¶3610.02.B, the percentage of the contract considered completed as of the end of the taxable year is equal to the ratio of: (1) the cumulative costs allocable to the contract incurred in the taxable year and all preceding taxable years; to (2) the total costs allocable to the contract that the taxpayer expects to incur. The total estimated contract costs may be different for the different years of the contract. 33 Apparently, a physical completion method is not available to measure the percentage of completion. 34
/Footnote/ 33 Id., Q & A-20.
/Footnote/ 34 Notice 89-15, 89-1 C.B. 634, Q & A-20, provides for only the method described above and the simplified method described below. Cf. Regs. §1.451-3(c)(2).
A cash method taxpayer should not treat a cost as incurred in the taxable year in which it is paid for purposes of determining the total amount of costs allocable to the contract incurred in a particular taxable year. Rather, in determining the percentage of completion, costs are taken into account in the taxable year in which they are incurred, regardless of the taxpayer's over-all method of accounting. Similarly, under the percentage of completion method, costs allocable to the contract are deductible in the year incurred, regardless of the taxpayer's overall method of accounting. For this purpose, an item is treated as incurred when it would properly be taken into accounting under an accrual method of accounting. 35
/Footnote/ 35 Notice 89-15, 89-1 C.B. 634, Q & A-21 and 33.
3. "Look-back" Rules
a. In General
A "look-back" provision applies with respect to any portion of a contract accounted for under either the percentage of completion method or the percentage of completion-capitalized cost method. 36 Upon completion of the contract, the contractor computes the income that would have been reported in each year of the contract if actual total contract price and costs had been used instead of estimated total contract price and costs. To the extent the contractor understated income in any year of the contract, the government is due interest from the contractor on the imputed underpayment of tax from each taxable year until the year in which the contract is completed. Conversely, if the contract overstated income in any year of the contract, the contractor is due a refund of interest on the overpayment of income tax from the taxable year until the year in which the contract is completed. 37
/Footnote/ 36 See §460(b)(3); Regs. §1.460-6. For purposes of the look-back method, any amount received or accrued after completion of the contract is taken into account by discounting such amount to its value as of the completion of the contract. The applicable discount rate is the federal mid-term rate (determined under §1274(d)) as of the time the amount was received or accrued. Note, however, that the taxpayer may elect out of this rule under §460(b)(3) and (6). For discussion of the determination of the applicable federal rate, see ¶1840.
/Footnote/ 37 See §460(b)(2). The amount of any interest due or to be refunded as a result of applying the look-back method is computed and reported on Form 8697, Interest Computation Under the Look-back Method for Completed Long-Term Contracts. Regs. §1.460-6(f).
Example—Refund Due Taxpayer
Contractor T uses the percentage of completion method for a long-term contract. At the end of year one of the contract, T has incurred one-third of the estimated $300 total costs to be incurred or $100. The fixed price of the contract is $600. T takes into gross income in year one one-third ($100/$300) of the total revenues, or $200, and reports a profit of $100 ($200 revenues less $100 costs incurred). the contract is completed in year two, and actual costs are determined to be $400. Thus, T should have included only one-fourth ($100/$400) of the total contract price in gross income, and reported $50 profit ($150 revenues less $100 expenses). Under the look-back rule, the government owes T one year's interest on the excess tax paid by T in year one of the contract.
The look-back rules do not apply to contracts that: (1) must be completed within two years of the contract commencement date; and (2) have a gross contract price that does not exceed the lesser of $1 million or 1% of the taxpayer's average gross receipts for the three taxable years preceding the year the contract is completed. 38
/Footnote/ 38 §460(b)(3)(B). Regs. §1.460-6(b)(3)
In addition, taxpayers may elect not to apply the look-back method with respect to a long-term contract if for each prior contract year, the cumulative taxable income (or loss) under the contract as determined using estimated contract price and costs is within 10% of the cumulative taxable income (or loss) as determined using actual contract price and costs. 38.1
/Footnote/ 38.1 §460(b)(6)(A). Section 460(b)(6) was enacted by the 1997 TRA, §1211, and is effective generally for contracts completed in taxable years ending after August 5, 1997. For purposes of §167(g), §460(b)(6) applies to property placed in service after September 13, 1995.
Taxpayers may also elect not to reapply the look-back method with respect to a contract if, as of the close of any taxable year after the year the contract is completed, the cumulative taxable income (or loss) under the contract is within 10% of the cumulative look-back income (or loss) as of the close of the most recent year in which the look-back method was applied (or would have applied but for the other de minimis exception described above). 38.2
/Footnote/ 38.2 §460(b)(6)(B).
To make the election, a taxpayer must attach a statement to its timely filed original federal income tax return (including extensions) for the taxable year the election is to become effective or to an amended return for that year, provided the amended return is filed on or before March 31, 1998. 38.3 The statement must: 38.4
• have the legend "NOTIFICATION OF ELECTION UNDER SECTION 460(b)(6)";
• provide the taxpayer's name and identifying number and the effective date of the election; and
• identify the trades or businesses that involve long-term contracts.
/Footnote/ 38.3 Regs. §1.460-6(j). If a taxpayer had elected to use the delayed reapplication method under Regs. §1.460-6(e), an election not to apply the look back method in de minimis cases automatically revokes the election to use the delayed reapplication method for contracts subject to the election. Id.
/Footnote/ 38.4 Id. Consolidated groups are subject to consistency rules analogous to those in Regs. §1.460-6(e)(2) and Regs. §1.460-6(d)(4)(ii)(C). Id.
An election applies to all long-term contracts completed during and after the taxable year for which the election if effective. An election may not be revoked without the IRS' consent. 38.5
/Footnote/ 38.5 Regs. §1.460-6(j).
The "contract commencement date" is the first date on which any costs allocable to the contract are incurred, except that bidding and negotiation-related expenses are not "costs" for this purpose. 39
/Footnote/ 39 §460(g).
Interest charged or credited under the look-back method is computed in a three-step procedure. 40 First, the percentage of completion method is reapplied to completed contracts using the actual, rather than estimated, total contract price and costs. 41 Thus, income from the completed contracts is reallocated among prior tax years. Second, the reallocated income is used to recompute tax liability, which is then compared to the reported tax liability. 42 Any difference is treated as a hypothetical underpayment or overpayment of tax. Third, the interest rate applicable for overpayments 43 is applied to the overpayment or underpayment, the result of which is paid by, or credited to, the taxpayer. 44
/Footnote/ 40 §460(b)(2); Regs. §1.460-6(c).
/Footnote/ 41 §460(b)(2)(A); Regs. §1.460-6(c)(2).
/Footnote/ 42 §460(b)(2)(B); Regs. §1.460-6(c)(3).
/Footnote/ 43 §460(b)(7).
/Footnote/ 44 §460(b)(2)(C); Regs. §1.460-6(c)(4).
For purposes of the look-back method, only one rate of interest applies for each accrual period. An accrual period with respect to a taxable year begins on the day after the return due date (determined without regard to extensions) for the taxable year and ends on such return due date for the following taxable year. 44.1
/Footnote/ 44.1 §460(b)(7).
Taxpayers may elect to use a simplified method for calculating look-back interest. 45 Under the simplified marginal impact method, a taxpayer calculates the hypothetical underpayments or overpayments of tax for a prior year based on an assumed marginal tax rate. 46 A taxpayer using this method must use it for each long-term contract for which it reports income. 47
/Footnote/ 45 Regs. §1.460-6(d)(1). Certain pass-through entities which are not closely held are required to use this method. See Regs. §1.460-6(d)(4).
/Footnote/ 46 Regs. §1.460-6(d)(1).
/Footnote/ 47 Id.
The election to use the simplified marginal impact method is made by stating that the election is being made on a timely filed income tax return (including extensions) for the first tax year the election is to apply. The election applies to all applications of the look-back method to all eligible long-term contracts for the tax year for which the election is made and for any subsequent tax year. The election may not be revoked without the consent of the IRS. 48
/Footnote/ 48 Regs. §1.460-6(d)(4)(ii). See PLR 9511005 (IRS granted permission to revoke election to calculate look-back interest under the simplified marginal impact method; however, if the taxpayer wishes to reelect this method within the next six years, which is the number of years the method had been used, it must obtain IRS permission).
b. Pass-Through Entities
In the case of any partnership, S corporation or trust (other than certain closely-held entities), a simplified look-back method applies at the entity level. 49 Under the simplified method, the amount of taxes deemed overpaid or underpaid under a contract in any year is determined by multiplying: (1) the amount of contract income overreported or underreported for the year; by (2) the highest corporate tax rate, or, if more than 50% of the interests in the entity are held by individuals directly or through one or more other pass-through entities at all times during the year, the highest individual tax rate. 50
/Footnote/ 49 §460(b)(4)(A).
/Footnote/ 50 See §460(b)(4)(A) and §460(b)(4)(C).
The simplified look-back method does not apply to: (1) any contract unless substantially all of the income from such contract is from sources within the United States; and (2) any "closely-held pass-through entity." 51 For these purposes, a closely-held pass-through entity is any partnership, S corporation or trust in which 50% or more of the value of the beneficial interests are owned directly or indirectly by five or fewer persons at any time during any taxable year for which there is income under the contract. 52
/Footnote/ 51 §460(b)(4)(B).
/Footnote/ 52 §460(b)(4)(C). Rules similar to the constructive ownership rules of §1563(e) apply for purposes of determining ownership. §460(b)(4)(c)(iii).
4. Other Provisions
Because the long-term contract rules do not provide substantial tax deferral opportunities, the incentive to classify a contract as a long-term contract lies, in most instances, with the IRS. Under prior rules, it was not uncommon for the IRS to contend that a contract did not qualify for the completed contract method on the ground that the customer, rather than the taxpayer, incurred the risk of loss during construction. Under the revised rules, however, whether the customer has title to, control over, or risk of loss with respect to the property is irrelevant. 53 The taxpayer is permitted and required to sever and aggregate contracts where appropriate. 54
/Footnote/ 53 Notice 89-15, 89-1 C.B. 634, Q & A-4. Further, it is irrelevant that the parties characterize the agreement as being for the sale of property. Id.
/Footnote/ 54 Id., Q & A-38. The standards to be used in severing or aggregating contracts are set forth in Regs. §1.451-3(e), discussed at ¶3610.03.C, infra. Under prior law, only the IRS could sever or aggregate contracts. See Notice 89-15, 89-1 C.B. 634, Q & A-38.
¶3610.02.B. Cost and Revenue Allocation
1. General Rules Applicable to Long-Term Contracts
All costs (including, where applicable, research and experimental costs and interest costs) that directly benefit or are incurred by reason of the long-term contract activities of the taxpayer must be allocated to those contracts in the same manner that costs are allocated to extended period long-term contracts under the rules discussed at ¶3610.03.B. 55 Such costs include all storage, handling, and processing costs incurred with respect to the long-term contract activities of the taxpayer. 56
/Footnote/ 55 Notice 89-15, 89-1 C.B. 634, Q & A-39.
/Footnote/ 56 Id.
On the income side, "retainages" and "hold-backs" are to be included in total expected contract income. 57 For example, contract revenues that include amounts payable only on satisfactory performance must be included as current contract income. 58 Awards and incentive payments are also includable in income at the time it is reasonable to assume performance goals will be met. 59
/Footnote/ 57 Id., Q & A-27. See also TAM 9249004 (According to the National Office, the enactment of §460 automatically revoked a taxpayer's earlier IRS ruling that allowed the taxpayer to account for retainages under the deferral method).
/Footnote/ 58 Id.
/Footnote/ 59 Id., Q & A-28.
Reimbursements for costs incurred in performing a long-term contract are included in total contract price in determining the amount included in gross income in the taxable year under the percentage of completion method. Similarly, reimbursed costs allocable to a contract that have been incurred by the taxpayer are treated as contract costs in determining percentage of completion for the taxable year in which such costs are incurred. 60
/Footnote/ 60 Id., Q & A-31.
a. Contract Costs and Tracing
The indirect costs required to be allocated to a long-term contract may be allocated to particular contracts using either a specific identification (or "tracing") method, the standard costs method, or a method using burden rates (such as ratios based on direct costs, hours, or other items, or similar formulas), so long as the method employed reasonably allocates indirect costs among long-term contracts. The allocation method used for a particular cost must be applied consistently to all of the taxpayer's long-term contracts. 61
/Footnote/ 61 Id., Q & A-40.
The taxpayer must account for each long-term contract separately. Generally, both the direct and indirect costs incurred during the taxable year attributable to long-term contract activities must be allocated to particular long-term contracts for the taxable year in which such costs are incurred. 62
/Footnote/ 62 Id.
b. Non-Contract Costs
Total contract costs are to be estimated based on the facts and reasonable estimates as of the last day of the taxable year. Events that occur after the end of the taxable year that were not reasonably subject to estimate as of the last day of the taxable year are not taken into account. 63 For example, an unanticipated strike occurring after the close of the taxable year, but before the tax return is filed, will not affect the estimation of total contract costs. 64
/Footnote/ 63 Notice 89-15, 89-1 C.B. 634, Q & A-24.
/Footnote/ 64 Id. Example. The example also indicates that a substantial change order should not ordinarily affect the estimate for the preceding taxable year.
Total estimated contract costs do not include any contingency allowance for costs that, as of the end of the year for which the estimate is made, are unforeseeable or extraordinary and are not reasonably expected to be incurred in the performance of the contract. Such contingencies include prolonged third-party litigation, abnormal weather conditions (considering the season and the job site), prolonged strikes, and prolonged delays in securing required permits and licenses. Also excluded from allocable costs are follow-on contract costs, which are treated as severable. 65
/Footnote/ 65 Id., Q & A-25 and 26.
Nondeductible costs are not taken into account in determining: (1) expected total costs allocable to a contract; or (2) costs allocable in a contract and incurred through the end of the taxable year. 66 Also excluded are independent research and development expense, expenses for unsuccessful bids and proposals, and marketing, selling and advertising expenses. 67
/Footnote/ 66 Id., Q & A-30. The Notice cites as an example meal and entertainment expenses disallowed under §274.
/Footnote/ 67 Notice 89-15, 89-1 C.B. 634, Q & A-39.
2. Cost-Plus and Federal Contracts
In the case of a cost-plus long-term contract or a Federal long-term contract, any cost not otherwise allocated to the contract under the general rule of the preceding section must be allocated to the contract if the cost is identified by the taxpayer (or a related person) as being attributable to such contract, pursuant to the contract or any federal, State, or local law or regulation. 68
/Footnote/ 68 Id.
3. Allocation of Interest Expense
In general, interest on any indebtedness directly attributable to production expenditures with respect to a long-term contract must be assigned to such contract. Interest on any other indebtedness is assigned to such contract to the extent that the taxpayer's interest costs could have been reduced if production expenditures (not attributable to the indebtedness discussed in the previous sentence) had not been incurred. 69 (This is referred to as the "avoided cost" method.) De minimis exceptions to the interest allocation rules are applied on a contract-by-contract basis for taxpayers not using the accrual method for long-term contracts. 70
/Footnote/ 69 See §460(c)(3)(A), which requires interest attributed to long-term contracts to be allocated to the contract in the same manner as interest costs are allocated to property produced by the taxpayer under §263A(f). For discussion of these rules, see ¶3570.
/Footnote/ 70 See §460(c)(3)(C). For discussion of these rules, see ¶3570.
Production expenditures are the costs (whether or not incurred during the production period) required to be capitalized with respect to the long-term contract. 71 The production period is the period beginning on the later of the contract commencement date (i.e., when contract costs other than bidding or negotiation expenses are first incurred), or, if the taxpayer uses the accrual method with respect to long-term contracts, the date by which at least 5% of the total estimated costs (including design and planning costs) under the contract have been incurred. The production period ends on the contract completion date. 72
/Footnote/ 71 §263A(f)(4)(C).
/Footnote/ 72 See §460(c)(3)(B).
Note: Because there is current deduction of all costs related to a contract accounted for on the percentage of completion method, there is effectively no capitalization of interest required for such contracts.
4. Simplified Method
A simplified method of allocating costs of any long-term contract is available for purposes of applying the percentage of completion method. 73 Under this method, only certain costs are used in determining both: (1) costs allocated to the contract and incurred before the close of the taxable year; and (2) total estimated contract costs. These costs are: (a) direct material and labor costs; and (b) depreciation, amortization and cost recovery allowances on equipment and facilities 74 directly used to construct or produce the subject matter of the contract. Direct material costs include the costs of materials such as raw materials, land, equipment and components that become an integral part of the subject matter of a long-term contract and the costs of those materials that are consumed in the ordinary course of building, construction, installing, or manufacturing the subject matter of a long-term contract. 75
/Footnote/ 73 See Notice 89-15, 89-1 C.B. 634, Q & A-22 and 23.
/Footnote/ 74 These are included only to the extent otherwise allowable.
/Footnote/ 75 Notice 89-15, 1989-1 C.B. 634, Q & A-22.
A taxpayer using the percentage of completion-capitalized cost method that also properly uses the cash method may use the simplified method. A taxpayer that uses the percentage of completion method for long-term contracts of substantial duration, and the percentage of completion-capitalized cost method for long-term contracts of less than substantial duration, may not use the simplified method for its long-term contracts of substantial duration. 76
/Footnote/ 76 Id., Q & A-23.
5. Special Rules
If a taxpayer incurs costs (such as bidding and proposal costs, and raw land acquisition costs) allocable to a contract in a taxable year ending before the contract is entered into, the percentage of completion method does not require inclusion of any portion of the expected contract revenue in gross income in such prior taxable year. 77 Such costs are to be capitalized if at the time they are incurred it is "reasonably foreseeable" that they related to a future long-term contract, and they would otherwise properly be allocated to a long-term contract. Otherwise, they must be capitalized under §263A. In any case, the cost must be allocated to the contract in the year in which the contract is entered into in determining the completion percentage. 78
/Footnote/ 77 Id., Q & A-29 and 36.
/Footnote/ 78 Id., Q & A-29.
Under the percentage of completion method, a cost that is allocable to a long-term contract is treated as incurred in the taxable year in which all the events have occurred which determine the fact of the liability, regardless of the taxpayer's method of accounting, i.e., the accrual method applies. Thus, costs that are not treated as incurred as of the end of the taxable year for failure to satisfy such "all events" test, including the "economic performance" standard of §461(h), are not deductible. Similarly, such costs are not treated as contract costs incurred through the end of the taxable year in determining percentage of completion (although those costs are taken into account in determining total expected contract costs). 79
/Footnote/ 79 Id., Q & A-33. For discussion of the general rules governing the timing of income and deductions, see ¶3540 and ¶3560.
The costs of materials and supplies are deductible under the percentage or completion method for the first taxable year in which the costs both are allocable to the contract and have been incurred. 80 Costs of direct materials and supplies that are purchased specifically for a particular long-term contract are allocable to the contract in the taxable year in which such costs are incurred. The costs of other direct materials and supplies (such as those previously held by the taxpayer) are allocable to the contract in the taxable year in which such materials are "dedicated" to the contract. 81 Examples of "dedication" include: (1) delivery of materials to a job site (if only one contract is being performed at that site); (2) association of materials with a specific contract (for example, by purchase order, entry on books and records, or shipping instructions); and (3) if not previously assigned, the physical incorporation of the materials into the subject matter of the contract, or the consumption of the materials in the production of the subject matter of the contract. The cost that is allocated to a contract is to be determined using the taxpayer's method of accounting for such materials or supplies (e.g., specific identification, FIFO or LIFO) based on the taxable year in which such items are dedicated to the contract. 82
/Footnote/ 80 Notice 89-15, 1989-1 C.B. 634, Q & A-34.
/Footnote/ 81 Id., Q & A-35.
/Footnote/ 82 Id.
¶3610.02.C. Exceptions
1. Construction Contracts of Small Contractors
An exemption from the general rules is provided for "construction contracts" entered into by certain small contractors who estimate that the construction contracts will be completed within two years from the commencement date. 83 A "construction contract" is a contract for the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property. 84
/Footnote/ 83 See §460(e)(1).
/Footnote/ 84 §460(e)(4).
An eligible small contractor is one whose average gross receipts for the three taxable years preceding the taxable year in which the contract is entered into do not exceed $10,000,000. 85 To prevent taxpayers from circumventing the statute by using multiple entities, in calculating the $10,000,000 limitation, a contractor's gross receipts include the gross receipts of any incorporated or unincorporated trade or business under common control with the taxpayer 86 and any member of a controlled group of corporations 87 that includes the taxpayer. Regulations are to prescribe attribution rules that will count the gross receipts of certain partnerships, joint ventures and corporations in which the taxpayer is a member and which enter into construction contracts. 88
/Footnote/ 85 §460(e)(1)(B)(ii).
/Footnote/ 86 Regs. §1.52-1(b) contains the applicable definition of "common control." See §460(e)(2)(A).
/Footnote/ 87 Section 460(e) borrows the definition of "controlled group" from §1563(a). In applying the controlled group definition, however, a more-than-50% control requirement applies, rather than the more-than-80% control level of §1563(a)(1).
/Footnote/ 88 §460(e)(2) (flush language).
With respect to the application of the $10,000,000 limitation to members of a controlled group of corporations, the IRS maintains that if a taxpayer is a member of a controlled group on the first day of the taxable year in which a construction contract is entered into by the taxpayer, the gross receipts of the controlled group for the preceding three years count towards the $10,000,000 limitation regardless of whether the taxpayer was a member of the controlled group for any of the three years. Conversely, if a taxpayer is not a member of a controlled group on the first day of the taxable year in which a construction contract is entered into, the fact that the taxpayer may have been a member of a controlled group during the three-year period is ignored. 89
/Footnote/ 89 Notice 89-15, 1989-1 C.B. 634, Q & A-45. The Notice does not provide guidance on this issue with respect to commonly-controlled businesses.
Contracts qualifying for the small construction contract exception are eligible for the pre-1986 rules (i.e., the regulations applicable to non-extended period, long-term contracts). 90 Because such contracts involve the construction of real property, however, they are subject to the interest capitalization rules, regardless of their duration. 91 For discussion of the pre-1986 TRA rules, see ¶3610.03.
/Footnote/ 90 H.R. Rep. No. 841, 99th Cong., 2d Sess. at II-312 (1986).
/Footnote/ 91 Id.
2. Home Construction Contracts
Certain home construction contracts are also exempted. 92 A "home construction contract" is a construction contract with respect to which 80% or more of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of: (1) dwelling units 93 in buildings containing four or fewer dwelling units; and (2) improvements to real property directly related to such dwelling units and located on the site of such dwelling units. 94 All costs attributable to the building, construction, reconstruction, or rehabilitation of the dwelling units, and allocable to the contract, including the costs of materials and raw land, are includible for purposes of the 80% test. 95 The cost of roads, sewers and other "off-site" common facilities are also includible. 96 Finally, for purposes of defining a "dwelling unit," a townhouse or rowhouse is treated as a separate unit regardless of the number of such structures that may be attached. 97
/Footnote/ 92 §460(e)(1), as amended by P.L. 100-647, §5041(b)(1), §5041(e), effectively generally to contracts entered into after June 21, 1988.
/Footnote/ 93 As defined in §168(e)(2)(A)(ii). See Notice 89-15, 1989-1 C.B. 634, Q & A-43.
/Footnote/ 94 §460(e)(6)(A).
/Footnote/ 95 Notice 89-15, 1989-1 C.B. 634, Q & A-43.
/Footnote/ 96 Id., Q & A-44.
/Footnote/ 97 §460(e)(6)(A) (flush language).
3. Residential Construction Contracts
A special provision permits taxpayers to use a 70/30 split (rather than 90/10) in applying the percentage of completion-capitalized cost method to "residential construction contracts." 98 A residential construction contract must meet the same requirements as a home construction contract, except that the limitation of no more than four dwelling units per building is inapplicable. 99
/Footnote/ 98 §460(e)(5). The pre-1986 TRA rules are not available for such contracts.
/Footnote/ 99 §460(e)(6)(B).
In applying the requirement that 80% of the total contract cost be attributable to constructing the portion of the property comprised of dwelling units to a mixed-use building (e.g., one containing both apartments and retail or office space), the cost attributable to "dwelling units" are the sum of: (1) the costs attributable solely to the dwelling units; and (2) a pro rata amount of the other costs not attributable solely to the dwelling units (but which are not attributable solely to the other uses). This allocation must be based on the relative amount of space devoted to the dwelling units and the other uses. 100 Consequently, if 75% of the space in a building will be used for apartment units and 25% for retail space, 75% of the contractor's land cost is attributable to the apartments. The cost of all appliances installed in the apartments is attributable to the apartments, however, since this cost is solely attributable to the apartments. 101
/Footnote/ 100 Notice 89-15, 1989-1 C.B. 634, Q & A-41.
/Footnote/ 101 Id.
¶3610.02.D. Miscellaneous
A contract for the manufacture of property is not treated as a long-term contract unless the contract entails the manufacture of either: (1) a unique item not normally included in the taxpayer's finished goods inventory; or (2) an item that normally requires more than 12 calendar months to complete (without regard to the period of the contract). 102 In determining whether an item normally requires more than 12 calendar months to complete, all activities of the taxpayer and its related parties with respect to the manufacturing process must be taken into account. 103 The rules discussed at ¶3610.03.C, below, generally govern the determination of whether contracts should be aggregated or severed. 104
/Footnote/ 102 §460(f)(2). This provision codified the definition contained in Regs. §1.451-3(b)(1)(ii). For discussion, see ¶3610.01.A.
/Footnote/ 103 Notice 89-15, 1989-1 C.B. 634, Q & A-5. Sections 707(b) and 267(b) determine whether a related party relationship exists, provided that the determination is made without regard to §267(f)(1)(A) and by substituting "80%" for "50%" when analyzing stock ownership of a C corporation under subsections (b)(2), (b)(8), (b)(10)(A) and (b)(12) of §267.
/Footnote/ 104 See Notice 89-15, 1989-1 C.B. 634, Q & A-37, which incorporates Regs. §1.451-3(e).
¶3610.02.E. The 10% Method
For long-term contracts entered into after July 10, 1989 (unless entered into pursuant to a written, irrevocable bid or proposal submitted before July 11, 1989), taxpayers may elect to use the 10% method. 105 The 10% method is identical to the percentage of completion method except that income and expenses are not taken into account for any contract for which less than 10% of the estimated total contract costs have been incurred by the end of the taxable year. 106 Instead, such income and expenses are taken into account in the first year in which the 10% threshold is met. 107
/Footnote/ 105 §460(b)(5) as added by §7621(b) of the 1989 Act. Note: The Statement of Managers report for the 1989 Act (p. 137) contradicts the 1989 Act by stating that the 10% method election applies only to contracts entered into after 1989.
/Footnote/ 106 §460(b)(5)(B) as added by §7621(b) of the 1989 Act.
/Footnote/ 107 Id.
The 10% method does not apply to any taxpayer which uses a simplified method of allocating costs. 108 The 10% method, however, is taken into account in applying the look-back method, 109 in determining alternative minimum taxable income, 110 and in determining adjusted current earnings under the alternative minimum tax. 111
/Footnote/ 108 §460(b)(5)(D)(i) as added by §7621(b) of the 1989 Act. The rules for the simplified procedure for allocating costs are contained in §460(b)(3)(A) as redesignated by the 1989 Act.
/Footnote/ 109 §460(b)(5)(D)(ii) as added by §7621(b) of the 1989 Act.
/Footnote/ 110 The Statement of Managers report for the 1989 Act, p. 136.
/Footnote/ 111 Id.
The election, once made, applies to all of a taxpayers long-term contracts for the taxable year in which the election is made and all subsequent taxable years. 112
/Footnote/ 112 §460(b)(5)(C) as added by §7621(b) of the 1989 Act.
¶3610.02.F. Effective Dates
The TRA 1986 amendments generally apply to long-term contracts entered into after February 28, 1986. 113 If a contract is entered into before March 1, 1986 and is subsequently assigned, the assignee must account for the contract under §460 unless: (1) there are no changes to the terms of the contract in connection with the assignment; and (2) the assignee agrees to perform all of the assignor's remaining obligations and becomes entitled to all remaining payments under the contract. If these two conditions are satisfied, §460 will not apply to the contract even though the assignor retains no liability under the contract. Further, a contract is eligible for this transition rule regardless of whether the assignment is to a related or unrelated party and regardless of whether the assignment arises in a taxable sale or a nontaxable transaction. 114
/Footnote/ 113 P.L. 99-514, §804(d)(1).
/Footnote/ 114 Notice 89-15, 1989-1 C.B. 634, Q & A-10.
The 70/30 split requirement, enacted by the 1987 Revenue Act, generally applies to contracts entered into after October 13, 1987 and to contracts resulting from the acceptance of a bid made before June 21, 1988. The June 21, 1988 effective date applies only with respect to bids that could not be revoked or altered by the contractor at any time on or after June 21, 1988. The amendments to §460 made by TAMRA (including the 90/10 split) are effective for contracts entered into on or after June 21, 1988. 115
/Footnote/ 115 P.L. 100-647, §5041(e)(1). The TAMRA amendments do not apply to "qualified ship contracts" as defined in §10203(b)(2) of the 1987 Act. A "qualified ship contract" is a contract for the construction of not more than five ships within the United States, provided that the ships are not constructed for the United States government and the taxpayer reasonably expects to complete the contract within five years of the contract commencement date (as defined by §460(g)). TAMRA §5041(e)(1)(C); 1987 Act, §10203(b)(2).
The changes made by the 1989 Act (i.e., the repeal of the percentage of completion-capitalized cost method and the enactment of the 10% method) generally apply to contracts entered into after July 10, 1989; however, such changes do not apply to contracts resulting from the acceptance of a written, irrevocable bid or proposal submitted before July 11, 1989. 116
/Footnote/ 116 §7621(d) of the 1989 Act.
¶3610.03
Rules for Contracts Exempt From the Post-February 28, 1986 Rules
¶3610.03.A. Introduction
The rules explained at ¶3610.02, generally do not apply to contracts entered into before March 1, 1986. Moreover, certain post-February 28, 1986, contracts are exempt from these rules. 117 This section discusses the rules applicable to such contracts, as well as certain general principles of continuing applicability.
/Footnote/ 117 See ¶3610.02.C, above. A taxpayer with both exempt and nonexempt contracts within the same trade or business may use a method of accounting other than the percentage of completion method for all exempt contracts, even though the taxpayer must use the percentage of completion method for all nonexempt contracts. Rev. Rul. 92-28, 1992-15 I.R.B. 41.
1. Percentage of Completion Method
Under the percentage of completion method of accounting, a taxpayer reports income from a long-term contract each year based on that portion of the "gross contract price" that corresponds to the percentage of the entire contract that has been completed during the taxable year. 118 The term "gross contract price" means the original stated price in the contract plus any modifications to which the parties to the contract have agreed by the end of the taxpayer's taxable year. 119 Thus, for example, a change order to a contract that increases or decreases contract price and that has been approved by both the taxpayer and the customer by the end of the year is included in calculating the amount a taxpayer must include in income under the percentage of completion method. Change orders or other modifications that have not been approved by both parties or any retainages or holdbacks 120 (whether or not provided for in the contract) do not affect "gross contract price."
/Footnote/ 118 Regs. §1.451-3(c)(1).
/Footnote/ 119 See Regs. §1.451-3(d)(3)(iv).
/Footnote/ 120 Berger Engineering Co. v. Comr., 20 T.C.M. 1518, (1961); Orino v. Comr., 34 B.T.A. 726 (1936); Allhands v. Comr., 10 B.T.A. 1089 (1928).
The percentage of the contract completed during the year may be determined by either of two methods: the cost method or the physical completion method. 121 Under the cost method, costs incurred on the contract as of the end of the year are divided by estimated total cost of the contract in order to determine the percentage of completion. Any method of cost comparison may be used so long as the method is used consistently and clearly reflects the taxpayer's income. Thus, taxpayers may calculate the percentage of completion on a contract by dividing the total direct and indirect costs to date by the estimated total direct and indirect costs for the contract; use of direct costs alone or direct labor costs are also authorized. 122
/Footnote/ 121 See Regs. §1.451-3(c)(2). The physical completion method apparently is unavailable for contracts covered by the rules discussed at ¶3610.02, above. See Notice 89-15, 1989-1 C.B. 634, Q & A-20.
/Footnote/ 122 See id.
Example—Cost Method
The taxpayer enters into a contract in year one to manufacture a piece of custom machinery for $1,000,000. The contract is expected to be completed late in year two and as of the end of year one, the taxpayer estimates that its direct and indirect costs of performing the contract will be $900,000. At the end of year one, the taxpayer has incurred $250,000 of direct and indirect costs on the contract. Using the cost method of calculating the percentage of completion and both direct and indirect costs for comparison, the contract would be 27.77% complete at the end of year one. Therefore, the taxpayer would report $277,778 of gross income from the contract on its year one tax return.
Under the physical completion method, the taxpayer may choose criteria for comparing the work performed under the contact with the total work to be performed under the contract, so long as the criteria clearly reflect the earning of income with respect to the contract. This approach may be properly used in situations in which progress on the contract can be accurately measured by engineers' or architects' certificates or in road building contracts where mileage is used and the terrain remains relatively similar from mile to mile. 123
/Footnote/ 123 Regs. §1.451-3(c)(2). Care should be taken in using the physical completion method, however, so that inconsistent factors, such as varying terrain, are not ignored. See id.
Under either method of determining the completion percentage it is important to maintain records to support the taxpayer's calculation. Under the cost method, the taxpayer must not only retain records of costs incurred as of the end of the taxable year, but also must retain architects' or engineers' certificates supporting the estimated total cost. Similarly, under the physical completion method, architects' or engineers' certificates are required to calculate both the completion to date and the total work to be done under the contract. 124
/Footnote/ 124 Id.
Regardless of which method is used, all costs incurred during the year with respect to the contract are deducted. 125 Materials on hand at the beginning and end of the year must be taken into account in calculating the cost incurred (i.e., inventories must be used), and costs relating to guarantees, warranties, maintenance and other services agreements are disregarded. 126
/Footnote/ 125 Regs. §1.451-3(c)(3).
/Footnote/ 126 Id.
Operation of the percentage of completion method may be demonstrated by the following examples:
Example—Net Gain
The taxpayer agrees to build a multi-story building on the customer's land for $10,000,000. At the end of year one, the taxpayer has incurred $1,750,000 of total direct and indirect costs, has no materials at the job site that have not been used in the construction, and estimates that the total direct and indirect cost at completion will be $9,000,000. Using the cost method of calculating percentage of completion, in year one the taxpayer will take into income $1,944,444 ($1,750,000/$9,000,000 x $10,000,000) and will deduct the $1,750,000 for a net profit on the contract in year one of $194,444. At the end of year two, the taxpayer has incurred $6,500,000 of total direct and indirect costs (including the costs incurred in year one), has no materials at the job site that have not yet been used in construction, and (based on revised engineers' certificates) now estimates that total direct and indirect cost at completion will be $9,500,000. In year two, the taxpayer will take into income $4,897,661 ([$6,500,000/$9,500,000 x $10,000,000] - $1,944,444) and will deduct the $4,750,000 of costs incurred during year two ($6,500,000 - $1,750,000) for a net profit on the contract in year two of $147,661. In year three, the taxpayer finishes the contract for a total direct and indirect cost of $9,400,000. The taxpayer takes the remaining contract price of $3,157,895 ($10,000,000 - [$1,944,444 + $4,897,661]) into income and deducts the costs incurred in year three, $2,900,000 ($9,400,000 - $6,500,000), for a net profit in year three of $257,895. Total net income from the contract over the three years is $600,000 ($194,444 + $147,661 + 257,895).
Example—Net Loss
Assume the same facts as above through year one. At the end of year two, the taxpayer has incurred $6,500,000 of total direct and indirect costs (including the costs incurred in year one), has no materials at the job site which have not yet been used in construction, and now estimates that the total direct and indirect costs at completion will be $11,000,000. In year two, the taxpayer will take into income $3,964,647 ([$6,500,000/$11,000,000 x $10,000,000] - $1,944,444) and will deduct the $4,750,000 of costs incurred during year two ($6,500,000 - $1,750,000) for a net loss on the contract in year two of $785,353. In year three, the taxpayer finishes the contract for a total direct and indirect cost of $11,200,000. The taxpayer takes the remaining contract price of $4,090,909 ($10,000,000 - [$1,944,444 + $3,964,647]) into income and deducts the costs incurred in year three, $4,700,000 ($11,200,000 - $6,500,000, for a net loss in year three of $609,091. The total net loss from the contract over the three years is $1,200,000 ($194,444 - $785,353 - $609,091).
2. Completed Contract Method
Under the completed contract method of accounting, the taxpayer takes the gross contract price of a long-term contract into income in the year the contract is completed. 127 Similarly, deduction of all costs properly allocable to the contract is deferred and the costs are deducted in the year of completion. 128 Thus, if the taxpayer in the first example at the end of the discussion of the percentage of completion method had used the completed contract method, the taxpayer would have reported no income and taken no deductions with respect to the contract during years one and two, and would have taken the entire $10,000,000 contract price into income in year three with a $9,400,000 deduction of all direct and indirect costs at the same time for net income of $600,000. Similarly, if the taxpayer had incurred $11,200,000 of costs on the contract, the loss would have been recognized only in year three upon completion of the contract, even if the taxpayer had known in year one that overruns on the contract would produce a loss.
/Footnote/ 127 Regs. §1.451-3(d)(1).
/Footnote/ 128 Id.
In many cases, uncertainties will exist that make it difficult for the taxpayer to calculate income under the contract, either because the customer is claiming that the price should be reduced or additional work should be performed or because the taxpayer's outstanding claims for an increase in contract price (for example, due to change orders) remain unresolved. The regulations provide rules to cover these dispute situations. These rules are, in general, very favorable to the taxpayer.
Generally, a taxpayer may reduce the contract price for amounts "reasonably in dispute" due to claims by the customer that the purchase price should be reduced or that additional work is to be done. 129 On the other hand, the taxpayer is not required to increase the contract price for amounts that it has claimed to be due but which the customer is disputing. 130 This does not extend, however, to increases in contract price to which the customer has agreed, but which the customer does not pay because of insufficient funds or similar reasons. 131 When the income to be recognized is reduced because of customer claims, or because taxpayer claims for additional payment are not included in gross contract price in the year of completion, any additional income is recognized in the year the dispute is resolved or the work is completed. 132
/Footnote/ 129 Regs. §1.451-3(d)(2).
/Footnote/ 130 Regs. §1.451-3(d)(3). See, in particular, Regs. §1.451-3(d)(3)(iv).
/Footnote/ 131 Regs. §1.451-3(d)(3)(iv).
/Footnote/ 132 Regs. §1.451-3(d)(2)(i), Regs. §1.451-3(d)(3)(iii).
Example—Disputed Amounts
The taxpayer enters into a contract to construct a building for the customer in year one at a price of $10,000,000. Late in year three, the building is ready for occupancy and the customer has taken possession of the building. The taxpayer uses the completed contract method of accounting for its construction contracts and the taxpayer's total costs for the building are $9,000,000. At the end of year three, there are a number of change orders for work done during construction which the taxpayer has submitted and priced at $400,000. The customer has informed the taxpayer that he believes the change order work is within the original scope of the contract and that the customer will not pay the additional amount. In addition, the customer is claiming that certain heating and cooling work on the building is not in accordance with the specifications and is demanding that the taxpayer either bring the work up to specification or reduce the contract price by $500,000. The taxpayer contends that the heating and cooling work meets the contract specifications.
In reporting its year three income, the taxpayer will treat the contract as complete. The gross contract price ($10,000,000) will be reduced by the amount reasonably in dispute under the customer's claim ($500,000) and will not be increased by the amount of the taxpayer's claim ($400,000). Thus, the taxpayer will report $9,500,000 of income from the contract and deduct the $9,000,000 of costs for a net profit of $500,000. If the disputes are resolved in year four by the taxpayer performing an additional $200,000 of work on the heating and cooling system and by increasing the contract price by $300,000 for the change orders, the taxpayer will report the remaining $800,000 of income from the contract (the $500,000 from the customer's claim plus the $300,000 increase in contract price) and deduct the $200,000 cost of work on the heating and cooling system.
The exception to these rules occurs when customer claims for price reduction or additional work are sufficiently large to make it impossible to determine whether the contract will result in a profit or a loss. 133 In such circumstances, the contract is held in suspense for tax purposes, with no income or loss being reported in the year of final completion and acceptance. Additionally, if the contractor will have a loss on the contract regardless of a buyer's claim, the loss reported on completion may not exceed the loss the contractor would sustain without the claim. 134 This is accomplished by deferring deduction of an amount of the contractor's costs incurred equal to the reduction in gross contract price for the buyer's claim.
/Footnote/ 133 Regs. §1.451-3(d)(2)(ii).
/Footnote/ 134 Regs. §1.451-3(c)(2)(v).
Example—Dispute Precluding Determination of Profit or Loss
The taxpayer enters into a contract to construct a building for the customer in year one at a price of $10,000,000. Late in year three, the building is ready for occupancy and the customer has taken possession of the building. The taxpayer uses the completed contract method of accounting for its construction contracts and the taxpayer's total costs for the building are $9,700,000. If the customer claims in year three that the heating and cooling system does not meet specifications and that the contract price must either be reduced by $500,000 or the contractor must bring the system up to specification, it is not possible to determine by the end of year three whether the taxpayer will have a profit or loss on the contract. Accordingly, the taxpayer reports no income or deductions on the contract in year three. If the contractor brings the heating and cooling system up to specifications in year four at a cost of $200,000, the taxpayer will report the entire $10,000,000 contract price in year four and will deduct the $9,900,000 of costs incurred under the contract.
Example—Loss Assured Without Regard to Dispute
If the taxpayer in the preceding example had incurred $10,100,000 of costs by the end of year three, the taxpayer would have reported $9,500,000 of income from the contract in year three (gross contract price reduced by the customer's claim) and deducted $9,600,000 of costs (the costs incurred reduced by the amount of reduction in the contract price for the customer's claim). If the work were satisfactorily corrected in year four for an additional $200,000 of cost, the taxpayer would report the remaining $500,000 of contract price as income and would deduct the deferred costs ($500,000) plus the additional cost of correction ($200,000).
¶3610.03.B. Rules for Allocating Costs to Long-Term Contracts
Because the completed contract method of accounting allows deferral of income from a long-term contract until completion, the question of what costs must also be deferred and deducted at completion is of great importance.
1. Distinction Between Long-Term Contracts and Extended Period Long-Term Contracts
The regulations provide two methods of allocating costs to long-term contracts for deferral, depending on whether the contract is an extended period long-term contract. For the most part, the types of costs that must be deferred are the same under both methods, with extended period long-term contracts requiring the deferral of additional costs.
An extended period long-term contract is any long-term contract that the taxpayer estimates will not be completed within the two-year period beginning on the first date that the taxpayer incurs any costs allocable to the contract. 135 The taxpayer's determination as to the expected length of the contract is made at the time the taxpayer enters into the contract. Allocable costs for determining the contract commencement date do not include pre-contract costs such as bidding expenses or negotiation expenses. 136
/Footnote/ 135 Regs. §1.451-3(b)(3)(i).
/Footnote/ 136 Id.
There are two exceptions to this definition of extended period long-term contract. First, contracts for the building, construction, erection of, or installation of integral components to improvements to real property are tested with a three-year rather than two-year standard. 137 Alternatively, these types of contracts for improvements to real property will be treated as not extended period long-term contracts regardless of their length if the taxpayer's annual gross receipts (including those of any affiliated businesses) for the three taxable years preceding execution of the contract do not exceed $25,000,000. 138
/Footnote/ 137 Regs. §1.451-3(b)(3)(ii)(A). These are referred to as "construction" contracts. The regulations provide that improvements to real property include reconstruction and rehabilitation. An improvement to real property includes buildings or other structures intended to be permanently affixed to real property, roadways, dams or bridges, but does not include such items as vessels or offshore drilling platforms. An integral component to an improvement to real property includes property not produced at the site of the real property but intended to be permanently affixed to an improvement to real property, for example, elevators and central heating and cooling systems. Id.
/Footnote/ 138 Regs. §1.451-3(b)(3)(ii)(B). Regs. §1.451-3(b)(3)(iii) provides detailed rules for calculating the gross receipts. These include affiliation rules.
Contract commencement will generally occur on the first date of any of the following:
• the taxpayer incurs design or engineering costs allocable to the contract, other than design or engineering costs incurred solely for purposes of bidding for the contract;
• materials or equipment are shipped to the jobsite; or
• workers whose labor cost is treated as direct labor are sent to the jobsite. 139
The initial estimate of a contract's length should include reasonable allowances for delay, rework, change orders, technology or design problems and similar contingencies. 140 However, if the contract schedules a completion or delivery date, this will be treated as evidence of a reasonable estimate, particularly if there are bona fide penalties for failure to meet the scheduled date. In any event, taxpayers need to maintain contemporaneous written records to support the reasonableness of their estimate. 141
/Footnote/ 139 Regs. §1.451-3(b)(3)(i).
/Footnote/ 140 Regs. §1.451-3(b)(3)(iv).
/Footnote/ 141 Id.
If the contract is completed in a shorter time than expected, this will not change the classification of the contract. 142 If, however, the contract is treated as not an extended period long-term contract and it is completed in more than two years (more than three years in the case of a construction contract), the reasonableness of the initial estimate will be subject to question. In such an instance, the taxpayer will need to be able to support its initial calculation or point to unforeseeable factors (such as prolonged third-party litigation, abnormal weather, prolonged strikes or prolonged delays in securing required permits or licenses that could not be anticipated) which are primarily responsible for the delay. 143 If the taxpayer cannot provide such support or attribute the delay to unforeseen factors, the taxpayer will treat the contract as an extended period long-term contract for the third (or fourth) taxable year and, according to the regulations, should file amended returns for prior years using the cost allocation rules applicable to extended period long-term contracts. 144 Contracts that avoid extended period treatment because of the $25,000,000 gross receipts test are not reclassified if the taxpayer's gross receipts increase in subsequent years. 145
/Footnote/ 142 Regs. §1.451-3(b)(3)(iv)(A).
/Footnote/ 143 Id.
/Footnote/ 144 Regs. §1.451-3(b)(3)(iv)(B).
/Footnote/ 145 Id.
2. Allocation of Direct Costs
Regardless of whether the contract is an extended period long-term contract, all direct material and labor costs must be allocated to the contract and deferred. 146 Direct material costs are the cost of all materials that become an integral part of the subject matter of the contract and other materials that are consumed in the ordinary course of performing the contract. In accounting for material costs the taxpayer must use its standard inventory methods. 147 Direct labor cots include the costs of labor which can be identified to or associated with the contract. 148 This includes the following items paid or incurred on behalf of employees engaged in direct labor: 149
• basic compensation
• overtime pay
• vacation and holiday pay
• sick leave pay (other than payments pursuant to a wage continuation plan under §105(d) as it existed prior to its repeal in 1983)
• shift differential
• payroll taxes
• payments to a supplemental unemployment benefit plan
/Footnote/ 146 Regs. §1.451-3(d)(5)(i), Regs. §1.451-3(d)(6)(i).
/Footnote/ 147 Regs. §1.451-3(d)(8)(iii)(A).
/Footnote/ 148 Regs. §1.451-3(d)(5)(i), Regs. §1.451-3(d)(6)(i). Direct labor is allocated among various long term contracts on a tracing or specific identification method. If such a method is not practical, the taxpayer may use any reasonable method that reasonably allocates labor costs among contracts that have been completed and those that have not been completed during the year. Regs. §1.451-3(d)(3)(ii).
/Footnote/ 149 Regs. §1.451-3(d)(5)(i).
3. Allocation of Indirect Costs
Indirect costs are costs other than direct material and labor that are incident to and necessary for the performance of particular long-term contracts. 150 Certain indirect costs must also be allocated to long-term contracts, whether or not the contract is an extended period long-term contract. These always-allocated indirect costs are:
• repair expenses of equipment or facilities used in the performance of particular long-term contracts; 151
• maintenance of equipment or facilities used in the performance of particular long-term contracts; 152
• utilities such as heat, light, and power, relating to equipment or facilities used in the performance of particular long-term contracts; 153
• rent of equipment or facilities used in the performance of particular long-term contracts; 154
• indirect labor and contract supervisory wages, including basic compensation, over-time pay, vacation and holiday pay, sick leave pay (other than payments pursuant to a wage continuation plan under §105(d) as it existed prior to its repeal in 1983), shift differential, payroll taxes and contributions to a supplemental unemployment benefit plan incurred in the performance of particular long-term contracts; 155
• indirect materials and supplies used in the performance of particular long-term contracts; 156
• tools and equipment, not capitalized, used in the performance of particular long-term contracts; 157
• costs of quality control and inspection incurred in the performance of particular long-term contracts; 158
• taxes otherwise allowable as a deduction under §164 (other than state and local, and foreign income taxes) to the extent such taxes are attributable to labor, materials, supplies, equipment or facilities used in the performance of particular long-term contracts; 159
• depreciation, amortization and cost recovery allowances reported for the taxable year for financial purposes on equipment and facilities used in the performance of particular long-term contracts (but not in excess of the depreciation, amortization or cost recovery allowable for tax purposes; 160
• cost depletion incurred in the performance of particular long-term contracts; 161
• administrative costs incurred in the performance of particular long-term contracts (but not including any cost of selling or any return of capital); 162
• compensation paid to officers attributable to services performed on particular long-term contracts (other than incidental or occasional services); 163
• costs of insurance incurred in the performance of particular long-term contracts, such as insurance on machinery and equipment used in the construction of the subject matter of a long-term contract. 164
/Footnote/ 150 Regs. §1.451-3(d)(5)(ii), Regs. §1.451-3(d)(6)(ii).
/Footnote/ 151 Regs. §1.451-3(d)(5)(ii)(A), Regs. §1.451-3(d)(6)(ii)(A).
/Footnote/ 152 Regs. §1.451-3(d)(5)(ii)(B), Regs. §1.451-3(d)(6)(ii)(B). See TAM 8936001 and TAM 9022001 (Indirect costs associated with idle equipment, except depreciation, must be allocated as provided in Regs. §1.451-3(d)(5)(ii)).
/Footnote/ 153 Regs. §1.451-3(d)(5)(ii)(C), Regs. §1.451-3(d)(6)(ii)(C).
/Footnote/ 154 Regs. §1.451-3(d)(5)(ii)(D), Regs. §1.451-3(d)(6)(ii)(D).
/Footnote/ 155 Regs. §1.451-3(d)(5)(ii)(E), Regs. §1.451-3(d)(6)(ii)(E).
/Footnote/ 156 Regs. §1.451-3(d)(5)(ii)(F), Regs. §1.451-3(d)(6)(ii)(F).
/Footnote/ 157 Regs. §1.451-3(d)(5)(ii)(G), Regs. §1.451-3(d)(6)(ii)(G).
/Footnote/ 158 Regs. §1.451-3(d)(5)(ii)(H), Regs. §1.451-3(d)(6)(ii)(H).
/Footnote/ 159 Regs. §1.451-3(d)(5)(ii)(I), Regs. §1.451-3(d)(6)(ii)(I).
/Footnote/ 160 Regs. §1.451-3(d)(5)(ii)(J), Regs. §1.451-3(d)(6)(ii)(J).
/Footnote/ 161 Regs. §1.451-3(d)(5)(ii)(K), Regs. §1.451-3(d)(6)(ii)(K).
/Footnote/ 162 Regs. §1.451-3(d)(5)(ii)(L), Regs. §1.451-3(d)(6)(ii)(L).
/Footnote/ 163 Regs. §1.451-3(d)(5)(ii)(M), Regs. §1.451-3(d)(6)(ii)(N).
/Footnote/ 164 Regs. §1.451-3(d)(5)(ii)(N), Regs. §1.451-3(d)(6)(ii)(O).
Additionally, certain indirect costs are not required to be allocated to either extended period or non-extended period long-term contracts. Therefore, indirect costs are currently deductible to the extent that they qualify as ordinary and necessary business expenses or are specifically deductible under a provision of the Code. These nonallocated indirect expenses are:
• marketing, selling and advertising expenses; 165
• bidding expenses incurred in the solicitation of contracts not awarded to the taxpayer; 166
• interest; 167
• general and administrative expenses (but not including any costs directly attributable to an extended period long-term contract or costs which directly benefit or are incurred by reason of the taxpayer's extended period long-term contract activities) and compensation paid to officers attributable to the performance of services that do not directly benefit or are not incurred by reason of any extended period long-term contracts; 168
• research and experimental expenses (described in §174) neither directly attributable to particular extended period long-term contracts in existence at the time such expenses are incurred nor incurred under any agreement to perform research or experimentation; 169
• losses deductible under §165; 170
• 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 not enroute to or not located at a job-site); 171
• income taxes attributable to income received from long-term contracts; 172
• contributions paid to or under a pension or annuity plan allowable as a deduction under §404 (and §404A if applicable) to the extent such contributions represent past service costs; and 173
• costs attributable to strikes. 174
/Footnote/ 165 Regs. §1.451-3(d)(5)(iii)(A), Regs. §1.451-3(d)(6)(iii)(A).
/Footnote/ 166 Regs. §1.451-3(d)(5)(iii)(A), Regs. §1.451-3(d)(6)(iii)(B). Bidding expenses do not include §174 research and experimentation expenses. Regs. §1.451-3(d)(6)(ii)(S).
/Footnote/ 167 Regs. §1.451-3(d)(5)(iii)(D), Regs. §1.451-3(d)(6)(iii)(C).
/Footnote/ 168 Regs. §1.451-3(d)(5)(iii)(E), Regs. §1.451-3(d)(6)(iii)(D).
/Footnote/ 169 Regs. §1.451-3(d)(5)(iii)(F), Regs. §1.451-3(d)(6)(iii)(E).
/Footnote/ 170 Regs. §1.451-3(d)(5)(iii)(G), Regs. §1.451-3(d)(6)(iii)(F).
/Footnote/ 171 Regs. §1.451-3(d)(5)(iii)(I), Regs. §1.451-3(d)(6)(iii)(G).
/Footnote/ 172 Regs. §1.451-3(d)(5)(iii)(J), Regs. §1.451-3(d)(6)(iii)(H).
/Footnote/ 173 Regs. §1.451-3(d)(5)(iii)(K), Regs. §1.451-3(d)(6)(iii)(I).
/Footnote/ 174 Regs. §1.451-3(d)(5)(iii)(L), Regs. §1.451-3(d)(6)(iii)(J).
The final class of indirect costs consists of those indirect costs that must be allocated to extended period long-term contracts, but that may be deducted currently (assuming that they represent ordinary and necessary business expenses, or are otherwise deductible under a specific Code section) for contracts that are not extended period long-term contracts. These costs are:
• depreciation, amortization and cost recovery allowances on facilities or equipment used in the performance of long-term contracts in excess of depreciation, amortization and cost recovery allowances reported by the taxpayer in its financial reports, 175
• percentage depletion in excess of cost depletion, 176 administrative, service or support costs that directly benefit or are incurred by reason of the long-term contracts of the taxpayer, 177
• deductible pension, annuity, other deferred compensation contributions or other employee benefit expenses in excess of contributions representing past service costs, 178
• research and experimental expenditures directly attributable to particular extended period long-term contracts, 179
• rework labor, scrap and spoilage to the extent incurred in the performance of particular extended period long-term contracts, 180 and
• bidding expenses incurred in the solicitation of particular extended period long-term contracts ultimately awarded the taxpayer. 181
/Footnote/ 175 Compare Regs. §1.451-3(d)(5)(iii)(I) with Regs. §1.451-3(d)(6)(ii)(J).
/Footnote/ 176 Compare Regs. §1.451-3(d)(5)(iii)(H) with Regs. §1.451-3(d)(6)(ii)(K).
/Footnote/ 177 Compare Regs. §1.451-3(d)(5)(iii)(E) with Regs. §1.451-3(d)(6)(ii)(L), (M), and (d)(9).
/Footnote/ 178 Compare Regs. §1.451-3(d)(6)(iii)(I) with Regs. §1.451-3(d)(6)(ii)(P).
/Footnote/ 179 Compare Regs. §1.451-3(d)(5)(ii)(F) with Regs. §1.451-3(d)(6)(ii)(Q).
/Footnote/ 180 Compare Regs. §1.451-3(d)(5)(iii)(L) with Regs. §1.451-3(d)(6)(ii)(R).
/Footnote/ 181 Compare Regs. §1.451-3(d)(5)(iii)(A) with Regs. §1.451-3(d)(6)(ii)(S). For extended period long-term contracts, taxpayers must defer all bidding expenses until contract award. Upon notification of the award to another bidder or notification that there will be no award, the expenses may be deducted by the taxpayer. If the taxpayer receives a partial award of the contract, only expenses related to the lost portion may be deducted currently. However, if the bid was for a multi-unit contract, all bidding expenses are allocated to the contract if the taxpayer is awarded a contract for any amount of units. Regs. §1.451-3(d)(6)(ii)(S).
¶3610.03.C. Severing and Aggregating Contracts
The question whether a given agreement between the contractor and the customer constitutes one or several contracts is important in determining the deferral available under the completed contract method. When the contract is profitable, it is ordinarily in the taxpayer's interest from a tax standpoint for completion to be delayed as long as possible. Similarly, if a contract is producing a loss, the taxpayer ordinarily would like to reach completion as quickly as possible so that the loss can be deducted. The issue of severing (treating what is in form a single contract as more than one contract) and aggregating (treating what is in form more than one contract as a single contract) can have a significant impact.
The determination of whether to sever or aggregate a contract is dependent on "all the facts and circumstances," 182 so it is difficult to establish hard and fast rules. Among the factors to be considered are: 183
• whether there is separate delivery or separate acceptance of units representing a portion of the subject matter of the contract,
• whether portions of the contract are independently priced or use different pricing formulas,
• the presence or absence of a business purpose for one agreement rather than several agreements (such as where one contract is used to provide for two or more unrelated subject matters, neither of which is the primary subject matter), 184 or several agreements rather than one agreement (such that a reasonable business person would not have entered into one of the agreements for the terms agreed upon without also entering into the other agreement at the terms, or better, agreed upon), 185
• customary commercial practice,
• the dealings between the parties to the contract,
• the nature of the subject matter to the contract,
• the total number of units to be constructed, manufactured or installed under the contract,
• the contemplated time between the completion of each unit, and
• whether the number of units to be provided under the contract has been increased by option or change order. 186
/Footnote/ 182 Regs. §1.451-3(e)(1)(ii).
/Footnote/ 183 See id.
/Footnote/ 184 See Regs. §1.451-3(e), Example (7); Regs. §1.451-3(e)(1)(vi).
/Footnote/ 185 Regs. §1.451-3(e)(1)(vii). See Regs. §1.451-3(e)(2), Example (2). See also Point Comfort Venture v. Comr., T.C. Memo 1990-574 where the court held that a contract to demolish a smelting plant and other buildings may not be aggregated with contracts to sell scrap metal in determining whether the transactions qualify for the completed contract method of accounting.
/Footnote/ 186 Regs. §1.451-3(e)(1)(viii). See Regs. §1.451-3(e)(2), Example (3).
¶3610.03.D. Dispositions of Long-Term Contracts Before Completion
If a taxpayer using the completed contract method disposes of the contract, whether by sale, distribution to shareholders on liquidation, or otherwise, the taxpayer must recognize income on the portion of the contract performed notwithstanding that the income would not otherwise be recognized under the taxpayer's method of accounting. 187 This rule prevents taxpayers (particularly corporations) from escaping taxation through use of the completed contract method. When gain or loss is recognized on the sale or other disposition of a contract accounted for under the completed contract method, the transaction will give rise to ordinary income or loss, rather than capital gain or loss. 188
/Footnote/ 187 Jud Plumbing & Heating, Inc. v. Comr., 153 F.2d 681 (5th Cir. 1946); Stephens Marine, Inc. v. Comr., 430 F.2d 679 (9th Cir. 1970); Standard Paving Co. v. Comr., 190 F.2d 330 (10th Cir. 1951).
/Footnote/ 188 See Comr. v. Kuckenberg, 309 F.2d 202 (9th Cir. 1962), cert. denied, 373 U.S. 909 (1963); Pridemark, Inc. v. Comr., 345 F.2d 35 (4th Cir. 1965).
Example—Disposition of Contract
The taxpayer is a corporation that uses the completed contract method for all of its long-term building construction contracts. In year one it enters into a contract to build an office building for $10,000,000. During year two, the corporation is liquidated and its assets distributed to the sole corporate shareholder. At the time of the liquidation, the corporation had incurred $4,500,000 of costs and expected that total cost of the building would be $9,500,000. On the corporation's final Federal income tax return, it will report $4,736,842 of the contract price as income and will deduct the $4,500,000 of costs for a net profit of $236,842.
Note: The "recapture" principle does not apply to taxpayers using the percentage of completion method because income is recognized throughout the performance of the contract.
When the distribution is from a partnership to a partner, the earned income in the uncompleted contract that has been accounted for under the completed contract method is treated as an unrealized receivable. 189 If the partner receives more than his pro rata share of the unrealized receivables of the partnership in the distribution, the partnership must treat the excess distributed receivables as having been sold or exchanged at fair market value. 190
/Footnote/ 189 See §751(c).
/Footnote/ 190 §751(b).