SERVICE PROVIDES GUIDANCE RELATING TO CHANGE IN ACCOUNTING METHOD FOR LONG-TERM CONTRACTS.

Notice 88-66

This notice provides guidance with respect to the amendment of section 460 of the Internal Revenue Code, regarding the accounting for long-term contracts, by section 10203 of the Revenue Act of 1987 (the "1987 Act"), Pub. L. No. 100-203, 101 Stat. 1330. This notice amplifies the provisions of Notice 87-61, 1987-38 I.R.B. 40. This notice and Notice 87-61 relate to the procedures by which taxpayers may change their methods of accounting for long-term contracts for purposes of section 460 of the Code. As a result of the amendment of section 460 of the Code by the 1987 Act, certain taxpayers may wish to reconsider whether it is desirable to change their method of accounting for long-term contracts. Thus, in addition to providing guidance under section 460 of the Code, the provisions of this notice extend the period of time provided in Notice 87-61 during which taxpayers may automatically change to the percentage of completion method of accounting as modified by section 460 of the Code ("the percentage of completion method") for all long-term contracts entered into after February 28, 1986.

I. BACKGROUND.

Section 460 of the Code provides that, in the case of a long- term contract (except as provided in section 460(e) of the Code), items are to be taken into account using (i) the percentage of completion -- capitalized cost method, or (ii) the percentage of completion method. Section 460 is effective for long-term contracts entered into by the taxpayer after February 28, 1986.

As initially enacted, section 460 of the Code required that, under the percentage of completion -- capitalized cost method of accounting for long-term contracts, 40 percent of the items with respect to each contract are to be taken into account using the percentage of completion method, and 60 percent of the items with respect to each contract are to be taken into account using the taxpayer's "normal" method of accounting for long-term contracts, subject to the requirements of section 460, including the cost allocation requirements of section 460(c). Section 10203 of the 1987 Act modified the percentage of completion-capitalized cost method to require that, for contracts entered into after October 13, 1987 (with certain exceptions contained in section 10203(b)(2) of the 1987 Act), 70 percent of the items with respect to each contract are to be taken into account using the percentage of completion method and the remaining 30 percent are to be taken into account using the taxpayer's "normal" method, subject to the requirements of section 460, including the cost allocation requirements of section 460(c). For purposes of section 460, a taxpayer's normal method of accounting for long-term contracts is the method the taxpayer was using to account for long-term contracts immediately prior to the effective date of section 460.

Any taxpayer that, immediately prior to the effective date of section 460, accounted for contracts based on the position that such contracts were long-term contracts under section 1.451-3(b) of the Income Tax Regulations, shall be required to account for such contracts (and any successor contracts) under section 460 unless such taxpayer obtains the consent of the Commissioner to change its method of accounting. The term "successor contracts", as used in the preceding sentence, shall mean all contracts which, under the criteria and methods used by the taxpayer prior to the effective date of section 460 in determining whether a contract was a long-term contract under section 1.451-3(b) of the Regulations, would be classified by such taxpayer as long-term contracts under section 1.451-3(b), regardless of whether such criteria and methods are correct. Thus, for example, the criteria and methods used by a taxpayer in determining that items were "unique" prior to February 28, 1986, and thus were produced under long-term contracts, will continue to be used by the taxpayer unless the taxpayer obtains the consent of the Commissioner to change its method of accounting under the applicable administrative procedures in effect at the time of change (e.g., Rev. Proc. 84-74, 1984-2 C.B. 736). See H.R. Rep. No. 495, 100th Cong., 2d Sess. 923 (1987).

II. TAXPAYERS USING THE PERCENTAGE OF COMPLETION -- CAPITALIZED COST METHOD.

Except as provided in Notice 87-61, any taxpayer reporting income from long-term contracts immediately prior to the effective date of section 460 using a method of accounting other than the percentage of completion method is required to use the percentage of completion -- capitalized cost method of accounting for all long-term contracts entered into by the taxpayer after February 28, 1986.

For contracts entered into after February 28, 1986, and before October 14, 1987, the percentage of completion -- capitalized cost method requires that 40 percent of the items with respect to each contract be taken into account using the percentage of completion method, and the remaining 60 percent be taken into account using the taxpayer's normal method of accounting for long-term contracts. For contracts entered into after October 13, 1987, the percentage of completion -- capitalized cost method requires that 70 percent of the items with respect to each contract be taken into account using the percentage of completion method and that the remaining 30 percent be taken into account using the taxpayer's normal method of accounting for long-term contracts. (However, see section III, relating to automatic changes to the percentage of completion method.)

The change in the percentage of completion -- capitalized cost method shall be effectuated by using a "cut-off" method with respect to contracts entered into after October 13, 1987, i.e., the taxpayer shall not change its method of accounting for contracts entered into on or before October 13, 1987 and no adjustment under section 481(a) of the Code shall be computed. Taxpayers described in this section II using the percentage of completion -- capitalized cost method of accounting for long-term contracts shall follow the notification procedures of section V of this notice.

III. AUTOMATIC CHANGE TO PERCENTAGE OF COMPLETION METHOD.

For purposes of section 460 of the Code, any taxpayer using a method of accounting other than the percentage of completion method as its normal method of accounting for long-term contracts (e.g., a taxpayer using the completed contract, cash or an accrual method of accounting) may automatically change its method of accounting to the percentage of completion method (including, if elected, the simplified cost-to-cost method provided in Notice 87-61) either for --

1) all items under all long-term contracts entered into by the taxpayer after October 13, 1987, or

2) all items under all long-term contracts entered into by the taxpayer after February 28, 1986.

Thus, a taxpayer may use the percentage of completion -- capitalized cost method for all contacts entered into after February 28, 1986 and before October 14, 1987, and may, under the terms of this notice, automatically change its method of accounting to the percentage of completion method for all items under all contracts entered into after October 13, 1987. Alternatively a taxpayer may, under the terms of this notice, use the percentage of completion method for all items under all long-term contracts entered into after February 28, 1986. (The effect of alternative (2) of this section III regarding contracts entered into after February 28, 1986 is to extend the period, initially set forth in Notice 87-61, within which taxpayers may elect to use the percentage of completion method for all such contracts.)

The period for filing amended returns for taxpayers changing their method of accounting to the percentage of completion method is provided in section V of this notice. See also section VI of this notice which permits taxpayers to elect whether to include contracts described in section 460(e)(1) of the Code in a change in method of accounting under this section III. Any taxpayer described in this section III shall follow the notification procedures of section V of this notice.

IV. CHANGES IN METHOD OF ACCOUNTING REQUIRING COMMISSIONER'S CONSENT.

A change in method of accounting to the percentage of completion method other than a change for --

1) all items under all long-term contracts entered into by the taxpayer after October 13, 1987, or

2) all items under all long-term contracts entered into by the taxpayer after February 28, 1986,

will constitute a change in method of accounting that requires the consent of the Commissioner. For example, if a calendar year taxpayer wishes to change to the percentage of completion method from the percentage of completion -- capitalized cost method for its taxable year beginning on January 1, 1988, such taxpayer is required to obtain the consent of the Commissioner with respect to such change in method of accounting (including the calculation of the resulting section 481(a) adjustment). Prior to obtaining such consent, the taxpayer is required to account for all long-term contracts entered into after February 28, 1986, under section 460 of the Code using a "cut-off" method as provided in this notice and in Notice 87-61.

V. NOTIFICATION PROCEDURES FOR CERTAIN METHODS OF ACCOUNTING.

Any taxpayer described in section II or III of this notice shall complete and file a statement notifying the Service of its use of the various methods of accounting (including the simplified cost-to-cost method provided in Notice 87-61) permitted under this notice with the taxpayer's Federal income tax return for the first taxable year ending after October 13, 1987, for which the taxpayer is required to account under section 460 for long-term contracts. The taxpayer shall type or legibly print the following language at the top of the statement required to be filed: "NOTIFICATION PROCEDURES UNDER SECTION V OF NOTICE 88-**". Any amended return filed by a taxpayer described in section III for the purpose, in whole or in part, of changing a taxpayer's method of accounting as described in this notice must be filed on or before 180 days after the date that this notice is published in the Internal Revenue Bulletin. The taxpayer shall type or legibly print the following language at the top of each amended return: "NOTIFICATION PROCEDURES UNDER SECTION V OF NOTICE 88-**".

Notwithstanding the requirements of the preceding paragraph, with respect to any taxpayer who has (i) filed a Federal income tax return on which the statement described in the preceding paragraph was required to be included, (ii) failed to file the statement described in the preceding paragraph with such return, and (iii) otherwise properly used the method of accounting as required or allowed under sections II or III of this notice, such taxpayer may file a statement indicating the use of its method of accounting under the following procedures. Such statement shall be attached to the taxpayer's first Federal income tax return filed subsequent to 90 days after the publication of this notice in the Internal Revenue Bulletin for which the taxpayer is required to account under section 460 for long-term contracts. (A taxpayer, at its option, may attach such a statement with a return filed before the date described in the preceding sentence.) The taxpayer shall type or legibly print the following language at the top of the statement required to be filed: "NOTIFICATION PROCEDURES UNDER SECTION V OF NOTICE 88-**". Any use of a method of accounting described in this section V shall be effectuated by using a "cut-off" method with respect to contracts entered into after February 28, 1986, or October 13, 1987, as the case may be, i.e., the taxpayer shall not compute a section 481(a) adjustment with respect to its use of the new method of accounting.

VI. CERTAIN CONSTRUCTION CONTRACTS.

With the exception of the interest capitalization requirements of section 460(c)(3) of the Code, section 460 does not apply to any contract for the construction of real property entered into by a taxpayer if (i) the taxpayer reasonably estimates (at the time the contract is entered into) that the contract will be completed within the 2-year period beginning on the contract commencement date; and (ii) the taxpayer's average annual gross receipts for the 3 taxable years preceding the taxable year in which the contract is entered into do not exceed $10 million. See section 460(e)(1) of the Code.

However, a taxpayer that wishes to change its method of accounting to the percentage of completion method for all items under all long-term contracts, including long-term contracts described in section 460(e)(1), may make such change in method of accounting under section III of this Notice 88-**. In addition, a taxpayer that makes such change may also elect to use the simplified cost-to-cost method, as provided in Notice 87-61. Alternatively, such a taxpayer may make a change in method of accounting under section III of this notice with respect only to long-term contracts not described in section 460(e)(1), thus retaining its previous method of accounting for contracts described in section 460(e)(1).

Moreover, in applying section 56(a)(3) to determine alternative minimum taxable income with respect to contracts described in section 460(e)(1), a taxpayer may elect to use the simplified cost-to-cost method as provided in Notice 87-61. The preceding sentence liberalizes the provisions of section IX of Notice 87-61, which allowed such an election to be made only by taxpayers properly using the cash method of accounting for long-term contracts.

Thus, for example, assume a taxpayer (taxpayer B) is in the business of costructing and selling houses. Customers enter into contracts with B to purchase the houses, with such contracts typically providing that such purchase shall be consummated after the construction of the house is completed, and after certain other events have occurred (e.g., financing for the house is obtained). Under these facts, B is treated as constructing property under a long-term contract (as defined in section 460(f)) with respect to any house that is under construction as of the end of a taxable year and for which a contract for sale of such house is in effect.

Thus, if B meets the requirements of section 460(e)(1) of the Code, section 460 (except for the interest capitalization requirements of section 460(c)(3)) does not apply to B's long-term contracts. Similarly, section 263A does not apply to the construction of such homes. (See section 263A(c)(4) However, as discussed in Notice 87-61, under the alternative minimum tax ("AMT"), B is required to account for all long-term contracts using the percentage of completion method even though the contracts are exempted under section 460(e)(1) from the percentage of completion method for regular tax purposes. Under this Notice 88-**, B may use the simplified cost-to-cost method of applying the percentage of completion method for AMT purposes, regardless of B's method of accounting for long-term contracts for regular tax purposes.

In contrast, assume that B does not meet the requirements of section 460(e)(1) (e.g., B's average annual gross receipts under section 460(e)(1)(B) exceed $10,000,000). Thus, the requirements of section 460 (including, for example, the use of the look-back method and the percentage of completion method) would apply to B's long-term contracts. As section IX of Notice 87-61 provides, B is allowed to use the simplified cost-to-cost method of applying the percentage of completion method for AMT purposes only if B uses the simplified cost-to-cost method for regular tax purposes. Finally, assume that B has houses under construction as of the end of a taxable year and that no contracts with customers have been entered into for the sale of such houses. With respect to these houses, B is not producing property under a long-term contract because no such contracts exist. Instead, B is constructing property subject to section 263A which, in contrast to section 460(e)(1), does not contain any exceptions for construction contracts under its provisions.

PROCEDURAL INFORMATION

This notice serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(2) of the regulations and may be relied upon to the same extent as a revenue ruling or a revenue procedure.

The collection of information in this notice has been submitted to the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 and has been approved by OMB (Control Number 1545-1011).

DRAFTING INFORMATION

The principal author of this notice is Paulette C. Galanko of the Legislation and Regulations Division. For further information regarding this notice, contact Ms. Galanko at (202) 566-3238 (not a toll-free call).