Accounting for Long-Term Contracts

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-208156-91]

RIN 1545-AQ30

Accounting for Long-Term Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations describing how

income from a long-term contract must be accounted for under section

460 of the Internal Revenue Code, which was enacted by the Tax Reform

Act of 1986. A taxpayer manufacturing or constructing property under a

long-term contract will be affected by these proposed regulations. This

document also provides notice of a public hearing on the proposed

regulations.

DATES: Written comments and outlines of oral comments to be presented

at the public hearing scheduled for September 14, 1999, at 10 a.m. must

be received by August 3, 1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-208156-91), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-

208156-91), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW., Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet by selecting the ``Tax Regs''

option on the IRS Home Page, or by submitting comments directly to the

IRS Internet site at http://www.irs.ustreas.gov/tax__regs/

regslist.html. The public hearing will be held in the IRS Auditorium,

7th Floor, Internal Revenue Building, 1111 Constitution Avenue, NW.,

Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

John M. Aramburu or Leo F. Nolan II at (202) 622-4960; concerning

submissions of comments, the hearing, and/or to be placed on the

building access list to attend the hearing, Michael L. Slaughter of the

Regulations Unit at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in this notice of proposed

rulemaking have been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)). Comments on the collections of information should be

sent to the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC

20224. Comments on the collections of information should be received by

July 6, 1999. Comments are specifically requested concerning:

Whether the proposed collections of information are necessary for

the proper performance of the functions of the Internal Revenue

Service, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed

collections of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collections of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in

Sec. 1.460-1(e)(4). The information collected in Sec. 1.460-1(e)(4) is

required to notify the Commissioner of the taxpayer's decision to sever

or aggregate one or more contracts under the regulations. This

collection of information is mandatory. The likely respondents are for-

profit entities.

Estimated total reporting burden: 50,000 hours.

Estimated average burden per respondent: 1 hour.

Estimated number of respondents: 50,000.

Estimated annual frequency of responses: On occasion.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid OMB control number.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

Section 460, which was enacted by section 804 of the Tax Reform Act

of 1986 (1986 Act), Public Law 99-514 (100 Stat. 2085, 2358-2361),

generally requires a taxpayer to determine the taxable income from a

long-term contract using the percentage-of-completion method. Section

460 was amended by section 10203 of the Omnibus Budget Reconciliation

Act of 1987, Public Law 100-203 (101 Stat. 1330, 1330-394); by sections

1008(c) and 5041 of the Technical and Miscellaneous Revenue Act of

1988, Public Law 100-647 (102 Stat. 3342, 3438-3439 and 3673-3676); by

sections 7621 and 7811(e) of the Omnibus Budget Reconciliation Act of

1989, Public Law 101-239 (103 Stat. 2106, 2375-2377 and 2408-2409); by

section 11812 of the Omnibus Budget Reconciliation Act of 1990, Public

Law 101-508 (104 Stat. 1388, 1388-534 to 1388-536); by sections

1702(h)(15) and 1704(t)(28) of the Small Business Job Protection Act of

1996, Public Law 104-188 (110 Stat. 1755, 1874, 1888); and by section

1211 of the Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat.

788, 998-1000).

Section 460(h) directs the Secretary to prescribe regulations to

the extent necessary or appropriate to carry out the purpose of section

460, including regulations to prevent a taxpayer from avoiding section

460 by using related parties, pass-through entities, intermediaries,

options, and other similar arrangements.

Explanation of Provisions

1. Overview

Before the enactment of section 460, Sec. 1.451-3 of the Income Tax

Regulations permitted a taxpayer to determine the income from a long-

term contract using either the completed-contract method (CCM) or the

percentage-of-completion method, in addition to the cash receipts and

disbursements method, if otherwise permissible, or an accrual method.

Under the CCM, a taxpayer does not report income until a contract is

complete, even though payments are received in years prior to

completion. The percentage-of-completion method, on the other hand,

requires a taxpayer to recognize income according to the percentage of

the contract that is completed during each taxable year.

Section 460 generally requires the income from a long-term contract

to be determined using the percentage-of-completion method based on a

cost-to-

[[Page 24097]]

cost comparison (PCM). However, the income from certain exempt

construction contracts still may be determined using the CCM, the

exempt-contract percentage-of-completion method (EPCM), or any other

permissible method. Contracts that are not long-term contracts must be

accounted for using a permissible method of accounting other than a

long-term contract method (i.e., a method other than the PCM, the CCM,

or the EPCM). See section 446 and the regulations thereunder.

The IRS and Treasury Department provided guidance on section 460 in

Notice 89-15 (1989-1 C.B. 634) and in Notice 87-61 (1987-2 C.B. 370).

These proposed regulations generally incorporate the relevant

provisions of Sec. 1.451-3 and the notices under section 460. However,

these proposed regulations also modify and amplify certain rules

provided in Sec. 1.451-3 and notices under section 460. Specifically,

for example, these regulations provide an exception for de minimis

construction activities, modify the contract completion rules, clarify

the treatment of non-long-term contract activities, modify the severing

and aggregating rules to emphasize pricing and to prevent severance by

taxpayers of contracts accounted for using the PCM, clarify the

consistency rule provided in Notice 89-15, provide an inventory

exception to the related party rules, provide safe harbors for

determining whether a manufactured item is unique, and modify the

normal time to complete an item to conform to the production period in

section 263A.

These proposed regulations will apply to any contract entered into

on or after final regulations are published in the Federal Register.

2. Definition of Long-Term Contract

Under section 460(f), long-term contract generally means any

contract for the manufacture, building, installation, or construction

of property if the contract is not completed within the taxable year

the taxpayer enters into the contract (contracting year). For this

purpose, manufacturing concerns only personal property, and building,

installation, and construction (construction) concern only real

property.

Section 460 continues the policy established in Sec. 1.451-3(b)(1)

of excluding a manufacturing contract from the definition of long-term

contract unless the contract involves the manufacture of (1) a unique

item of a type that is not normally included in the finished goods

inventory of the taxpayer or (2) an item normally requiring more than

12 calendar months to complete, regardless of the duration of the

contract.

A contract is a contract for the manufacture or construction of

property if such activities are necessary for the taxpayer's

contractual obligations to be fulfilled and are not complete when the

parties enter into the contract. However, a contract is not a

construction contract if it requires the provision of land by the

taxpayer and the estimated total allocable contract costs attributable

to the taxpayer's construction activities are less than 10 percent of

the total contract price. This de minimis construction rule may affect

the result of facts similar to those in Foothill Ranch Company

Partnership v. Commissioner, 110 T.C. No. 8 (1998), in which the Tax

Court concluded that the sale of land could be accounted for using the

PCM since construction of buildings and improvements was necessary to

fulfill the taxpayer's obligations under the sales agreements and those

obligations were not completed in the tax year of the sale.

3. Date Taxpayer Enters Into a Long-Term Contract

The proposed regulations provide that a taxpayer enters into a

long-term contract in the taxable year that the contract binds both the

taxpayer and the customer under applicable law. If a taxpayer delays

entering into a contract to avoid section 460, however, the taxpayer

will be treated as having entered into the contract on the date the

taxpayer or a related party incurs any allocable contract costs, other

than bidding or negotiating costs. If a taxpayer must sever an accepted

change order or exercised option from a long-term contract, the

taxpayer enters into another contract with the customer when the change

order is accepted by the taxpayer or when the option is exercised by

the customer, whichever is applicable.

4. Date Taxpayer Completes a Long-Term Contract

The proposed regulations provide that a long-term contract is

completed in the earlier taxable year (completion year) that: (1) the

customer uses the subject matter for any purpose (other than testing)

and 5 percent or less of the total allocable contract costs

attributable to the subject matter remain to be incurred by the

taxpayer; or (2) the subject matter of the contract is finally

completed and accepted. A taxpayer must determine whether a contract

has been finally completed and accepted during the taxable year based

upon an analysis of all relevant facts and circumstances. To the extent

that the ``use'' rule requires a taxpayer to treat a contract as

completed before final completion and acceptance have occurred, the

proposed regulations explicitly adopt a rule different from that

considered in Ball, Ball and Brosamer, Inc. v. Commissioner, 964 F.2d

890 (9th Cir. 1992), aff'g T.C. Memo. 1990-454. In Ball, the Ninth

Circuit held that the contract for construction of a space shuttle

complex was not completed in 1983, notwithstanding that the performance

report indicated the contract was 100 percent complete and the customer

was using the subject matter for its intended purpose, since the

remaining work to be done in 1984 (such as installing runway

extensions, airfield lighting, drainage and a laser tracking system)

was an integral part of the contract and the contract specifically

provided that use was not deemed acceptance.

The regulations also provide that if a contract accounted for using

the CCM requires the construction of a primary subject matter and a

secondary subject matter, the contract is completed when the primary

subject matter is completed. A taxpayer must separate the gross

receipts and costs related to the incomplete secondary item(s) from the

long-term contract and account for them using a permissible method of

accounting.

5. Non-Long-Term Contract Activities

The performance of any activity other than manufacturing or

construction is a non-long-term contract activity. If the performance

of a non-long-term contract activity, such as engineering and

designing, is incident to or necessary for the manufacture or

construction of the subject matter of one or more of the taxpayer's

long-term contracts, the taxpayer must allocate the gross receipts and

costs attributable to that activity to the long-term contract(s)

benefitted. Otherwise, the proposed regulations require the taxpayer to

account for such gross receipts and costs using a permissible method of

accounting other than a long-term contract method of accounting. See

Rev. Rul. 82-134 (1982-2 C.B. 88) (engineering and construction

management services); Rev. Rul. 80-18 (1980-1 C.B. 103) (engineering

and construction management services); and Rev. Rul. 70-67 (1970-1 C.B.

117) (architectural services).

6. Severing and Aggregating Contracts

Section 460(f)(3) provides that the Secretary may prescribe

regulations to treat two or more contracts which are interdependent as

one contract and to respect a contract which is properly

[[Page 24098]]

treated as an aggregation of separate contracts. The proposed

regulations allow the Commissioner, and generally require a taxpayer,

to sever and aggregate contracts when necessary to clearly reflect

income.

The proposed rules provide three criteria for determining whether

severance or aggregation is required. First, independent pricing of

items is necessary for an agreement to be severed into two or more

contracts. On the other hand, interdependent pricing of items in

separate agreements is necessary for two or more agreements to be

aggregated into one contract. Second, an agreement may not be severed

into two or more contracts, unless it provides for separate delivery or

separate acceptance of portions of the subject matter of the agreement.

However, separate delivery or separate acceptance of portions of the

subject matter of the agreement by itself does not necessarily require

severance of the agreement. Third, an agreement may not be severed into

two or more contracts if a reasonable businessperson would not have

entered into separate agreements containing the terms allocable to each

severed contract. Similarly, two or more agreements may not be

aggregated into one contract, unless a reasonable businessperson would

not have entered into one of the agreements for the terms agreed upon

without also entering into the other agreement. The criteria adopted in

the proposed regulations generally are consistent with the Tax Court's

conclusions in Sierracin Corporation v. Commissioner, 90 T.C. 341

(1988), acq. 1990-2 C.B. 1, and General Dynamics Corporation v.

Commissioner, T.C. Memo 1997-420.

Under the proposed regulations, a taxpayer may not apply the

severance rule described in the preceding paragraph if the entire

contract would be accounted for using the PCM. However, the

Commissioner may sever a contract accounted for using the PCM as

necessary to clearly reflect income. In addition, a taxpayer must sever

a long-term contract (not accounted for using the PCM) that increases

the number of units to be supplied to the customer, such as through the

exercise of an option or the acceptance of a ``change order,'' if the

contract provides for separate delivery or separate acceptance of the

additional units.

7. Classifying Long-Term Contracts

The proposed regulations provide that a taxpayer's method of

classifying contracts is a method of accounting. Thus, a taxpayer must

request the consent of the Commissioner to change its method of

classifying contracts. However, if the classification of a particular

type of contract is no longer appropriate for subsequent contracts of

that type as a result of a change in underlying facts, such as when a

manufactured item no longer is unique due to a reduction in the extent

of design or no longer requires 12 months to produce, a change in the

classification of such subsequent contracts is not a change in method

of accounting. To the extent that the consistency rule in Notice 89-15

(Q&A-7) was interpreted to prevent taxpayers from changing the

classification of a particular type of subsequent contracts when the

underlying facts have changed, the proposed regulations clarify the

consistency rule.

Under the proposed regulations, a taxpayer must classify a contract

that requires the taxpayer to manufacture personal property and to

construct real property separately as a manufacturing and a

construction contract, unless 95 percent or more of the estimated total

allocable contract costs are reasonably allocable to the manufacturing

activities or to the construction activities (in which case the

taxpayer may chose to classify as either a manufacturing or a

construction contract, as appropriate).

8. Long-Term Contracts of Related Parties

The proposed regulations contain rules similar to those in Notice

89-15 (Q&A-8) for an activity of a taxpayer that is incident to or

necessary for a related party's long-term contract subject to PCM. The

taxpayer must account for the gross receipts and costs from such an

activity using the PCM, even if this activity is not otherwise subject

to section 460. The proposed regulations contain an inventory exception

for subassemblies and components sold to a related party, however, when

the taxpayer regularly carries these items in its finished goods

inventories and 80 percent or more of the gross receipts from the sale

of these items typically comes from unrelated parties.

To determine the percentage of the contract that has been completed

by the end of the taxable year (completion factor), the taxpayer with

the long-term contract must take into account the related party's

activity that is incident to or necessary for its long-term contract at

the time it incurs the liability to the related party, rather than when

the related party incurs costs to perform the activity.

9. Unique Items

Section 460 applies if a taxpayer manufactures a unique item of a

type that is not normally included in the finished goods inventory of

the taxpayer and if the contract is not completed by the close of the

contracting year. As in Sec. 1.451-3(b)(1)(ii), the proposed

regulations provide that unique means specifically designed for the

needs of a customer. Thus, a contract may require the taxpayer to

manufacture more than one unit of a unique item.

The proposed regulations contain three safe harbors concerning

contracts to manufacture unique items. First, an item is not unique if

the taxpayer normally completes the item within 90 days. Second, an

item customized from a taxpayer's existing design is not unique if the

total allocable contract costs attributable to customizing activities

that are incident to or necessary for the production of the item does

not exceed 5 percent of the estimated total costs allocable to the

item. Thus, contracts to manufacture items that do not require either

significant design or lengthy production periods ordinarily will not be

subject to section 460. Third, a unique item ceases to be unique no

later than when the taxpayer normally carries similar items in its

finished goods inventory.

The proposed regulations adopt criteria different from those in

Sierracin, supra, which was decided two years after the enactment of

section 460, but concerned the taxpayer's use of the CCM for taxable

years ending before the enactment of section 460. In Sierracin, the Tax

Court developed a two-prong test for determining whether an item is

unique. That test provided that an item is unique if (1) it is designed

for the needs of a specific customer and (2) the taxpayer's contracts

are subject to unpredictable manufacturing risks that make it difficult

for the taxpayer to determine the ultimate profit or loss on an interim

basis.

The regulations incorporate the Sierracin criterion regarding

design, but exclude the criterion regarding unpredictable manufacturing

risk because that criterion was developed primarily to justify the

taxpayer's use of the CCM. See, e.g., GCM 7998 (IX-2 C.B. 206, 208);

Rev. Rul. 70-67 (1970-1 C.B. 117); Staff of Joint Comm. on Taxation,

99th Cong., 1st Sess., Tax Reform Proposals: Accounting Issues (JCS-39-

86) 46 (Comm. Print 1985). Manufacturing risk is not relevant under the

PCM because the taxpayer is required to use reasonable estimates,

adjusted annually, while the contract is being performed and because

the taxpayer is required to use the look-back method to correct for

estimation errors when the contract is completed. Thus, the rationale

supporting the

[[Page 24099]]

consideration of manufacturing risk as a prerequisite to the use of the

CCM, that the taxpayer is unable to determine its total contract costs,

is not applicable to contracts subject to the PCM.

10. 12-Month Completion Period

The proposed regulations provide that a manufactured item normally

requires more than 12 months to complete if its production period, as

defined in Sec. 1.263A-12, is reasonably expected to exceed 12 months,

determined at the end of the contracting year. In general, the

production period for an item or unit begins when the taxpayer's incurs

at least 5 percent of the estimated total allocable contract costs,

including planning and design expenditures, allocable to the item or

unit, and the production period ends when the item or unit is ready for

shipment to the taxpayer's customer. In the case of components that

have to be assembled or reassembled into an item or unit at the

customer's facility by the taxpayer's employees or agents, the

production period ends when the components are assembled or reassembled

into an operable item or unit.

For this purpose, the proposed regulations contain rules requiring

a taxpayer to treat the activities of a related party as the activities

of the taxpayer to prevent the taxpayer from avoiding section 460.

However, if the inventory exception discussed in paragraph 8 above is

satisfied, a taxpayer considers the activities of a related party as it

incurs the liability to the related party rather than as the related

party performs the activity.

11. Definition of Construction Contract

Section 460(e)(4) and the proposed regulations provide that a

construction contract is any contract for the building, construction,

reconstruction, or rehabilitation of, or the installation of any

integral component to, or improvements of, real property. Thus, a

contract to install an integral component to real property can be

subject to section 460 even if the installation activity is not

accompanied by any other construction activity.

12. Exempt Construction Contracts

Section 460(e)(1) exempts two types of construction contracts from

the general scope of section 460. These exempt construction contracts

are: (1) home construction contracts and (2) 2-year construction

contracts of a small contractor. A small contractor is a taxpayer that

satisfies the $10,000,000 gross receipts test discussed below. The 2-

year construction requirement is satisfied if the taxpayer reasonably

estimates, when entering into the contract, that the contract will be

completed within 2 years from the contract commencement date.

13. Home Construction Contracts

Section 460(e)(6) provides that a construction contract is a home

construction contract if the taxpayer (including a subcontractor

working for a general contractor) reasonably expects to attribute 80

percent or more of the estimated total contract costs, determined at

the close of the contracting year, to the construction of (1) a

dwelling unit or a building containing four or fewer dwelling units and

(2) improvements to real property directly related to the dwelling

units and located on the site of the dwelling units. For this purpose,

a dwelling unit means a house or an apartment used to provide living

accommodations in a building or structure, but does not include a unit

in a hotel, motel, or other establishment more than one-half of the

units in which are used on a transient basis. In addition, a taxpayer

must treat each townhouse or rowhouse as a separate building. The

proposed regulations provide that a taxpayer includes in the cost of

the dwelling units their allocable share of the cost of any common

improvements (e.g., sewers, roads, clubhouses) that benefit the

dwelling unit and that the taxpayer is contractually obligated, or

required by law, to construct within the tract or tracts of land

containing the dwelling units.

14. $10,000,000 Gross Receipts Test

Section 460(e)(1)(B)(ii) provides that the $10,000,000 gross

receipts test is satisfied if the taxpayer's average annual gross

receipts for the three taxable years preceding the contracting year do

not exceed $10,000,000. For this purpose, section 460(e)(2) mandates

the aggregation of gross receipts of all trades or businesses under

common control with the taxpayer. Section 460(e)(2) also provides that

the Secretary shall prescribe regulations providing attribution rules

that take into account taxpayers who engage in construction contracts

through partnerships, joint ventures, and corporations.

The proposed regulations require the aggregation of gross receipts

under the common control rules in Sec. 1.263A-3(b)(3), other than the

rules applicable to single employers under section 414(m) and the

regulations thereunder. In addition, the regulations require the

attribution of construction-related gross receipts of persons that own,

or are owned by, the taxpayer, but that are not subject to Sec. 1.263A-

3(b)(3). These rules are similar to those that applied to the

$25,000,000 gross receipts test under prior law.

15. Accounting for Long-Term Contracts--In General

The proposed regulations prescribe permissible methods of

accounting for long-term contracts subject to section 460(a). A

taxpayer must use the PCM and may elect to use the 10-percent method.

In addition, the regulations prescribe permissible methods of

accounting for exempt construction contracts (exempt contract methods).

Permissible exempt contract methods of accounting include the PCM, the

EPCM, the CCM, or any other permissible method.

Section 460(e)(5) allows a taxpayer to determine the income from a

residential construction contract using the percentage-of-completion/

capitalized-cost method (PCCM). A taxpayer also may determine the

income from a qualified ship contract using the PCCM. Under this

method, a taxpayer must determine the income from the long-term

contract using the PCM for the applicable percentage and using its

exempt contract method for the remaining percentage of the contract.

The proposed regulations reserve on the accounting for mid-contract

change in taxpayers. The IRS and Treasury Department request comments

regarding the treatment of transfers of long-term contracts prior to

completion.

16. Percentage-of-Completion Method

The proposed regulations provide that under the PCM, a taxpayer

generally includes a portion of the total contract price in income for

each taxable year that the taxpayer incurs contract costs allocable to

the long-term contract. To determine the income from a long-term

contract, the taxpayer first computes the completion factor for the

contract, which is the percentage of the estimated total allocable

contract costs that the taxpayer has incurred (based on the all events

test of section 461, including economic performance, regardless of the

taxpayer's method of accounting) through the end of the taxable year.

Second, the taxpayer computes the amount of cumulative gross receipts

from the contract by multiplying the completion factor by the total

contract price, which is the amount that the taxpayer reasonably

expects to receive under the contract. Third, the taxpayer computes the

amount of current-year gross receipts, which is the difference between

the cumulative gross receipts for the current taxable year and the

cumulative gross receipts for the immediately preceding taxable year.

[[Page 24100]]

This difference may be a loss (a negative number) if a taxpayer has

overstated its completion factor for the immediately preceding taxable

year. Fourth, the taxpayer takes into account both the current-year

gross receipts and the amount of allocable contract costs actually

incurred during the taxable year. To the extent any portion of the

total contract price has not been included in taxable income by the

completion year, section 460(b)(1) and the proposed regulations require

the taxpayer to include that portion in income for the taxable year

following the completion year.

Under the proposed regulations, total contract price includes all

bonuses, awards, and incentive payments if it is reasonably estimated

that they will be received, even if the all events test has not yet

been met. If, by the end of the completion year, a taxpayer cannot

reasonably estimate whether a contingency will be satisfied, the bonus,

award, or incentive payment is not includable in total contract price.

If it is determined after the taxable year following the completion

year that an amount included in total contract price will not be

earned, the taxpayer should deduct that amount in the year of the

determination.

The proposed regulations provide that allocable contract costs

under the PCM are determined using either of the following prescribed

cost allocation methods--a method based on the extended period contract

allocation rules in Sec. 1.451-3(d)(6) or the simplified cost-to-cost

method.

17. 10-Percent Method

Section 460 generally permits a taxpayer to elect to delay the

application of the PCM to each long-term contract until the taxable

year the taxpayer has incurred at least 10 percent of the estimated

total allocable contract costs. Once elected, the 10-percent method

applies to all of the taxpayer's long-term contracts entered into

during and after the election year. Under section 460(b)(5), however, a

taxpayer may not elect the 10-percent method if the taxpayer determines

allocable direct and indirect costs using the simplified cost-to-cost

method.

18. Cost Allocation Rules

Section 460(c) provides cost allocation rules for long-term

contracts subject to the PCM. Section 460(c)(1) provides generally that

all costs which directly benefit, or are incurred by reason of, the

long-term contract activities of the taxpayer must be allocated to the

long-term contract in the same manner as costs are allocated to

extended-period long-term contracts under section 451 and the

regulations thereunder (Sec. 1.451-3(d)(6) through (9)). Section

460(c)(2), however, also requires a taxpayer to allocate costs

identified under a cost-plus long-term contract or a federal long-term

contract even if these costs would not be allocable under the cost

allocation rules for extended-period long-term contracts. In addition,

section 460(c)(3) requires a taxpayer to allocate interest expense to a

long-term contract (whether or not the contract is subject to the PCM)

as if the rules of section 263A(f) (concerning the allocation of

interest costs to property produced by the taxpayer) apply. Finally,

sections 460(c)(4) and (5) describe costs that generally are not

allocable to long-term contracts.

Because many taxpayers subject to the cost allocation rules of

section 460 also are subject to the cost allocation rules of section

263A for non-long-term contracts, and because the cost allocation rules

of section 263A generally follow the cost allocation rules applicable

to extended-period long-term contracts, the proposed regulations

provide that a taxpayer generally must allocate costs to a contract

subject to section 460(a) in the same manner as direct and indirect

costs are capitalized to property produced by a taxpayer under section

263A. The regulations provide exceptions, however, that reflect the

differences in the cost allocation rules of sections 263A and 460.

19. Simplified Cost-To-Cost Method

The proposed regulations permit a taxpayer to elect to allocate

contract costs using the simplified cost-to-cost method.

Under the simplified cost-to-cost method, a taxpayer must determine

a contract's completion factor based upon only direct material costs;

direct labor costs; and depreciation, amortization, and cost recovery

allowances on equipment and facilities directly used to manufacture or

construct property under the contract. A taxpayer may allocate costs

using the simplified cost-to-cost method only if the taxpayer

determines the taxable income from all long-term contracts using the

PCM.

20. Cost Allocation Rules for Exempt Construction Contracts

The proposed regulations, which supersede Sec. 1.451-3(d)

(concerning the CCM), provide cost allocation rules for exempt

construction contracts accounted for using the CCM. These rules provide

that a taxpayer may allocate direct and indirect contract costs in the

same way as currently required under Sec. 1.451-3(d)(5) for long-term

contracts that are not extended-period long-term contracts. The

regulations also permit a taxpayer to allocate indirect costs as

provided in section 263A. A homebuilder, however, is required to

capitalize the costs of its home construction contracts under section

263A and the regulations thereunder, unless the contract will be

completed within 2 years of the contract commencement date and the

taxpayer satisfies the $10,000,000 gross receipts test previously

discussed.

21. Alternative Minimum Taxable Income

Section 56 generally requires a taxpayer (not exempt under section

55(e)) to determine the amount of alternative minimum taxable income

(AMTI) from a long-term contract using the PCM. Though section 56(a)(3)

excludes all home construction contracts from this requirement, the

Internal Revenue Code does not exclude the exempt construction

contracts of a small contractor, residential construction contracts, or

qualified ship contracts. Section 56(a)(3) requires a small contractor

to use the simplified cost-to-cost method to determine the completion

factor of an exempt construction contract when computing AMTI.

Because the Code sometimes requires a taxpayer to compute AMTI and

taxable income using different rules, a taxpayer generally must

determine a contract's completion factor using the AMTI-modified, cost-

to-cost PCM. The proposed regulations adopt the provisions of section

IX of Notice 87-61, which permit a taxpayer to elect to determine a

contract's completion factor for AMTI purposes using the accounting and

cost allocation methods used to compute regular taxable income. A

taxpayer is required, however, to comply with section 55 when computing

AMTI.

22. Changes in Method of Accounting

For the first taxable year that includes the date these regulations

are published as final regulations in the Federal Register, the

proposed regulations generally grant a taxpayer consent to change its

method of accounting to comply with the provisions of these regulations

for contracts entered into on or after the date these regulations are

published as final regulations in the Federal Register. Because this

change is made on a cutoff basis, a section 481(a) adjustment is not

required.

[[Page 24101]]

23. Request for Comments

The IRS and Treasury Department invite comments regarding the

application and effectiveness of the de minimis construction rule. The

IRS and Treasury Department also welcome comments concerning the

application of the unique-item rule, including the usefulness and terms

of the safe harbors and approaches for determining when an item will

cease being unique. Comments are requested concerning the 12-month

production period rule, especially with respect to the application of

Sec. 1.263A-12 and consideration of related party activities.

Proposed Effective Date

These regulations are proposed to be effective for contracts

entered into on or after the date they are published in the Federal

Register as final regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required.

It also has been determined that section 553(b) of the

Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to

these regulations. Pursuant to section 7805(f) of the Internal Revenue

Code, this notice of proposed rulemaking will be submitted to the Chief

Counsel for Advocacy of the Small Business Administration for comment

on its impact on small business. It is hereby certified that the

collection of information in this notice of proposed rulemaking will

not have a significant economic impact on a substantial number of small

entities. The regulations require a taxpayer to attach a statement to

its original Federal income tax return if the taxpayer severs or

aggregates a long-term contract. The statement is needed so the

Commissioner can determine whether the taxpayer properly severed or

aggregated the contract. It is uncommon for a taxpayer that has a long-

term contract to sever or aggregate that contract. In addition, if a

contract is severed or aggregated and a statement is required, it is

estimated that it will, on average, only take one hour to complete.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any electronic or written comments (a

signed original and eight (8) copies) that are submitted timely to the

IRS. The IRS and Treasury specifically request comments on the clarity

of the proposed rule and how it may be made easier to understand. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for September 14, 1999, at 10

a.m. in the IRS Auditorium, 7th Floor, Internal Revenue Building, 1111

Constitution Avenue, NW., Washington, DC. Due to building security

procedures, visitors must enter at the 10th Street entrance, located

between Constitution and Pennsylvania Avenue, NW. In addition, all

visitors must present photo identification to enter the building.

Because of access restrictions, visitors will not be admitted beyond

the immediate entrance area more than 15 minutes before the hearing

starts. For information about having your name placed on the building

access list to attend the hearing, see the FOR FURTHER INFORMATION

CONTACT section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who

wish to present oral comments at the hearing must submit written

comments and an outline of the topics to be discussed and the time to

be devoted to each topic (signed original and eight (8) copies by

August 3, 1999. A period of 10 minutes will be allotted to each person

for making comments. An agenda showing the scheduling of the speakers

will be prepared after the deadline for receiving outlines has passed.

Copies of the agenda will be available free of charge at the hearing.

Drafting Information: The principal author of these proposed

regulations is Leo F. Nolan II, Office of Assistant Chief Counsel

(Income Tax and Accounting). However, other personnel from the IRS and

Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entry for Sec. 1.460-4 and adding the following entries in

numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Sec. 1.460-1 also issued under 26 U.S.C. 460(h).

Sec. 1.460-2 also issued under 26 U.S.C. 460(h).

Sec. 1.460-3 also issued under 26 U.S.C. 460(h).

Sec. 1.460-4 also issued under 26 U.S.C. 460(h) and 1502.

Sec. 1.460-5 also issued under 26 U.S.C. 460(h). * * *

Sec. 1.446-1 [Amended]

Par. 2. Section 1.446-1 is amended as follows:

1. In the second sentence of paragraph (c)(1)(iii), the language

``451'' is removed and ``460'' is added in its place.

2. In the fourth sentence of paragraph (e)(2)(ii)(a), the language

``Sec. 1.451-3'' is removed and ``Sec. 1.460-4'' is added in its place.

Sec. 1.451-3 [Removed]

Par. 3. Section 1.451-3 is removed.

Sec. 1.451-5 [Amended]

Par. 4. Section 1.451-5 is amended, in the first sentence of

paragraph (b)(3), by removing the language ``Sec. 1.451-3'' and adding

``Sec. 1.460-4'' in its place.

Par. 5. Section 1.460-0 is amended by:

1. Revising the introductory text.

2. Revising the entries for Secs. 1.460-1 through 1.460-3, 1.460-

4(a)-(i), and 1.460-5.

3. Revising the entry for Sec. 1.460-6(c)(4)(iv).

4. Removing the entries for Secs. 1.460-7 and 1.460-8.

The revisions read as follows:

Sec. 1.460-0 Outline of regulations under section 460.

This section lists the paragraphs contained in Sec. 1.460-1 through

Sec. 1.460-6.

Sec. 1.460-1 Long-term contracts.

(a) Overview.

(1) In general.

(2) Exceptions to required use of PCM.

(i) Exempt construction contract.

(ii) Qualified ship or residential construction contract.

(b) Definitions.

(1) Long-term contract.

(2) Contract for the manufacture, building, installation, or

construction of property.

(i) In general.

(ii) De minimis construction activities.

(3) Allocable contract costs.

(4) Related party.

(5) Contracting year.

(6) Completion year.

(7) Contract commencement date.

(8) Incurred.

(c) Entering into and completing long-term contracts.

(1) In general.

(2) Date contract entered into.

(i) In general.

(ii) Options and change orders.

(3) Date contract completed.

(i) In general.

(ii) Secondary items.

(iii) Subcontracts.

(iv) Final completion and acceptance.

[[Page 24102]]

(A) In general.

(B) Contingent compensation.

(C) Assembly or installation.

(D) Disputes.

(d) Allocation among activities.

(1) In general.

(2) Non-long-term contract activity.

(e) Severing and aggregating contracts.

(1) In general.

(2) Facts and circumstances.

(i) Independent pricing.

(ii) Interdependent pricing.

(iii) Separate delivery or acceptance.

(iv) Reasonable businessperson.

(3) Exceptions.

(i) No severance for PCM.

(ii) Options and change orders.

(4) Statement with return.

(f) Classifying contracts.

(1) In general.

(2) Hybrid contracts.

(3) Method of accounting.

(4) Use of estimates.

(i) Estimating length of contract.

(ii) Estimating allocable contract costs.

(g) Special rules for activities benefitting long-term contracts

of a related party.

(1) Related party use of PCM.

(i) In general.

(ii) Inventory exception.

(2) Total contract price.

(3) Completion factor.

(h) Effective date.

(1) In general.

(2) Change in method of accounting.

(i) [Reserved]

(j) Examples.

Sec. 1.460-2 Long-term manufacturing contracts.

(a) In general.

(b) Unique.

(1) In general.

(2) Safe harbors.

(i) Short production period.

(ii) Customized item.

(iii) Inventoried item.

(c) Normal time to complete.

(1) In general.

(2) Production by related parties.

(d) Qualified ship contracts.

(e) Examples.

Sec. 1.460-3 Long-term construction contracts.

(a) In general.

(b) Exempt construction contracts.

(1) In general.

(2) Home construction contract.

(i) In general.

(ii) Townhouses and rowhouses.

(iii) Common improvements.

(iv) Mixed use costs.

(3) $10,000,000 gross receipts test.

(i) In general.

(ii) Single employer.

(iii) Attribution of gross receipts.

(c) Residential construction contracts.

Sec. 1.460-4 Methods of accounting for long-term contracts.

(a) Overview.

(b) Percentage-of-completion method.

(1) In general.

(2) Computations.

(3) Post-completion-year income.

(4) Total contract price.

(i) In general.

(A) Definition.

(B) Contingent compensation.

(C) Non-long-term contract activities.

(ii) Estimating total contract price.

(5) Completion factor.

(i) Allocable contract costs.

(ii) Cumulative allocable contract costs incurred.

(iii) Estimating total allocable contract costs.

(iv) Pre-contracting-year costs.

(v) Post-completion-year costs.

(6) 10-percent method.

(i) In general.

(ii) Election.

(c) Exempt contract methods.

(1) In general.

(2) Exempt-contract percentage-of-completion method.

(i) In general.

(ii) Determination of work performed.

(d) Completed-contract method.

(1) In general.

(2) Post-completion-year income and costs.

(3) Gross contract price.

(4) Contracts with disputed claims.

(i) In general.

(ii) Taxpayer assured of profit or loss.

(iii) Taxpayer unable to determine profit or loss.

(iv) Dispute resolved.

(e) Percentage-of-completion/capitalized-cost method.

(f) Alternative minimum taxable income.

(1) In general.

(2) Election to use regular completion factors.

(g) Method of accounting.

(h) Examples.

(i) Mid-contract change in taxpayer. [Reserved]

* * * * *

Sec. 1.460-5 Cost allocation rules.

(a) Overview.

(b) Cost allocation method for contracts subject to PCM.

(1) In general.

(2) Special rules.

(i) Direct material costs.

(ii) Components and subassemblies.

(iii) Simplified production methods.

(iv) Costs identified under cost-plus long-term contracts and

federal long-term contracts.

(v) Interest.

(A) In general.

(B) Production period.

(C) Application of section 263A(f).

(vi) Research and experimental expenses.

(vii) Service costs.

(A) Simplified service cost method.

(1) In general.

(2) Example.

(B) Jobsite costs.

(C) Limitation on other reasonable cost allocation methods.

(c) Simplified cost-to-cost method.

(1) In general.

(2) Election.

(d) Cost allocation rules for exempt construction contracts

reported using CCM.

(1) In general.

(2) Indirect costs.

(i) Indirect costs allocable to exempt construction contracts.

(ii) Indirect costs not allocable to exempt construction

contracts.

(3) Large homebuilders.

(e) Cost allocation rules for contracts subject to the PCCM.

(f) Special rules applicable to costs allocated under this

section.

(1) Nondeductible costs.

(2) Costs incurred for non-long-term contract activities.

(g) Method of accounting.

Sec. 1.460-6 Look-back method.

* * * * *

(c) * * *

(4) * * *

(iv) Additional interest due on look-back interest only after

tax liability due.

* * * * *

Par. 6. Sections 1.460-1 through 1.460-3 are revised to read as

follows:

Sec. 1.460-1 Long-term contracts.

(a) Overview--(1) In general. This section provides rules for

determining whether a contract for the manufacture, building,

installation, or construction of property is a long-term contract under

section 460 and what activities must be accounted for as a single long-

term contract. Specific rules for long-term manufacturing and

construction contracts are provided in Secs. 1.460-2 and 3,

respectively. A taxpayer generally must determine the income from a

long-term contract using the percentage-of-completion method described

in Sec. 1.460-4(b) (PCM) and the cost allocation rules described in

Sec. 1.460-5(b) or (c). In addition, after a contract subject to the

PCM is completed, a taxpayer generally must apply the look-back method

described in Sec. 1.460-6 to determine the amount of interest owed on

any hypothetical underpayment of tax, or earned on any hypothetical

overpayment of tax, attributable to accounting for the long-term

contract under the PCM.

(2) Exceptions to required use of PCM--(i) Exempt construction

contract. The requirement to use the PCM does not apply to any exempt

construction contract described in Sec. 1.460-3(b). Thus, a taxpayer

may determine the income from an exempt construction contract using any

accounting method permitted by Sec. 1.460-4(c) and, for contracts

accounted for using the completed-contract method (CCM), any cost

allocation method permitted by Sec. 1.460-5(d).

(ii) Qualified ship or residential construction contract. The

requirement to use the PCM applies only to a portion of a qualified

ship contract described in Sec. 1.460-2(d) or residential construction

contract described in Sec. 1.460-3(c). A taxpayer generally may

determine the income from a qualified ship contract or residential

construction contract using

[[Page 24103]]

the percentage-of-completion/capitalized-cost method (PCCM) described

in Sec. 1.460-4(e), but must use a cost allocation method described in

Sec. 1.460-5(b) for the entire contract.

(b) Definitions--(1) Long-term contract. A long-term contract

generally is any contract for the manufacture, building, installation,

or construction of property if the contract is not completed within the

contracting year, as defined in paragraph (b)(5) of this section.

However, a contract for the manufacture of property is a long-term

contract only if it also satisfies either the unique item or 12-month

requirements described in Sec. 1.460-2. A contract for the manufacture

of personal property is a manufacturing contract. In contrast, a

contract for the building, installation, or construction of real

property is a construction contract.

(2) Contract for the manufacture, building, installation, or

construction of property--(i) In general. A contract is a contract for

the manufacture, building, installation, or construction of property if

the manufacture, building, installation, or construction of the subject

matter of the contract is necessary for the taxpayer's contractual

obligations to be fulfilled and if the manufacture, building,

installation, or construction has not been completed when the parties

enter into the contract. Whether the customer has title to, or control

over, the property (or bears the risk of loss from the property) is not

relevant. Furthermore, how the parties characterize their agreement

(e.g., as a contract for the sale of property) is not relevant.

(ii) De minimis construction activities. Notwithstanding paragraph

(b)(2)(i) of this section, a contract is not a construction contract

for purposes of section 460 if the contract includes the provision of

land by the taxpayer and the estimated total allocable contract costs,

as defined in paragraph (b)(3) of this section, attributable to the

taxpayer's construction activities are less than 10 percent of the

contract's total contract price, as defined in Sec. 1.460-4(b)(4)(i).

For this purpose, a contract's estimated total allocable contract costs

include a proportionate share of the estimated cost of any common

improvement that benefits the subject matter of the contract if the

taxpayer is contractually obligated, or required by law, to construct

the common improvement.

(3) Allocable contract costs. Allocable contract costs are costs

that are allocable to a long-term contract under Sec. 1.460-5.

(4) Related party. A related party is a person whose relationship

to a taxpayer is described in section 707(b) or 267(b), determined

without regard to section 267(f)(1)(A) and determined by substituting

``at least 80 percent'' for ``more than 50 percent'' with regard to the

ownership of the stock of a corporation in sections 267(b)(2), (8),

(10)(A), and (12).

(5) Contracting year. The contracting year is the taxable year in

which a taxpayer enters into a contract as described in paragraph

(c)(2) of this section.

(6) Completion year. The completion year is the taxable year in

which a taxpayer completes a contract as described in paragraph (c)(3)

of this section.

(7) Contract commencement date. The contract commencement date is

the date that a taxpayer or related party first incurs any allocable

contract costs, such as design and engineering costs, other than

expenses attributable to bidding and negotiating activities. Generally,

the contract commencement date is relevant in applying Sec. 1.460-

6(b)(3) (concerning the de minimis exception to the look-back method

under section 460(b)(3)(B)); Sec. 1.460-5(b)(2)(v)(B)(1)(i) (concerning

the production period subject to interest allocation); Sec. 1.460-2(d)

(concerning qualified ship contracts); and Sec. 1.460-3(b)(1)(ii)

(concerning the construction period for exempt construction contracts).

(8) Incurred. Incurred has the meaning given in Sec. 1.461-1(a)(2)

(concerning the taxable year of deduction under the accrual method of

accounting), regardless of a taxpayer's overall method of accounting.

See Sec. 1.461-4(d)(2)(ii) for economic performance rules concerning

the PCM.

(c) Entering into and completing long-term contracts--(1) In

general. To determine when a contract is entered into under paragraph

(c)(2) of this section, and when a contract is completed under

paragraph (c)(3) of this section, a taxpayer must consider all relevant

activities performed by itself, by related parties, and by the

customer, that are incident to or necessary for the long-term contract.

In addition, to determine whether a contract is completed in the

contracting year, the taxpayer may not consider when it expects to

complete the contract.

(2) Date contract entered into--(i) In general. A taxpayer enters

into a contract on the date that the contract binds both the taxpayer

and the customer under applicable law, even if the contract is subject

to unsatisfied conditions not within the taxpayer's control (such as

obtaining financing). If a taxpayer delays entering into a contract for

a principal purpose of avoiding section 460, however, the taxpayer will

be treated as having entered into a contract not later than the

contract commencement date.

(ii) Options and change orders. A taxpayer enters into a new

contract on the date that the customer exercises an option or similar

provision in a contract if that option or similar provision must be

severed from the contract under paragraph (e) of this section.

Similarly, a taxpayer enters into a new contract on the date that it

accepts a change order or other similar agreement if the change order

or other similar agreement must be severed from the contract under

paragraph (e) of this section.

(3) Date contract completed--(i) In general. A taxpayer's contract

is completed upon the earlier of--

(A) Use of the subject matter of the contract by the customer

(other than for testing) and at least 95 percent of the total allocable

contract costs attributable to the subject matter have been incurred by

the taxpayer; or

(B) Final completion and acceptance of the subject matter of the

contract.

(ii) Secondary items. The date a contract accounted for using the

CCM is completed is determined without regard to whether one or more

secondary items have been used or finally completed and accepted. If

any secondary items are incomplete at the end of the taxable year in

which the primary subject matter of a contract is completed, the

taxpayer must separate the portion of the gross contract price and the

allocable contract costs attributable to the incomplete secondary

item(s) from the completed contract and account for them using a

permissible method of accounting. A permissible method of accounting

includes a long-term contract method of accounting only if a separate

contract for the secondary item(s) would be a long-term contract, as

defined in paragraph (b)(1) of this section.

(iii) Subcontracts. In the case of a subcontract, the subject

matter of the subcontract is the relevant subject matter under

paragraph (c)(3)(i) of this section.

(iv) Final completion and acceptance--(A) In general. Except as

otherwise provided in this paragraph (c)(3)(iv), to determine whether

final completion and acceptance of the subject matter of a contract

have occurred, a taxpayer must consider all relevant facts and

circumstances. Nevertheless, a taxpayer may not delay the completion of

a contract for the principal purpose of deferring federal income tax.

(B) Contingent compensation. Final completion and acceptance is

determined without regard to any contractual term that provides for

[[Page 24104]]

additional compensation that is contingent on the successful

performance of the subject matter of the contract. A taxpayer must

account for all contingent compensation that is not includible in total

contract price under Sec. 1.460-4(b)(4)(i), or in gross contract price

under Sec. 1.460-4(d)(3), using a permissible method of accounting. For

application of the look-back method for contracts accounted for using

the PCM, see Sec. 1.460-6(c)(1)(ii) and (2)(vi).

(C) Assembly or installation. Final completion and acceptance is

determined without regard to whether the taxpayer has an obligation to

assist or supervise assembly or installation of the subject matter of

the contract where the assembly or installation is not performed by the

taxpayer or a related party. A taxpayer must account for the gross

receipts and costs attributable to such an obligation using a

permissible method of accounting, other than a long-term contract

method.

(D) Disputes. Final completion and acceptance is determined without

regard to whether a dispute exists at the time the taxpayer tenders the

subject matter of the contract to the customer. For contracts accounted

for using the CCM, see Sec. 1.460-4(d)(4). For application of the look-

back method for contracts accounted for using the PCM, see Sec. 1.460-

6(c)(1)(ii) and (2)(vi).

(d) Allocation among activities--(1) In general. Long-term contract

methods of accounting (the PCM, the CCM, the PCCM, and the exempt-

contract percentage-of-completion method (EPCM)) apply only to the

gross receipts and costs attributable to long-term contract activities.

Gross receipts and costs attributable to long-term contract activities

means amounts included in total contract price or gross contract price,

whichever is applicable, as determined under Sec. 1.460-4, and costs

allocable to the contract, as determined under Sec. 1.460-5. Gross

receipts and costs attributable to non-long-term contract activities

(as defined in paragraph (d)(2) of this section) generally must be

taken into account using permissible methods of accounting other than a

long-term contract method. See section 446(c) and Sec. 1.446-1(c).

However, if the performance of a non-long-term contract activity is

incident to or necessary for the manufacture, building, installation,

or construction of the subject matter of one or more of the taxpayer's

long-term contracts, the gross receipts and costs attributable to that

activity must be allocated to the long-term contract(s) benefitted as

provided in Secs. 1.460-4(b)(4)(i) and 1.460-5(f)(2), respectively.

Similarly, if a single long-term contract requires a taxpayer to

perform a non-long-term contract activity that is not incident to or

necessary for the manufacture, building, installation, or construction

of the subject matter of the long-term contract, the gross receipts and

costs attributable to that non-long-term contract activity must be

separated from the contract and accounted for using a permissible

method of accounting other than a long-term contract method. But see

paragraph (g) of this section for related party rules.

(2) Non-long-term contract activity. Non-long-term contract

activity means the performance of an activity other than manufacturing,

building, installation, or construction, such as the provision of

architectural, design, engineering, and construction management

services; the performance under a guarantee, warranty, and maintenance

agreement; and the development of software.

(e) Severing and aggregating contracts--(1) In general. After

application of the allocation rules of paragraph (d) of this section,

the severing and aggregating rules of this paragraph (e) may be applied

by the Commissioner or the taxpayer as necessary to clearly reflect

income (such as, to prevent the unreasonable deferral of recognition of

income or the premature recognition of loss). Under the severing and

aggregating rules, one agreement may be treated as two or more

contracts, and two or more agreements may be treated as one contract.

Except as provided in paragraph (e)(3)(ii) of this section, a taxpayer

must determine whether to sever an agreement or to aggregate two or

more agreements based on all the facts and circumstances known at the

end of the contracting year.

(2) Facts and circumstances. Whether an agreement should be

severed, or two or more agreements should be aggregated, depends on the

following factors:

(i) Independent pricing. Independent pricing of items in an

agreement is necessary for the agreement to be severed into two or more

contracts. In the case of an agreement for several similar items, if

the price to be paid for the items is determined under different terms

or formulas (for example, if some items are priced under a cost-plus

incentive fee arrangement and later items are to be priced under a

fixed-price arrangement), then the difference in the pricing terms or

formulas indicates that the items are independently priced.

(ii) Interdependent pricing. Interdependent pricing of items in

separate agreements is necessary for two or more agreements to be

aggregated into one contract. A single price negotiation for similar

items ordered under one or more agreements indicates that the items are

interdependently priced.

(iii) Separate delivery or acceptance. An agreement may not be

severed into two or more contracts unless it provides for separate

delivery or separate acceptance of items that are the subject matter of

the agreement. However, the separate delivery or separate acceptance of

items by itself does not necessarily require an agreement to be

severed.

(iv) Reasonable businessperson. Two or more agreements to perform

manufacturing or construction activities may not be aggregated into one

contract unless a reasonable businessperson would not have entered into

one of the agreements for the terms agreed upon without also entering

into the other agreement(s). Similarly, an agreement to perform

manufacturing or construction activities may not be severed into two or

more contracts if a reasonable businessperson would not have entered

into separate agreements containing terms allocable to each severed

contract. For example, a single agreement to manufacture a prototype of

an item, which would result in a substantial loss, and ten additional

units of the item, which would result in a substantial gain, may not be

severed into one contract for the prototype and another contract for

the ten additional units under this paragraph (e)(2)(iv) because a

reasonable businessperson would not have entered into a separate

contract to manufacture the prototype. For purposes of this paragraph

(e)(2)(iv), a taxpayer's expectation that the parties would enter into

another agreement, when agreeing to the terms contained in the first

agreement, is irrelevant.

(3) Exceptions--(i) No severance for PCM. A taxpayer may not sever

under this paragraph (e) a long-term contract that would be accounted

for using the PCM.

(ii) Options and change orders. Except as provided in paragraph

(e)(3)(i) of this section, a taxpayer must sever an agreement that

increases the number of units to be supplied to the customer, such as

through the exercise of an option or the acceptance of a change order,

if the agreement provides for separate delivery or separate acceptance

of the additional units.

(4) Statement with return. If a taxpayer severs an agreement or

aggregates two or more agreements under this paragraph (e) during the

taxable year, the taxpayer must attach a statement to its original

Federal income tax return for that year. This statement

[[Page 24105]]

must contain the following information--

(i) The legend NOTIFICATION OF SEVERANCE OR AGGREGATION UNDER SEC.

1.460-1(e);

(ii) The taxpayer's name;

(iii) The taxpayer's employer identification number or social

security number;

(iv) The identity of each agreement being severed or aggregated;

(v) The method of accounting used for each contract; and

(vi) A description of the reason(s) for severance or aggregation.

(f) Classifying contracts--(1) In general. A taxpayer must

determine the classification of a contract (e.g., as a long-term

manufacturing contract, long-term construction contract, non-long-term

contract) based on all the facts and circumstances known no later than

the end of the contracting year.

(2) Hybrid contracts. A long-term contract that requires a taxpayer

to perform both manufacturing and construction activities (hybrid

contract) generally must be classified as two contracts, a

manufacturing contract and a construction contract. However, a hybrid

contract may be classified as a manufacturing (or construction)

contract if at least 95 percent of the estimated total allocable

contract costs are reasonably allocable to the manufacturing (or

construction) activities.

(3) Method of accounting. A taxpayer's method of classifying

contracts is a method of accounting under section 446 and, thus, may

not be changed without the Commissioner's consent. If a taxpayer's

method of classifying contracts is unreasonable, that classification

method is an impermissible accounting method.

(4) Use of estimates--(i) Estimating length of contract. A taxpayer

must use a reasonable estimate of the time required to complete a

contract when necessary to classify the contract (e.g., to determine

whether the five-year completion rule for qualified ship contracts

under Sec. 1.460-2(d), or the two-year completion rule for exempt

construction contracts under Sec. 1.460-3(b), is satisfied; but, not to

determine whether a contract is completed within the contracting year

under paragraph (b)(1) of this section). To be considered reasonable,

an estimate of the time required to complete the contract must include

anticipated time for delay, rework, change orders, technology or design

problems, or other problems that reasonably can be anticipated

considering the nature of the contract and prior experience. A contract

term that specifies an expected completion or delivery date may be

considered evidence that the taxpayer reasonably expects to complete or

deliver the subject matter of the contract on or about the date

specified, especially if the contract provides bona fide penalties for

failing to meet the specified date. If a taxpayer classifies a contract

based on a reasonable estimate of completion time, the contract will

not be reclassified based on the actual (or another reasonable estimate

of) completion time. A taxpayer's estimate of completion time will not

be considered unreasonable if a contract is not completed within the

estimated time primarily because of unforeseeable factors not within

the taxpayer's control, such as third-party litigation, extreme weather

conditions, strikes, or delays in securing permits or licenses.

(ii) Estimating allocable contract costs. A taxpayer must use a

reasonable estimate of total allocable contract costs when necessary to

classify the contract (e.g., to determine whether a contract is a home

construction contract under Sec. 1.460-(3)(b)(2)). If a taxpayer

classifies a contract based on a reasonable estimate of total allocable

contract costs, the contract will not be reclassified based on the

actual (or another reasonable estimate of) total allocable contract

costs.

(g) Special rules for activities benefitting long-term contracts of

a related party--(1) Related party use of PCM--(i) In general. Except

as provided in paragraph (g)(1)(ii) of this section, if a related party

and its customer enter into a long-term contract subject to the PCM,

and a taxpayer performs any activity that is incident to or necessary

for the related party's long-term contract, the taxpayer must account

for the gross receipts and costs attributable to such activity using

the PCM, even if this activity is not otherwise subject to section

460(a). This type of activity may include, for example, the performance

of engineering and design services, and the production of components

and subassemblies that are reasonably expected to be used in the

production of the subject matter of the related party's contract.

(ii) Inventory exception. A taxpayer is not required to use the PCM

under this paragraph (g) to account for components and subassemblies if

the taxpayer regularly carries these items in its finished goods

inventories and 80 percent or more of the gross receipts from the sale

of these items typically comes from unrelated parties.

(2) Total contract price. If a taxpayer is required to use the PCM

under paragraph (g)(1)(i) of this section, the total contract price (as

defined in Sec. 1.460-4(b)(4)(i)) is the fair market value of the

taxpayer's activity that is incident to or necessary for the

performance of the related party's long-term contract. The related

party also must use the fair market value of the taxpayer's activity as

the cost it incurs for the activity. The fair market value of the

taxpayer's activity may or may not be the same as the amount the

related party pays the taxpayer for that activity.

(3) Completion factor. To compute a contract's completion factor

(as described in Sec. 1.460-4(b)(5)), the related party must take into

account the fair market value of the taxpayer's activity that is

incident to or necessary for the performance of the related party's

long-term contract when the related party incurs the liability to the

taxpayer for the activity, rather than when the taxpayer incurs the

costs to perform the activity.

(h) Effective date--(1) In general. Except as otherwise provided,

this section and Secs. 1.460-2 through 1.460-5 are applicable for

contracts entered into on or after the date these regulations are

published as final regulations in the Federal Register.

(2) Change in method of accounting. Any change in a taxpayer's

method of accounting necessary to comply with this section and

Secs. 1.460-2 through 1.460-5 is a change in method of accounting to

which the provisions of section 446 and the regulations thereunder

apply. For the first taxable year that includes the date these

regulations are published as final regulations in the Federal Register,

a taxpayer is granted the consent of the Commissioner to change its

method of accounting to comply with the provisions of this section and

Secs. 1.460-2 through 1.460-5 for long-term contracts entered into on

or after the date these regulations are published as final regulations

in the Federal Register. A taxpayer that wants to change its method of

accounting under this paragraph (h)(2) must follow the automatic

consent procedures in Rev. Proc. 98-60 (1998-51 I.R.B. 16) (see

Sec. 601.601(d)(2) of this chapter, except that the scope limitations

in section 4.02 of Rev. Proc. 98-60 do not apply. Because a change

under this paragraph (h)(2) is made on a cutoff basis, a section 481(a)

adjustment is not required. Moreover, the taxpayer does not receive

audit protection under section 7 of Rev. Proc. 98-60 in connection with

a change under this paragraph (h)(2). A taxpayer that wants to change

its exempt-contract method of accounting is not granted the consent of

the Commissioner under this paragraph (h)(2) and must file a Form 3115,

Application for Change in

[[Page 24106]]

Accounting Method, to obtain consent. See Rev. Proc. 97-27 (1997-1 C.B.

680) (see Sec. 601.601(d)(2) of this chapter).

(i) [Reserved]

(j) Examples. The following examples illustrate the rules of this

section:

Example 1. Contract for manufacture of property. B notifies C,

an aircraft manufacturer, that it wants to purchase an aircraft of a

particular type. At the time C receives the order, C has on hand

several partially completed aircraft of this type; however, C does

not have any completed aircraft of this type on hand. C and B agree

that B will purchase one of these aircraft after it has been

completed. C retains title to and risk of loss with respect to the

aircraft until the sale takes place. The agreement between C and B

is a contract for the manufacture of property under paragraph

(b)(2)(i) of this section, even if labeled as a contract for the

sale of property, because the manufacture of the aircraft is

necessary for C's obligations under the agreement to be fulfilled

and the manufacturing was not complete when B and C entered into the

agreement.

Example 2. De minimis construction activity. C, a master

developer that uses a calendar taxable year, owns 5,000 acres of

undeveloped land worth $50,000,000. To obtain permission from the

local county government to improve this land, a service road must be

constructed on this land to benefit all 5,000 acres. In 2001, C

enters into a contract to sell a 1,000-acre parcel of undeveloped

land to B, a residential developer, for its fair market value,

$10,000,000. In this contract, C agrees to construct a service road

running through the land that C is selling to B and through the

4,000 adjacent acres of undeveloped land that C has sold to several

other residential developers for its fair market value, $40,000,000.

C reasonably estimates that it will incur a liability of $50,000 to

construct this service road, which will be owned and maintained by

the county. C must reasonably allocate the cost of the service road

among the benefitted parcels. The portion of the estimated total

allocable contract costs that C allocates to the 1,000 acre parcel

being sold to B (based upon its fair market value) is $10,000

($50,000 x ($10,000,000/$50,000,000)). Construction of the service

road is finished in 2002. Because the estimated total allocable

contract costs attributable to C's construction activities, $10,000,

are less than 10 percent of the contract's total contract price,

$10,000,000, C's contract with B is not a construction contract

under paragraph (b)(2)(ii) of this section. Thus, C's contract with

B is not a long-term contract under paragraph (b)(2)(i) of this

section, notwithstanding that construction of the service road is

not completed in 2001.

Example 3. Completion--customer use. In 2002, C, a calendar year

taxpayer, enters into a contract to construct a building for B. In

November of 2003, the building is completed in every respect

necessary for its intended use, and B occupies the building. In

early December of 2003, B notifies C of some minor deficiencies that

need to be corrected, and C agrees to correct them in January 2004.

C reasonably estimates that the cost of correcting these

deficiencies will be less than five percent of the total allocable

contract costs. C's contract is complete under paragraph

(c)(3)(i)(A) of this section in 2003 because in that year, B used

the building and C had incurred at least 95 percent of the total

allocable contract costs attributable to the building. C must use a

permissible method of accounting for any deficiency-related costs

incurred after 2003.

Example 4. Completion--customer use. In 1999, C, whose taxable

year ends December 31, agrees to construct a shopping center, which

includes an adjoining parking lot, for B. By October 2000, C has

finished constructing the retail portion of the shopping center. By

December 2000, C has graded the entire parking lot, but has paved

only one-fourth of it because inclement weather conditions prevented

C from laying asphalt on the remaining three-fourths. In December

2000, B opens the retail portion of the shopping center and the

paved portion of the parking lot to the general public. C reasonably

estimates that the cost of paving the remaining three-fourths of the

parking lot when whether permits will exceed 5 percent of C's total

allocable contract costs. Even though B is using the subject matter

of the contract, C's contract is not completed in December 2000

under paragraph (c)(3)(i)(A) of this section because C has not

incurred at least 95 percent of the total allocable contract costs

attributable to the subject matter.

Example 5. Non-long-term contract activity. On January 1, 1999,

C, whose taxable year ends December 31, enters into a single long-

term contract to design and manufacture a satellite and to develop

computer software enabling B to operate the satellite. At the end of

1999, C has not finished manufacturing the satellite. Designing the

satellite and developing the computer software are non-long-term

contract activities that are incident to and necessary for the

taxpayer's manufacturing of the subject matter of a long-term

contract because the satellite could not be manufactured without the

design and would not operate without the software. Thus, under

paragraph (d)(1) of this section, C must allocate these non-long-

term contract activities to the long-term contract and account for

the gross receipts and costs attributable to designing the satellite

and developing computer software using the PCM.

Example 6. Non-long-term contract activity. C agrees to

manufacture equipment for B under a long-term contract. In a

separate contract, C agrees to design the equipment being

manufactured for B under the long-term contract. Under paragraph

(d)(1) of this section, C must allocate the gross receipts and costs

related to the design to the long-term contract because designing

the equipment is a non-long-term contract activity that is incident

to and necessary for the manufacture of the subject matter of the

long-term contract.

Example 7. Severance. On January 1, 1999, C, a construction

contractor, and B, a real estate investor, enter into an agreement

requiring C to build two office buildings in different areas of a

large city. The agreement provides that the two office buildings

will be completed by C and accepted by B in 1999 and 2000,

respectively, and that C will be paid $1,000,000 and $1,500,000 for

the two office buildings, respectively. The agreement will provide C

with a reasonable profit from the construction of each building.

Unless C is required to use the PCM to account for the contract, the

taxpayer is required to sever this contract under paragraph (e)(2)

of this section because the buildings are independently priced, the

agreement provides for separate delivery and acceptance of the

buildings, and, as each building will generate a reasonable profit,

a reasonable businessperson would have entered into separate

agreements for the terms agreed upon for each building.

Example 8. Severance. C, a large construction contractor with a

calendar taxable year, accounts for its construction contracts using

the PCM and has elected to use the 10-percent method described in

Sec. 1.460-4(b)(6). In September 1999, C enters into an agreement to

construct 4 buildings in 4 different cities. The buildings are

independently priced and the contract provides a reasonable profit

for each of the buildings. In addition, the agreement requires C to

deliver one building per year in 2000, 2001, 2002, and 2003. As of

December 31, 1999, C has incurred 25 percent of the estimated total

allocable contract costs attributable to one of the buildings, but

only 5 percent of the estimated total allocable contract costs

attributable to all 4 buildings included in the agreement. Under

paragraph (e)(3)(i) of this section, C may not sever this contract

because it is accounted for using the PCM. Using the 10-percent

method, C does not take into account any portion of the total

contract price or any incurred allocable contract costs attributable

to this agreement in 1999. Upon examination of C's 1999 tax return,

the Commissioner determines that C entered into one agreement for 4

buildings rather than 4 separate agreements each for one building

solely to take advantage of the deferral obtained under the 10-

percent method. Consequently, in order to clearly reflect the

taxpayer's income, the Commissioner may require C to sever the

agreement into 4 separate contracts under paragraph (e)(2) of this

section because the buildings are independently priced, the

agreement provides for separate delivery and acceptance of the

buildings, and a reasonable businessperson would have entered into

separate agreements for these buildings.

Example 9. Aggregation. In 1999, C, a shipbuilder, enters into

two agreements with the Department of the Navy as the result of a

single negotiation. Each agreement obligates C to manufacture a

submarine. Because the submarines are of the same class, their

specifications are similar. Because C has never manufactured

submarines of this class, however, C anticipates that it will incur

substantially higher costs to manufacture the first submarine, to be

delivered in 2005, than to manufacture the second submarine, to be

delivered in 2008. If the agreements are treated as separate

contracts, the first contract probably will produce a substantial

loss, while the second contract probably will produce substantial

profit. Based upon these facts, aggregation is required under

paragraph

[[Page 24107]]

(e)(2) of this section because the submarines are interdependently

priced and a reasonable businessperson would not have entered the

first agreement without also entering into the second.

Example 10. Aggregation. In 1999, C, a manufacturer of aircraft

and related equipment, agrees to manufacture 10 military aircraft

for foreign government B and to deliver the aircraft by the end of

2001. When entering into the agreement, C anticipates that it might

receive production orders from B over the next 20 years for as many

as 300 more of these aircraft. The negotiated contract price

reflects C's and B's consideration of the expected total cost of

manufacturing the 10 aircraft, the risks and opportunities

associated with the agreement, and the additional factors the

parties considered relevant. The negotiated price provides a profit

on the sale of the 10 aircraft even if C does not expect to receive

any additional production orders from B. It is unlikely, however,

that C actually would have wanted to manufacture the 10 aircraft but

for the expectation that it would receive additional production

orders from B. In 2001, B accepts delivery of the 10 aircraft. At

that time, B orders an additional 20 aircraft of the same type for

delivery in 2005. When negotiating the price for the additional 20

aircraft, C and B consider the fact that the expected unit cost for

this production run of 20 aircraft will be lower than the unit cost

of the 10 aircraft completed and accepted in 2001, but substantially

higher than the expected unit cost of future production runs. Based

upon these facts, aggregation is not permitted under paragraph

(e)(2) of this section. Because the parties negotiated the prices of

both agreements considering only the expected production costs and

risks for each agreement standing alone, the terms and conditions

agreed upon for the first agreement are independent of the terms and

conditions agreed upon for the second agreement. The fact that the

agreement to manufacture 10 aircraft provides a profit for C

indicates that a reasonable businessperson would have entered into

that agreement without entering into the agreement to manufacture

the additional 20 aircraft.

Example 11. Classification and completion. In 1999, C agrees to

manufacture and install an industrial machine for B. The agreement

requires C to deliver the machine in August 2001 and to install and

test the machine in B's factory. At least 95 percent of the

estimated total allocable contract costs are reasonably allocable to

C's manufacturing activities. In addition, the agreement requires B

to accept the machine when the tests prove that the machine's

performance will satisfy the environmental standards set by the

Environmental Protection Agency (EPA), even if B has not obtained

the required operating permit. Because of technical difficulties, C

cannot deliver the machine until December 2001, when B conditionally

accepts delivery. C classifies the agreement as a manufacturing

contract under paragraph (f) of this section because 95 percent of

the total allocable contract costs are attributable to C's

manufacturing activities. C, whose taxable year ends December 31,

installs the machine in December 2001 and then tests it through

February 2002. B accepts the machine in February 2002, but does not

obtain the operating permit from the EPA until January 2003. Under

paragraph (c)(3)(i)(B) of this section, C's contract is finally

completed and accepted in February 2002, even though B does not

obtain the operating permit until January 2003, because C completed

all its obligations under the contract and B accepted the machine in

2002.

Sec. 1.460-2 Long-term manufacturing contracts.

(a) In general. Section 460 generally requires a taxpayer to

determine the income from a long-term manufacturing contract using the

percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A

contract not completed in the contracting year is a long-term

manufacturing contract if it involves the manufacture of personal

property that is--

(1) A unique item of a type that is not normally carried in the

finished goods inventory of the taxpayer; or

(2) An item that normally requires more than 12 calendar months to

complete (regardless of the duration of the contract or the time to

complete a deliverable quantity of the item).

(b) Unique--(1) In general. Unique means designed for the needs of

a specific customer. A contract may require the taxpayer to manufacture

more than one unit of a unique item. To determine whether an item is

designed for the needs of a specific customer, a taxpayer must consider

the extent to which research, development, design, engineering,

retooling, and similar activities are required to produce the item. In

addition, a taxpayer must consider whether the same item could be sold

to other customers (with or without minor modifications).

(2) Safe harbors. Notwithstanding paragraph (b)(1) of this section,

an item is not unique if it satisfies one or more of the following safe

harbors--

(i) Short production period. An item is not unique if it normally

requires 90 days or less to complete the item;

(ii) Customized item. An item is not unique if the total allocable

contract costs attributable to customizing (such as research,

development, design, engineering, retooling, and similar activities)

that are incident to or necessary for the production of the item does

not exceed 5 percent of the estimated total allocable contract costs

allocable to the item; or

(iii) Inventoried item. A unique item ceases to be unique no later

than when the taxpayer normally carries similar items in its finished

goods inventory.

(c) Normal time to complete--(1) In general. The amount of time

normally required to complete an item is the item's reasonably expected

production period, as described in Sec. 1.263A-12, determined at the

end of the contracting year. Thus, the expected production period for

an item generally would begin when a taxpayer incurs at least five

percent of the costs allocable to the item and end when the item is

ready to be held for sale and all reasonably expected production

activities are complete. In the case of components that are assembled

or reassembled into an item or unit at the customer's facility by the

taxpayer's employees or agents, the production period ends when the

components are assembled or reassembled into an operable item or unit.

To the extent that several distinct activities related to the

production of the item are expected to occur simultaneously, the period

during which these distinct activities occur is not counted more than

once.

(2) Production by related parties. To determine the time normally

required to complete an item, a taxpayer must consider all relevant

production activities performed by itself and by related parties, as

defined in Sec. 1.460-1(b)(4). For example, if a taxpayer's item

requires a component or subassembly manufactured by a related party,

the taxpayer must consider the time the related party takes to complete

the component or subassembly and, for purposes of determining the

beginning of an item's production period, the costs incurred by the

related party that are allocable to the component or subassembly.

However, if both requirements of the inventory exception under

Sec. 1.460-1(g)(1)(ii) are satisfied, a taxpayer does not consider the

activities performed or the costs incurred by a related party when

determining the normal time to complete an item.

(d) Qualified ship contracts. A taxpayer may determine the income

from a long-term manufacturing contract that is a qualified ship

contract using either the PCM or the percentage-of-completion/

capitalized-cost method (PCCM) of accounting described in Sec. 1.460-

4(e). A qualified ship contract is any contract entered into after

February 28, 1986, to manufacture in the United States not more than 5

seagoing vessels if the vessels will not be manufactured directly or

indirectly for the United States Government and if the taxpayer

reasonably expects to complete the contract within 5 years of the

contract commencement date. Under Sec. 1.460-1(e)(3)(i), a contract to

produce more than 5 vessels for which the PCM would be required cannot

be severed in order to be classified as a qualified ship contract.

[[Page 24108]]

(e) Examples. The following examples illustrate the rules of this

section:

Example 1. Unique item and classification. In December 1999, C

enters into a contract with B to design and manufacture a new type

of industrial equipment. C reasonably expects the normal production

period for this type of equipment to be 8 months. Because the new

type of industrial equipment requires a substantial amount of

research, design and engineering to produce, C determines that the

equipment is a unique item and its contract with B is a long-term

contract. After delivering the equipment to B in September 2000, C

contracts with B to produce five additional units of industrial

equipment using the same basic design as the previous unit of

industrial equipment but changing certain specifications. These

additional units, which also are expected to take 8 months to

produce, will be delivered to B in 2001. C determines that the

research, design, engineering, retooling and similar customizing

costs necessary to produce the five additional units of equipment

does not exceed 5% of the estimated total allocable contract costs.

Consequently, the additional units of equipment satisfy the safe

harbor in paragraph (b)(2)(ii) of this section and are not unique

items. Although C's contract with B to produce the five additional

units is not completed within the contracting year, the contract is

not a long-term contract since the additional units of equipment are

not unique items and do not normally require more than 12 months to

produce. C must classify its second contract with B as a non-long

term contract, notwithstanding that it classified the previous

contract with B for a similar item as a long-term contract, because

the determination of whether a contract is a long-term contract is

made on a contract by contract basis. Such a change in

classification is not a change in method of accounting because the

change in classification results from a change in underlying facts.

Example 2. 12-month rule--related party. C manufactures cranes

that it regularly carries in finished goods inventory. C purchases

one of the crane's components from R, a related party under

Sec. 1.460-1(b)(4). R does not carry this crane component in

finished goods inventory; therefore, C does not satisfy the

inventory exception and must consider the activities of R as R

incurs costs and performs the activities rather than as C incurs a

liability to R. The normal time period between the time that both C

and R incur 5% of the costs allocable to the crane and the time that

R completes the component is 5 months. C normally requires an

additional 8 months to complete production of the crane after

receiving the integral component from R. C's crane is an item of a

type that normally requires more than 12 months to complete under

paragraph (c) of this section because the production period from the

time that both C and R incur 5% of the costs allocable to the crane

until the time that production of the crane is complete is normally

13 months.

Example 3. 12-month rule--duration of contract. The facts are

the same as in Example 2, except that C enters into a sales contract

with B on December 31, 1999 (the last day of C's taxable year), and

delivers a completed crane to B on February 1, 2000. C's contract

with B is a long-term contract under paragraph (a)(2) of this

section because the contract is not completed in the contracting

year, 1999, and the crane is an item that normally requires more

than 12 calendar months to complete (regardless of the duration of

the contract).

Example 4. 12-month rule--normal time to complete. The facts are

the same as in Example 3, except that C (and R) actually complete

B's crane in only 10 calendar months. The contract is a long-term

contract because the normal time to complete a crane, not the actual

time to complete a crane, is the relevant criterion for determining

whether an item is subject to paragraph (a)(2) of this section.

Sec. 1.460-3 Long-term construction contracts.

(a) In general. Section 460 generally requires a taxpayer to

determine the income from a long-term construction contract using the

percentage-of-completion method described in Sec. 1.460-4(b) (PCM). A

contract not completed in the contracting year is a long-term

construction contract if it involves the building, construction,

reconstruction, or rehabilitation of real property; the installation of

an integral component to real property; or the improvement of real

property (collectively referred to as construction). Real property

means land, buildings, and inherently permanent structures, as defined

in Sec. 1.263A-8(c)(3), such as roadways, dams, and bridges. Real

property does not include vessels, offshore drilling platforms, or

unsevered natural products of land. An integral component to real

property includes property not produced at the site of the real

property but intended to be permanently affixed to the real property,

such as elevators and central heating and cooling systems. Thus, for

example, a contract to install an elevator in a building is a

construction contract because a building is real property, but a

contract to install an elevator in a ship is not a construction

contract because a ship is not real property.

(b) Exempt construction contracts--(1) In general. The general

requirement to use the PCM and the cost allocation rules described in

Sec. 1.460-5(b) or (c) does not apply to any long-term construction

contract described in this paragraph (b) (exempt construction

contract). Exempt construction contract means any--

(i) Home construction contract; and

(ii) Other construction contract that a taxpayer estimates (when

entering into the contract) will be completed within 2 years of the

contract commencement date, provided the taxpayer satisfies the

$10,000,000 gross receipts test described in paragraph (b)(3) of this

section.

(2) Home construction contract--(i) In general. A long-term

construction contract is a home construction contract if a taxpayer

(including a subcontractor working for a general contractor) reasonably

expects to attribute 80 percent or more of the estimated total

allocable contract costs (including the cost of land, materials, and

services), determined as of the close of the contracting year, to the

construction of--

(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I),

contained in buildings containing 4 or fewer dwelling units (including

buildings with 4 or fewer dwelling units that also have commercial

units); and

(B) Improvements to real property directly related to, and located

at the site of, the dwelling units.

(ii) Townhouses and rowhouses. Each townhouse or rowhouse is a

separate building.

(iii) Common improvements. A taxpayer includes in the cost of the

dwelling units their allocable share of the cost that the taxpayer

reasonably expects to incur for any common improvements (e.g., sewers,

roads, clubhouses) that benefit the dwelling units and that the

taxpayer is contractually obligated, or required by law, to construct

within the tract or tracts of land that contain the dwelling units.

(iv) Mixed use costs. If a contract involves the construction of

both commercial units and dwelling units within the same building, a

taxpayer must allocate the costs among the commercial units and

dwelling units using a reasonable method or combination of reasonable

methods, such as specific identification, square footage, or fair

market value.

(3) $10,000,000 gross receipts test--(i) In general. The

$10,000,000 gross receipts test is satisfied if a taxpayer's (or

predecessor's) average annual gross receipts for the 3 taxable years

preceding the contracting year do not exceed $10,000,000, as determined

using the principles of the gross receipts test for small resellers

under Sec. 1.263A-3(b), except as otherwise provided in paragraphs

(b)(3)(ii) and (iii) of this section.

(ii) Single employer. To apply the gross receipts test, a taxpayer

is not required to aggregate the gross receipts of persons treated as a

single employer solely under section 414(m) and any regulations

prescribed under section 414.

(iii) Attribution of gross receipts. A taxpayer must aggregate a

proportionate share of the construction-related gross receipts of any

person that has a five

[[Page 24109]]

percent or greater interest in the taxpayer. In addition, a taxpayer

must aggregate a proportionate share of the construction-related gross

receipts of any person in which the taxpayer has a five percent or

greater interest. For this purpose, a taxpayer must determine ownership

interests as of the first day of the taxpayer's contracting year and

must include indirect interests in any corporation, partnership,

estate, trust, or sole proprietorship according to principles similar

to the constructive ownership rules under sections 1563(e), (f)(2), and

(f)(3)(A). However, a taxpayer is not required to aggregate under this

paragraph (b)(3)(iii) any construction-related gross receipts required

to be aggregated under paragraph (b)(3)(i) of this section.

(c) Residential construction contracts. A taxpayer may determine

the income from a long-term construction contract that is a residential

construction contract using either the PCM or the percentage-of-

completion/capitalized-cost method (PCCM) of accounting described in

Sec. 1.460-4(e). A residential construction contract is a home

construction contract, as defined in paragraph (b)(2) of this section,

except that the building or buildings being constructed contain more

than 4 dwelling units.

Par. 7. Section 1.460-4 is amended by adding paragraphs (a) through

(i) to read as follows:

Sec. 1.460-4 Methods of accounting for long-term contracts.

(a) Overview. This section prescribes permissible methods of

accounting for long-term contracts. Paragraph (b) of this section

describes the percentage-of-completion method under section 460(b)

(PCM) that a taxpayer generally must use to determine the income from a

long-term contract. Paragraph (c) of this section lists permissible

methods of accounting for exempt construction contracts described in

Sec. 1.460-3(b)(1) and describes the exempt-contract percentage-of-

completion method (EPCM). Paragraph (d) of this section describes the

completed-contract method (CCM), which is one of the permissible

methods of accounting for exempt construction contracts. Paragraph (e)

describes the percentage-of-completion/capitalized-cost method (PCCM),

which is a permissible method of accounting for qualified ship

contracts described in Sec. 1.460-2(d) and residential construction

contracts described in Sec. 1.460-3(c). Paragraph (f) of this section

provides rules for determining the alternative minimum taxable income

(AMTI) from long-term contracts that are not exempted under section 56.

Paragraph (g) of this section provides rules concerning consistency in

methods of accounting for long-term contracts. Paragraph (h) of this

section provides examples illustrating the principles of this section.

Finally, paragraph (j) of this section provides rules for taxpayers

that file consolidated tax returns.

(b) Percentage-of-completion method--(1) In general. Under the PCM,

a taxpayer generally must include in income the portion of the total

contract price, as defined in paragraph (b)(4)(i) of this section, that

corresponds to the percentage of the entire contract that the taxpayer

has completed during the taxable year. The percentage of completion

must be determined by comparing allocable contract costs incurred with

estimated total allocable contract costs. Thus, the taxpayer includes a

portion of the total contract price in gross income as the taxpayer

incurs allocable contract costs.

(2) Computations. To determine the income from a long-term

contract, a taxpayer--

(i) Computes the completion factor for the contract, which is the

ratio of the cumulative allocable contract costs that the taxpayer has

incurred through the end of the taxable year to the estimated total

allocable contract costs that the taxpayer reasonably expects to incur

under the contract;

(ii) Computes the amount of cumulative gross receipts from the

contract by multiplying the completion factor by the total contract

price;

(iii) Computes the amount of current-year gross receipts, which is

the difference between the amount of cumulative gross receipts for the

current taxable year and the amount of cumulative gross receipts for

the immediately preceding taxable year (the difference can be a

positive or negative number); and

(iv) Takes both the current-year gross receipts and the allocable

contract costs incurred during the current year into account in

computing taxable income.

(3) Post-completion-year income. If a taxpayer has not included the

total contract price in gross income by the completion year, as defined

in Sec. 1.460-1(b)(6), the taxpayer must include the remaining portion

of the total contract price in gross income for the taxable year

following the completion year. For the treatment of post-completion

costs, see paragraph (b)(5)(v) of this section. See Sec. 1.460-

6(c)(1)(ii) for application of the look-back method as a result of

adjustments to total contract price.

(4) Total contract price--(i) In general--(A) Definition. Total

contract price means the amount that a taxpayer reasonably expects to

receive under a long-term contract, including holdbacks, retainages,

and cost reimbursements. See Sec. 1.460-6(c)(1)(ii) and (2)(vi) for

application of the look-back method as a result of changes in total

contract price.

(B) Contingent compensation. Any amounts related to contingent

rights or obligations, such as bonuses, awards, incentive payments, and

amounts in dispute, are included in total contract price as soon as it

is reasonably estimated that they will be received, even if the all

events test has not yet been met. For example, if a bonus is payable to

a taxpayer for meeting an early completion date, the bonus is

includable in total contract price at the time (and to the extent) that

the taxpayer can predict the achievement of the corresponding objective

with reasonable certainty. Similarly, a portion of the contract price

that is in dispute is included in total contract price at the time and

to the extent that the taxpayer can reasonably expect the dispute will

be resolved in the taxpayer's favor (without regard to when the

taxpayer receives payment for the amount in dispute or when the dispute

is finally resolved.) If a taxpayer has not included an amount of

contingent compensation in total contract price under this paragraph

(b)(4)(i) by the taxable year following the completion year, the

taxpayer must account for that amount of contingent compensation using

a permissible method of accounting. If it is determined after the

taxable year following the completion year that an amount included in

total contract price will not be earned, the taxpayer should deduct

that amount in the year of the determination.

(C) Non-long-term contract activities. Total contract price

includes an allocable share of the gross receipts attributable to a

non-long-term contract activity, as defined in Sec. 1.460-1(d)(2), if

the activity is incident to or necessary for the manufacture, building,

installation, or construction of the subject matter of the long-term

contract. Total contract price also includes amounts reimbursed for

independent research and development costs, or bidding and proposal

costs, under a federal or cost-plus long-term contract (as defined in

section 460(d)), regardless of whether the research and development, or

bidding and proposal, activities are incident to or necessary for the

performance of that long-term contract.

(ii) Estimating total contract price. A taxpayer must estimate the

total contract price based upon all the facts and circumstances known

as of the last day

[[Page 24110]]

of the taxable year. For this purpose, an event that occurs after the

end of the taxable year must be taken into account if its occurrence

was reasonably foreseeable and its income was subject to reasonable

estimation as of the last day of that taxable year.

(5) Completion factor--(i) Allocable contract costs. A taxpayer

must use a cost allocation method permitted under either Sec. 1.460-

5(b) or (c) to determine the amount of cumulative allocable contract

costs and estimated total allocable contract costs that are used to

determine a contract's completion factor. Allocable contract costs

include a reimbursable cost that is allocable to the contract.

(ii) Cumulative allocable contract costs incurred. To determine a

contract's completion factor for a taxable year, a taxpayer must take

into account the cumulative allocable contract costs that have been

incurred, as defined in Sec. 1.460-1(b)(8), through the end of the

taxable year.

(iii) Estimating total allocable contract costs. A taxpayer must

estimate total allocable contract costs for each long-term contract

based upon all the facts and circumstances known as of the last day of

the taxable year. For this purpose, an event that occurs after the end

of the taxable year must be taken into account if its occurrence was

reasonably foreseeable and its cost was subject to reasonable

estimation as of the last day of that taxable year. To be considered

reasonable, an estimate of total allocable contract costs must include

costs attributable to delay, rework, change orders, technology or

design problems, or other problems that reasonably can be anticipated

considering the nature of the contract and prior experience. However,

estimated total allocable contract costs do not include any contingency

allowance for costs that, as of the end of the taxable year, are not

reasonably expected to be incurred in the performance of the contract.

For example, estimated total allocable contract costs do not include

any costs attributable to factors not reasonably foreseeable at the end

of the taxable year, such as third-party litigation, extreme weather

conditions, strikes, and delays in securing required permits and

licenses. In addition, the estimated costs of performing other

agreements that are not aggregated with the contract under Sec. 1.460 -

1(e) that the taxpayer expects to incur with the same customer (e.g.,

follow-on contracts) are not included in estimated total allocable

contract costs for the initial contract.

(iv) Pre-contracting-year costs. If a taxpayer reasonably expects

to enter into a long-term contract in a future taxable year, the

taxpayer must capitalize all costs incurred prior to entering into the

contract that will be allocable to that contract (e.g., bidding and

proposal costs). A taxpayer is not required to compute a completion

factor, or to include in gross income any amount, related to allocable

contract costs for any taxable year ending before the contracting year

or, if applicable, the 10-percent year defined in paragraph (b)(6)(i)

of this section. In that year, the taxpayer is required to compute a

completion factor that includes all allocable contract costs that have

been incurred as of the end of that taxable year (whether previously

capitalized or deducted) and to take into account in computing taxable

income the related gross receipts and the previously capitalized

allocable contract costs.

(v) Post-completion-year costs. If a taxpayer incurs an allocable

contract cost after the completion year, the taxpayer must account for

that cost using a permissible method of accounting. See Sec. 1.460-

6(c)(1)(ii)2) for application of the look-back method as a result of

adjustments to allocable contract costs.

(6) 10-percent method--(i) In general. Instead of determining the

income from a long-term contract beginning with the contracting year, a

taxpayer may elect to use the 10-percent method under section

460(b)(5). Under the 10-percent method, a taxpayer does not include in

gross income any amount related to allocable contract costs until the

taxable year in which the taxpayer has incurred at least 10 percent of

the estimated total allocable contract costs (10-percent year). A

taxpayer must treat costs incurred before the 10-percent year as pre-

contracting-year costs described in paragraph (b)(5)(iv) of this

section.

(ii) Election. A taxpayer makes an election under this paragraph

(b)(6) by using the 10-percent method for all long-term contracts

entered into during the taxable year of the election on its original

federal income tax return for the election year. This election is a

method of accounting and, thus, applies to all long-term contracts

entered into during and after the taxable year of the election. An

electing taxpayer must use the 10-percent method to apply the look-back

method under Sec. 1.460-6 and to determine alternative minimum taxable

income under paragraph (f) of this section. This election is not

available if a taxpayer uses the simplified cost-to-cost method

described in Sec. 1.460-5(c) to compute the completion factor of a

long-term contract.

(c) Exempt contract methods--(1) In general. An exempt contract

method means the method of accounting that a taxpayer must use to

account for all its long-term contracts (and any portion of a long-term

contract) that are exempt from the requirements of section 460(a).

Thus, an exempt contract method applies to exempt construction

contracts, as defined in Sec. 1.460-3(b); the non-PCM portion of a

qualified ship contract, as defined in Sec. 1.460-2(d); and the non-PCM

portion of a residential construction contract, as defined in

Sec. 1.460-3(c). Permissible exempt contract methods include the PCM,

the EPCM described in paragraph (c)(2) of this section, the CCM

described in paragraph (d) of this section, or any other permissible

method. See section 446.

(2) Exempt-contract percentage-of-completion method--(i) In

general. Similar to the PCM described in paragraph (b) of this section,

a taxpayer using the EPCM generally must include in income the portion

of the total contract price, as described in paragraph (b)(4) of this

section, that corresponds to the percentage of the entire contract that

the taxpayer has completed during the taxable year. However, under the

EPCM, the percentage of completion may be determined as of the end of

the taxable year by using any method of cost comparison (such as

comparing direct labor costs incurred to date to estimated total direct

labor costs) or by comparing the work performed on the contract with

the estimated total work to be performed, rather than by using the

cost-to-cost comparison required by paragraphs (b)(2)(i) and (5) of

this section, provided such method is used consistently and clearly

reflects income. In addition, paragraph (b)(3) of this section

(regarding post-completion-year income), paragraph (b)(6) of this

section (regarding the 10-percent method) and Sec. 1.460-6 (regarding

the look-back method) do not apply to the EPCM.

(ii) Determination of work performed. For purposes of the EPCM, the

criteria used to compare the work performed on a contract as of the end

of the taxable year with the estimated total work to be performed must

clearly reflect the earning of income with respect to the contract. For

example, in the case of a roadbuilder, a standard of completion solely

based on miles of roadway completed in a case where the terrain is

substantially different may not clearly reflect the earning of income

with respect to the contract.

(d) Completed-contract method--(1) In general. Except as otherwise

provided in paragraph (d)(4) of this section, a taxpayer using the CCM

to

[[Page 24111]]

account for a long-term contract must take into account in the

contract's completion year, as defined in Sec. 1.460-1(b)(6), the gross

contract price and all allocable contract costs incurred by the

completion year. A taxpayer may not treat the cost of any materials and

supplies that were allocated to a contract, but actually remain on hand

when the contract is completed, as an allocable contract cost.

(2) Post-completion-year income and costs. If a taxpayer has not

included an item of contingent compensation (i.e. amounts for which the

all events test has not been satisfied) in gross contract price under

paragraph (d)(3) of this section by the completion year, the taxpayer

must account for this item of contingent compensation using a

permissible method of accounting. If a taxpayer incurs an allocable

contract cost after the completion year, the taxpayer must account for

that cost using a permissible method of accounting.

(3) Gross contract price. Gross contract price includes all amounts

(including holdbacks, retainages, and reimbursements) that a taxpayer

is entitled by law or contract to receive, whether or not the amounts

are due or have been paid. In addition, gross contract price includes

all bonuses, awards, and incentive payments, such as a bonus for

meeting an early completion date, to the extent the all events test is

satisfied. If a taxpayer performs a non-long-term contract activity, as

defined in Sec. 1.460-1(d)(2), that is incident to or necessary for the

manufacture, building, installation, or construction of the subject

matter of one or more of the taxpayer's long-term contracts, the

taxpayer must include an allocable share of the gross receipts

attributable to that activity in the gross contract price of the

contract(s) benefited by that activity. Gross contract price also

includes amounts reimbursed for independent research and development

costs, or bidding and proposal costs, under a federal or cost-plus

long-term contract (as defined in section 460(d)), regardless of

whether the research and development, or bidding and proposal,

activities are incident to or necessary for the performance of that

long-term contract.

(4) Contracts with disputed claims--(i) In general. The special

rules in this paragraph (d)(4) apply to a long-term contract accounted

for using the CCM with a dispute caused by a customer requesting a

reduction of the gross contract price or the performance of additional

work under the contract or by a taxpayer requesting an increase in

gross contract price, or both, on or after the date a taxpayer has

tendered the subject matter of the contract to the customer.

(ii) Taxpayer assured of profit or loss. If the disputed amount

relates to a customer's claim for either a reduction in price or

additional work and the taxpayer is assured of either a profit or a

loss on a long-term contract regardless of the outcome of the dispute,

the gross contract price, reduced (but not below zero) by the amount

reasonably in dispute, must be taken into account in the completion

year. If the disputed amount relates to a taxpayer's claim for an

increase in price and the taxpayer is assured of either a profit or a

loss on a long-term contract regardless of the outcome of the dispute,

the gross contract price must be taken into account in the completion

year. If the taxpayer is assured a profit on the contract, all

allocable contract costs incurred by the end of the completion year are

taken into account in that year. If the taxpayer is assured a loss on

the contract, all allocable contract costs incurred by the end of the

completion year, reduced by the amount reasonably in dispute, are taken

into account in the completion year.

(iii) Taxpayer unable to determine profit or loss. If the amount

reasonably in dispute affects so much of the gross contract price or

allocable contract costs that a taxpayer cannot determine whether a

profit or loss ultimately will be realized from a long-term contract,

the taxpayer may not take any of the gross contract price or allocable

contract costs into account in the completion year.

(iv) Dispute resolved. Any part of the gross contract price and any

allocable contract costs that have not been taken into account because

of the principles described in paragraph (d)(4) (i), (ii) or (iii) of

this section must be taken into account in the taxable year in which

the dispute is resolved. If a taxpayer performs additional work under

the contract because of the dispute, the term taxable year in which the

dispute is resolved means the taxable year the additional work is

completed, rather than the taxable year in which the outcome of the

dispute is determined by agreement, decision, or otherwise.

(e) Percentage-of-completion/capitalized-cost method. Under the

PCCM, a taxpayer must determine the income from a long-term contract

using the PCM for the applicable percentage of the contract and its

exempt contract method, as defined in paragraph (c) of this section,

for the remaining percentage of the contract. For residential

construction contracts described in Sec. 1.460-3(c), the applicable

percentage is 70 percent, and the remaining percentage is 30 percent.

For qualified ship contracts described in Sec. 1.460-2(d), the

applicable percentage is 40 percent, and the remaining percentage is 60

percent.

(f) Alternative minimum taxable income--(1) In general. Under

section 56(a)(3), a taxpayer (not exempt from the AMT under section

55(e)) must use the PCM to determine its AMTI from any long-term

contract entered into on or after March 1, 1986, that is not a home

construction contract, as defined in Sec. 1.460-3(b)(2). For AMTI

purposes, the PCM must include any election under paragraph (b)(6) of

this section (concerning the 10-percent method) or under Sec. 1.460-

5(c) (concerning the simplified cost-to-cost method) that the taxpayer

has made for regular tax purposes. For exempt construction contracts

described in Sec. 1.460-3(b)(1)(ii), a taxpayer must use the simplified

cost-to-cost method to determine the completion factor for AMTI

purposes. Except as provided in paragraph (f)(2) of this section, a

taxpayer must use AMTI costs and AMTI methods, such as the depreciation

method described in section 56(a)(1), to determine the completion

factor of a long-term contract (except a home construction contract)

for AMTI purposes.

(2) Election to use regular completion factors. Under this

paragraph (f)(2), a taxpayer may elect for AMTI purposes to determine

the completion factors of all of its long-term contracts using the

methods of accounting and allocable contract costs used for regular

federal income tax purposes. A taxpayer makes this election by using

regular methods and regular costs to compute the completion factors of

all long-term contracts entered into during the taxable year of the

election for AMTI purposes on its original federal income tax return

for the election year. This election is a method of accounting and,

thus, applies to all long-term contracts entered into during and after

the taxable year of the election. Although a taxpayer may elect to

compute the completion factor of its long-term contracts using regular

methods and regular costs, an election under this paragraph (f)(2) does

not eliminate a taxpayer's obligation to comply with the requirements

of section 55 when computing AMTI. For example, although a taxpayer may

elect to use the depreciation methods used for regular tax purposes to

compute the completion factor of its long-term contracts for AMTI

purposes, the taxpayer must use the depreciation methods permitted by

section 56 to compute AMTI.

[[Page 24112]]

(g) Method of accounting. A taxpayer that uses the PCM, EPCM, CCM,

PCCM, or elects the 10-percent method or special AMTI method (or

changes to another method of accounting with the Commissioner's

consent) must apply the method(s) consistently for all similarly

classified long-term contracts, until the taxpayer obtains the

Commissioner's consent under section 446(e) to change to another method

of accounting.

(h) Examples. The following examples illustrate the rules of this

section:

Example 1. PCM--estimating total contract price. On January 1,

1999, C, who uses a calendar taxable year, enters into a contract to

design and manufacture a satellite (a unique item). The contract

provides that C will be paid $10,000,000 for delivering the

completed satellite by December 1, 2000. The contract also provides

that C will receive a $3,000,000 bonus for delivering the satellite

by July 1, 2000, and an additional $4,000,000 bonus if the satellite

successfully performs its mission for five years. C is unable to

reasonably predict if the satellite will successfully perform its

mission for five years. If on December 31, 1999, C should reasonably

expect to deliver the satellite by July 1, 2000, the estimated total

contract price is $13,000,000 ($10,000,000 unit price + $3,000,000

production-related bonus). Otherwise, the estimated total contract

price is $10,000,000. In either event, the $4,000,000 bonus is not

includable in the estimated total contract price as of December 31,

1999, because C is unable to reasonably predict that the satellite

will successfully perform its mission for five years.

Example 2. PCM--computing income. (i) C, who uses a calendar

taxable year, determines the income from long-term contracts using

the PCM. During 1999, C agrees to manufacture for the customer, B, a

unique item for a total contract price of $1,000,000. Under C's

contract, B is entitled to retain 10 percent of the total contract

price until it accepts the item. By the end of 1999, C has incurred

$200,000 of allocable contract costs and estimates that the total

allocable contract costs will be $800,000. By the end of 2000, C has

incurred $600,000 of allocable contract costs and estimates that the

total allocable contract costs will be $900,000. In 2001, after

completing the contract, C determines that the actual cost to

manufacture the item was $750,000.

(ii) For each of the taxable years, C's income from the contract

is computed as follows:

----------------------------------------------------------------------------------------------------------------

Taxable year

--------------------------------------------------

1999 2000 2001

----------------------------------------------------------------------------------------------------------------

(A) Cumulative incurred costs................................ $200,000 $600,000 $750,000

(B) Estimated total costs.................................... $800,000 $900,000 $750,000

--------------------------------------------------

(C) Completion factor (in percent): (A)(B)........... 25.00 66.67 100.00

(D) Total contract price..................................... $1,000,000 $1,000,000 $1,000,000

--------------------------------------------------

(E) Cumulative gross receipts: (C) x (D)..................... $250,000 $666,667 $1,000,000

(F) Cumulative gross receipts: (prior year).................. (0) ($250,000) ($666,667)

--------------------------------------------------

(G) Current-year gross receipts.............................. $250,000 $416,667 $333,333

--------------------------------------------------

(H) Cumulative incurred costs................................ $200,000 $600,000 $750,000

(I) Cumulative incurred costs: (prior year).................. (0) ($200,000) ($600,000)

--------------------------------------------------

(J) Current-year costs....................................... $200,000 $400,000 $150,000

--------------------------------------------------

(K) Gross income (G)-(J)..................................... $50,000 $16,667 $183,333

----------------------------------------------------------------------------------------------------------------

Example 3. PCM--computing income with cost sharing. (i) C, who

uses a calendar taxable year, determines the income from long-term

contracts using the PCM. During 1999, C enters into a contract to

manufacture a unique item. The contract specifies a target price of

$1,000,000, a target cost of $600,000, and a target profit of

$400,000. C and B will share the savings of any cost under run

(actual total incurred cost is less than target cost) and the

additional cost of any cost overrun (actual total incurred cost is

greater than target cost) as follows: 30 percent to C and 70 percent

to B. By the end of 1999, C has incurred $200,000 of allocable

contract costs and estimates that the total allocable contract costs

will be $600,000. By the end of 2000, C has incurred $300,000 of

allocable contract costs and estimates that the total allocable

contract costs will be $400,000. In 2001, after completing the

contract, C determines that the actual cost to manufacture the item

was $700,000.

(ii) For each of the taxable years, C's income from the contract

is computed as follows (Note that the sharing of any cost under run

or cost overrun is reflected as an adjustment to C's target price

under paragraph (b)(4)(i) of this section):

----------------------------------------------------------------------------------------------------------------

Taxable year

--------------------------------------------------

1999 2000 2001

----------------------------------------------------------------------------------------------------------------

(A) Cumulative incurred costs................................ $200,000 $300,000 $700,000

(B) Estimated total costs.................................... $600,000 $400,000 $700,000

--------------------------------------------------

(C) Completion factor (in percent): (A) (B)......... 33.33 75.00 100.00

==================================================

(D) Target price............................................. $1,000,000 $1,000,000 $1,000,000

--------------------------------------------------

(E) Estimated total costs.................................... $600,000 $400,000 $700,000

(F) Target costs............................................. $600,000 $600,000 $600,000

--------------------------------------------------

(G) Cost (under run)/overrun: (E) - (F)...................... 0 ($200,000) $100,000

(H) Adjustment rate (in percent)............................. 70 70 70

--------------------------------------------------

(I) Target price adjustment.................................. 0 ($140,000) $70,000

--------------------------------------------------

[[Page 24113]]

(J) Total contract price: (D) + (I).......................... $1,000,000 $860,000 $1,070,000

==================================================

(K) Cumulative gross receipts: (C) x (J)................... $333,333 $645,000 $1,070,000

(L) Cumulative gross receipts: (prior year).................. (0) ($333,333) ($645,000)

--------------------------------------------------

(M) Current-year gross receipts.............................. $333,333 $311,667 $425,000

--------------------------------------------------

(N) Cumulative incurred costs................................ $200,000 $300,000 $700,000

(O) Cumulative incurred costs: (prior year).................. (0) ($200,000) ($300,000)

--------------------------------------------------

(P) Current-year costs....................................... $200,000 $100,000 $400,000

--------------------------------------------------

(Q) Gross income: (M) - (P).................................. $133,333 $211,667 $25,000

----------------------------------------------------------------------------------------------------------------

Example 4. PCM--10 percent method. (i) In November 1999, C, who

determines income using the PCM and who uses a calendar taxable

year, agrees to manufacture a unique item for $1,000,000. C

reasonably estimates that the total allocable contract costs will be

$600,000. By December 31, 1999, C has received $50,000 in progress

payments and incurred $40,000 of costs. C elects to use the 10

percent method effective for 1999 and all subsequent taxable years.

During 2000, C receives $500,000 in progress payments and incurs

$260,000 of costs. In 2001, C incurs an additional $300,000 of

costs, C finishes manufacturing the item, and receives the final

$450,000 payment.

(ii) For each of the taxable years, C's income from the contract

is computed as follows:

----------------------------------------------------------------------------------------------------------------

Taxable year

--------------------------------------------------

1999 2000 2001

----------------------------------------------------------------------------------------------------------------

(A) Cumulative incurred costs................................ $40,000 $300,000 $600,000

(B) Estimated total costs.................................... $600,000 $600,000 $600,000

--------------------------------------------------

(C) Completion factor (in percent) (A) (B).......... 6.67 50.00 100.00

(D) Total contract price..................................... $1,000,000 $1,000,000 $1,000,000

(E) Cumulative gross receipts: (C) x (D) *................. 0 $500,000 $1,000,000

(F) Cumulative gross receipts: (prior year).................. (0) (0) ($500,000)

--------------------------------------------------

(G) Current-year gross receipts.............................. 0 $500,000 $500,000

--------------------------------------------------

(H) Cumulative incurred costs................................ 0 $300,000 $600,000

(I) Cumulative incurred costs: (prior year).................. (0) (0) ($300,000)

--------------------------------------------------

(J) Current-year costs....................................... 0 $300,000 $300,000

--------------------------------------------------

(K) Gross income: (G) - (J).................................. 0 $200,000 $200,000

----------------------------------------------------------------------------------------------------------------

* Unless (C) < 10 percent.

Example 5. CCM contracts with disputes from customer claims. In

2001, C, who uses the CCM to account for exempt construction

contracts and uses a calendar taxable year, enters into a contract

to construct a bridge for B. The terms of the contract provide for a

$1,000,000 gross contract price. C finishes the bridge in 2002 at a

cost of $950,000. When B examines the bridge, B insists that C

either repaint several girders or reduce the contract price. The

amount reasonably in dispute is $10,000. In 2003, C and B resolve

their dispute, C repaints the girders at a cost of $6,000, and C and

B agree that the contract price is not to be reduced. Because C is

assured a profit of $40,000 ($1,000,000-$10,000-$950,000) in 2002

even if the dispute is resolved in B's favor, C must take this

$40,000 into account in 2002. In 2003, C will earn an additional

$4,000 profit ($1,000,000-$956,000-$40,000) from the contract with

B. Thus, C must take into account an additional $10,000 of gross

contract price and $6,000 of additional contract costs in 2003.

Example 6. CCM contracts with disputes from taxpayer claims. In

2003, C, who uses the CCM to account for exempt construction

contracts and uses a calendar taxable year, enters into a contract

to construct a building for B. The terms of the contract provide for

a $1,000,000 gross contract price. C finishes the building in 2004

at a cost of $1,005,000. B examines the building in 2004 and agrees

that it meets the contract's specifications; however, at the end of

2004, C and B are unable to agree on the merits of C's claim for an

additional $10,000 for items that C alleges are changes in contract

specifications and B alleges are within the scope of the contract's

original specifications. In 2005, B agrees to pay C an additional

$2,000 to satisfy C's claims under the contract. Because the amount

in dispute affects so much of the gross contract price that C cannot

determine in 2004 whether a profit or loss will ultimately be

realized, C may not take any of the gross contract price or

allocable contract costs into account in 2004. C must take into

account $1,002,000 of gross contract price and $1,005,000 of

allocable contract costs in 2005.

Example 7. CCM--contracts with disputes from taxpayer and

customer claims. C, who uses the CCM to account for exempt

construction contracts and uses a calendar taxable year, constructs

a factory for B pursuant to a long-term contract. Under the terms of

the contract, B agrees to pay C a total of $1,000,000 for

construction of the factory. C finishes construction of the factory

in 1999 at a cost of $1,020,000. When B takes possession of the

factory and begins operations in December 1999, B is dissatisfied

with the location and workmanship of certain heating ducts. As of

the end of 1999, C contends that the heating ducts as constructed

are in accordance with contract specifications. The amount of the

gross contract price reasonably in dispute with respect to the

heating ducts is $6,000. As of this time, C is claiming $14,000 in

addition to the original contract price for certain changes in

contract specifications which C alleges have increased his costs. B

denies that such changes have increased C's

[[Page 24114]]

costs. In 2000 the disputes between C and B are resolved by

performance of additional work by C at a cost of $1,000 and by an

agreement that the contract price would be revised downward to

$996,000. Under these circumstances, C must include in his gross

income for 1999, $994,000 (the gross contract price less the amount

reasonably in dispute because of B's claim, or $1,000,000-$6,000).

In 1999, C must also take into account $1,000,000 of allocable

contract costs (costs incurred less the amounts in dispute

attributable to both B and C's claims, or

$1,020,000-$6,000-$14,000). In 2000, C must take into account an

additional $2,000 of gross contract price ($996,000-$994,000) and

$21,000 of allocable contract costs ($1,021,000-$1,000,000).

(i) Mid-contract change in taxpayer. [Reserved]

* * * * *

Par. 8. Section 1.460-5 is revised to read as follows:

Sec. 1.460-5 Cost allocation rules.

(a) Overview. This section prescribes methods of allocating costs

to long-term contracts accounted for using the percentage-of-completion

method described in Sec. 1.460-4(b) (PCM), the completed-contract

method described in Sec. 1.460-4(d) (CCM), or the percentage-of-

completion/capitalized-cost method described in Sec. 1.460-4(e) (PCCM).

Exempt construction contracts described in Sec. 1.460-3(b) accounted

for using a method other than the PCM, CCM, or PCCM are not subject to

the cost allocation rules of this section (other than the requirement

to allocate production period interest under paragraph (b)(2)(v) of

this section). Paragraph (b) of this section describes the regular cost

allocation methods for contracts subject to the PCM. Paragraph (c) of

this section describes an elective simplified cost allocation method

for contracts subject to the PCM. Paragraph (d) of this section

describes the cost allocation methods for exempt construction contracts

reported using the CCM. Paragraph (e) of this section describes the

cost allocation rules for contracts subject to the PCCM. Paragraph (f)

of this section describes additional rules applicable to the cost

allocation methods described in this section. Paragraph (g) of this

section provides rules concerning consistency in method of allocating

costs to long-term contracts.

(b) Cost allocation method for contracts subject to PCM--(1) In

general. A taxpayer must allocate costs to each long-term contract

subject to the PCM in the same manner that direct and indirect costs

are capitalized to property produced by a taxpayer under Sec. 1.263A-

1(e) through (h), except as otherwise provided in paragraph (b)(2) of

this section. Thus, a taxpayer must allocate to each long-term contract

subject to the PCM all direct costs and certain indirect costs properly

allocable to the long-term contract (i.e., all costs that directly

benefit or are incurred by reason of the performance of the long-term

contract). However, see paragraph (c) of this section concerning an

election to allocate contract costs using the simplified cost-to-cost

method. As in section 263A, the use of the practical capacity concept

is not permitted. See Sec. 1.263A-2(a)(4).

(2) Special rules--(i) Direct material costs. The costs of direct

materials must be allocated to a long-term contract as of the earlier

of when a direct material is purchased specifically for that contract

or when dedicated, as defined in Sec. 1.263A--11(b)(2). For this

purpose, a direct material is purchased specifically for a long-term

contract if, when incurring the liability for the direct material, a

taxpayer reasonably expects to incorporate the direct material in the

subject matter of the contract. A taxpayer maintaining inventories

under Sec. 1.471-1 must determine allocable contract costs attributable

to direct materials using its method of accounting for such inventories

(e.g., FIFO, LIFO, specific identification).

(ii) Components and subassemblies. The costs of a component or

subassembly (component) produced by the taxpayer must be allocated to a

long-term contract as the taxpayer incurs costs to produce the

component if the taxpayer reasonably expects to incorporate the

component into the subject matter of the contract. Similarly, the cost

of a purchased component (including a component purchased from a

related party) must be allocated to a long-term contract as the

taxpayer incurs the cost to purchase the component if the taxpayer

reasonably expects to incorporate the component into the subject matter

of the contract. In all other cases, the cost of a component must be

allocated to a long-term contract when the component is dedicated, as

defined in Sec. 1.263A-11(b)(2). A taxpayer maintaining inventories

under Sec. 1.471-1 must determine allocable contract costs attributable

to components using its method of accounting for such inventories

(e.g., FIFO, LIFO, specific identification).

(iii) Simplified production methods. A taxpayer may not determine

allocable contract costs using the simplified production methods

described in Sec. 1.263A-2(b) and (c).

(iv) Costs identified under cost-plus long-term contracts and

federal long-term contracts. To the extent not otherwise allocated to

the contract under this paragraph (b), a taxpayer must allocate any

identified costs to a cost-plus long-term contract or federal long-term

contract (as defined in section 460(d)). Identified cost means any

cost, including a charge representing the time-value of money,

identified by the taxpayer or related person as being attributable to

the taxpayer's cost-plus long-term contract or federal long-term

contract under the terms of the contract itself or under federal,

state, or local law or regulation.

(v) Interest--(A) In general. If property produced under a long-

term contract is designated property, as defined in Sec. 1.263A-8(b)

(without regard to the exclusion for long-term contracts under

Sec. 1.263A-8(d)(2)(v)), a taxpayer must allocate interest incurred

during the production period to the long-term contract in the same

manner as interest is allocated to property produced by a taxpayer

under section 263A(f). See Secs. 1.263A-8 to 1.263A-12 generally.

(B) Production period. Notwithstanding Sec. 1.263A-12(c) and (d),

for purposes of this paragraph (b)(2)(v), the production period of a

long-term contract--

(1) Begins on the later of--

(i) The contract commencement date, as defined in Sec. 1.460-

1(b)(7); or

(ii) For a taxpayer using the accrual method of accounting for

long-term contracts, the date by which 5 percent or more of the total

estimated costs, including design and planning costs, under the

contract have been incurred; and

(2) Ends on the date that the contract is completed, as defined in

Sec. 1.460-1(c)(3).

(C) Application of section 263A(f). For purposes of this paragraph

(b)(2)(v), section 263A(f)(1)(B)(iii) (regarding an estimated

production period exceeding 1 year and a cost exceeding $1,000,000)

must be applied on a contract-by-contract basis; except that, in the

case of a taxpayer using an accrual method of accounting, that section

must be applied on a property-by-property basis.

(vi) Research and experimental expenses. Notwithstanding

Sec. 1.263A-1(e)(3)(ii)(P) and (iii)(B), a taxpayer must allocate

research and experimental expenses, other than independent research and

experimental expenses (as defined in section 460(c)(5)), to its long-

term contracts.

(vii) Service costs--(A) Simplified service cost method--(1) In

general. To use the simplified service cost method under Sec. 1.263A-

1(h), a taxpayer must allocate the otherwise capitalizable

[[Page 24115]]

mixed service costs among its long-term contracts using a reasonable

method. For example, otherwise capitalizable mixed service costs may be

allocated to each long-term contract based on labor hours or contract

costs allocable to the contract. To be considered reasonable, an

allocation method must be applied consistently and must not

disproportionately allocate service costs to contracts expected to be

completed in the near future.

(2) Example. The following example illustrates the rule of this

paragraph (b)(2)(vii)(A):

Example. Simplified service cost method. During 1999, C, which

uses a calendar taxable year, produces electronic equipment for

inventory and enters into long-term contracts to manufacture

specialized electronic equipment. C's method of allocating mixed

service costs to the property it produces is the labor-based,

simplified service cost method described in Sec. 1.263A-1(h)(4). For

1999, C's total mixed service costs are $100,000, C's section 263A

labor costs are $500,000, C's section 460 labor costs (i.e. labor

costs allocable to C's long-term contracts) are $250,000, and C's

total labor costs are $1,000,000. To determine the amount of mixed

service costs capitalizable under section 263A for 1999, C

multiplies the ``total mixed service costs'' incurred during 1999 by

its 1999 ``section 263A allocation ratio'' (section 263A labor

costs/total labor costs). Thus, C's capitalizable mixed service

costs for 1999 are $50,000 ($100,000 x $500,000/$1,000,000).

Thereafter, C allocates its capitalizable mixed service costs to

property produced remaining in ending inventory using its 263A

allocation method (e.g., burden rate, simplified production).

Similarly, to determine the amount of mixed service costs that are

allocable to C's long-term contracts for 1999, C multiplies the

``total mixed service costs'' incurred during 1999 by its 1999

``section 460 allocation ratio'' (section 460 labor/total labor

costs). Thus, C's allocable mixed service contract costs for 1999

are $25,000 ($100,000 x $250,000/ 1,000,000). Thereafter, C

allocates its allocable mixed service contract costs to each of its

long-term contracts proportionately based on the 1999 section 460

labor costs allocable to each long-term contract.

(B) Jobsite costs. If an administrative, service, or support

function is performed solely at the jobsite for a specific long-term

contract, the taxpayer may allocate all the direct and indirect costs

of that administrative, service, or support function to that long-term

contract. Similarly, if an administrative, service, or support function

is performed at the jobsite solely for the taxpayer's long-term

contract activities, the taxpayer may allocate all the direct and

indirect costs of that administrative, service, or support function

among all the long-term contracts performed at that jobsite. For this

purpose, jobsite means a production plant or a construction site.

(C) Limitation on other reasonable cost allocation methods. A

taxpayer may use any other reasonable method of allocating service

costs, as provided in Sec. 1.263A-1(f)(4), if, for the taxpayer's long-

term contracts considered as a whole, the--

(1) Total amount of service costs allocated to the contracts does

not differ significantly from the total amount of service costs that

would have been allocated to the contracts under Sec. 1.263A-1(f)(2) or

(3);

(2) Service costs are not allocated disproportionately to contracts

expected to be completed in the near future because of the taxpayer's

cost allocation method; and

(3) Taxpayer's cost allocation method is applied consistently.

(c) Simplified cost-to-cost method--(1) In general. Instead of

using the cost allocation method prescribed in paragraph (b) of this

section, a taxpayer may elect to use the simplified cost-to-cost

method, which is authorized under section 460(b)(3)(A). Under the

simplified cost-to-cost method, a taxpayer determines a contract's

completion factor based upon only direct material costs; direct labor

costs; and depreciation, amortization, and cost recovery allowances on

equipment and facilities directly used to manufacture or construct the

subject matter of the contract. An electing taxpayer must use the

simplified cost-to-cost method to apply the look-back method under

Sec. 1.460-6 and to determine alternative minimum taxable income under

Sec. 1.460-4(f).

(2) Election. A taxpayer makes an election under this paragraph (c)

by using the simplified cost-to-cost method for all long-term contracts

entered into during the taxable year of the election on its original

federal income tax return for the election year. This election is a

method of accounting and, thus, applies to all long-term contracts

entered into during and after the taxable year of the election. This

election is not available if a taxpayer does not use the PCM to account

for all long-term contracts or if a taxpayer elects to use the 10-

percent method described in Sec. 1.460-4(b)(6).

(d) Cost allocation rules for exempt construction contracts

reported using the CCM--(1) In general. For exempt construction

contracts reported using the CCM, other than contracts described in

paragraph (d)(3) of this section, a taxpayer must annually allocate the

cost of any activity that is incident to or necessary for the

taxpayer's performance under a long-term contract. A taxpayer must

allocate to each such exempt construction contract all direct costs as

defined in Sec. 1.263A-1(e)(2)(i) and all indirect costs either as

provided in Sec. 1.263A-1(e)(3) or as provided in paragraph (d)(2) of

this section.

(2) Indirect costs--(i) Indirect costs allocable to exempt

construction contracts. A taxpayer allocating costs under this

paragraph (d)(2) must allocate the following costs to an exempt

construction contract, other than a contract described in paragraph

(d)(3) of this section, to the extent incurred in the performance of

that contract--

(A) Repair of equipment or facilities;

(B) Maintenance of equipment or facilities;

(C) Utilities, such as heat, light, and power, allocable to

equipment or facilities;

(D) Rent of equipment or facilities;

(E) Indirect labor and contract supervisory wages, including basic

compensation, overtime pay, vacation and holiday pay, sick leave pay

(other than payments pursuant to a wage continuation plan under section

105(d) as it existed prior to its repeal in 1983), shift differential,

payroll taxes, and contributions to a supplemental unemployment

benefits plan;

(F) Indirect materials and supplies;

(G) Noncapitalized tools and equipment;

(H) Quality control and inspection;

(I) Taxes otherwise allowable as a deduction under section 164,

other than state, local, and foreign income taxes, to the extent

attributable to labor, materials, supplies, equipment, or facilities;

(J) Depreciation, amortization, and cost-recovery allowances

reported for the taxable year for financial purposes on equipment and

facilities to the extent allowable as deductions under chapter 1 of the

Internal Revenue Code (Code);

(K) Cost depletion;

(L) Administrative costs other than the cost of selling or any

return on capital;

(M) Compensation paid to officers other than for incidental or

occasional services;

(N) Insurance, such as liability insurance on machinery and

equipment; and

(O) Interest, as required under paragraph (b)(2)(v) of this

section.

(ii) Indirect costs not allocable to exempt construction contracts.

A taxpayer allocating costs under this paragraph (d)(2) is not required

to allocate the following costs to an exempt construction contract

reported using the CCM--

(A) Marketing and selling expenses, including bidding expenses;

[[Page 24116]]

(B) Advertising expenses;

(C) Other distribution expenses;

(D) General and administrative expenses attributable to the

performance of services that benefit the taxpayer's activities as a

whole (e.g., payroll expenses, legal and accounting expenses);

(E) Research and experimental expenses (described in section 174

and the regulations thereunder);

(F) Losses under section 165 and the regulations thereunder;

(G) Percentage of depletion in excess of cost depletion;

(H) Depreciation, amortization, and cost recovery allowances on

equipment and facilities that have been placed in service but are

temporarily idle (for this purpose, an asset is not considered to be

temporarily idle on non-working days, and an asset used in construction

is considered to be idle when it is neither en route to nor located at

a job-site), and depreciation, amortization and cost recovery

allowances under chapter 1 of the Code in excess of depreciation,

amortization, and cost recovery allowances reported by the taxpayer in

the taxpayer's financial reports;

(I) Income taxes attributable to income received from long-term

contracts;

(J) Contributions paid to or under a stock bonus, pension, profit-

sharing, or annuity plan or other plan deferring the receipt of

compensation whether or not the plan qualifies under section 401(a),

and other employee benefit expenses paid or accrued on behalf of labor,

to the extent the contributions or expenses are otherwise allowable as

deductions under chapter 1 of the Code. Other employee benefit expenses

include (but are not limited to): worker's compensation; amounts

deductible or for whose payment reduction in earnings and profits is

allowed under section 404A and the regulations thereunder; payments

pursuant to a wage continuation plan under section 105(d) as it existed

prior to its repeal in 1983; amounts includible in the gross income of

employees under a method or arrangement of employer contributions or

compensation which has the effect of a stock bonus, pension, profit-

sharing, or annuity plan, or other plan deferring the receipt of

compensation or providing deferred benefits; premiums on life and

health insurance; and miscellaneous benefits provided for employees

such as safety, medical treatment, recreational and eating facilities,

membership dues, etc.;

(K) Cost attributable to strikes, rework labor, scrap and spoilage;

and

(L) Compensation paid to officers attributable to the performance

of services that benefit the taxpayer's activities as a whole.

(3) Large homebuilders. A taxpayer must capitalize the costs of

home construction contracts under section 263A and the regulations

thereunder, unless the contract will be completed within two years of

the contract commencement date and the taxpayer satisfies the

$10,000,000 gross receipts test described in Sec. 1.460-3(b)(3).

(e) Cost allocation rules for contracts subject to the PCCM. A

taxpayer must use the cost allocation rules described in paragraph (b)

of this section to determine the costs allocable to the entire

qualified ship contract or residential construction contract accounted

for using the PCCM and may not use the simplified cost-to-cost method

described in paragraph (c) of this section.

(f) Special rules applicable to costs allocated under this

section--(1) Nondeductible costs. A taxpayer may not allocate any

otherwise allocable contract cost to a long-term contract if any

section of the Code disallows a deduction for that type of payment or

expenditure (e.g., an illegal bribe described in section 162(c)).

(2) Costs incurred for non-long-term contract activities. If a

taxpayer performs a non-long-term contract activity, as defined in

Sec. 1.460-1(d)(2), that is incident to or necessary for the

manufacture, building, installation, or construction of the subject

matter of one or more of the taxpayer's long-term contracts, the

taxpayer must allocate the costs attributable to that activity to such

contract(s).

(g) Method of accounting. A taxpayer that adopts or elects a cost

allocation method of accounting (or changes to another cost allocation

method of accounting with the Commissioner's consent) must apply that

method consistently for all similarly classified contracts, until the

taxpayer obtains the Commissioner's consent under section 446(e) to

change to another cost allocation method.

Par. 9. Section 1.460-6 is amended as follows:

1. A sentence is added to the end of paragraph (a)(2).

2. In the third sentence of paragraph (b)(1), the language ``by

substituting `80 percent' for `50 percent' with'' is removed and ``by

substituting `at least 80 percent' for `more than 50 percent' with'' is

added in its place.

3. The first sentence of paragraph (c)(1)(ii)(A) is revised.

4. The last two sentences of paragraph (c)(1)(ii)(B) are removed.

5. In the last sentence of paragraph (c)(1)(ii)(C)(2), the language

``Sec. 5h.6'' is removed and ``Sec. 301.9100-8 of this chapter'' is

added in its place.

6. In the fourth sentence of paragraph (c)(2)(v)(A), the language

``similarly'' is removed.

7. The first, second, fifth, and sixth sentences of paragraph

(c)(2)(v)(A) are removed.

8. In the first sentence of paragraph (c)(2)(vi)(B), the language

``Sec. 1.451-3(b)(2)(ii), (iii), (iv), and Sec. 1.451-3(d)(2), (3), and

(4)'' is removed and ``Sec. 1.460-4(b)(4)(i)'' is added in its place.

9. In the second sentence of paragraph (c)(2)(vi)(B), the language

``the percentage of completion method and'' is removed.

10. In the third sentence of paragraph (c)(2)(vi)(B), the language

``, for purpos

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